Working Paper Abstracts – 2001
Jim Poterba finds that consumers do not spend all of their assets during retirement, and he projects that the demand for assets will remain high when the baby boomers retire. Based on his forecast of continued high demand for capital, Poterba rejects the asset market meltdown hypothesis, which predicts a fall in stock prices when the baby boomers retire. I develop a rational expectations general equilibrium model with a bequest motive and an aggregate supply curve for capital. In this model, a baby boom generates an increase in stock prices, and stock prices are rationally anticipated to fall when the baby boomers retire, even though, as emphasized by Poterba, consumers do not spend all of their assets during retirement. This finding contradicts Poterba’s con-conclusion that continued high demand for assets by retired baby boomers will prevent a fall in the price of capital.
An Exploration of the Effects of Pessimism and Doubt on Asset Returns
Andrew B. Abel
The subjective distribution of growth rates of aggregate consumption is characterized by pessimism if it is first-order stochastically dominated by the objective distribution. Uniform pessimism is a leftward translation of the objective distribution of the logarithm of the growth rate. The subjective distribution is characterized by doubt if it is mean-preserving spread of the objective distribution. Pessimism and doubt both reduce the risk free rate and thus can help resolve the risk free rate puzzle. Uniform pessimism and doubt both increase the average equity premium and thus can help resolve the equity premium puzzle.
Variable Selection for Portfolio Choice
Yacine Ait-Sahalia and Michael W. Brandt
We study asset allocation when the conditional moments of returns are partly predictable. Rather than first model the return distribution and subsequently characterize the portfolio choice, we determine directly the dependence of the optimal portfolio weights on the predictive variables. We combine the predictors into a single index that best captures time-variations in investment opportunities. This index helps investors determine which economic variables they should track and, more importantly, in what combination. We consider investors with both expected utility (mean-variance and CRRA) and non-expected utility (ambiguity aversion and prospect theory) objectives and characterize their market-timing, horizon effects, and hedging demands.
Trading and Voting Choice
David K. Musto and Bilge Yilmaz
The political choice between candidates with different redistribution policies plays out very differently in a complete financial market. When voters have the opportunity to trade election-contingent securities, we find that 1) wealth considerations have no effect on voting, so the interaction between candidates’ redistribution policies and the distribution of wealth has no effect on who wins, 2) an election in which a candidate promises wealth redistribution results in redistribution of wealth, and the redistribution is the same regardless of who wins, and 3) if one candidate prefers some amount of redistribution and the other does not, the candidate who prefers redistribution will propose more redistribution than the amount he prefers.
The Role of Trading Halts in Monitoring a Specialist Market
Roger Edelen and Simon Gervais
We model an exchange as a collection of specialists, each a monopolist market maker in a subset of the stocks listed on the exchange. Specialists can obtain net private benefits at the expense of the exchange (the collection of all specialists) by quoting a privately optimal pricing schedule. Conversely, a coordinated pricing schedule makes all specialists and customers better off. However, coordination requires a system of monitoring and punishment, which can break down when information asymmetries between the exchange and a specialist are high. This breakdown can cause the specialist to seek a temporary halt to trading to alleviate unjustified punishment, or the exchange to halt trading to prevent the quoting of damaging privately optimal pricing schedules. We use a sample of NYSE halts and a proxy for the exchange-specialist information asymmetry to test this theory. As predicted, we find a significant increase in estimated information asymmetry immediately preceding trading halts.
Predictable Changes in NAV: The Wildcard Option in Transacting Mutual-fund Shares
John M.R. Chalmers, Roger Edelen and Gregory B. Kadlec
Economic distortions can arise when financial claims trade at prices set by an intermediary rather than by direct negotiation between principals. We demonstrate the problem in a specific context, the exchange of open-end mutual fund shares. Mutual funds typically set the price at which fund shares are exchanged (NAV) using an algorithm that fails to account for nonsynchronous trading in the fund’s underlying securities. This results in predictable changes in fund share prices, which lead to exploitable trading opportunities of 0.8% per trade at international and small-cap domestic equity funds. A simple modification to the pricing algorithm suggested by nonsynchronous trading theory eliminates much of this predictability. However, one can never rule out the possibility of distortions that arise from other unknown sources when intermediaries set prices.
