Operational Risk

Link to PDF File: Operational Risk

Robert A. Jarrow, Cornell University

This paper studies operational risk. We discuss its economic and mathematical characterization and its estimation. The insights for this characterization originate in the corporate finance and credit risk literature. Operational risk is of two types, either (i) the risk of a loss due to the firm’s operating technology, or (ii) the risk of a loss due to agency costs. These two types of operational risks generate loss processes with completely different characteristics. The mathematical characterization of these operational risks is modeled after the risk of default in the reduced form credit risk literature. We show that although it is conceptually possible to estimate the operational risk processes’ parameters using only market prices, the non-observability of the firm’s value makes this an unlikely possibility, except in rare cases. Instead, we argue that data internal to the firm, in conjunction with standard hazard rate estimation procedures, provides a more fruitful alternative. Finally, we show that the inclusion of operational risk into the computation of fair economic capital (as with revised Basel II) without the consideration of a firm’s NPV, will provide biased (too large) capital requirements.

Market risk, credit risk, liquidity risk and operational risk are the four significant risks of loss to a firm or a portfolio. Of these, market and credit risk are generally well understood, and liquidity risk is actively being studied. However, operational risk has not received much formal attention. Since much of our membership regularly values corporations and portfolios of corporations, this study about corporate valuation methods—and their limitations, should be of substantial interest to our membership.

Taxes, Estate Planning and Financial Theory: New Insights and Perspectives

Link to PDF File: Taxes, Estate Planning and Financial Theory: New Insights and Perspectives

Robert M. Dammon, Carnegie Mellon University
Chester S. Spatt, Carnegie Mellon University and Securities and Exchange Commission
Harold H. Zhang, University of Texas at Dallas

We examine how financial theory and economic principles offer guidance and predictions about the organization of investments and asset allocation decisions given the structure of taxes in estate--planning situations. We provide insight about many of the conventional approaches to estate planning and suggest how these strategies can be enhanced. For example, we show that the advantage of the reset provision by which the investor’s capital gains tax bases are adjusted to the market value at the time of death is greater in the presence of individual rather than joint ownership of assets, provided that at the first death of one of the joint owners the basis is reset to an average of the date of death value and the survivor’s original cost. We analyze asset location and distribution policies in the context of trusts that are outside of the taxable estate of its principal beneficiary as well as direct funds owned by the beneficiary, highlighting the interaction between estate taxation and the reset of the capital gains tax basis at death. We compare the optimal decisions for traditional tax-deferred accounts and after-tax (“Roth”) IRAs. Finally, we also examine the value and importance of borrowing in various contexts in estate planning.

With the growing availability of tax advantaged vehicles on personal account, personal investors face important decisions about how to manage and title their holdings. The results from this research project will help investment managers, sponsors and advisors better understand the implications of estate taxes for portfolio decisions about distributions, borrowing, and titling assets.

What Are Assets under Management Worth to Managers? (two papers produced)

Susan Christoffersen, McGill University and CIRANO
Richard Evans, Boston College
René Garcia, Université de Montréal and CIRANO
David Musto, The Wharton School

“What Determines the Value of Assets Under Management?”

We address the heterogeneity of mutual-fund investors, in particular, its significance to the timing and circumstances of redemptions. We find that the inflows to top performers make these funds’ future outflows more sensitive to their future performance, and we find that load funds attract investors more likely to remain, and less likely to respond to future performance. A regime-shifting model that attributes inflows to either sensitive or insensitive investors helps determine the performance sensitivity of future outflows. From this model, we are able to estimate the value of a new dollar brought into a fund and relate this to the characteristics of the fund at the time.

“The Economics of Mutual-Fund Brokerage: Evidence from the Cross Section of Investment Channels”

Retail investors often lack investment expertise. Mutual-fund brokers can help, but their incentives are mixed so it is an empirical question what value they add, both for consumers and for fund families. Investors pay more to invest through unaffiliated brokers than captive brokers, and while unaffiliated brokers add more value to redemptions, captive brokers add more value to inflows. No-load investors are less likely to sell their poor-performing funds and more likely to sell their winning funds, consistent with a disposition effect. Fund families benefit from a captive sales force through recapture of redemptions, but also suffer through cannibalization of inflows.

The two papers produced in this project will help investment managers better predict fund flows, which is essential to valuing fees from assets under management. The results help fund mutual distributors better choose the mix of funds to sponsor and the means by which the funds should be distributed.

Investor Sentiment and the Cross-section of Stock Returns

Link to PDF File: Investor Sentiment and the Cross-section of Stock Returns

Malcolm Baker, Harvard Business School
Jeffrey Wurgler, NYU

We examine how investor sentiment affects the cross-section of stock returns. Theory predicts that a broad wave of sentiment will disproportionately affect stocks whose valuations are highly subjective and are difficult to arbitrage. We test these predictions by examining how the cross-section of subsequent stock returns depends on beginning-of-period proxies for sentiment. We find that when investor sentiment is low, subsequent returns are relatively high on small stocks, very young stocks, high volatility stocks, unprofitable stocks, non-dividend-paying stocks, extreme-growth stocks, and distressed stocks, suggesting that these categories were relatively underpriced ex ante. When sentiment is high, on the other hand, the patterns largely reverse, suggesting that the same categories were relatively overpriced ex ante.

This research provides aggregate measures of investor sentiment and shows how they have been correlated with cross-sectional returns. The results will interest our members who make investment decisions based on sentiment.

