Working Paper Abstracts – 1997

Working Paper Abstracts – 1997


This paper solves the equilibrium problem in a pure-exchange, continuous-time economy in which some agents face information costs or other types of frictions effectively preventing them from investing in the stock market. Under the assumption that the restricted agents have logarithmic utilities, the existence of an equilibrium is demonstrated, and a complete characterization of equilibrium prices and consumption/investment policies is provided. The restricted agents’ consumption volatility is shown to be decreased in comparison to the benchmark economy in which all agents have free access to the stock market, while the unrestricted agents’ consumption volatility is increased. The impact of restricted participation on equilibrium prices is also discussed. A simple calibration shows that the model can help resolve some of the empirical asset pricing puzzles. In the special case of both classes of agents having logarithmic preferences, it is shown that restricted participation unambiguously decreases the real interest rate and increases the stock risk premium, as compared to a benchmark economy with costless access to the stock market.


We study the dynamic equilibrium behavior of security in an economy where nonfundamental risk arises from agents’ heterogeneous beliefs about extraneous processes. We provide a complete characterization of equilibrium in terms of the primitives of the economy, via construction of a representative agent with stochastic weights. Besides the standard pricing of fundamental risk, an agent now also prices the nonfundamental risk with a market price which is a risk-tolerance weighted average of his extraneous disagreement with all remaining agents. Consequently, for given risk tolerances, agents’ perceived state prices and consumption streams are more volatile in the presence of extraneous risk. The interest rate inherits additional terms arising from agents’ misperceptions about consumption growth, and from precautionary savings motives against the nonfundamental uncertainty.


A commonly held view in the financial and economic literature is that “free cash flow is bad” in the sense that, given the opportunity, shareholders would always choose to minimize its existence. This view of the world has motivated economists such as Jensen (1988, 1993) to conclude that takeovers, to the extent that they are driven by an overinvestment problem, are beneficial because they both facilitate ex post divestiture and also pose an ex ante threat on managers who overinvest. In this paper we challenge these widely-held beliefs and show that not only might shareholders optimally choose to allow for the existence of free cash flow in the future, but also that the existence of takeovers may actually exacerbate the problem of overinvestment rather than help resolve it.


The goal of this paper is to investigate whether specialists use quoted depth as a strategic choice variable. In particular, the paper investigates whether specialists manage quoted depth to reduce risks associated with information events. In order to study specialists’ behavior, quoted depth must be partitioned into the depth provided by the specialist and depth in place on the limit order book. To accomplish this partitioning, estimates of limit order books are compiled. The analysis details how specialists update their quotes in relation to an evolving limit order book. In addition, the analysis conducts an event study which shows that both specialists and limit order traders reduce depth around earnings announcements thereby reducing their exposure to adverse selection costs. The results also show that the specialists selectively supply liquidity by reflecting the interest on the limit order book on the side (or sides) of the market where they believe there is a chance of informed trading. Changes in quoted depth are shown to be consistent with specialists managing their inventory positions as well as having knowledge of the future value of the stock.


We develop a multi-period market model describing both the process by which traders learn about their ability and how a bias in this learning can create overconfident traders. A trader in our model initially does not know his own ability, that is, the probability that he will receive a valid signal in each period. He infers this ability from his successes and failures. In assessing his ability the trader takes too much credit for his successes, i.e. he weighs his successes more heavily than would a true Bayesian agent. This leads him to become overconfident. A trader’s expected level of overconfidence increases in the early stages of his career. Then, with more experience, he comes to better recognize his own ability. An overconfident trader trades too aggressively, thereby increasing trading volume and market volatility while lowering his own expected profits. Though a greater number of past successes indicates greater probable ability, a more successful trader may actually have lower expected profits in the next period than a less successful trader due to his greater overconfidence. Since overconfidence is generated by success, overconfident traders are not the poorest traders. Their survival in the market is not threatened. Overconfidence does not make traders wealthier, but the process of becoming wealthy can make traders overconfident.


A greater threat of takeover has two opposing effects on managerial compensation. The competition effect in the market for managers reduces compensation. The risk effect increases compensation by making mangers’ implicitly deferred compensation and firm-specific human capital less secure. Using a sample of about 450 large firms, we find that an increase in the threat of takeover from quartile 1 to quartile 3 reduces a typical CEO’s salary and bonus by between $22,800 and $211,600 due to the competition effect alone, but raises salary and bonus by between $41,500 and $255,300 due to the risk effect alone. The net effect is an increase of between $18,700 to $43,700.