High-and Low-Frequency Exchange Rate Volatility Dynamics: Range-Based Estimation of Stochastic Volatility Models
Sassan Alizadeh, Michael W. Brandt, and Francis X. Diebold
We propose using the price range in the estimation of stochastic volatility models. We show theoretically, numerically, and empirically that the range is not only a highly efficient volatility proxy, but also that it is approximately Gaussian and robust to microstructure noise. The good properties of the range imply that range-based Gaussian quasi-maximum likelihood estimation produces simple and highly efficient estimates of stochastic volatility models and extractions of latent volatility series. We use our method to examine the dynamics of daily exchange rate volatility and discover that traditional one-factor models are inadequate for describing simultaneously the high- and low-frequency dynamics of volatility. Instead, the evidence points strongly toward two-factor models with one highly persistent factor and one quickly mean-reverting factor.
Liquidity Supply and Demand: Empirical Evidence from the Vancouver Stock Exchange
Burton Hollifield, Patrik Sandas and Robert A. Miller
We analyze the costs and benefits of providing and using liquidity in a limit order market. Using a large and comprehensive data set which details the complete histories of orders and trades on the Vancouver Stock Exchange, we are able to model the order flow and measure market liquidity as it changes over time. We accomplish this by constructing a measure of the expected net payoffs to demanding or supplying liquidity, and using our data on order arrivals and placement decisions to make inferences about the traders’ demand for liquidity and the cost of entering orders in the market. Our results show that liquidity demand is indeed time varying, and is related to several key observable measures of market characteristics. Furthermore, we find evidence of unexploited profit opportunities in the market, perhaps implying that traders do not continuously monitor the market for profitable trades.
Sharing of Control as a Corporate Governance Mechanism
Armando Gomes and Walter Novaes
This paper identifies a new corporate governance mechanism: sharing control. We show that bargaining problems among multiple controlling shareholders may prevent inefficient investment decisions that harm minority shareholders. The same bargaining problems may block efficient investment decisions, though. By solving this trade-off, we show that the likelihood that shared control is efficient increases with three firm characteristics: over-investment problems, the cost of verifying cash flows, and financing requirements. The model provides testable implications for the role that large shareholders play in corporate governance, contrasting shared control and monitoring as alternative governance mechanisms.
Takeovers, Freezouts, and Risk Arbitrage
This paper develops a dynamic model of tender offers in which there is trading on the target’s shares during the takeover, and bidders can freeze out target shareholders (compulsorily acquire remaining shares not tendered at the bid price), features that prevail on almost all takeovers. We show that trading allows for the entry of arbitrageurs with large blocks of shares who can hold out a freeze-a threat that forces the bidder to offer a high preemptive bid. There is also a positive relationship between the takeover premium and arbitrageurs’ accumulation of shares before the takeover announcement, and the less liquid the target stock, the strong this relationship is. Moreover, freezeouts eliminate the free-rider problem, but front-end loaded bids, such as two-tiered and partial offers, do not benefit bidders because arbitrageurs can undo any potential benefit and eliminate the coerciveness of these offers. Similarly, the takeover premium is also largely unrelated to the bidder’s ability to dilute the target’s shareholders after the acquisition, also due to potential arbitrage activity.
Equilibrium Cross-Section of Returns
Joao Gomes, Leonid Kogan and Lu Zhang
We explicitly link expected stock returns to firm characteristics such as firm size and book-to-market ratio in a dynamic general equilibrium production economy. Despite the fact that stock returns in the model are characterized by an intertemporal CAPM with the market portfolio as the only factor, size and book-to-market play separate roles in describing the cross-section of returns. These firm characteristics appear to predict stock returns because they are correlated with the true conditional market ß of returns. These cross-sectional relations can subsist after one controls for a typical empirical estimate of market ß. This lends support to the view that the documented ability of size and book-to-market to explain the cross-section of stock returns is not necessarily inconsistent with a single-factor conditional CAPM model. Our model also gives rise to a number of additional implications for the cross-section of returns. In this paper, we focus on the business cycle properties of returns and firm characteristics. Our results appear consistent with the limited existing evidence and provide a benchmark for future empirical studies.
Multilateral Negotiations and Formation of Coalitions
This paper studies multilateral negotiations among n players in an environment where there are externalities and where contracts forming coalitions can be written and renegotiated. The negotiation process is modeled as a sequential game of offers and counteroffers, and we focus on the stationary subgame perfect equilibria, which jointly determine both the expected value of players and the Markov state transition probability that encodes the path of coalition formation. The existence of equilibria is established, and Pareto efficiency is guaranteed if the grand coalition is efficient, despite the existence of externalities. Also, for almost all games (except in a set of measure zero) the equilibrium is locally unique and stable, and the number of equilibria is finite and odd. Global uniqueness does not hold in general (a public good provision example has seven equilibria), but a sufficient condition for global uniqueness is derived. Using this sufficient condition, we show that there is a globally unique equilibrium in three-player superadditive games. Comparative statics analysis can be easily carried out using standard calculus tools, and some new insights emerge from the investigation of the classic apex and quota games.
