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Q Group - The institute for quantitative research in finance

Recently Completed Projects

From its inception through 2013, the Q Group funded over 300 academic research projects that provide unique approaches and insights into problems of significance to investment professionals. Recently completed projects appear below along with links to the papers.

Can Brokers Have It All?
Robert Battalio, University of Notre Dame
Shane A. Corwin, University of Notre Dame
Robert Jennings, Indiana University

We identify retail brokers that seemingly route orders to maximize order flow payments: selling market orders and routing limit orders to venues paying large liquidity rebates. Because venues offering high rebates also charge liquidity demanding investors high fees, fee structure may affect the arrival rate of marketable orders. If limit orders on low-fee venues fill when similarly priced orders on high-fee venues do not, routing orders to maximize rebates might not always be in customers’ best interests. Using proprietary limit order data, we document a negative relation between several measures of limit order execution quality and the relative fee level. Specifically, we show that when ‘identical’ limit orders are concurrently displayed on two venues, orders routed to the low-fee venue execute more frequently and suffer lower adverse selection. Using the NYSE’s TAQ data, we show that the negative relation between take fees and execution quality extends beyond our proprietary data set.

Exchange maker-taker pricing schemes can affect order submission decisions that brokers make to the disadvantage of their traders. Investment managers must be familiar with how these decisions can disadvantage them.

Related Securities and Equity Market Quality
Ekkehart Boehmer, EDHEC Business School
Sudheer Chava, Georgia Institute of Technology
Heather Tookes, Yale School of Management

We document that equity markets become less liquid and equity prices become less efficient when markets for single-name credit default swap (CDS) contracts emerge. This finding is robust across a variety of market quality measures. We analyze the potential mechanisms driving this result and find evidence consistent with negative trader-driven information spillovers that result from the introduction of CDS. These spillovers greatly outweigh the potentially positive effects associated with completing markets (e.g., CDS markets increase hedging opportunities) when firms and their equity markets are in “bad” states. In “good” states, we find some evidence that CDS markets can be beneficial.

The introduction of new contracts such as CDSs can change where price discovery primarily occurs for certain types of risk and market quality for correlated securities. The results of this study suggest that the introduction of CDS contracts may have hurt equity market quality.

Can Hedge Funds Time Market Liquidity?
Charles Cao, Texas A&M University
Yong Chen, Penn State University
Bing Liang, University of Massachusetts
Andrew Lo, MIT

We explore a new dimension of fund managers’ timing ability by examining whether they can time market liquidity through adjusting their portfolios’ market exposure as aggregate liquidity conditions change. Using a large sample of hedge funds, we find strong evidence of liquidity timing. A bootstrap analysis suggests that top-ranked liquidity timers cannot be attributed to pure luck. In out-of-sample tests, top liquidity timers outperform bottom timers by 4.0–5.5% annually on a risk-adjusted basis. We also find that it is important to distinguish liquidity timing from liquidity reaction, which primarily relies on public information. Our results are robust to alternative explanations, hedge fund data biases, and the use of alternative timing models, risk factors, and liquidity measures. The findings highlight the importance of understanding and incorporating market liquidity conditions in investment decision-making.

Knowing when and why fund managers outperform the market is very important to investment sponsors and to investment managers who want to improve their own performance. The results of this study help us better understand the market timing skills of hedge fund managers when faced with time-varying liquidity conditions.

Are Credit Ratings Still Relevant?
Sudheer Chava, Georgia Tech
Rohan Ganduri, Georgia Tech
Chayawat Ornthanalai, University of Toronto

We show that firms’ stock prices react significantly less to credit rating downgrade announcements when they have Credit Default Swap (CDS) contracts trading on their debts. We find that information in CDS spreads predict firms’ future rating downgrades and defaults, and document a significant information flow from the CDS to equity and bond markets before firms are downgraded. Further, term structures of CDS can be used to construct a more reliable measure of default risk premium for firms undergoing rating revisions. While the CDS market is not a perfect substitute for credit ratings, our results suggest that credit rating revisions have become less informative to equity investors in the presence of the CDS market.

Understanding the information content of credit ratings, and more generally, where information about credit quality can be found, is important both to equity analysts and to fixed income analysts. The results of this paper help us better understand the relation between stock prices and CDS prices.

Cross-Firm Information Flows and the Predictability of Stock Returns
Anna Scherbina, UC Davis
Bernd Schluschey, Federal Reserve Board

The authors identify leader stocks based on their ability to Granger-cause returns of other stocks and show that such leaders can reliably predict their followers’ returns out of sample. Leaders’ predictive ability is robust to firm- and industry-level controls and works at the level of individual stocks rather than industries. Many leaders cannot be easily detected using ex-ante firm characteristics: They often are small, belong to a different industry than their followers, or exhibit only a short-lived leadership. The authors find support for the conjecture that leaders tend to be at the center of important news developments that also affect their followers by showing that, all else equal, firms with greater news coverage have a larger number of followers. We furthermore find that, consistent with the view that equilibrium mispricing is related to arbitrage costs, more heavily traded stocks react to their leaders’ signals with a shorter delay. Finally, we present evidence that sophisticated investors trade on leaders’ signals.