A growing number of empirical studies suggest that beats of common stocks do not adequately explain cross-sectional differences in stock returns. Instead, a number of other variables (e.g., size, ratio of book to market, earnings/price) that have no basis in extant theoretical models seems to have significant predictive ability. Some interpret the findings as evidence of market efficiency. Others argue that the Capital Asset Pricing Model is an incomplete description of equilibrium price formation and these variables are proxies for additional risk factors. In this paper we review the evidence on the cross-sectional behavior of common stock returns on the U.S. and other equity markets around the world. We also report some new evidence on these cross-sectional relations using data from both U.S. and international stock markets. We find, among other results, that although the return premia associated with these ad hoc variables are significant in most international stock markets, the premia are uncorrelated across markets. The accumulating evidence prompts the following question: If these return premia occur primarily in January and are uncorrelated across major international equity markets, is it reasonable to characterize them as compensation for risk?


Equity costs of capital for individual firms are estimated using several models that relate expected returns to betas on one or more pervasive factors. A Bayesian approach incorporates prior uncertainty about an asset’s mispricing as well as uncertainty about betas and factor means. Substantial prior uncertainty about mispricing results in an estimated cost of equity close to that obtained with mispricing ruled out. Uncertainty about which pricing model to use appears to be less important, on average, than within-model parameter uncertainty. In the absence of mispricing uncertainty, uncertainty about factor means is generally the most important source of overall uncertainty about a firm’s cost of equity, although uncertainty about betas is nearly as important.


We study the problem of going public in the presence of moral hazard, adverse selection and multiple trading periods. In the multiperiod game managers strategically choose the level of extraction of private benefits and can develop a good reputation for expropriating low levels of private benefits. The costs of going public can be significantly reduced because of this reputation effect, and this can be an important factor in sustaining the emerging stock markets that offer weak protection to minority shareholders. Also, allowing controlling managers to issue non-voting shares can increase the stock market efficiency, because the reputation effect is stronger when managers can divest more without losing control.


Previous tests for liquidity constraints using consumption Euler equations have frequently split the sample on the basis of wealth arguing that low wealth consumers are more likely to be constrained. We propose alternative tests using different and more direct information on borrowing constraints obtained from the 1983 Survey of Consumer Finances. In a first stage we estimate probabilities of being constrained which are then utilized in a second sample, the Panel Study of Income Dynamics, to estimate switching regression models of the Euler equation. Our estimates indicate stronger excess sensitivity associated with the possibility of liquidity constraints than the sample splitting approach.


New York Stock Exchange specialists disseminate information to market participants by displaying price schedules consisting of quoted prices and depths for both the bid and the ask sides of the market. This paper examines how specialists revise these posted price schedules in response to changes in their trading environment. We estimate specialists’ quote-revision processes in the context of a simultaneous equations model using four potentially important factors: (1) changes in the limit order book, (2) transactions, (3) competition from regional exchanges, and (4) overall activity in the stock. Our results show that changes in the limit order book have a significant impact on the posted price schedule, while transactions and overall activity are secondary to the limit order book in determining the posted price schedule. In addition, we find evidence that specialists revise their quoted prices and depths in response to different events.


Chicago-based Morningstar rates the investment performance of mutual funds, assigning one to five stars with five being the best rating. This paper first documents the method that Morningstar uses in assigning these widely circulated ratings and then explores in detail the implications for the ranking of domestic equity mutual funds for June 1997. The empirical results show the following: First, it is less likely that a fund with a long history will receive the top rating of five stars than a fund with a short history. Second, Morningstar assigns its highest two ratings to nearly a half of the no load domestic diversified equity funds that it evaluates, while it assigns its lowest two ratings to just over a quarter of these funds. This large proportion of highly rated no load domestic diversified equity funds is due to the comparison group that Morningstar uses in ranking its funds. Specifically, Morningstar compares these no load funds to all domestic equity funds, which include both load and no load funds as well as sector funds, convertible bond funds, and other miscellaneous funds. Since Morningstar handicaps load funds for their load and penalizes sector funds for their lack of diversification, no load diversified equity funds receive more stars than they would if they were evaluated in terms of themselves alone.


We examine whether bond ratings contain pricing relevant information, that is unavailable to investors from other sources, by focusing on investor reaction to rating changes that were not accompanied by any economic fundamental event – Moody’s refinement of its rating system. This refinement was not accompanied by any fundamental change in the issuers’ risks, was not preceded by any announcement and was carried simultaneously for all bonds.

We find that rating information is valuable: (1) Prior to the release of Moody’s fine rating information, bond yield spreads were not perfectly correlated with the fine rating information Moody had but hadn’t made public; (2) Following Moody’s announcement of the fine ratings, bond prices adjusted to the new information; and (3) The prices of the stocks of the bond issuers also reacted to Moody’s new information. In accordance with the observation that stock value is convex function of the firm’s value while bond value is a concave function of the firm’s value, the stock price reaction was in the opposite direction to that of the bond prices. Lastly, the total-firm value was not significantly affected by the announcement of Moody’s fine ratings. We interpret this to mean that information conveyed by rating changes about default risk is largely diversifiable.