Working Paper Abstracts – 2007

01-07
Measuring Financial Asset Return and Volatility Spillovers, with Application to Global Equity Markets
Francis X. Diebold and Kamil Yilmaz

We provide a simple and intuitive measure of interdependence of asset returns and/or volatilities. In particular, we formulate and examine precise and separate measures of return spillovers and volatility spillovers. Our framework facilitates study of both non-crisis and crisis episodes, including trends and bursts in spillovers, and both turn out to be empirically important. In particular, in an analysis of sixteen global equity markets from the early 1990s to the present, we find sticking evidence of divergent behavior in the dynamics of return spillovers vs. volatility spillovers: Return spillovers display a gently increasing trend but no bursts, whereas volatility spillovers display no trend but clear bursts.

02-07
Competition and Fragmentation in the Equity Markets: The Effect of Regulation NMS
Marshall E. Blume

The 1974 Amendments to the Securities Exchange Act of 1934 set forth the goal of establishing a National Market System (NMS) in which all equity trades would be integrated into a common computerized trading system. The paper argues that such a system cannot serve the needs of all investors—large or small, informed or uninformed. The recently approved Regulation NMS is an attempt to impose such a common trading system onto the equity market. Large institutions with their resources will find ways to evade it and are already fragmenting the market with “dark pools” of liquidity. This Regulation will certainly result in unintended consequences, to the detriment of the US equity market.

03-07
Durability of Output and Expected Stok Returns
Joao Gomes, Leonid Kogin and Motohiro Yogo

The demand for durable goods is more cyclical than that for nondurable goods and services. Consequently, the cash flow and stock returns of durable-good producers are exposed to higher systematic risk. Using the NIPA input-output tables, we construct portfolios of durable-good, nondurable-good, and service producers. In a cross-section, a strategy that is long on durables and short on services earns a sizable risk premium. In the time series, a strategy that is long on durables and short on the market portfolio earns a countercyclical risk premium. We develop an equilibrium asset-pricing model that explains these empirical findings.

04-07
Predictable Returns and Asset Allocation: Should a Skeptical Investor Time the Market?
Jessica A. Wachter and Missaka Warusawitharana

Are excess returns predictable and if so, what does this mean for investors? Previous literature has tended toward two polar viewpoints: that predictability is useful only if the statistical evidence for it is incontrovertible, or that predictability should affect portfolio choice, even if the evidence is weak according to conventional measures. This paper models and intermediate view: that both data and theory are useful for decision-making. We investigate optimal portfolio choice for an investor who is skeptical about the amount of predictability in the data. Skepticism is modeled as an informative prior over the R2 of the predictive regression. We find that the evidence is sufficient to convince even an investor with highly skeptical prior to vary this portfolio on the basis of the dividend-price ratio and the yield spread. The resulting weights are less volatile and deliver superior out-of-sample performance as compared to the weights implied by an entirely model-based or data-based view.

05-07
Does Mutual Fund Performance Vary Over the Business Cycle?
Anthony A. Lynch and Jessica A. Wachter

Conditional factor models allow both risk loadings and performance over a period to be a function of information available at the start of the period. Much of the literature to date has allowed risk loadings to be time-varying while imposing either the assumption that conditional performance is constant or the assumption that conditional betas are linear in the information. We develop a new methodology that allows conditional performance to be a function of information available at the start of the period but does not make assumptions about the behavior of the conditional betas. This methodology uses the Euler equation restriction that comes out of the factor model rather than the beta pricing formula itself. It assumes that the stochastic discount factor (SDF) parameters are linear in the information. The Euler equation restriction that we develop can be estimated using GMM. We also use econometric techniques developed by Lynch and Wachter (2003) to take advantage of the longer data series available for the factor returns and the information variables. These techniques allow us to produce more precise parameter estimates than those obtained from the usual GMM estimation. We use our SDF-based method to assess the conditional performance of funds in the Elton, Gruber and Blake (1996) mutual fund data set. Using dividend yield and term spread to track the business cycle, we find that conditional mutual fund performance relative to conditional versions of the Fama-French and Carhart pricing models moves with the business cycle, and this business cycle variation in performance differs across large-NAV and small-NAV funds within at least on Weisenberger category. Moreover, the conditional performance of the large-NAV maximum capital gain portfolio is more pro cyclical than that of the small-NAV maximum capital gain portfolio. Maximum capital gain funds hold high growth stocks predominantly but we do not find any evidence of cyclical abnormal performance in the 5 lowest book-to-market portfolios of the 25 Fama-French portfolios.