Understanding how information flows and ultimately impacts asset prices can help investors better understand price dynamics. The results of this study help identify the impact of media coverage on price formation. They also can help investors better decide when it is most important to trade quickly.

Patient Capital Outperformance:  The Investment Skill of High Active Share Managers Who Trade Infrequently
Martijn Cremers, University of Notre Dame
Ankur Pareek, Rutgers Business School

This study shows that high active share portfolios (portfolios whose holdings differ substantially from the holdings of their benchmarks) outperform their benchmarks on average only if invested in patient investment strategies with stock holding periods of at least two years. Funds that trade frequently generally underperform, regardless of their active share. Among funds that infrequently trade, separating closet index funds from truly active funds is crucial. The average outperformance of the most patient and distinct portfolios equals 2.30% per year—net of costs—for retail mutual funds. Stocks held by patient and active institutions in general outperform by 2.22% per year and by hedge funds in particular by 3.64% per year, both gross of costs

Transaction costs are a well-known drag on investment performance. This study shows that funds that do not turnover much, but which take strong active positions, tend to perform better than those that trade frequently or those that do not take active positions. The results have strong implications for the design of active trading strategies and for the establishment of profitable investment disciplines.

The Determinants of Recovery Rates in the US Corporate Bond Market
Rainer Jankowitsch, Vienna University of Economics and Business
Florian Nagler, Vienna University of Economics and Business
Marti G. Subrahmanyam, New York University

The authors examine recovery rates of defaulted bonds in the US corporate bond market, based on a complete set of traded prices and volumes. A study of the trading microstructure around various types of default events is provided. They document temporary price pressure with high trading volumes on the default day and the following 30 days, and low trading activity thereafter. Based on this analysis, they determine market-based recovery rates and quantify various liquidity measures. They also study the relation between the recovery rates and these measures, considering additionally a comprehensive set of bond characteristics, firm fundamentals, and macroeconomic variables.

In the event of bankruptcy, bond values depend critically on ultimate recovery rates. The determinants of these rates therefore should be of particular interest to investment managers and sponsors who hold defaulted bonds, or bonds for which the probability of default is significant.

How Much Error is in the Tracking Error? The Impact of Estimation Risk on Fund Tracking Error
Artemiza Woodgate, Russell Investments
Andrew F. Siegel, University of Washington

The authors explain the poor out-of-sample performance of optimized portfolios (to minimize tracking-error relative to a given benchmark while achieving a specified expected excess return) in the presence of estimation error in the underlying asset means and covariances. Theoretical bias adjustments for this estimation risk are developed by taking mathematical expectations of asymptotically expanded future returns of portfolios formed with estimated weights. They provide closed-form adjustments for estimates of the expectation and standard deviation of the portfolio’s excess returns. The adjustments significantly reduce bias in global equity portfolios, reduce the costs of rebalancing portfolios, and are robust to sample size and to non-normality. Using these approximation methods it may be possible to assess, before investing, the effect of statistical estimation error on tracking-error-optimized portfolio performance.

Estimation errors in expected asset means and variances lead to poor out-of-sample performance of optimized portfolios. The authors provide theoretical bias adjustments that can permit managers to reduce the costs of rebalancing portfolios. The results should be of interest to quantitative managers who use portfolio optimizers and to investment sponsors who must evaluate the performance of such managers.

Prospect Theory and the Risk-Return Trade-off
Huijun Wang, University of Delaware
Jinghua Yan, SAC Capital
Jianfeng Yu, University of Minnesota

This paper studies the cross-sectional risk-return trade-off in the stock market. Although a positive relation between risk and expected return is generally expected, recent empirical evidence suggests that low-risk firms tend to earn higher average returns. The authors apply prospect theory to shed light on this apparent violation of a fundamental principle in Finance. Prospect theory posits that when facing prior loss relative to a reference point, individuals tend to be risk seeking rather than risk averse. Consequently, among stocks where investors face prior losses, a negative risk-return relation should exist. By contrast, among stocks where investors face capital gains, the traditional positive risk-return relation should emerge, since investors of these stocks are risk averse. Using several intuitive measures of risk, empirical support for these hypotheses is provided.

The relation of risk to return is of fundamental importance in investments. Using behavioral methods, this study explains why low-risk firms tend to earn higher returns than high risk firms. The results should interest investment managers who can condition their holdings based on predictions of investor behavior.

Comomentum:  Inferring Arbitrage Activity from Return Correlations
Dong Lou, London School of Economics
Christopher Polk, London School of Economics

The authors propose a novel measure of arbitrage activity to examine whether arbitrageurs can have a destabilizing effect in the stock market. They apply their insight to stock price momentum, a classic example of an unanchored strategy that exhibits positive feedback since arbitrageurs buy stocks when prices rise and sell when prices fall. Their measure, which they call comomentum, is the high-frequency abnormal return correlation among stocks on which a typical momentum strategy would speculate. They show that during periods of low comomentum, momentum strategies are profitable and stabilizing, reflecting an underreaction phenomenon that arbitrageurs correct. In contrast, during periods of high comomentum, these strategies tend to crash and revert, reflecting prior overreaction resulting from crowded momentum trading pushing prices away from fundamentals. Theory suggests that we should not find destabilizing arbitrage activity in anchored strategies. The authors find that a corresponding measure of arbitrage activity for the value strategy, covalue, positively forecasts future value strategy returns, and is positively correlated with the value spread, a natural anchor for the value-minus-growth trade. Additional tests at the firm, fund, and international level confirm that this approach to measuring arbitrage activity in the momentum strategy is sensible.