Offsetting the Incentives: Risk Shifting and Benefits of Benchmarking in Money Management

Link to PDF File: Offsetting the Incentives: Risk Shifting and Benefits of Benchmarking in Money Management

Suleyman Basak, London Business School and CEPR
Anna Pavlova, MIT
Alex Shapiro, New York University

Money managers are rewarded for increasing the value of assets under management, and predominantly so in the mutual fund industry. This gives the manager an implicit incentive to exploit the well-documented positive fund-flows to relative-performance relationship by manipulating her risk exposure. In a dynamic portfolio framework, we show that as the year-end approaches, the ensuing convexities in the manager’s objective induce her to closely mimic the index, relative to which her performance is evaluated, when the fund’s year-to-date return is sufficiently high. As her relative performance falls behind, she chooses to deviate from the index by either increasing or decreasing the volatility of her portfolio. The maximum deviation is achieved at a critical level of underperformance. It may be optimal for the manager to reach such deviation via selling the risky asset despite its positive risk premium. Under multiple sources of risk, with both systematic and idiosyncratic risks present, we show that optimal managerial risk shifting may not necessarily involve taking on any idiosyncratic risk. Costs of misaligned incentives to investors resulting from the manager’s policy are economically significant. We then demonstrate how a simple risk management practice that accounts for benchmarking can ameliorate the adverse effects of managerial incentives.

This research shows how managers who are subject to convexities in their compensation may manipulate their portfolios exposure to risk to maximize their own utility, which may adverse to the interests of their clients. The results will interest our members who need to better understand these incentives, either because they face them or because the provide them. The results will also interest members whose trading strategies might benefit from being able to predict how other managers will adjust their risk exposure.

Market Frictions, Price Delay, and the Cross-Section of Expected Returns

Link to PDF File: Market Frictions, Price Delay, and the Cross-Section of Expected Returns

Kewei Hou, Ohio State University
Tobias J. Moskowitz, University of Chicago

We parsimoniously characterize the severity of market frictions affecting a stock using the average delay with which its share price responds to information. The most severely delayed firms command a large return premium not explained by size, liquidity, other return premia, or microstructure effects. Moreover, delay captures part of the size effect and enhances the value premium. Idiosyncratic risk is priced only among the most delayed firms. Frictions associated with investor recognition appear most responsible for the impact of delay. The very small segment of delayed and neglected firms generates substantial cross-sectional variation in average returns, highlighting the importance of market frictions.

The results from this project will particularly interest our members who use momentum-based stock selection models and various arbitrage models. In particular, the results indicate where profits will most likely be found—at least in the past, and why various frictions might be related to profitable trading strategies.

Go Down Fighting: Short Sellers vs. Firms

Link to PDF File: Go Down Fighting: Short Sellers vs. Firms

Owen A. Lamont, Yale School of Management

I study battles between short sellers and firms. Firms use a variety of methods to impede short selling, including legal threats, investigations, lawsuits, and various technical actions intended to create a short squeeze. These actions create short sale constraints. Consistent with the hypothesis that short sale constraints allow stocks to be overpriced, firms taking anti-shorting actions have in the subsequent year very low abnormal returns of about -2 percent per month.

This paper identifies a highly persistent indicator of negative investment performance: the vocal resistance of management to short sellers. Any member who is engaged in any stock selection model will want to be aware of these results.

Understanding Comovement

Link to PDF File: Understanding Comovement

Nicholas Barberis, University of Chicago
Andrei Shleifer, Harvard University
Jeffrey Wurgler, New York University

We consider two broad views of return comovement: the traditional view, derived from frictionless economies with rational investors, which attributes it to comovement in news about fundamental value, and an alternative view, in which market frictions or noise-trader sentiment delink it from comovement in fundamentals. Building on Vijh (1994), we use data on inclusions into the S&P 500 to distinguish these views. After inclusion, a stock’s beta with the S&P goes up. In bivariate regressions which control for the return of non-S&P stocks, the increase in S&P beta is even larger. These results are generally stronger in more recent data. Our findings cannot easily be explained by the fundamentals-based view and provide new evidence in support of the alternative friction- or sentiment-based view.

Many of our members are engaged in risk management activities of one form or another. Invariably, these activities depend on assumptions about how securities move with each other. The results of this study help separate two sources of comovement: fundamental information and market frictions. The former generally cannot be traded upon, unless the comovements are not synchronous. The later may provide valuable trading opportunities to those managers who can characterize the effects of various frictions.

Evaluating Fixed Income Fund Performance with Stochastic Discount Factors

Link to PDF File: Evaluating Fixed Income Fund Performance with Stochastic Discount Factors

Wayne Ferson, Boston College
Darren Kisgen, University of Washington
Tyler Henry, University of Washington

This paper shows how to evaluate the performance of managed portfolios using stochastic discount factors (SDFs) from continuous-time term structure models. Our approach addresses a bias in performance measurement, described by Goetzmann, Ingersoll and Ivkovic (2000) and Ferson and Khang (2002), that arises when fund managers may trade within the return measurement interval. The solution gives rise to empirical factors formed as time-averages of the underlying state variables in the model. We find that these empirical factors contribute explanatory power in factor model regressions and reduce the pricing errors of the SDF models for dynamic strategy returns. We illustrate our approach on a sample of U.S government bond funds during 1986-2000. This example represents the first conditional performance evaluation for US fixed income mutual funds. During 1986-2000 government bond funds as a group returned less on average than bond portfolios that don’t pay expenses. Their returns vary more across term structure states than across characteristics-grouped portfolios formed on the basis of fund size, age, expenses and other common characteristics. High spot rates, high term structure slopes and low term structure convexity states predict higher conditional expected returns. However, after risk adjustment none of these performance differences is economically significant.

Accurate performance evaluation is of great importance to our members. Sponsors are interested in evaluating managers and managers must evaluate their performance to manage it. This paper identifies problems associated with performance evaluation of bond portfolios that arise because managers trade within the return measurement interval. The authors provide improved methods that better discriminate among returns, and in particular, show that actively managed government bond returns did not underperform passive performance measures in 1986-2000 as previously thought.