06-07
Deliberation and Security Design in Bankruptcy
Hulya Eraslan and Bilge Yilmaz

We consider negotiations among the claimants of a bankrupt firm in which claimants have private information about various operational restructuring alternatives, and can communicate prior to a proposal. Our setup differs from typical bargaining games with incomplete information in two ways. First, the proposals can be made using securities. Second, the negotiations are over two interdependent issues: what to do with the firm and who gets what. In line with Chapter 11 bankruptcy proceedings we first analyze the case in which both issues are negotiated simultaneously. We show that simultaneous negotiation leads to efficient operational restructuring. Moreover, any efficient equilibrium requires that the original senior claimants receive senior securities of the reorganized firm. Next, we analyze the cases in which the two issues are negotiated sequentially. If the first issue is what to do with the firm, then efficient operational restructuring is not possible. In contrast, if the first issue is who gets what, then sequential negotiation is efficient. In comparison to simultaneous negotiation, efficient sequential negotiation may result in junior claimant capturing a larger surplus.

07-07
Information Based Trade
Philip Bond and Hulya Eraslan

We study the possibility of trade for purely informational reasons. We depart from previous analyses (notably Grossman and Stiglitz 1980 and Milgrom and Stokey 1982) by allowing the final payoff of the asset being traded to depend on an action taken by its eventual owner. A leading example is the trade of a controlling stake in a corporation. We characterize conditions under which equilibria with trade exist. We discuss implications for when trade occurs, the correlation of actions with trade, and the efficiency of equilibrium actions.

08-07
Asset Prices Under Habit Formation and Reference-Dependent Preferences
Motohiro Yogo

This article explains the high level and the countercyclical variation of the equity premium in a consumption-based asset pricing model with low large scale risk aversion. Investors have gain-loss utility over consumption relative to slowly time-varying habit. Stocks deliver low returns in recessions when consumption falls below habit; investors therefore require a high premium for holding stocks. The model’s conditional moment restrictions are tested on consumption and asset returns data. The empirical estimate of large-scale risk aversion is low, whereas the estimate of loss aversion agrees with prior experimental evidence.

09-07
The Responses of Corporate Financing and Investment to Changes in the Supply of Credit: A Antural Experiment
Michael Lemmon and Michael R. Roberts

We examine how and why shocks to the supply of credit impact corporate financing and investment using the collapse of Drexel Burnham Lambert, Inc., the passage of the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA), and regulatory changes in the insurance industry as an exogenous contraction in the supply of below-investment-grade credit after 1989. A difference-in-differences empirical strategy reveals that substitution to bank debt and alternative sources of capital (e.g., equity) was extremely limited and, as a result, net investment decreased almost one for one with the contraction in net issuing activity. Despite this sharp change in behavior, corporate leverage ratios remained relatively stable, a result of the contemporaneous decline in debt issuances and investment. Our findings illustrate that intermediary uniqueness and government regulation can generate distinctly segmented capital markets that amplify the effects of fluctuations in the supply of capital on firm behavior.

10-07
Control Rights and Capital Structure: An Empirical Investigation
Michael R. Roberts and Amir Sufi

We show that a large number of financing decisions of solvent firms are dictated by creditors, who use the transfer of control rights accompanying financial covenant violations to address incentive conflicts between managers and investors. After showing that financial covenant violations occur among almost one third of all publicly listed firms, we find that creditors use the threat of accelerating the loan to reduce net debt issuing activity by over 2% of assets per annum immediately following a covenant violation. Further, this decline is persistent in that net debt issuing activity fails to return to pre-violation levels even after two years, resulting in a gradual decline in leverage of almost 3%. These findings represent the first, of which we are aware, piece of empirical evidence highlighting the role of control rights in shaping corporate financial policies outside of bankruptcy.