Externalities and Renegotiations in Three-Player Coalitional Bargaining
We study strategic three-player coalitional bargaining problems in an environment with externalities where contracts forming coalitions can be written and renegotiated. The theory yields a unique stationary subgame perfect Nash equilibrium outcome (the coalitional bargaining value). This solution has an intuitive economic interpretation using credible outside options, and it can either be the Nash bargaining solution, for games where the worth of all pairwise coalition is less than a third of the grand coalition value; the Shapley value, for games where the sum of the values created by all pairwise coalitions is greater than the grand coalition value; or the nucleolus, for games where only the ‘natural coalition’ among two ‘natural partners’ creates significant value, and those where only the two pairwise coalitions including a ‘pivotal player’ create significant value.
How Does the Internet Affect Trading? Evidence from Investor Behavior in 401(K) Plans
James J. Choi, David Laibson and Andrew Metrick
We analyze the impact of a Web-based trading channel on trader behavior and performance in two large corporate 401(k) plans. After 18 months of Web access, trading frequency at the sample firms doubles relative to a control group of firms without a Web channel. Web trades tend to be smaller than trades made through other channels and Web traders tend to have smaller portfolios than other traders, so the Web’s impact on portfolio turnover is substantially smaller than its effect on trading frequency. There is no evidence that any of this new trading on the Web is successful; if anything, Web traders underperform in their market-timing trades. We find no evidence of a Web impact on “speculative behavior” such as positive feedback trading, herding, or short-term trading. While Web traders do differ from other traders in some of these speculative activities, these differences appear to be driven by selection effects rather than caused by the Web.
Simulated Likelihood Estimation of Diffusions with an Application to Exchange Rate Dynamics in Incomplete Markets
Michael W. Brandt and Pedro Santa-Clara
We present an econometric method for estimating the parameters of a diffusion model from discretely sampled data. The estimator is transparent, adaptive, and inherits the asymptotic properties of the generally unattainable maximum likelihood estimator. We use this method to estimate a new continuous-time model of the joint dynamics of interest rates in two countries and the exchange rate between the two currencies. The model allows financial markets to be incomplete and specifies the degree of incompleteness as a stochastic process. Our empirical results offer several new insights into the dynamics of exchange rates.
Stocks are Special Too: An Analysis of the Equity Lending Market
Christopher C. Geczy, David K. Musto and Adam V. Reed
Short-sellers are generally obliged to borrow shares, and provide collateral as security. Lenders rebate interest they earn on the collateral, but the rebate shrinks as stocks grow scarce, i.e. go “on special.” With daily rebate data from one of the highest-volume equity lenders, we characterize the equity lending market in general, and in three situations where the availability and cost of loans are potentially important: initial public offerings, merger speculation, and long-short “factor” portfolio construction. We find that IPOs are generally borrowable in the wholesale market, but are invariably on special at first. Specialness generally decreases with the float and increases with performance, but IPOs trading below their offering prices are also relatively more expensive to borrow. The market for borrowing a stock is significantly affected by the expiration of the 30-day restriction on lending by syndicate members, and also by the expiration of insider lockups. Merger arbitrage strategies lead to increased specialness in acquirers’ stocks, especially when acquiring firms are small or target firms are large. Similarly, specialness is increasing the profitability of the arbitrage strategy, but the additional costs associated with borrowing special stock do not substantially decrease profits to merger arbitrage strategies. However, the inability to borrow acquirer’s stock reduces profits by an economically, although not statistically, significant amount. Growth stocks are more than five times as expensive to borrow as value stocks and about three times as expensive as the average stock. However, the absolute cost of shorting growth stocks, large stocks or stocks with low momentum is not large economically and does not directly support the limits to arbitrage story explaining the persistence of premia associated with stocks along the value-growth, size and momentum dimensions. We find that while imposing these realistic constraints ex ante on popular equity factor models lowers the factor premia and increases their volatilities, their optimal Sharpe ratios do not fall much. Statistical rejection of the Fama-French (1993) and Carhart (1997) models is stronger when the constraints are imposed; however, it is only marginally stronger. Finally, while constraints appear not to alter estimates of mutual fund performance on average, they do significantly change portfolio style characterizations, especially along the dimension of value versus growth.