A Rational Model of Active Portfolio Management

Link to PDF File: A Rational Model of Active Portfolio Management

Richard Green, Carnegie-Mellon University
Jonathan Berk, University of California, Berkeley

We develop a simple rational model of active portfolio management that provides a natural benchmark against which to evaluate observed relationship between returns and fund flows. Many effects widely regarded as anomalous are consistent with this simple explanation. In the model, investments with active managers do not outperform passive benchmarks because of the competitive market for capital provision, combined with decreasing returns to scale in active portfolio management. Consequently, past performance cannot be used to predict future returns, or to infer the average skill level of active managers. The lack of persistence in actively managed returns does not imply that differential ability across managers is nonexistent or unrewarded, that gathering information about performance is socially wasteful, or that chasing performance is pointless. A strong relationship between past performance and the flow of funds exists in our model: Indeed, this is the market mechanism that ensures that no predictability in performance exists. Choosing parameters to match the flow-performance relationship and survivorship rates, we find these features of the data are consistent with the vast majority (80%) of active managers having at least enough skill to make back their fees. (Accepted Summer, 2003)

Understanding the relations among performance, fund flows, fund scale, and manager compensation is essential to choosing a good investment manager, to successfully running a profitable investment manager, to retaining successful managers, and to selling investment management services. Thus the topics in this study thus should be of great interest to our members. This study is of particular importance because it provides a simple explanation for why skilled managers do not outperform passive benchmarks.

Equilibrium Asset Pricing Under Heterogeneous Information

Link to PDF File: Equilibrium Asset Pricing Under Heterogeneous Information

Bruno Biais, Toulouse University and CEPR
Peter Bossaerts, California Institute of Technology and CEPR
Chester Spatt, Carnegie Mellon University

The authors theoretically and empirically analyze the implications of heterogeneous information for equilibrium asset pricing and portfolio choice. The theoretical framework, directly inspired by Admati (1985), implies that with partial information aggregation, portfolio separation fails, buy-and-hold strategies are not optimal, and investors should structure their portfolios using the information contained in prices in order to cope with winner’s curse problems. They implement empirically such a price-contingent portfolio allocation strategy and show that it outperforms economically and statistically the passive/indexing buy-and-hold strategy. They thus demonstrate that prices reveal information, in contrast with the homogeneous information CAPM, but only partially, consistent with a Noisy Rational Expectations Equilibrium. The success of their price-contingent strategy does not proxy for the success of trading strategies based purely on historical performance, such as momentum investment. (Accepted Summer, 2003)

Members engaged in investment management—either as managers or sponsors—need to understand well the implications of heterogeneous information for portfolio choice. Simple theories based on common information such as the CAPM suggest that prices reveal no information about future returns. With heterogeneous, prices reveal information so that conditioning portfolio choice on price can produce enhanced returns relative to passive strategies.

Evidence on the Speed of Convergence to Market Efficiency

Link to PDF File: Evidence on the Speed of Convergence to Market Efficiency

Tarun Chorida, Emory University
Richard Roll, UCLA
Avanidhar Subrahmanyam, UCLA

Daily returns for large and mid-cap stocks listed on the New York Stock Exchange are not serially dependent. In contrast, order imbalances on the same stocks are highly persistent from day to day. These two empirical facts can be reconciled if sophisticated investors react to order imbalances within the trading day by engaging in countervailing trades sufficient to remove serial dependence over the daily horizon. How long does this actually take? The pattern of intra-day serial dependence, over intervals ranging from five minutes to one hour, reveals traces of efficiency-crating actions. For the stocks in our sample, it takes longer than five minutes for astute investors to begin such activities. By 30 minutes, they are well along on their daily quest. (Accepted Winter 2003.)

Members engaged in the management of large portfolios must be very sensitive to the origins of their transaction costs since their trading generally will move the market. Members whose management strategies depend on identifying these price moves must be aware of their origins and of their predictability. This research shows that although intraday order imbalances tend to persist from day to day, it appears that trades can recognize them and trade against them within an hour. Thus large traders have less than an hour to take liquidity before others start to take it in front of them.

Liquidity of Emerging Markets

Link to PDF File: Liquidity of Emerging Markets

David A. Lesmond, Tulane University

Adopting the security return model developed by Lesmond, Ogden, and Trzcinka (1999), liquidity measures are estimated for all securities and time periods for which daily prices are available in 31 emerging markets from 1991 to 2000. The correlation of the liquidity estimate with the bid-ask spread is over 80% in all 23 of the emerging markets for which spreads are available. The liquidity estimate is significantly related to trade difficulty, trading activity, and market quality. (Accepted Spring 2003.)

Those of our members who trade or invest in emerging markets must be sensitive to the costs of trade there. However, those costs can be difficult to measure. This study provides proxies for emerging market transaction costs that will allow traders to better predict the costs of trading in various markets.

Informed Trading in Stock and Option Markets

Link to PDF File: Informed Trading in Stock and Option Markets

Stewart Mayhew, University of Georgia
Sugato Chakravarty, Purdue University
Huseyin Gulen, Virginia Tech

The authors investigate how much price discovery occurs in the option market, and how much in the underlying stock market, using Hasbrouck’s (1995) method. This method decomposes observed prices into a permanent, random-walk component interpreted as the implied efficient price, and a temporary component due to temporary mispricing or order imbalances. A market’s share of price discovery is defined as the proportion of innovations to the efficient price occurring in each market. The analysis examines transactions data from ISSM and the Berkeley Options Data Base for a sample of sixty stocks over a period of five years (1988-1992).

Across firms in the sample, the information share attributable to the option market is about 17% with estimates for individual firms ranging from about 12% to about 23%. The authors find evidence that more price discovery occurs in the option market when option volume is higher and stock volume is lower, and when option effective spread are narrower and stock effective spreads are wider. In the cross-section, option market price discovery appears to be greater for high-volatility stocks; however, it tends to be lower on days of extreme positive or negative excess returns. (Accepted Fall 2002.)