Momentum and overreaction characterize many assets, but they both can’t simultaneously be useful to investment managers. Knowing the relation between the two phenomena and which phenomenon will characterize the near future is of obvious importance to managers who consider momentum and overreaction when making portfolio decisions.

The Role of Institutional Investors in Voting: Evidence from the Securities Lending Market
Reena Aggarwal, Georgetown University
Pedro A. C. Saffi, University of Cambridge
Jason Sturgess, DePaul University

Using the unique setting of the securities lending market, the authors find that institutional investors restrict lending supply and/or call back loaned shares prior to the record date to exercise their voting right. Loan demand and the price of borrowing also increase around the proxy voting record date. They estimate the value of voting rights by institutional investors in a simultaneous equation framework and show that lenders of shares value their shares more than borrowers. Institutions place a greater value on voting rights for firms with weak corporate governance, poor performance, and higher institutional ownership. The value of the vote also is higher when contentious proposals such as non-routine and those related to compensation, anti-takeover, and corporate control are on the ballot. Examining the subsequent vote outcome, the authors find higher recall to be associated with less support for management and more support for shareholder proposals. These results indicate that institutional investors value their vote and use the proxy process as an important channel for affecting corporate governance.This project explores what factors relating to both forecasting the empirical distribution of future returns and the risk neutralization process go into the market’s risk neutral volatility parameter. Daily risk neutral densities are extracted from S&P 500 index options from 1996-2011 using a model-free procedure. Both risk neutral volatility and realized volatility from the observation date through option expiration are computed to compare the sensitivity of the two volatility measures to a wide range of variables relating to different manifestations of volatility, such as tail risk, and to the risk neutralization process, such as the general level of consumer confidence and the size of recent volatility forecast errors.

Institutional managers who have lent shares that they want to vote must recall those shares. The security lending market thus can provide information about the demand to vote shares. This study examines the determinants of that demand. The results should interest managers, sponsors, and corporate executives who are involved in corporate governance issues as well as short sellers who want to maintain positions during a vote, or who need to predict how costly borrowing will be during various votes.

What is Risk Neutral Volatility?
Stephen Figlewski, New York University Stern School of Business

A security’s expected payoff under the real world distribution for stock returns includes risk premia to compensate investors for bearing different types of stock market risk. But Black-Scholes and the great majority of derivatives valuation models developed from it produce the same option prices as would be seen under modified probabilities in a world of investors who were indifferent to risk. Implied volatility and other parameters extracted from options market prices embed these modified “risk neutral” probabilities that combine investors’ objective predictions of the real world returns distribution with their risk preferences. Under Black-Scholes assumptions, real world volatility and risk neutral volatility are equal. But Black-Scholes pricing does not hold in the real world because of unhedgeable risks that bear nonzero risk premia, and the risk neutral volatility that goes into option prices is not the market’s best estimate of the volatility that will actually occur.

This project explores what factors relating to both forecasting the empirical distribution of future returns and the risk neutralization process go into the market’s risk neutral volatility parameter. Daily risk neutral densities are extracted from S&P 500 index options from 1996-2011 using a model-free procedure. Both risk neutral volatility and realized volatility from the observation date through option expiration are computed to compare the sensitivity of the two volatility measures to a wide range of variables relating to different manifestations of volatility, such as tail risk, and to the risk neutralization process, such as the general level of consumer confidence and the size of recent volatility forecast errors.

Understanding option pricing and the information that goes into it is of obvious interest to practitioners who use financial engineering methods to characterize risk and volatility dynamics. Risk neutral volatilities have the potential to provide model-free market-based information about volatility.

Capital Structure, Derivatives and Equity Market Quality
Ekkehart Boehmer, EDHEC Business School
Sudheer Chava, Georgia Tech University
Heather E. Tookes, Yale University

We examine how the existence of a market for individual equity options, publicly traded corporate bonds or credit default swap (CDS) contracts affects equity market quality for a panel of NYSE listed firms during 2003-2007. We find that firms with listed equity options have more liquid equity and more efficient stock prices. By contrast, firms with traded CDS contracts have less liquid equity and less efficient stock prices, especially when equity markets are in a “good” state (i.e., when there are more liquidity traders, less disagreement and the firm is further away from default). The impact of having a publicly traded bond is more mixed, but is generally negative. Trading activity in related markets, rather than their existence, plays a strong negative role for liquidity but not for price efficiency. Our findings are robust cross-sectionally, in the time series, and after implementing a matched-sample methodology. Taken together, our results imply an overall negative effect of related markets when those markets are tied to debt in a firm’s capital structure.

