Working Paper Abstracts – 1998

Working Paper Abstracts – 1998

Executive Compensation & the Boundary of the Firm: The Case of Short-Lived Projects
Gary Gorton and Bruce D. Grundy

We consider the problem of moral hazard in the team of managers employed in a firm when the principal/firm owner can play an active role in determining team output. Unless the principal’s compensation is non-decreasing in firm value there is an additional moral hazard problem since the principal will have an incentive to reduce output. In this context we determine team, and hence firm, size and solve for the form of optimal managerial compensation contracts. In particular we determine conditions under which optimal contracts will have option-like features.

Customer-Controlled Firms: The Case of Stock-Exchanges
Carmine Di Noia

In many industries there are firms whose owners are also customers. They have contrasting interests: they get more utility as the firm’s profits increase, and the prices of the good decreases as their private consumer surplus increases. An interesting example is the stock exchange industry. This paper shows that a customer-owned monopolist always achieves first-best social outcome, but in customer-controlled firms, profits are not necessarily maximized and minority shareholders are damaged. When customers have equal unit demand, less profits arise if they hold a share of the firm’s capital higher than their percentage over the total number of customers. When customers have equal downward demand, the firm never maximizes profits; besides, if the share of capital of customers-owners is somewhat less than the weight of customer-owners over total customers, the firm will always price at 0. Customer-controlled stock exchanges are welfare efficient if the customers (listed firms, intermediaries, price vendors, etc.) hold an amount of capital equal to their proportion over the total number of customers. They never price at the monopoly price and, thus, do not maximize profit. This finding casts some doubt on the policy of listing a stock-exchange company itself on exchanges.


In recent years, the number of downgrades in corporate bond ratings has exceeded the number or upgrades. This fact has led some to conclude that the credit quality of US corporate debt has declined. However, declining credit quality is not the only possible explanation. An alternative explanation of this apparent decline in credit quality is that the rating agencies are now using more stringent standards in assigning ratings. An ordered probit analysis of a panel of firms from 1978 through 1995 suggests that rating standards have indeed become more stringent. The implication is that at least part of the downward trend in ratings is the result of changing standards and does not reflect a decline in credit quality.

Costs of Equity Capital and Model Mispricing
Lubos Pástor and Robert F. Stambaugh
The Journal of Finance, Volume 54, No. 1, February 1999, pp. 67-121.

Costs of equity for individual firms are estimated in a Bayasian framework using several factor-based pricing models. Substantial prior uncertainty about mispricing often produces an estimated cost of equity close to that obtained with mispricing precluded, even for a stock whose average return departs significantly from the pricing model’s prediction. Uncertainty about which pricing model to use is less important, on average, that within-model parameter uncertainty. In the absence of mispricing uncertainty, uncertainty about factor premiums is generally the largest source of overall uncertainty about a firm’s cost of equity, although unertainty about betas is nearly as important.

An Analysis of Mutual Fund Design: The Case of Investing in Small-Cap Stocks
Donald B. Keim
The Journal of Financial Economics, Volume 51, No. 2, February 1999, pp. 173-194.

In 1982, Dimensional Fund Advisors launched a mutual fund intended to capture the returns of small-cap stocks. The “9-10 Fund” is based on the CRSP 9-10 Index, an index of small-cap stocks comprising the 9th and 10th deciles of NYSE market capitalization. Although linked to the CRSP 9-10 Index, the design of the 9-10 Fund incorporates investment rules and a trading strategy that are aimed at minimizing the potentially excessive trade costs associated with such illiquid stocks. The design causes the Fund’s security weightings to deviate from the CRSP 9-10 weightings. The resulting return deviations between the 9-10 Fund and the CRSP 9-10 Index are sometimes large. On average, the 9-10 Fund provided a 2.2% premium over the 9-10 Index over the 1982-95 period. This paper decomposes the return difference between the 9-10 Fund and the CRSP 9-10 Index. We show that both the investment rules and the trade strategy components of the Fund’s design contribute significantly to the return difference, although the magnitude and significance of their relative impacts vary over the life of the Fund.

Capital Market Equilibrium with Mispricing and Arbitrage Activity
Süleyman Basak and Benjamin Croitoru

This paper develops a general equilibrium, continuous time model where portfolio constraints generate mispricing between redundant securities. Constrained consumption-portfolio optimization techniques are adapted to incorporate redundant, possibly mispriced, securities. We demonstrate the necessity of mispricing for equilibrium when agents are heterogeneous enough. The construction of a representative agent with stochastic weights allows us to characterize prices and allocations, given mispricing occurs, in a general setting. Under logarithmic preferences, we provide explicit conditions for mispricing and closed-form expressions for all economic quantities. Existence of an equilibrium where mispricing occurs with positive probability is verified in a specific case. We demonstrate how mispricing induces agents to engage in riskless arbitrage trades.