Members involved in high frequency trading need to understand where price leadership occurs among the various instruments that depend on essentially the same underlying risks. The results in this study indicate that the contribution of equity options to price information is smaller than that of the underlying stocks.

All That Glitters: The Effect of Attention and News on the Buying Behavior of Individual and Institutional Investors

Link to PDF File: All That Glitters: The Effect of Attention and News on the Buying Behavior of Individual and Institutional Investors

Brad M. Barber, University of California at Davis
Terrance Odean, University of California at Berkeley

We test the hypothesis that individual investors are more likely to be net buyers of attention-grabbing stocks than are institutional investors. We speculate that attention-based buying is a result of the difficulty that individual investors have searching the thousands of stocks they can potentially buy. Individual investors don’t face the same search problem when selling, because they tend to sell only a small subset of all stocks—those they already own. We look at three indications of how likely stocks are to catch investors’ attention: daily abnormal trading volume, daily returns, and daily news. We calculate net order imbalances for more than 66,000 individual investors with accounts at a large discount brokerage, 647,000 individual investors with accounts at a large retail brokerage, 14,000 individual investor accounts at a small discount brokerage, and 43 professional money managers. Individual investors tend to be net purchasers of stocks on high attention days—days that those stocks experience high abnormal trading volume, days following extreme price moves, and days on which stocks are in the news. Institutional investors are more likely to be net buyers on days of low abnormal trading volume than on those with high abnormal trading volume. Their reaction to extreme price moves depends upon their investment style. The tendency of individual investors to be net buyers of attention-grabbing stocks is greatest on days of negative returns. We speculate that this tendency may contribute to momentum in small stocks with losses. (Accepted Spring 2002.)

Members who trade equities must be sensitive to the origins of liquidity, whether they be rational or seemingly not. This study documents a tendency for individual traders to buy stocks in the news, those with high volumes and large price changes.

Commonality in Order Flow: Its Sources and Its Effects on Trading Costs and Returns

Jarrad Harford, University of Washington
Aditya Kaul, University of Alberta

We examine the pervasiveness of common order flow in the stock market, propose a hierarchy of sources comprising broad market, indexing and industry effects, and evaluate the explanatory power of these sources. Finally, we assess the economic relevance of these sources by studying their impact on trading costs and returns. Stocks show significant pairwise correlations in order flow, which have increased over time. These correlations are substantially larger for stocks in the most common index, the S&P 500. Order flow for individual S&P stocks is affected positively by aggregate S&P order flow and lagged returns. Smaller, though significant, broader market and industry effects are also discernible in order flow for all stocks. Returns and trading costs are positively correlated across non-S&P stocks and more strongly so across S&P stocks. Returns and trading costs for both samples vary with aggregate S&P and non-S&P order flow, suggesting that specialists can identify periods when basket trading is heavy. The documented effects are most striking for medium trades and at the end of the day. Importantly, the pairwise order flow, trading cost and return correlations become negligible after accounting for common factors. Overall, our evidence is consistent with the hypotheses that (a) while market-wide effects are also relevant, indexing has an especially important role in creating economically significant effects through common order flow and (b) these commonalities manifest themselves through institutional transactions. (Accepted Spring 2002.)

Stocks Are Special Too: An Analysis of the Equity Lending Market

Christopher C. Geczy, University of Pennsylvania
David K. Musto, University of Pennsylvania
Adam V. Reed, University of North Carolina

With a year of equity loans by a major lender, we measure the effect of actual short-selling costs and constraints on trading strategies that involve short-selling. We find the loans of IPO’s, DotComs, large-cap, growth and low-momentum stocks to be cheap relative to the strategies’ documented profits and that investors who can short only stocks that are cheap and easy to borrow can enjoy at least some of the profits of unconstrained investors. Most IPO’s are loaned on their first settlement days and throughout their first months, and the underperformance around lockup expiration is significant even for the IPO’s that are cheap and easy to borrow. The effect of short-selling frictions appears strongest in merger arbitrage. Acquirers’ stock is expensive to borrow, especially when the acquirer is small, though the major influence on trading profits is not through expense but availability. (Accepted Spring 2002.)

Takeover Defenses of IPO Firms

Laura Casares Field, Penn State University
Jonathan M. Karpoff, University of Washington and Emory University

Many firms deploy takeover defenses when they go public. IPO managers tend to deploy defenses when their compensation is high, shareholdings are small, and oversight from non-managerial shareholders is weak. The presence of a defense is negatively related to subsequent acquisition likelihood, yet has no impact on takeover premiums for firms that are acquired. These results do not support arguments that takeover defenses facilitate the eventual sale of IPO firms at high takeover premiums. Rather, they suggest that managers shift the cost of takeover protection onto non-managerial shareholders. Thus, agency problems are important even for firms at the IPO stage. (Accepted Spring 2002.)

Recovering Stochastic Processes from Option Prices

Jens Carsten Jackwerth, University of Wisconsin (Madison) and University of Konstanz
Mark Rubinstein, University of California at Berkeley

How do stock prices evolve over time? The standard assumption of geometric Brownian motion, questionable as it has been right along, is even more doubtful in light of the stock market crash of 1987 and the subsequent prices of U.S. index options. With the development of rich and deep markets in these options, it is now possible to use options prices to make inferences about the risk-neutral stochastic process governing the underlying index. We compare the ability of models including Black-Scholes, naïve volatility smile predictions of traders, constant elasticity of variance, displaced diffusion, jump diffusion, stochastic volatility, and implied binomial trees to explain otherwise identical observed option prices that differ by strike prices, times-to-expiration, or times. The latter amounts to examining predictions of future implied volatilities.