When the risks inherent in equities trade in different forms in various markets, liquidity in the equity market may be enhanced or impaired. Market quality may improve if the additional markets generate more demand for trading in the underlying securities or if they improve price formation. Market quality may suffer if the other markets siphon trading interest from the underlying equity markets. This study examines the effect of related markets on the liquidity in the equity markets. The results are important to regulators who may want to control the proliferation of trading venues. They also are important to equity investors who need to determine whether sufficient liquidity is available for their trading strategies.

Short-Selling Bans Around the World: Evidence from the 2007-09 Crisis
Alessandro Beber, University of Amsterdam
Marco Pagano, University di Napoli Federico II

Most stock exchange regulators around the world reacted to the 2007-2009 crisis by imposing bans or regulatory constraints on short-selling. Short-selling restrictions were imposed and lifted at different dates in different countries, often applied to different sets of stocks and featured different degrees of stringency. We exploit this considerable variation in short-sales regimes to identify their effects on liquidity, price discovery and stock prices. Using panel data and matching techniques, we find that bans (i) were detrimental for liquidity, especially for stocks with small market capitalization, high volatility and no listed options; (ii) slowed down price discovery, especially in bear market phases, and (iii) failed to support stock prices, except possibly for U.S. financial stocks.

Many investment managers employ short selling strategies and many more are affected by those who do. This project examines the effects upon the markets of restrictions on short selling strategies during periods of market stress. The results are important for public policy and for planning trading strategies during market crises.

Macroeconomic Uncertainty, Difference in Beliefs, and Bond Risk Premia
Andrea Buraschi, Imperial College London
Paul Whelan, Imperial College London

In this paper, we study empirically the implications of macroeconomic disagreement for the time variation in bond market risk premia. If there is a source of heterogeneity in the belief structure of the economy, then differences in beliefs can affect equilibrium asset prices, and the dynamics of disagreement may generate a source of predictable variation in excess bond returns. Using survey data on macroeconomic forecasts of fundamentals spanning interest rates, real aggregates and inflation variables at different horizons, we propose a new empirically observable proxy to aggregate macroeconomic disagreement and find a number of novel results.

Difference in beliefs affect asset pricing because they affect how investors value assets and thus their trading decisions. The authors construct empirical measures of belief dispersion from survey data and show that these measures help explain bond returns. These results are of obvious importance to fixed income managers, and they provide insights that may benefit equity managers.

Are Stocks Really Less Volatile in the Long Run?
Lubos Pástor, University of Chicago Booth School of Business
Robert F. Stambaugh, Wharton School of the University of Pennsylvania

According to conventional wisdom, annualized volatility of stock returns is lower over long horizons than over short horizons, due to mean reversion induced by return predictability. In contrast, we find that stocks are substantially more volatile over long horizons from an investor’s perspective.

This perspective recognizes that parameters are uncertain, even with two centuries of data, and that observable predictors imperfectly deliver the conditional expected return. Mean reversion contributes strongly to reducing long-horizon variance, but it is more than offset by various uncertainties faced by the investor, especially uncertainty about the expected return. The same uncertainties reduce desired stock allocations of long-horizon investors contemplating target-date funds.

The Market for Borrowing Corporate Bonds
Paul Asquith, MIT
Parag A. Pathak, MIT

This paper describes the market for borrowing corporate bonds using a comprehensive dataset from a major lender. The cost of borrowing corporate bonds is comparable to the cost of borrowing equity, between 10 and 20 basis points per year. Factors that increase borrowing costs are percentage of inventory lent, loan size, and rating. Trading strategies based on cost or amount of borrowing do not yield excess returns. Bonds with corresponding CDS contracts are more actively lent than those without. Finally, the 2007 Credit Crunch increased the variance but did not affect average borrowing cost or size of loan activity.

The profitability of investment strategies that use short corporate bond positions depends on the costs of borrowing these securities. This study examines those costs and identifies their primary determinants. The results should interest investment managers that are employ these strategies as well as those interested in market structure.

Does the Tail Wag the Dog? The Price Impact of CDS Trading
Dragon Yongjun Tang, University of HongKong
Hong Yan, University of South Carolina and Shanghai Advanced Institute of Finance

We investigate empirically whether credit default swaps (CDS) spreads are influenced by shifts in demand/supply dynamics in the market. We find that while changes in CDS spreads are insensitive to accumulated trading volume, net buying interest (NBI), a measure we construct to measure latent trade imbalance between trades, predicts CDS price changes. Between two consecutive trades, CDS spread increases by 16% for the highest NBI group, but the most negative NBI group (most net selling interest) sees an average decrease of 10% in CDS spreads. This price impact of latent trade imbalance exists even in the absence of significant stock price movements. While part of this price impact of net buying interest comes from its information content for future changes in CDS spreads, liquidity of CDS contracts is another source. We show that the effect of NBI is three times stronger in the least liquid CDS contracts than in the most liquid CDS contracts. Furthermore, funding liquidity attenuates the initial price impact and accelerates the subsequent price reversal.

Many investment managers now use credit default swaps to manage risk in fixed income portfolios and others glean information from CDS prices. Both groups need to be aware of price dynamics associated with trading these swaps. The results from this project identify how CDS liquidity is related to order flow and information flows in the common stocks of the reference entities.