11-07
Predictive Systems: Living with Imperfect Predictors
Lubos Pastor and Robert F. Stambaugh

The standard regression approach to modeling return predictability seems too restrictive in one way but too lax in another. A predictive regression models expected returns as an exact linear function of a given set of predictors but does not exploit the likely economic property that innovations in expected returns are negatively correlated with unexpected returns. We develop and alternative framework—a predictive system—that accommodates imperfect predictors and beliefs about that negative correlation. In this framework, the predictive ability of imperfect predictors is supplemented by information in lagged returns as well as lags of the predictors. Compared to predictive regressions, predictive systems deliver different and substantially more precise estimates of expected returns as well as different assessment of a given predictor’s usefulness.

12-07
Incentives for Information Producation in Markets Where Prices Affect Real Investment
James Dow, Itay Goldstein and Alexander Guembel

A fundamental role of financial markets is to gather information on firms’ investment opportunities, and so help guide investment decisions. In this paper we study the incentives for information production when prices perform this allocational role. If firms cancel planned investments following poor stock market response, the value of their shares will become insensitive to information on investment opportunities, so that speculators will be deterred from producing information ex ante. Based on this insight, we derive several new results on the determinants of information production and the resulting firm value and investment policy. We show that information production on investment opportunities is distinctly different than that on assets in place, and argue that some overinvestment increases firm value.

13-07
Corporate Bankruptcy Reorganizationa: Estimates from a Bargaining Model
Hulya Eraslan

When a firm files for Chapter 11 bankruptcy in the U.S., negotiations take place among its claimants to decide what to do with the firm and who gets what. If an agreement cannot be reached, then the firm is likely to be liquidated. Consequently, the liquidation value of the firm plays a crucial role in the deal that is struck among the claimants. In this paper, I use a novel approach to measure the unobserved liquidation value of a firm that relies on the information contained in the allocations that are agreed upon in Chapter 11 negotiations. I do so by estimating a game theoretic model that captures the influence of liquidation value on the equilibrium allocations using a newly collected data set. I find that liquidation values are higher when the industry conditions are more favorable, and the real interest rates are higher. I use the estimated model to conduct a counterfactual experiment to quantitatively assess the impact of mandatory liquidation on the equilibrium allocations.

14-07
Vauable Information & Costly Liquidity: Evidence from Individual Mutual Fund Trades
Susan E. K. Christoffersen, Donald B. Keim and David K. Musto

15-07
Why Do Household Portfolio Shares Rise in Wealth?
Jessica A. Wachter and Motohiro Yogo

In the cross-section of U.S. households, the portfolio share in risky assets rises in wealth. The standard life-cycle model with power utility and non-tradable labor income has the counterfactual implication that the portfolio share declines in wealth. We develop a life-cycle model in which household utility depends on two types of consumption goods, basic and luxury. The model predicts that the expenditure share for basic goods declines in total consumption and the variance of consumption growth rises in the level of consumption. When calibrated to match these two predictions in household consumption data, the model explains portfolio shares that rise in wealth.

16-07
Does the Stock Market Fully Value Intangibles? Employee Satisfaction and Equity Prices
Alex Edmans

This paper analyzes the relationship between employee satisfaction and long-run stock performance. A portfolio of stocks selected by Fortune magazine as the “Best Companies for Work For in America” in January 1998 earned average annual returns of 14% by the end of 2005, over double the market return, and a monthly four-factor alpha of 0.64%. The portfolio also outperformed industry- and characteristics-matched benchmarks. These findings have two main implications. First, they suggest that employee satisfaction improves corporate performance rather than representing inefficiently excessive non-pecuniary compensation. Second, they imply that the stock market does not fully value intangibles, even when they are made visible by a publicly available survey. This suggests that intangible investment generally may not be incorporated into short-term prices, providing support for managerial myopia theories.