Certain naïve predictive models used by traders seem to perform best, although some academic models are not far behind. We find that the better performing models all incorporate the negative correlation between index level and volatility. Further improvements to the models seem to require predicting the future at-the-money implied volatility. However, an “efficient markets result” makes these forecasts difficult, and improvements to the option pricing models might then be limited. (Accepted Spring 2002.)

Market Microstructure and the Dynamic Relation of Stock Returns and Trading Flows

Terence Lim, Goldman Sachs Asset Management, formerly at Dartmouth College

Market microstructure theories of trading predict that lead-lag relationships exist between stock returns and trading flows. This study examines the dynamic relationship between daily returns and signed trading flow for a large sample of individual NYSE stocks between 1993 and 1999. The empirical evidence suggests that, at the forecast horizons studied in this paper, the reversal of stock returns following trading flow innovations is more consistent with the predictions of non-informational than with informational trading models. Also, the response of trading flows following return innovations suggest that feedback trading is more important at short horizons of up to one week, while value-motivated trading is more important at longer horizons. Economically, the magnitude of predictability is not large, but may be useful to investors interested in minimizing trading costs. (Accepted Spring 2002.)

Family Values and the Star Phenomenon

Vikram Nanda, University of Michigan
Z. Jay Wang, University of Michigan
Lu Zheng, University of Michigan

Most mutual funds belong to fund families, yet little is known of the influence of family membership on fund strategy and performance. We examine the extent to which a fund’s cash in flows are affected by the performance of other funds in the family – and the consequences of such spillover effects. The cash flow response to fund performance has been documented to be asymmetric, suggesting that even stand-alone funds may seek to create ‘stars’ to attract large cash in flows. We argue that for a family with positive spillover effects between funds, the impact of a star performer is amplified. This can increase the incentives to both pursue star-driven strategies and to increase the size of the family. Our empirical results indicate a strong positive spillover effect from star fund performers, resulting in higher cash in flow for other funds in the family as well. We show that the probability of obtaining a star performance is increasing in family size and in the negative correlation of fund returns. However, factors that increase the odds of producing a star fund and, potentially, attracting more cash in flow to a fund family – are also found to be factors associated with a lower average performance. Hence, a star-based marketing strategy, presumably aimed at less informed investors, does them no favor. (Accepted Spring 2002.)

Star Power: The Effect of Morningstar Ratings on Mutual Fund Flows

Diane Del Guercio, University of Oregon
Paula A. Tkac, Federal Reserve Bank of Atlanta

Morningstar, Inc. has been hailed in both academic and practitioner circles as having the most influential rating system in the mutual fund industry. This study investigates Morningstar’s influence by estimating the value of a star rating in terms of the asset flow it generates for the typical fund. The authors use event-study methods on a sample of 3,388 domestic equity mutual funds from November 1996 to October 1999 to isolate the “Morningstar effect” from other influences on fund flow.

The authors separately study initial rating events, whereby a fund is rated for the first time upon their 36-month anniversary, and rating change events. An initial 5-star rating results in average six-month abnormal flow of $26 million, or 53% above normal expected flow. Following rating changes, they find economically and statistically significant abnormal flow in the expected direction, positive for rating upgrades and negative for rating downgrades. Furthermore, they observe an immediate flow response, suggesting that some investors vigilantly monitor this information and view the rating change as “new” info rmation on fund quality. Overall, the results indicate that Morningstar ratings have unique power to affect asset flow. (Accepted Fall 2001.)

Liquidity, Volatility, and Equity Trading Costs across Countries and Over Time

Ian Domowitz, Pennsylvania State University
Ananth Madhavan, Marshall School of Business at USC

Actual investment performance reflects the underlying strategy of the portfolio manager and the execution costs incurred in realizing those objectives. Execution costs, especially in illiquid markets, can dramatically reduce the notional return to an investment strategy. This research project ex­amined the interactions between cost, liquidity, and volatility, and their determinants using panel-data for 42 countries from September 1996 to December 1998. The results show that trading costs vary widely across countries; emerging markets in particular have significantly higher trading costs even after correcting for factors affecting costs such as market capitalization and volatility. The authors analyze the inter-relationships between turnover, equity trading costs, and volatility, and investigate the impact of these variables on equity returns. Their results show that increased volatility, acting through costs, reduces a portfolio' s expected return. However, higher volatility reduces turnover also, mitigating the actual impact of higher costs on returns. Further, turnover is inversely related to trading costs, providing a possible explanation for the in­crease in turnover in recent years. The results demonstrate that the composition of global effi­cient portfolios can change dramatically when cost and turnover are taken into account. (Accepted Fall 2000.)

Mutual Fund Performance: An Empirical Decomposition into Stock-Picking Talent, Style, Transactions Costs, and Expenses

Russ Wermers, University of Colorado

The project uses a new database to perform a comprehensive analysis of the mutual fund industry. The results show that funds hold stocks that outperform the market by 1.3 percent per year, but their net returns underperform by one percent. Of the 2.3 percent difference between these results, 0.7 percent is due to the underperformance of non-stock holdings, while 1.6 percent is due to expenses and transactions costs. Thus, funds pick stocks well enough to cover their costs. In addition, high-turnover funds beat the Vanguard Index 500 fund on a net return basis. This evidence supports the value of active mutual fund management. (Accepted Spring 2000.)

Another Look at Option Listing Effects

Stewart Mayhew, Purdue University
Vassil Mihov, Purdue University

Prior research shows that introduction of options affects the volatility, liquidity, price and other characteristics of the underlying stock. These results, however, do not adequately account for the fact that option listing is endogenous, a result of decisions made by exchanges and regulators. In this paper, the authors investigate factors affecting exchanges listing decisions by comparing the characteristics of stocks selected for option listing to other stocks that were eligible but not listed. Firm size, volume, and volatility are positively related to the probability of listing, but their relative contributions have changed significantly over time. The authors use these results to construct various matched samples to re-examine some option listing effects reported in the literature using control ­sample methods. Contrary to previous results, they find that in recent subperiods, volatility increases with option listing, consistent with the hypothesis that forward-looking exchanges list options in anticipation of increasing volatility. (Accepted Fall 1999.)