On Tournament Behavior in Hedge Funds: High Water Marks, Fund Liquidation, and the Backfilling Bias
George O. Aragon, Arizona State University
Vikram Nanda, Georgia Tech University

We analyze risk shifting by poorly performing hedge funds—and test predictions on the extent to which risk choices are related to the fund’s incentive contract, risk of fund closure and dissemination of performance information. Consistent with theoretical arguments, we find that the propensity for losing funds to increase risk is significantly weaker among those that tie the manager’s incentive pay to the fund’s high-water mark (HWM)—suggesting a possible benefit from such incentive structures—and among funds that face little immediate risk of liquidation. Risk shifting behavior is affected by both absolute and relative fund performance and is found to be more prevalent in the back filled period, when some funds may be at an incubation stage. Overall, the combination of factors such as high-water mark provisions, low risk of fund closure and the reporting of performance to a database appear to make poorly performing funds more conservative with regard to risk-shifting.

Although investment sponsors expect that their managers will faithfully follow agreed upon investment policies, managers often have incentives to manage to promote their own advisory services. This project examines the determinants of risk shifting by hedge funds when funds are underperforming. The results identify circumstances under which managers may give more weight to their own needs than might be appropriate, and methods for controlling this problem.

Estimating and Examining Movements in Housing Market Demand and Supply Indices
Jeff Fisher, Indiana University
Dean Gatzlaff, Florida State University
David Geltner, Massachusetts Institute of Technology
Donald Haurin, Ohio State University

This study examines the magnitude and movements of alternative index measures for single-family housing. More specifically, the study estimates standard hedonic, selection-corrected hedonic and constant-liquidity (demand and supply) indices using a large dataset from a single state-Florida. Results indicate that standard hedonic estimates are selective; however, the magnitude of the correction is very small, especially at the statewide level. Changes in the constructed demand and supply indices are shown to vary each period from the selection-correction (and standard hedonic) measures; are correlated with key economic variables; and are found to precede inter-temporal changes in the value indices. The pattern of the differences is consistent with the notion that buyer reservation prices respond quicker (or greater) to new relevant information and that seller reservation prices appear to be “sticky.”

Many investment sponsors and their managers hold and trade single family mortgage securities. The values of these securities depend on property values. Estimates of these values often incorporate information from housing indices. Understanding biases in these indices therefore is very important to those investment professionals whose performance depends on deep insights into housing market values.

Short Sellers and Financial Misconduct
Jonathan M. Karpoff, University of Washington
Xiaoxia Lou, University of Delaware

We examine whether short sellers detect firms that misrepresent their financial statements, and whether their trading conveys external costs or benefits to other investors. Abnormal short interest increases steadily in the 19 months before the misrepresentation is publicly revealed, particularly when the misconduct is severe. Short selling is associated with a faster time-to-discovery, and it dampens the share price inflation that occurs when firms misstate their earnings. These results indicate that short sellers anticipate the eventual discovery and severity of financial misconduct. They also convey external benefits, helping to uncover misconduct and keeping prices closer to fundamental values.

Although theory suggests that short selling should make prices more efficent, few empirical studies have been undertake to provide support for this proposition. The current public policy debate on short selling thus is often based on emotional and political issues rather than on hard facts. This study help fill this void. The result will interest active investment managers who employ short selling strategies and passive investment managers whose performance depend on fairly priced securities.

A Matter of Style: The Causes and Consequences of Style Drift in Institutional Portfolios
Russ Wermers, University of Maryland

The equity style orientation of an institutional portfolio has a large influence on its yearly returns. This paper analyzes the causes and consequences of portfolio “style drift” among U.S. equity mutual funds by developing new portfolio holdings-based measures of drift. These holdings-based measures allow a decomposition of style drift into components that result from active versus passive portfolio decisions by a fund manager in three different equity style dimensions: size, book-to-market, and price momentum. We find that a significant amount of style drift results from active manager trades, therefore, managers that trade more frequently tend to manage portfolios with greater style drift. In addition, managers of growth-oriented funds and small funds, and managers having good stock picking track records, tend to have higher levels of style drift than other managers; these managers also deliver better future portfolio performance as a result of their trades, even after accounting for their higher trading costs. Consistent with this superior performance, managers do not seem to be concerned with controlling style drift. Overall, our findings suggest that controlling the style drift of a fund manager does not necessarily result in higher performance for investors.

Style drift and its causes greatly concerns investment sponsors who generally prefer to hold risks that they understand and can predict. Using measures based on portfolio holdings, this research project examines components of style drift and shows that much drift results from the selection decisions of active manager, many of whom produce better performance as a result of their decisions. Close management of style drift therefore may not always be in the best interests of investment sponsors.

Attention Allocation over the Business Cycle
Marcin Kacperczyk, New York University
Laura Veldkamp, New York University
Stijn Van Nieuwerburgh, New York University

The invisibility of information precludes a direct test of attention allocation theories. To surmount this obstacle, we develop a model that uses an observable variable—the state of the business cycle—to predict attention allocation. Attention allocation, in turn, predicts aggregate investment patterns. Because the theory begins and ends with observable variables, it becomes testable. We apply our theory to a large information-based industry, actively managed equity mutual funds, and study its investment choices and returns. Consistent with the theory, which predicts cyclical changes in attention allocation, we find that in recessions, funds’ portfolios (1) covary more with aggregate payoff-relevant information, (2) exhibit more cross-sectional dispersion, and (3) generate higher returns. The results suggest that some, but not all, fund managers process information in a value-maximizing way for their clients and that these skilled managers outperform others.