The Information Contained in Stock Exchange Seat Prices
Donald B. Keim and Ananth Madhavan

Exchange seats are capital assets that confer access to the trading floor. As such, their prices reflect expectations about future activity and returns for the market as a whole. For this reason, the process by which seat prices are determined provides valuable information about beliefs of market participants who have the most intimate contact with the trading process. This paper examines the auction market for New York Stock Exchange (NYSE) seat using the complete intra-daily record of trades, bids and offers for the seat market for the 1973-1994 period. Our analysis yields several new results on the evolution of beliefs and their relation to asset prices. In contrast to traditional theories of bid-ask spreads that emphasize inventory costs or asymmetric information, we show that seat spreads reflect the heterogeneity of beliefs about future market performance. Our tests confirm that seat transactions and quotas do contain information about these beliefs, and our measure of divergence in opinion has predictive power regarding future stock market returns.

The Cost of Institutional Equity Trades
Donald B. Keim and Ananth Madhavan
The Financial Analysts Journal, Volume 54, No. 4, July/August 1998, pp. 50-69

This paper examines the empirical evidence on the cost of equity trades for institutional investors. There is considerable practical and academic interest in the measurement and analysis of trading costs. We discuss some of the results that emerge from the recent literature on institutional trading costs and augment those findings with new evidence from a large sample of institutional trades. The evidence we discuss includes: (i) implicit trading costs (such as the price impact of a trade and the opportunity costs of failing to execute) are economically significant relative to explicit costs (and relative to realized portfolio returns); (ii) equity trading costs vary systematically with trade difficulty and order placement strategy; (iii) differences in market design, investment style, trading ability, and reputation are also important determinants of trading costs; (iv) even controlling for trade complexity, there is considerable variation in trading costs across institutions; (v) accurate prediction of trading costs requires more detailed data on the entire order submission process, especially information on pre-trading decision variables such as the trading horizon. We also discuss the implications of equity trading costs for policy makers and investors. For example, the concept of “best execution” is difficult to measure and, therefore, enforce for institutional investors.

Currency Prices, the Nominal Exchange Rate, and Security Prices in a Two-Country Dynamic Monetary Equilibrium
Süleyman Basak and Mike Gallmeyer
Mathematical Finance, Volume 9, No. 1, January 1999, pp. 1-30.

This paper examines a continuous-time two-country dynamic monetary equilibrium in which countries with possibly heterogeneous tastes and endowments hold their own money for the purpose of transaction services formulated via money in the utility function. Given a price system, no-arbitrage pricing results are provided for the price of each money and the nominal exchange rate. Characterizations are provided for equilibrium prices for general time-additive preferences and non-Markovian exogenous processes. Under a Markovian structure of model primitives, the currency prices are shown to solve a bivariate system of partial differential equations. Assuming that each country is endowed with heterogeneous separable power utility and the exogenous quantities all follow geometric Brownian motions, an equilibrium is shown to exist and additional characterization is provided. A further example of non-separable Cobb-Douglass preferences is investigated. The additional features over the customary environment of homogeneous logarithmic preferences are emphasized.


On the Fluctuations in Consumption and Market Returns in the Presence of Labor and Human Capital: An Equilibrium Analysis
Süleyman Basak

We examine the effects of human capital on consumption, stock market, and other fluctuations in a general equilibrium continuous-time model. A representative consumer-worker-investor derives utility from consumption and leisure. A representative firm demands labor as the sole input to a stochastic production technology, driven by general (possibly non-multiplicative) shocks. For Cobb-Douglas utility and multiplicative shocks, labor is non-stochastic, and consumption and stock market volatility are equated, as under no human capital. Deviations from this are analyzed. For logarithmic utility and “constant elasticity of substitution” production technology, cases are identified where the presence of labor causes consumption to be smoother than the stock market.


