Review of Finance - Advance Access

Rating opaque borrowers: why are unsolicited ratings lower?

Bannier, C. E., Behr, P., Guttler, A. — Sat, 14 Nov 2009 20:50:48 PST

This paper examines why unsolicited ratings tend to be lower than solicited ratings. Both self-selection among issuers and strategic conservatism of rating agencies may be reasonable explanations. Analyses of default incidences of non-U.S. borrowers between January 1996 and December 2006 show that rating conservatism may play a role for industrial firms, but self-selection cannot be fully rejected. Neither can it for insurance companies, though data restrictions impede further conclusions. For unsolicited bank ratings, however, we find strong evidence that rating conservatism is an important cause. The downward bias also appears to increase along with banks’ opaqueness.

Fear of the Unknown: Familiarity and Economic Decisions

Cao, H. H., Han, B., Hirshleifer, D., Zhang, H. H. — Fri, 13 Nov 2009 20:18:38 PST

Evidence indicates that people fear change and the unknown. We model this behavior as familiarity bias in which individuals focus on adverse scenarios in evaluating defections from the status quo. The model explains portfolio underdiversification, home and local biases. More importantly, equilibrium stock prices reflect an unfamiliarity premium. In an international setting, our model predicts that while the standard CAPM fails to hold with respect to the world market portfolio, a modified CAPM holds wherein the market portfolio is replaced with a portfolio of the stock holdings of investors not subject to familiarity bias.

Out-of-Court Restructuring versus Formal Bankruptcy in a Non-Interventionist Bankruptcy Setting

Jostarndt, P., Sautner, Z. — Thu, 12 Nov 2009 23:11:32 PST

We investigate debt restructurings in Germany for a sample of 116 financially distressed companies. About half of the firms succeed in restructuring their debt in a workout while the others file for bankruptcy. Our evidence suggests that firms which have higher leverage, owe more debt to banks, and exhibit higher going concern values are more likely to conduct a workout. Bankruptcy is more likely for firms with deficient lender coordination and a high fraction of collateralized debt. An analysis of stock returns suggests that the market uses similar information to predict workouts. 84% of the bankrupt firms were ultimately liquidated.

Helping Hand or Grabbing Hand? Central vs. Local Government Shareholders in Chinese Listed Firms

Cheung, Y.-L., Rau, P. R., Stouraitis, A. — Wed, 21 Oct 2009 02:05:50 PDT

We analyze related party transactions between Chinese publicly listed firms and their state-owned shareholders to examine whether companies benefit or lose from the presence of government shareholders and politically connected directors. Minority shareholders seem to be expropriated in firms controlled by local governments, firms with a large proportion of local government directors on their board, firms without central government directors, and firms in provinces where local government bureaucrats are less likely to be prosecuted for corruption. In contrast, firms controlled by the central government (or having central government affiliated directors), benefit in related party transactions with their government parents.

Myopic Investment Management

Eriksen, K. W., Kvaloy, O. — Sun, 04 Oct 2009 18:11:03 PDT

Myopic loss aversion (MLA) has been proposed as an explanation for the equity premium puzzle, and experiments indicate that investors exhibit behavior consistent with MLA. But a caveat is that a large bulk of financial assets is managed by investment managers whose objectives may differ substantially from those of private investors. Most importantly they manage their clients' money, not their own. In this paper we test experimentally how individuals take risk with other people's ("clients") money. We find that subjects behave consistently with MLA over their clients' money and take less risk with their clients' money than with their own.

The Limits of the Limits of Arbitrage

Brav, A., Heaton, J.B., Li, S. — Sun, 04 Oct 2009 01:46:48 PDT

We test the limits of arbitrage argument for the survival of irrationality-induced financial anomalies by sorting securities on their individual residual variability as a proxy for idiosyncratic risk – a commonly asserted limit to arbitrage – and comparing the strength of anomalous returns in low versus high residual variability portfolios. We find no support for the limits of arbitrage argument to explain undervaluation anomalies (small value stocks, value stocks generally, recent winners, and positive earnings surprises) but strong support for the limits of arbitrage argument to explain overvaluation anomalies (small growth stocks, growth stocks generally, recent losers, and negative earnings surprises). Other tests also fail to support the limits of arbitrage argument for the survival of overvaluation anomalies and suggest that at least some of the factor premiums for size, book-to-market, and momentum are unrelated to irrationality protected by limits to arbitrage.

Cash Breeds Success: The Role of Financing Constraints in Patent Races

Schroth, E., Szalay, D. — Mon, 28 Sep 2009 20:14:03 PDT

This paper studies the impact of financing constraints in patent races. We develop a model of optimal contracting where firms finance their R&D expenditures with an investor who cannot verify their effort. In equilibrium, firms are more likely to win the more cash and assets they hold prior to the race, and the less cash and assets their rivals hold prior to the race. Evidence from US pharmaceutical patents awarded between 1975 and 1999 supports our theoretical predictions.