How managers allocate their attention to investment prospects is an important determinant of their success. The best managers focus on those potential investment opportunities about which they have the greatest comparative advantage in understanding. During the course of a business cycle, the rewards to different types of research vary with changes in the complexity of the valuation problem. Accordingly, the nature of manager attention also must vary through the business cycle, which is what the authors identify.

The Troves of Academe: Asset Allocation, Risk Budgeting and the Investment Performance of University Endowment Funds
Keith C. Brown, Texas
Lorenzo Garlappi, Texas
Cristian-Ioan Tiu, SUNY-Buffalo

We use a unique data set for university endowment funds to study the relationship between asset allocation decisions and the performance of multiple asset class portfolios. Our analysis shows that although endowments differ substantially in their capital commitments to various asset classes, the volatility and the associated policy portfolio returns are remarkably similar across the sample. Moreover, while the risk-adjusted performance of the average endowment is not reliably different from zero, more actively managed funds generate statistically and economically significant annual alphas that are three to eight percent greater than those for more passive endowments. This finding is consistent with endowment managers attempting to exploit their security selection abilities by over-weighting asset classes in which they appear to have superior active management skills. Contrary to both efficient market theory and prevailing industry beliefs, we find that asset allocation is not related to portfolio returns in the cross section but does appear to indirectly influence risk-adjusted performance.

Academic endowment funds represent a large and growing fraction of institutionally managed investment funds. This research will examine how these funds make investment allocation decisions. Investment managers will be interested in these results because they serve this market and because these decisions can be large enough to affect the market. Donors and the endowments themselves also will have a strong interest in the results as stakeholders in these funds.

Asset-Pricing Anomalies and Financial Distress
Doron Avramov, Hebrew University of Jerusalem
Tarun Chordia, Emory University
Gergana Jostova, George Washington University
Alexander Philipov, George Mason University

This paper explores commonalities across asset-pricing anomalies. In particular, we assess implications of financial distress for the profitability of anomaly-based trading strategies. Strategies based on price momentum, earnings momentum, credit risk, dispersion, idiosyncratic volatility, and capital investments derive their profitability from taking short positions in high credit risk firms that experience deteriorating credit conditions. Such distressed firms are highly illiquid and hard to short sell, which could establish nontrivial hurdles for exploiting anomalies in real time. The value effect emerges from taking long positions in high credit risk firms that survive financial distress and subsequently realize high returns. The accruals anomaly is an exception—it is robust amongst high and low credit risk firms as well as during periods of deteriorating, stable, and improving credit conditions.

Investment managers who trade on anomalies need to understand the origins of the anomalies so that they can best determine when to trade on them. The proposed research will identify how anomalies vary with credit conditions. The results should be of particular interest given the current credit problems that firms are experiencing.

A Tale of Two Anomalies: The Implication of Investor Attention for Price and Earnings Momentum
Kewei Hou, Ohio State
Lin Peng, Baruch College
Wei Xiong, Princeton

We examine the role of investor attention in explaining the profitability of price and earnings momentum strategies. Using trading volume and market state to measure cross-sectional and time-series variations of investor attention, we find that price momentum profits are higher among high volume stocks and in up markets, but that earnings momentum profits are higher among low volume stocks and in down markets. In the long run, price momentum profits reverse but earnings momentum profits do not. These results suggest that price underreaction to earnings news weakens with investor attention, but price continuation caused by investors’ overreaction strengthens with attention.

Price and earnings momentum strategies are among the most common quantitative strategies that our members pursue. The inter-relationship between these two forms of momentum, and their separate dependencies on trading volume therefore should be of substantial interest to our members.

A Multiple Lender Approach to Understanding Supply and Search in the Equity Lending Market
Adam C. Kolasinski, University of Washington
Adam V. Reed, University of North Carolina
Matthew C. Ringgenberg, University of North Carolina

Although a large body of research has investigated the effects of short sale constraints, very little is understood about the origin of these constraints in the one-trillion-dollar equity lending market. Using a unique database comprising data from twelve lenders, we find significant dispersion in share loan fees across lenders, and we find that the dispersion is increasing in share loan demand and various proxies for search costs, including a stock’s illiquidity and the number of small lenders making loans. These findings are consistent with the existence of search frictions between share borrowers and lenders, as Duffie, Garleanu, and Pedersen (2002) suggest. We further analyze the effect of search frictions by examining the response of shorting cost to exogenous shocks in demand. We find that for stocks with moderate demand, loan fees are largely insensitive to demand shocks. However, for stocks with high demand, an increase in demand triples the already higher abnormal loan fees. Our findings help reconcile seemingly conflicting findings in the literature regarding the existence of both small and large effects of shifts in demand on price. We highlight the importance of search costs by showing that the various parameters in firms’ share loan supply schedules are closely related to cross-sectional differences in search costs. We conclude that short sale constraints could be slackened by the reintroduction of a central clearinghouse of share loans, which would reduce search costs.