17-07
The Economics of Private Equity Funds
Andrew Metrick and Ayako Yasuda

This paper analyzes the economics of the private equity industry using a novel model and dataset. We obtain data from a large investor in private equity funds, with detailed records on 238 funds raised between 1992 and 2006. Fund managers earn revenue from a variety of fees and profit-sharing rules. We build a model to estimate the expected revenue to managers as a function of these rules, and we test how this estimated revenue varies across the characteristics of our sample funds. Among our sample funds, about 60 percent of expected revenue comes from management fees, a fixed-revenue component that is not sensitive to performance. We find major differences between venture capital (VC) funds and buyout (BO) funds—the two main sectors of the private equity industry. In general, BO fund managers earn lower revenue per managed dollar than do managers of VC funds, but nevertheless these BO managers earn substantially higher revenue per partner and per professional than do VC managers. Furthermore, BO managers build on their prior experience by raising larger funds, which leads to significantly higher revenue per partner and per professional, despite the fact that these larger funds have lower revenue per dollar. Conversely, while prior experience by VC managers does lead to higher revenue per partner in later funds, it does not lead to higher revenue per professional. Taken together, these results suggest that the BO business is more scalable than the VC business.

18-07
Optimal Retirement Benefit Guarantees
Stavros Panageas

The majority of countries that switched to funded private account retirement systems opted to complement such systems with explicit guarantees to retirees and agents saving for retirement. The motivation was that a social insurance system should provide a minimum standard of living in retirement. This paper studies the optimal deign of such guarantees. Particular attention is paid to moral hazard, i.e. the incentive to take more risk once the guarantees are in place. Surprisingly, the simple policy of complementing private accounts with a fixed annuity in retirement is shown to be an optimal policy in the baseline model. It is also shown that the standard practice of pricing retirement benefit guarantees as contingent claims and then choosing the minimum cost guarantee may be a misleading indicator for welfare comparisons between alternative policies.

19-07
Sources of Lifetime Income
Mark Huggett, Gustavo Ventura and Amir Yaron

Is lifetime inequality mainly due to differences across people established early in life or to differences in luck experienced over the working lifetime? We answer this question within a model that features idiosyncratic shocks to human capital, estimated directly from data, as well as heterogeneity in ability to learn, initial human capital, and initial wealth – features which are chosen to match observed properties of earnings dynamics by cohorts. We find that as of the age 20, differences in initial conditions account for more of the variation in lifetime utility, lifetime earnings and lifetime wealth than do differences in shocks received over the lifetime. Among initial conditions, variation in initial human capital is substantially more important than variation in learning ability or initial wealth for determining how an agent fares in life. An increase in an agent’s profile, whereas, an increase in learning ability affects expected utility by producing a steeper expected earnings profile.

20-07
Optimal Income Taxation
Andrew B. Abel

In an economy with identical infinitely-lived household that obtain utility from leisure as well as consumption, Chamley (1986) and Judd (1985) have shown that the optimal tax system to pay for an exogenous stream of government purchases involves a zero tax rate on capital in the long run, with tax revenue collected by a distortionary tax on labor income. Extending the results of Hall and Jorgenson (1971) to general equilibrium, I show that if purchasers of capital are permitted to deduct capital expenditures from taxable income, then a constant tax rate on capital income is non-distortionary. Importantly, even though this specification of the capital income tax imposes a zero effective tax rate on capital, the capital income tax can collect substantial revenue. Provided that the government purchases do not exceed gross capital income less gross investment, the optimal tax system will consist of a positive tax rate on capital income and a zero tax rate on labor income – just the opposite of the results of Chamley and Judd.

21-07
The Equity Premium Implied By Producation
Urban J. Jermann

This paper studies the determinants of the equity premium as implied by producers’ first-order conditions. A simple closed form expression is presented for the Sharpe ratio as a function of investment volatility and technology parameters. Calibrated to the U.S. postwar economy, the model can match the historical first and second moments of the market return and the risk free interest rate. The market’s Sharpe ratio and the market price of risk are very volatile.