Management Turnover and Corporate Governance Changes Following the Revelation of Fraud
Anup Agrawal, Jeffrey J. Jaffe and Jonathan M. Karpoff

Anecdotal evidence suggests that top managers of firms that are investigated or charged with criminal fraud lose their jobs. From a theoretical perspective, it is plausible that fraud scandals create incentives to change managers, in an attempt to improve the firm’s performance, reinvest in lost reputational capital, or limit the firm’s exposure to liabilities that arise from the fraud. It also is possible that fraud creates incentives to change the composition of the firm’s board, to improve the external monitoring of managers or to rent new directors’ valuable reputational or political capital. Despite such claims, we find little systematic evidence that firms suspected or charged with fraud have unusually high turnover among either senior managers or directors. In univariate comparisons, there is some evidence that firms committing fraud have higher managerial and director turnover. But in multivariate tests that control for other firm attributes, such evidence disappears. These findings indicate that the revelation of fraud does not, in general, increase the net benefits from managerial or corporate governance changes. We conclude that the revelation of fraud does not fundamentally change the firm’s optimal leadership structure.

Capital Market Equilibrium with Differential Taxation
Süleyman Basak and Mike Gallmeyer

This paper studies the dynamics of equilibrium security prices when agents face differential dividend taxation. We construct a continuous-time equilibrium via a representative agent with stochastic weights. Agents differ in their pricing of risk inducing agent-specific consumption-based CAPMs, with differential taxation appearing as an additional factor. The interest-rate, stock price, and consumption dynamics are also impacted. Under logarithmic preferences, risk is transferred from the higher-taxed to the lower-taxed agent, and the interest rate decreases to counteract extra precautionary savings against this suboptimally shared risk. Numerical analysis reveals further tax rate, time-to-horizon, and dividend risk effects. For most wealth allocations, the stock return volatility is increased above the no-tax benchmark.

Understanding the Nature of the Risks and the Source of Rewards to Momentum Investing
Bruce D. Grundy and J. Spencer Martin

It is well established that recent prior winner and loser stocks exhibit return continuation; a momentum strategy of buying recent winners and shorting recent losers appears profitable in the post 1945 era. In contrast, the risk exposure of such a strategy has not been well understood; the strategy’s unconditional average risk exposure can be deceptive. The stock selection method of a momentum strategy guarantees that large and time varying factor exposures will be borne in accordance with the performance of the common risk factors during the periods in which stocks were ranked to determine their winner/loser status. Because the factors themselves display trivial momentum, extreme factor realizations induce noise which obscures the study of the momentum phenomenon. This noise is penetrated in two ways. First, measurements of the factor exposure of momentum strategies are made during both formation and investment periods. Raw returns to the strategies are adjusted for factor risk with two striking results: the momentum phenomenon is remarkably stable across subperiods in the entire time series of post 1926 stock returns; and factor models can explain around ninety-five percent of the variability of returns on portfolios of the top and bottom ten percent of prior winners and losers, but cannot explain their mean returns. Second, alternative momentum strategies are studied which base winner or loser status on stock-specific return components over some ranking period. Such strategies are more profitable than those based on total returns. Evidence is also presented that neither industry effects nor cross-sectional differences in expected returns are the primary cause of the observed momentum phenomenon.

Eighths, Sixteenths and Market Depth: Changes in Tick Size and Liquidity Provision on the NYSE
Michael A. Goldstein and Kenneth A. Kavajecz

We use limit order data provided by the New York Stock Exchange (NYSE) to investigate the impact of reducing the minimum tick size on the liquidity of the market. Specifically, we analyze both spreads and depths (quoted and on the limit order book) for periods before and after the NYSE’s change from eighths to sixteenths. Similar to other studies, we find that quoted spreads and quoted depth declined after the change. However, we find that depth declined throughout the entire limit order book as well. The combined effect of smaller spreads and reduced cumulative depth in the limit order book has made liquidity demanders trading small orders better off while those trading large orders worse off. The benefit to the small orders occurs mostly in frequently traded stocks, while small orders in infrequently traded stocks see little, if any, benefit.

A Theory of Dividends Based on Tax Clienteles
Franklin Allen, Antonio Bernardo and Ivo Welch

This paper offers a novel explanation for why some firms prefer to pay dividends rather than repurchase shares. It is well-known that institutional investors are relatively less taxed than individual investors, and that this induces “dividend clientele” effects. We argue that these clientele effects are the very reason for the presence of dividends, because institutions have a relative advantage in monitoring firms or in detecting firm quality. Firms paying dividends attract relatively more institutions and perform better. The theory is consistent with some documented regularities, such as a reluctance of firms to cut dividends, and offers novel empirical implications, such as a prediction that is the tax difference between institutions and retail investors that determines dividend payments, not the absolute tax payments

Are Transactions and Market Orders More Important than Limit Orders in the Quote Updating Process?
Ron Kaniel and Hong Liu

Transactions, market orders and limit orders are three major factors which affect a specialist’s information set and her inventory position. In modeling a specialist’s quote updating process, before any exclusion of any of these factors, one should first address the fundamental question of their relative importance in this process. This question, however, has received little attention both in the theoretical and empirical microstructure literature. Using a simple nonparametric test we investigate the relative importance of these three factors. We demonstrate that both transactions and market orders affect the quote updating process significantly more than limit orders, and that transactions affect it more than market orders. Furthermore, we find that market orders convey more information than limit orders about the value of the underlying security. These results hold even after controlling for transaction and order size.