Equity lending market efficiency is a primary determinant of investment performance for managers who borrow or lend stocks. This results of this research project help identify the determinants of lending fees. The results show that the fees depend on search costs, which suggests that central clearing could substantially increase the efficiency of this market.

The Failure Mechanics of Dealer Banks
Darrell Duffie, Graduate School of Business, Stanford University

I explain the key failure mechanics of large dealer banks, and some policy implications. This is not a review of the financial crisis of 2007-2009. Systemic risk is considered only in passing. Both the nancial crisis and the systemic importance of large dealer banks are nevertheless obvious and important motivations.

Should Benchmark Indices Have Alpha?
Martijn Cremers, Yale School of Management
Antti Petajisto, Yale School of Management
Eric Zitzewitz, Dartmouth College

Standard Fama-French and Carhart models produce economically and statistically significant nonzero alphas even for passive benchmark indices such as the S&P 500 and the Russell 2000. The authors find that these alphas primarily arise from the disproportionate weight the Fama-French factors place on small value stocks that have performed well, and from the CRSP value-weighted market index which is a downward-biased benchmark for stocks. They explore alternative ways to construct these factors as well as alternative models constructed from common and easily tradable benchmark indices. Such index-based models outperform the standard models both in terms of asset pricing tests and performance evaluation of mutual fund managers.

A very large fraction of institutional money is either indexed to-or evaluated relative to-market benchmark indices. Accordingly, the properties of these indices are of paramount importance to investment managers and investment sponsors. This research examines systematic performance characteristics of various indices in comparison to various market factors. The results help explain performance shortfalls and gains that may be due to the benchmark measures rather than to active (or in some cases, passive) strategies.

Stock Price Jumps and Cross-Sectional Return Predictability
George J. Jiang, University of Arizona
Tong Yao, University of Iowa

In rational continuous-time asset pricing models, compensation for risk is represented by the continuous drift of asset prices, whereas jumps are the effect of large information or liquidity shocks. The authors use this distinction to evaluate risk-based explanations of cross-sectional stock return predictability. Based on the CRSP data from 1927 to 2005, they find that individual stock price jumps tend to be idiosyncratic and predominantly positive, presenting an interesting contrast to mostly negative jumps in market portfolios. More importantly, several well-known patterns of return predictability, including the size effect, the liquidity premium, and to a moderate extent the value premium, are the result of cross-sectional differences in stock price jumps. The evidence presents a challenge to theories that attribute such return predictability to simple differences in risk premium. The authors further explore several alternative hypotheses within the rational asset pricing paradigm, such as the martingale restriction on jumps, jump risk premium effect, investor preference for skewness, and discontinuity in expected returns. However, none of them can be reconciled with the empirical evidence.

Extreme volatility affects many investment strategies, and most particularly quantitative strategies using options. For many of our members, discrete price jumps represent either their greatest risks or their greatest opportunities. The results in this paper help better identify which securities are most subject to these jumps.

Differences in Governance Practices Between U.S. and Foreign Firms: Measurement, Causes, and Consequences
Reena Aggarwal, Georgetown University
Isil Erel, Ohio State University
René Stulz, Ohio State University
Rohan Williamson, Georgetown University

The authors construct a firm-level governance index that increases with minority shareholder protection. Compared with matching firms, only 12.68% of foreign firms have a higher index. The value of foreign firms falls as their index decreases relative to the index of matching U.S. firms. The results suggest that lower country-level investor protection and other country characteristics make it suboptimal for foreign firms to invest as much in governance as U.S. firms do. Overall, they find that minority shareholders benefit from governance improvements and do so partly at the expense of controlling shareholders.

As sponsors and their investment managers continue to seek investment returns abroad, issues of corporate governance in the international cross-section are of increasing importance, especially since governance often determines how investment opportunities and returns are split between public investors and others. This research project addresses a problem in the previous literature: too often comparisons of the effect of governance have not controlled for other important determinants of performance. The results allow sponsors and their investment managers to better understand the risks that they take when investing abroad.

Hedge Fund Activism, Corporate Governance, and Firm Performance
Alon Brav, Duke University
Wei Jiang, Columbia University
Frank Partnoy, University of San Diego
Randall Thomas, Vanderbilt University

Using a large hand-collected data set from 2001 to 2006, we find that activist hedge funds in the U.S. propose strategic, operational, and financial remedies and attain success or partial success in two-thirds of the cases. Hedge funds seldom seek control and in most cases are no confrontational. The abnormal return around the announcement of activism is approximately 7%, with no reversal during the subsequent year. Target firms experience increases in payout, operating performance, and higher CEO turnover after activism. Our analysis provides important new evidence on the mechanisms and effects of informed shareholder monitoring.

The corporate activism of hedge funds has increased substantially in the last few years. This study shows that their activities very often have produced benefits for themselves and for other shareholders. Accordingly, these funds appear to have improved corporate efficiency. The results will interest our members who engage in corporate activism, as well as those who benefit from it.