Common Factors in Prices, Order Flows and Liquidity

Joel Hasbrock, New York University
Duane J. Seppi, Carnegie Mellon University

How important are cross-stock common factors in the price discovery/liquidity provision process in equity markets? Joel and Duane investigate two aspects of this question for the thirty Dow stocks. Using principal components and canonical correlation analyses they find that both returns and order flows are characterized by common factors. Commonality in the order flows explains roughly half of the commonality in returns. They also examine variation and common covariation in various liquidity proxies and market depth (trade impact) coefficients. Liquidity proxies such as the bid-ask spread and bid-ask quote sizes exhibit time variation which helps explain time variation in trade impacts. The common factors in these liquidity proxies are relatively small, however. (Accepted Late Spring 1999.)

Dividend Tax Credits, the Ex-Day, and Cross-Border Tax Arbitrage: The Case of Germany

Robert L. McDonald, Northwestern University

German dividends typically carry a tax credit which makes the dividend worth 42.86% more to a taxable German shareholder than to a tax-exempt or foreign shareholder. Bob shows that, as a result of the credit, the ex-day drop exceeds the dividend by more than one-half of the tax credit, and that futures and option prices embed more than one-half of the tax credit. These findings are consistent with costly tax arbitrage activity by German investors, who face tax risk due to anti-arbitrage rules. The existence of the credit creates opportunities for cross-border tax arbitrage and implies it is tax-efficient for foreign investors to hold derivatives rather than investing directly in German stocks. (Accepted Late Spring 1999.)

Macroeconomic Factors Do Influence Aggregate Stock Returns

Mark J. Flannery, University of Florida
Airs A. Protopapadakis, University of Southern California

The authors evaluate the effects of 17 series of macro announcements on the daily returns to the value-weighted market portfolio, over the 1980-96 period. The aim is to identify candidates for macroeconomic “risk factors,” in the context of a MGARCH model. They find six strong candidates: the balance of trade, CPI, PPI, the employment report, housing starts, and some of the monetary aggregates. Surprisingly, the list does not include GNP or industrial production. Several tests show that the results are robust. (Accepted Late Spring 1999.)

Equilibrium Former Curves for Commodities

Bryan R. Routledge, Carnegie Mellon University
Duane J. Seppi, Carnegie Mellon University
Chester S. Spatt, Carnegie Mellon University

This paper presents an equilibrium model of the term structure of forward prices for storable commodities. Our approach differs from Brennan (1991) and Schwartz (1997) in that we do not explicitly assume an exogenous “convenience yield.” Rather, our spot commodity has an embedded timing option that is absent in forward contracts, which arises from a non-negativity constraint on inventory. The value of this option changes over time as a function of both the endogenous inventory and exogenous transitory shocks to supply and demand. Our model makes predictions about the volatilities of forward prices at different horizons and shows how conditional violations of the “Samuelson effect” can occur. We address the related issue of dynamically trading near-dated forward contracts to hedge a long-dated position. We also present a tractable extension of the model with a permanent second factor and a calibration of the model to crude oil futures price data. (Accepted Late Spring 1999.)

Preferencing, Internalization, Best Execution and Dealer Profits

Oliver Hansch, Pennsylvania State University
Narayan Y. Naik, London Business School
S. Viswanathan, Duke University

The practices of preferencing and internalization have been alleged to support collusion, cause worse execution, and lead to wider spreads in dealership style markets relative to auction style markets. For a sample of London Stock Exchange stocks, we find that preferenced trades pay higher spreads. They do not, however, generate higher dealer profits. Internalized trades pay lower spreads. We do not find a relation between the extent of preferencing or internalization, and spreads across stocks. These results do not lend support to the “collusion” hypothesis but are consistent with a “costly search and trading relationships” hypothesis. (Accepted Late Spring 1999.)

Intraday and Long-Run Return Volatility: Heterogeneous News Arrivals and Intraday Seasonals

Torben G. Andersen, University of Virginia
Tim Bollerslev, Northwestern University

Torben and Time completed two papers in connection with this project.

The first paper, “Heterogeneous Information Arrivals and Return Volatility Dynamics: Uncovering the Long-Run in High Frequency Returns,” considers how to simultaneously incorporate long-term and short-term volatility dymanics in the same model. The authors show that by interpreting overall volatility as the manifestation of numerous heterogeneous information arrivals, sudden bursts of volatility typically will have both short-run and long-run components. Long-memory characteristics therefore constitute an intrinsic feature of the return generating process, rather than a manifestation of occasional structural shifts, as others have suggested. An examination of five-minute Deutschemark-U.S. Dollar exchange rates demonstrates the usefulness of the model.

The second paper, “Deutsche Mark-Dollar Volatility: Intraday Activity Patterns, Macroeconomic Announcements, and Longer Run Dependencies,” extends the empirical results of the first paper. It provides a more detailed characterization of the volatility in the Deutsche mark-dollar foreign exchange market. Their approach captures the intraday activity patterns, the macroeconomic announcements, and the volatility persistence (ARCH) known from daily returns. The different features are separately quantified and shown to account for a substantial fraction of return variability, both at the intraday and daily level. The implications of the results for the interpretation of the fundamental “driving forces” behind the volatility process is also discussed. (Accepted Spring 1999.)