IPO Information Aggregation and Underwriter Quality

Wang, W., Yung, C. — Mon, 21 Sep 2009 06:30:18 PDT

A key distinction between some models of IPO pricing (e.g., auctions and bookbuilding) and others (e.g., fixed-priced models) is whether price discovery occurs in the primary or secondary market. Higher investment bank reputation is associated with 1) more active filing price revisions and 2) reduced secondary market volatility, indicating greater resolution of uncertainty before trading begins. Revisions of nonreputable banks cluster on exactly zero dollars. Finally, the "partial adjustment" phenomenon – often attributed to information aggregation – is primarily due to the behavior of reputable underwriters. We conclude that theoretical models of primary market information aggregation are better suited for reputable underwriters.

When It Cannot Get Better or Worse: The Asymmetric Impact of Good and Bad News on Bond Returns in Expansions and Recessions

Beber, A., Brandt, M. W. — Sat, 19 Sep 2009 03:50:48 PDT

We examine empirically the response of bond returns and their volatility to good and bad macroeconomic news during expansions and recessions. We find that macroeconomic announcements are most important when they contain bad news for bond returns in expansions and, to a lesser extent, good news in contractions. In expansions, the bond market responds most strongly to bad news in non-farm payrolls, while in recessions good news about inflation is relatively more important. We also document that macroeconomic news impacts the volatility of bond returns at all maturities by increasing jump intensities and altering the jump size distribution.

How Duration Between Trades of Underlying Securities Affects Option Prices

Cartea, A., Meyer-Brandis, T. — Fri, 17 Jul 2009 07:26:23 PDT

We propose a model for stock price dynamics that explicitly incorporates random waiting times between trades, also known as duration, and show how option prices can be calculated using this model. We use ultra-high-frequency data for blue-chip companies to motivate a particular choice of waiting-time distribution and then calibrate risk-neutral parameters from options data. We also show that the convexity commonly observed in implied volatilities may be explained by the presence of duration between trades. Furthermore, we find that, ceteris paribus, implied volatility decreases in the presence of longer durations, a result consistent with the findings of Engle (2000) and Dufour and Engle (2000) which demonstrates the relationship between levels of activity and volatility for stock prices. Finally, by directly employing information given by time-stamps of trades, our approach provides a direct link between the literature on stochastic time changes and business time (see Clark (1973)) and, at the same time, highlights the link between number and time of arrival of transactions with implied volatility and stochastic volatility models.

Corporate Financing Activities and Contrarian Investment

Bali, T. G., Demirtas, K. O., Hovakimian, A. — Fri, 17 Jul 2009 06:01:45 PDT

This paper investigates the risk versus mispricing explanation of superior returns to contrarian strategies using the interactions between value-to-market indicators and corporate financing transactions that increase or decrease a firm's outstanding equity. Portfolio-level analyses and firm-level cross-sectional regressions indicate that the well-documented contrarian profits soar when value stocks which repurchase shares (value repurchasers) and growth stocks which issue shares (growth issuers) are considered. Various risk measures indicate that value repurchasers are not riskier than growth issuers. Furthermore, time-series of realized growth rates, analysts' long-term growth estimates, and sensitivity of portfolio returns to investor sentiment support the misvaluation explanation.

A Long-Run Risks Model of Asset Pricing with Fat Tails

Wang, Z., Bidarkota, P. V. — Tue, 14 Jul 2009 04:29:49 PDT

We explore the effects of fat tails on the equilibrium implications of the long-run risks model of asset pricing by introducing innovations with dampened power law to consumption and dividends growth processes. We estimate the model structural parameters by maximum likelihood. We find that the stochastic volatility model with fat tails can generate implied risk premium, expected risk free rate and their volatilities comparable to the magnitudes observed in data. The model with fat tails leads to a significant increase in implied risk premia over the benchmark Gaussian model, but similar values for other equilibrium quantities of interest.

Bankers on the Boards of German Firms: What They Do, What They Are Worth, and Why They Are (Still) There

Dittmann, I., Maug, E., Schneider, C. — Fri, 08 May 2009 17:40:09 PDT

We analyze the role of bankers on the boards of German non-financial companies for the period from 1994 to 2005. We find that banks that are represented on a firm's board promote their own business as lenders and as M&A advisors. They also seem to act as financial experts who help firms to obtain funding, especially in difficult times. We find little evidence that bankers monitor management and suggest that bankers on the board cause a decline in the valuations of non-financial firms. Banks’ equity ownership declined sharply during our sample period and the German financial system lost some of its formerly distinctive features.