Risk Arbitrage in Takeovers
Francesca Cornelli and David D. Li

The paper studies the role of risk arbitrage in takeover contests. We show that arbitrageurs have an incentive to accumulate non-trivial stakes in a company target of a takeover. For each arbitrageur, the knowledge of his own presence (and that he will tender a positive fraction of his shares) is an informational advantage which guarantees that there is a scope for trade with the other shareholders. In equilibrium, the number of arbitrageurs buying shares and the number of shares they buy are determined endogenously. The paper also presents a range of empirical implications, including the relationship between trading volume, takeover premium, bidder’s toehold, liquidity of the shares and the probability that the takeover will succeed.

Revenue Efficiency and Change of Control: The Case of Bankruptcy
Francesca Cornelli and Leonardo Felli

The restructuring of a bankrupt company often entails a change of control. By efficiency of a bankruptcy procedure it is usually meant that the control is allocated into the hands of those who can maximize its value. In this paper we focus instead on how to allocate control with a procedure that allows the creditors to maximize their returns. The conclusion is that creditors should be allowed to retain a fraction of the shares of the company.

Asset Pricing Models: Implications for Expected Returns and Portfolio Selection
A. Craig MacKinlay and Lubos Pástor

Implications of factor-based asset pricing models for estimation of expected returns and for portfolio selection are investigated. In the presence of model mispricing due to a missing factor, the mispricing and the residual covariance matrix are linked together. Imposing a strong form of this link leads to expected return estimates that are more precise and more stable over time than unrestricted estimates. Optimal portfolio weights that incorporate the link when no factors are observable are proportional to expected return estimates, effectively using an identity matrix as a covariance matrix. The resulting portfolios perform well both in simulations and in out-of-sample comparisons.

Optimal Consumption of a Divisible Durable Good
Domenico Cuoco and Hong Liu

We examine the intertemporal optimal consumption and investment problem in a continuous-time economy with a divisible durable good. Consumption services are assumed to be proportional to the stock of the good held and adjustment of the stock is costly, in that it involves the payment of a proportional transaction cost. For the case in which the investor has an isoelastic utility function and asset prices follow a geometric Brownian motion, we establish the existence of an optimal policy and provide an explicit representation for the value function. We show that the investor acts so as to maintain the ratio of the stock of the durable to total wealth in a fixed (nonstochastic) range and that the optimal investment policy involves stochastic portfolio weights. The dependence of the optimal policies on the parameters of the model is also discussed.

The Equity Premium and Structural Breaks
Lubos Pástor and Robert F. Stambaugh

Evidence of structural breaks in the historical return distribution raises concerns about averaging a long series to estimate the current equity premium. Data before a break are relevant if one believes that large shifts in the premium are unlikely or that the premium is associated, to some degree, with volatility. The equity excess-return series over two centuries exhibits multiple structural breaks, the latest of which occurs early in the current decade. The average excess return since that break is nearly 10%, but incorporating prior beliefs as described above produces substantially lower estimates of the equity premium.

Ex-Ante Real Rates and Inflation Risk Premiums: A Consumption-Based Approach
Ayelet Balsam, Shmuel Kandel and Ori Levy

This paper sets out to quantify, with the use of consumption-based CAPM, the risk premiums inherent in the Israeli market for index-linked and non-index-linked bonds. In contrast to what has appeared in the macroeconomics literature, this study quantifies the size and dynamics of two such premiums: one is related to the inflation uncertainty in a nominal risk-free bond, and the other is related to the inflation uncertainty in an index-linked bond, caused by the indexation lag. This enables an approximation of the size and time-variation of the real ex-ante risk-free rate of return, and an evaluation of the accuracy of the method used by the Bank of Israel to measure inflation expectations. It is shown that the inflation risk premium term and the indexation-lag risk premium term depend heavily and positively on the degree of relative risk aversion, and that the latter is inconsequential. As a result, we claim that the bias caused due to the overlooking both these risk premiums in the computation of inflation expectations depends on assumptions regarding the degree of relative risk aversion.