Valuing Growth

Jonathan Berk, University of California at Berkeley
Vasant Naik, University of British Columbia
Richard Green, Carnegie-Mellon University

The paper, “Valuation and Return Dynamics of R&D Ventures,” develops and analyzes a model of a multi-stage investment project that captures many features of R&D ventures and start-up companies. An important feature these problems share is that the firm learns about the potential profitability of the project throughout its life, but that “technical uncertainty” about the research and development effort itself is only resolved through additional investment by the firm. In addition, the risks associated with the ultimate cash flows the firm realizes on completion of the project have a systematic component, while the purely technical risks are idiosyncratic. Their model captures these different sources of risk, and allows them to study their interaction in determining the risk premium earned by the venture during development. The results show that the systematic risk, and required risk premium, of the venture are highest early in its life, and decrease as it approaches completion, despite the idiosyncratic nature of the technical risk. (Accepted Spring 1999.)

Population Aging and the Expected Return on Financial Assets

James M. Poterba, MIT

The paper, “Population Age Structure and Asset Returns: An Empirical Investigation,” examines the association between population age structure and the returns on stocks and bonds. The paper is motivated by the claim that the aging of the “Baby Boom” cohort in the United States is a key factor in explaining the recent rise in asset values. The paper summarizes household age-asset accumulation profiles using data from the Survey of Consumer Finances. The results show that although asset accumulation peaks near age 60, wealthy households with substantial asset holdings appear to decumulate slowly, if at all, after retirement. The historical relationship between demographic structure and real returns on Treasury bills, long-term government bonds, and corporate stock does not suggest any robust relationship between demographic structure and asset returns. (Accepted Fall 1998.)

A Re-examination of the Benefits of Emerging Markets

Philippe Jorion, University of California, Irvine
William Goetzmann, Yale University

The paper, “Global Stock Markets in the Twentieth Century,” attempts to determine when the high returns of US stocks in the twentieth century are due to a survivorship bias. The results show that the US equities had the highest real returns of all 39 countries examined over 1921 to 1996. The high US returns therefore appears to be the exception rather than the rule. (Accepted Spring 1998.)

The Design and Rating of Securities

Peter DeMarzo, University of California, Berkeley
Darrell Duffie, Stanford University

Philippe and Will produced two papers in connection with this project.

The first paper, “A Liquidity-Based Model of Security Design,” examines securitization decisions. The model considers the tension between a desire to securitize assets when higher return investments are available to the issuer versus the illiquidity associated with those assets when the public knows that the issuer hold private information about them. The results show when standard debt is optimal. They also imply that the riskiness of the debt increases with the issuer’s retention costs of the assets. The paper is forthcoming in Econometrica.

The second paper, “The Pooling and Tranching of Securities,” is solely authored by Peter DeMarzo. In it, he considers how an intermediary should sell off assets when it has private information about their values. If it has superior information, it is generally better to sell the assets individually rather than sell them in a single pool. If the intermediary can create a multi-tranch instrument, however, it may be optimal to pool and tranch. (Accepted Spring 1998.)

The Specialist’s Discretion: Stopped Orders and Price Improvement

Mark J. Ready, University of Wisconsin-Madison

When a market order arrives, the NYSE specialist can offer a $1/8 better price to gain priority over the limit orders on the book and to trade for his own account. Alternatively, the specialist can “stop” the market order, which means he guarantees execution at the current quote but provides the possibility of price improvement. Ready constructs a model which shows that specialists can use stops to sample the future order flow before making a commitment to trade. His empirical evidence demonstrates that both stops and immediate price improvement impose adverse selection costs on limit order traders. (Accepted Summer 1997.)

The Pricing and Hedging of Mortgage-Backed Securities: A Multivariate Density Estimation Approach

Kobi Boudoukh, New York University
Matt Richardson, New York University
Richard Stanton, University of California at Berkeley
Robert Whitelaw, New York University

Two papers were produced in connection with this project.

The first paper, “A New Strategy for Dynamically Hedging Mortgage-Backed Securities,” proposes and empirically evaluates a hedging strategy in which the hedge ratio is derived from estimates of the joint distribution of Mortgage-Backed Securities, T-Note futures, and concurrent macro-economic variables. The resulting dynamic hedge changes with changes in the macroeconomy. The results show that the method meaningfully reduces residual variation when compared to static methods.

The second paper, “Pricing Mortgage-Backed Securities in a Multifactor Interest Rate Environment: A Multivariate Density Estimation Approach,” shows that the prices of Mortgage-Backed Securities are well described by a function of the level and slope of the term structure, and by another hard-to-classify common factor. The interest rate level provides information about moneyness of the prepayment option, the expected level of prepayments, and the average life of the cash flows. The term structure slope provides information about the rate at which the cash flows should be discounted. (Accepted Winter 1997.)

Option Pricing with Infinitely Divisible Distributions

Steve Heston, Washington University

The project paper analyzes option pricing for “unhedgeable” processes. Such processes include processes in which discrete jumps can take place. The paper shows that there is a unique set of homogenous-path independent arbitrage-free contingent claim prices. Option pricing formulas for infinitely divisible continuous time processes are derived by taking limits of discrete models. The results include the Black-Scholes model, and a two parameter generalization of the model that depends on both volatility and skewness. (Accepted Winter 1996.)

The following project were completed within the last five years. Free copies of the project papers may be obtained by giving the attached order sheet to Andy McCulloch. Copies of the most recent papers may also be picked up at the back of the conference room.

Accounting Valuation, Market Expectation, and the Book-to-Market Effect

Richard Frankel, University of Michigan
Charles M. C. Lee, Cornell University

Richard and Charles produced two papers in connection with this project.

The first paper, “Accounting Valuation, Market Expectation, and the Book-to-Market Effect,” shows that an accounting based model of value can produce a value-to-book variable that is a better predictor of cross-sectional returns than is the frequently examined book-to-market ratio. They further show that analyst earning forecasts are predictable, and that the predictive value of the value-to-book ratio can be improved by incorporating analyst forecast errors.