Who Monitors the Mutual Fund Manager, New or Old Shareholders?
Woodrow T. Johnson, University of Oregon

This study tests whether mutual fund shareholders continue to trade in response to fund returns after they make their initial investment in fund shares. It decomposes the relationship between fund returns and shareholder flow in a large, proprietary panel of all shareholder transactions in one mid-size no-load mutual fund family. Results show that both new and old shareholders buy shares during periods of good returns; however, shareholder outflow is essentially unrelated to fund returns. This lack of a return-sell relationship is not driven by locked-in pension assets, shareholders’ ignorance of ongoing fund returns, or embedded capital gains. However, there is evidence that exchanges between equity funds in the family are more correlated with returns of the destination fund than with returns of the origination fund. This may indicate that flow between equity mutual funds is driven by shareholders buying new funds rather than selling old funds.

The challenges of managing the investor demands for liquidity in a mutual fund depend on the flows into and out of the fund. So too does the profitability of running the mutual fund. These results produced in this study help us better understand the determinants of fund flows by invested shareholders. The decomposition of flows between new and old shareholders within and across funds in a fund complex provides information about the stickiness of funds within the fund family.

When Should Firms Share Credit with Employees? Evidence from Anonymously Managed Mutual Funds
Massimo Massa, INSEAD
Jonathan Reuter, University of Oregon
Eric Zitzewitz, Dartmouth College

We study the economics of sharing credit with employees, using the U.S. mutual fund industry as our testing ground. Between 1993 and 2004, the share of funds that disclosed manager names to their investors fell significantly. We hypothesize that the choice between named and anonymous management reflects a tradeoff between the marketing and incentive benefits of naming managers and the costs associated with increased ex-post bargaining power. Consistent with this tradeoff, we find that funds with named managers receive more positive media mentions, have greater inflows, and suffer less return diversion, but that departures of named managers reduce inflows, especially for funds with strong past performance. To the extent that the hedge fund boom differentially increased outside opportunities for successful named managers, we predict that it should have increased the costs associated with naming managers and led to more anonymous management. Indeed, we find that the shift towards anonymous management is greater in those asset classes and geographical areas with more hedge fund activity.

Mutual funds that name their managers allow those managers to acquire reputations in the market. When those reputations are good, the managers become more valuable. Funds that employ managers with good reputation may attract flows, but they also may have to pay their managers more or risk losing them, especially to hedge funds. The potential for obtaining a valuable reputation thus also provides strong incentives for the managers to work harder. The results produced in this project show that the decision to name the managers has significant implications for mutual fund management companies.

The Fundamentals of Commodity Futures Returns
Gary B. Gorton, The Wharton School, University of Pennsylvania and NBER
Fumio Hayashi, University of Tokyo and NBER
K. Geert Rouwenhorst, Yale University

Commodity futures risk premiums vary across commodities and over time depending on the level of physical inventories, as predicted by the Theory of Storage. Using a comprehensive dataset on 31 commodity futures and physical inventories between 1969 and 2006, we show that the convenience yield is a decreasing, non-linear relationship of inventories. Price measures, such as the futures basis, prior futures returns, and spot returns reflect the state of inventories and are informative about commodity futures risk premiums. The excess returns to Spot and Futures Momentum and Backwardation strategies stem in part from the selection of commodities when inventories are low. Positions of futures markets participants are correlated with prices and inventory signals, but we reject the Keynesian “hedging pressure” hypothesis that these positions are an important determinant of risk premiums.

Commodities are becoming an increasing important asset class as economic development and population growth make them relatively scarce and cause their prices to become more volatile. Characterizations of how their prices are formed, and of regularities in their prices thus are quite important to investment managers. This study shows how risk premiums have varied over time and in relation to inventories. The results should be of particular note to investors in and managers of hedge funds that seek to profit by effectively offering price insurance to hedgers in the futures markets.

The Selection and Termination of Investment Management Firms by Plan Sponsors
Amit Goyal, Emory University
Sunil Wahal, Arizona State University

We examine the selection and termination of investment management firms by 3,400 plan sponsors between 1994 and 2003. Plan sponsors hire investment managers after large positive excess returns but this return chasing behavior does not deliver positive excess returns thereafter. Investment managers are terminated for a variety of reasons, including but not limited to underperformance. Excess returns after terminations are typically indistinguishable from zero but in some cases positive. In a sample of round-trip firing and hiring decisions, we find that if plan sponsors had stayed with fired investment managers, their excess returns would be no different from those delivered by newly hired managers. We uncover significant variation in pre and post-hiring and firing returns that is related to plan sponsor characteristics.

The allocation of funds to managers is among the most important decisions that plan sponsors make. The receipt or loss of those funds is the most important determinant of manager profitability. This study examines flows to and from investment managers to determine their causes and their effects. The results indicate that although sponsors often chase returns, their decisions do not produce excess returns on average.

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

Two papers were produced as part of this project.

In the first, “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 Second paper is titled “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
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
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
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
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
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
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
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
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
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
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
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 Has brouck’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 mis pricing 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
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 under performance 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 native 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 micro structure 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

Morning star, 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 Morning star’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 “Morning star 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” information on fund quality. Overall, the results indicate that Morning star 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 under perform by one percent. Of the 2.3 percent difference between these results, 0.7 percent is due to the under performance 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.)

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.)

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