Dynamic Processes of Social and Economic Interactions: On the Persistence of Inefficiencies
Armando Gomes and Phillppe Jehiel
This paper considers the efficiency and convergence properties of dynamic processes of social and economic interactions such as exchange economies, multilateral negotiations, merger and divestiture transactions, or legislative bargaining. The key general feature of the economy is that agents can implement any move from one state to another as long as a pre-specified subset of agents approve of it. By means of examples, we show that inefficiencies may occur even in the long run. Persistent inefficiencies take the form of cycles between states or of convergence to an inefficient state. When agents are sufficiently patient, we show very generally that the initial state from which the process starts plays no role in the long run properties of equilibria. Also, when there exists an efficient state that is externality free (in the sense that a move away from that state does not hurt the agents whose consent is not required for the move), then the system must converge to this efficient state in the long run. Conversely, long run efficiency can only be attained in a robust way if there exists an efficient externality-free state. It is thus more important to design transitions guaranteeing the existence of an efficient externality-free state rather than to implement a fine initialization of the process.
Corporate Governance and Equity Prices
Paul A. Gompers, Joy L. Ishii and Andrew Metrick
Corporate-governance provisions related to takeover defenses and shareholder rights vary substantially across firms. In this paper, we use the incidence of 24 different provisions to build a “Governance Index” for about 1,500 firms per year, and then we study the relationship between this index and several forward-looking performance measures during the 1990s. We find a striking relationship between corporate governance and stock returns. An investment strategy that bought the firms in the lowest decile of the index (strongest shareholder rights) and sold the firms in the highest decile of the index (weakest shareholder right) would have earned abnormal returns of 8.5 percent per year during the sample period. Furthermore, the Governance Index is highly correlated with firm value. In 1990, a one-point increase in the index is associated with a 2.4 percentage-point lower value for Tobin’s Q. By 1999, this difference had increased significantly, with a one-point increase in the index associated with an 8.8 percentage-point lower value for Tobin’s Q. Finally, we find that weaker shareholder rights are associated with lower profits, lower sales growth, higher capital expenditures, and a higher amount of corporate acquisitions. We conclude with a discussion of several causal interpretations.
Mutual fund performance and seemingly unrelated assets
Lubos Pastor and Robert F. Stambaugh
Estimates of standard performance measures can be improved by using returns on assets not used to define those measures. Alpha, the intercept in a regression of a fund’s return on passive benchmark returns, can be estimated more precisely by using information in returns on non-benchmark passive assets, whether or not one believes those assets are priced by the benchmarks. A fund’s Sharpe ratio can be estimated more precisely by using returns on other assets as well as the fund. New estimates of these performance measures for a large universe of equity mutual funds exhibit substantial differences from the usual estimates.
Investing in Equity Mutual Funds
Lubos Pastor and Robert F. Stambaugh
We construct optimal portfolios of equity funds by combining historical returns on funds and passive indexes with prior views about asset pricing and skill. By including both benchmark and nonbenchmark indexes, we distinguish pricing-model inaccuracy from managerial skill. Even modest confidence in a pricing model helps construct portfolios with high Sharpe ratios. Investing in active mutual funds can be optimal even for investors who believe active managers cannot outperform passive indexes. Optimal portfolios exclude hot-hand funds even for investors who believe momentum is priced. Our large universe of funds offers no close substitutes for the Fama-French and momentum benchmarks.
Liquidity Risk and Expected Stock Returns
Lubos Pastor and Robert F. Stambaugh
This study investigates whether market-wide liquidity is a state variable important for asset pricing. We find that expected stock returns are related cross-sectionally to the sensitivities of returns to fluctuations in aggregate liquidity. Our monthly liquidity measure, an average of individual-stock measures estimated with daily data, relies on the principle that order flow induces greater return reversals when liquidity is lower. Over a 34-year period, the average return on stocks with high sensitivities to liquidity exceeds that for stocks with low sensitivities by 7.5% annually, adjusted for exposures to the market return as well as size, value, and momentum factors.
On the Invariance of the Rate of Return to Convex Adjustment Costs
Andrew B. Abel
The Modified Golden Rule, which relates the rate of return on capital and the growth rate of the capital stock along long-run growth paths that maximize the utility of a representative infinitely-lived consumer, is invariant to the introduction of convex capital adjustment costs. Therefore, along balanced growth paths in neoclassial optimal growth models with an exogenous long-run growth rate of capital, the rate of return is invariant to the introduction of convex adjustment costs, though the capital-labor ratio is reduced along such paths. In AK models, convex adjustment cost reduce the growth rate and rate of return on capital.