The second paper, “Accounting Diversity and International Valuation,” explores the accounting-based valuation model in an international context. The model that produces a measure of firms’ fundamental value that is theoretically immune to accounting differences across countries. The authors explain why the model has the potential to become a vehicle by which accounting numbers produced under alternative systems can be translated into consistent value estimates. Empirical results show that the model helps explain cross-border stock prices. (Accepted Fall 1996.)

How Are Stock Prices Affected by the Location of Trade

Kenneth A. Froot, Harvard University

The project paper (co-authored with Emil Dabora) examines trading in three pairs of “Siamese twin” companies. Twins are companies that are essentially similar in terms of ownership rights and cash flows, but which trade under different names in different markets. For example, Royal Dutch Petroleum and Shell Transport and Trading, plc are a pair of “twins.” The authors find that the prices of the twins are more closely correlated with their home market indices than standard valuation theory would suggest. The authors examine some possible explanations for the result, but ultimately conclude that markets are segmented by frictions other than international transactions costs. (Accepted Fall 1996.)

Alternate Hedge Ratios for Bonds Subject to Credit Risk

Frank Skinner, New York University

The project paper introduces eight new methods for computing hedge ratios for credit-risky bonds. It then conducts a horse race to determine which, if any, of these methods performs better than hedge ratios based on modified Macaulay duration and modified Macaulay duration with convexity. The results suggest that a pure interest rate hedge ratio consistently outperforms the modified Macaulay methods for high credit quality portfolios. For lower quality bonds, the results show that a hedge that employs a corporate index as the hedging instrument performs best. Finally, the results show that most of the benefits of diversification are achieved for relatively small portfolios of nine bonds. (Accepted Fall 1996.)

Do Independent Directors Matter?

Sanjai Bhagat, University of Colorado
Bernard Black, Columbia University

The project paper examines how long-term stock performance is related to the fraction of the corporate board that is composed of independent directors. The results show that the proportion of independent directors has little association with performance. If anything, an effect appears to run from performance to the proportion of inside directors. Following poor performance firms tend to have independent directors appointed to their boards. The results suggest that there is little empirical support for the current push for a higher proportion of independent directors on large company boards. (Accepted Fall 1996.)

Returns of Gold and Gold-Mine Shares

David Brown, Indiana University

The project paper (co-authored with Scott Hoover) argues that since gold mines are options on the price of gold, gold mine stock returns should have option-like properties. The authors develop and estimate a pricing model for gold stocks and for gold stock portfolios. The results suggest confirm that gold stock returns are useful for forecasting gold volatility. They also show that gold mine stock returns lead gold returns. Finally, they show that gold mine stocks are a poor substitute for gold in broadly diversified portfolios. (The correlation between gold and gold stocks is low.) The results are important because they identify option characteristics of equity. All equities, in principal, have these characteristics. They are most easily found in gold because of the special nature of the underlying production technology. The results have application to other extraction stocks, and, to some extent, to stocks of bankrupt and near bankrupt companies. (Accepted Fall 1996.)

Stochastic Volatility: Univariate and Multivariate Extensions

Eric Jacquier, Cornell University
Nicholas G. Polson, University of Chicago
Peter Rossi, University of Chicago

This projects applies Jacquier, Polson and Rossi’s innovative stochastic volatility estimation methods to models of fat-tailed and skewed conditional distributions that are appropriate for modeling leverage effects, stochastic factor structures and stochastic discounts. The results show strong evidence for non-normal conditional returns in stock returns and exchange rates. These characteristics suggest strong implications for option pricing models and other models that depend on stochastic volatility. (Accepted Spring 1996.)

Corporate Debt Value, Bond Covenants, and Optimal Capital Structure

Hayne Leland, University of California at Berkeley

Hayne produced two papers in connection with this project.

The first paper, “Corporate Debt Value, Bond Covenants, and Optimal Capital Structure," examines corporate debt values and capital structure in a unified analytical framework. The paper derives closed-form results for the value of long-term risky debt and yield spreads, for optimal capital structure. The results are attractive because neither debt values nor capital structure can be fully understood in isolation. The results will help us to better understand how to value junk bonds and why firms would choose to issue junk bonds instead of investment grade debt.

The second paper, “Bond Prices, Yield Spreads, and Optimal Capital Structure with Default Risk,” extends the previous work to include debt of arbitrary maturity. (The methods used in the former paper could only examine very short term debt or infinitely lived debt.) The work thus extends Merton’s results on zero coupon bonds to bonds that pay coupons. (Accepted Fall 1995.)

Informal Restructuring of Debt in Default: Theory, Evidence and Implications for Valuation and Investment Strategies

Kose John, New York University

Kose produced two papers in connection with our research contract.

The first, “The Voluntary Restructure of Large Firms in Response to Performance Decline” (with Larry Lang and Jeffry Netter) is an empirical study of voluntary corporate restructurings. The authors characterize the common elements of the restructurings. The topic is important because the recent weakening of the takeover market. This paper was published in the Journal of Finance.

The second paper, “Asset Sales and Increase in Focus” (with Eli Ofek), examines asset and stock performance following restructurings that increase the focus of the firm. The results show that such restructurings benefit the shareholders. Alternative explanations for the divestiture decisions do not seem to provide as much explanatory value as the refocusing hypothesis. (Accepted Spring 1995.)

An Experimental Evaluation of the Proposed Treasury Auction Mechanism

Vernon Smith, University of Arizona

The project report describes experiments that Vernon and his co-authors ran to determine whether the Treasury’s proposed English clock auction would be subject to implicit collusive manipulations. Although this auction mechanism is designed to minimize to potential for collusion, collusive equilibria are still possible. Whether they are obtained is therefore an experimental question. The results show that collusive equilibria are occasionally obtained among student players, but they are not stable. The proposed auction mechanism offers potential improvement over the existing sealed bid mechanism. (Accepted Spring 1995.)