Inflation Targeting and Exchange Rate Regimes: Evidence from the Financial Markets

Brenner, M., Sokoler, M. — Thu, 30 Apr 2009 08:49:17 PDT

Inflation targeting is gaining popularity as a framework for conducting monetary policy. At the same time many countries employ some sort of foreign exchange intervention policy assuming that these two policies can coexist. This paper attempts to show that both policies are not sustainable. Israel is a classic test case. We test our hypothesis using information from the financial markets. The results support the hypothesis that both policies cannot be sustained in the long run. The conclusion is that a credible monetary policy aimed at inflation targets should be conducted in a free floating exchange rate regime.

Securities Auctions under Moral Hazard: An Experimental Study

Kogan, S., Morgan, J. — Tue, 14 Apr 2009 17:11:54 PDT

In many settings, including venture capital financing, mergers and acquisitions, and lease competition, the structure of the contracts over which firms compete differs. Furthermore, the structure of the contract affects the future incentives of the firm to engage in value-creating activities by potentially diluting effort or investment incentives. We study, both theoretically and in the lab, the performance of debt and equity auctions in the presence of both private information and hidden effort. We show that the revenues to sellers in debt and equity auctions differ systematically depending on the returns to entrepreneurial effort. Using a controlled laboratory experiments we test the model's predictions and find strong support for the theory.

Corporate Governance Externalities

Acharya, V. V., Volpin, P. F. — Tue, 14 Apr 2009 17:11:25 PDT

When firms compete in the managerial labor market, the choice of corporate governance by a firm affects, and is affected by, the choice of governance by other firms. Firms with weaker governance offer managers more generous incentive compensation, which induces firms with good governance to also overpay their management. Due to this externality, overall level of governance in the economy can be inefficiently low. Poor governance can in fact be employed by incumbent firms to deter entry by new firms. Such corporate governance externalities have important implications for regulatory standards, ownership structure of firms, and the market for corporate control.

Franchising Microfinance

Bubna, A., Chowdhry, B. — Thu, 09 Apr 2009 05:54:23 PDT

Financial intermediaries worldwide are seeking mechanisms for participating in micro lending. Using informed "local capitalists" as bank's on-lenders fails due to borrowers' incentive to default with multiple credit sources. A coalition of local capitalists may not resolve the problem in the presence of a monopoly moneylender with superior skills in lending and enforcement. A credible competitive threat to the moneylender can only arise if the local capitalist coalition also provides information sharing benefits that lower their cost of lending vis-à-vis the moneylender. Franchising allows local capitalists to form such a coalition. We analyze conditions under which welfare-enhancing franchising would obtain.

Market Anticipation of Fed Policy Changes and the Term Structure of Interest Rates

Heidari, M., Wu, L. — Thu, 26 Mar 2009 01:59:36 PDT

The Federal Reserve adjusts the federal funds target rate discretely, causing discontinuity in short-term interest rates. Unlike Poisson jumps, these adjustments are well anticipated by the market. We propose a term structure model that incorporates an anticipated jump component with known arrival times but random jump size. We find that doing so improves the model performance in capturing the term structure behavior. The mean jump sizes extracted from the term structure match the realized target rate changes well. Specification analysis indicates that the jump sizes show strong serial dependence and dependence on the interest-rate factors.

A Convergence Model of the Term Structure of Interest Rates

Ajevskis, V., Vitola, K. — Thu, 25 Dec 2008 12:13:33 PST

This paper develops a convergence model of the term structure of interest rates in context of entering the European Monetary Union (EMU). Compared to other models developed so far in this field, our model specification ensures convergence of the domestic short-term interest rates to the euro area ones. We achieve this convergence by stating that the spread between domestic and euro short-term interest rate follows the Brownian bridge process. We also develop an econometric counterpart of the theoretical model. To tackle the problem of nonstationarity and nonlinearity of the model, we apply the extended Kalman filter for coefficient estimation.

Robust Portfolio Optimisation with Multiple Experts

Lutgens, F., Schotman, P. C. — Thu, 25 Dec 2008 12:13:23 PST

We consider mean-variance portfolio choice of a robust investor. The investor receives advice from J experts, each with a different prior for expected returns and risk, and follows a min-max portfolio strategy. The robust investor endogenously combines the experts' estimates. When experts agree on the main return generating factors, the investor relies on the advice of the expert with the strongest prior. Dispersed advice leads to averaging of the alternative estimates. The robust investor is likely to outperform alternative strategies. The theoretical analysis is supported by numerical simulations for the 25 Fama-French portfolios and for 81 European country and value portfolios.