Working Paper Abstracts – 2002
Defined Contribution Pensions: Plan Rules, Participant Decisions, and the Path of Least Resistance
James J. Choi, David Laibson, Brigitte C. Madrian and Andrew Metrick
We assess the impact on savings behavior of several different 401(k) plan features, including automatic enrollment, automatic cash distributions, employer matching provisions, eligibility requirements, investment options, and financial education. We also present new survey evidence on individual savings adequacy. Many of our conclusions are based on an analysis of micro-level administrative data on the 401(k) savings behavior of employees in several large corporations that implemented changes in their 401(k) plan design. Our analysis identifies a key behavioral principle that should partially guide the design of 401(k) plans: employees often follow “the path of least resistance.” For better or for worse, plan administrators can manipulate the path of least resistance to powerfully influence the savings and investment choices of their employees.
For Better or For Worse: Default effects and 401(k) Savings Behavior
James J. Choi, David Laibson, Brigitte C. Madrian and Andrew Metrick
In the last several years, many employers have decided to automatically enroll their new employees in the company 401(k) plan. Using several years of administrative data from three large firms, we analyze the impact of automatic enrollment on 401(k) participation rates, savings behavior, and asset accumulation. We find that although employees can opt out of the 401(k) plan, few choose to do so. As a result, automatic enrollment has a dramatic impact on retirement savings behavior: 401(k) participation rates at all three firms exceed 85%, but participants tend to anchor at a low default savings rate and in a conservative investment vehicle. We find that initially, about 80% of participants accept both the default savings rate (2% or 3% for our three companies) and the default investment fund (a stable value or money market fund.) Even after three years, half of the plan participants subject to automatic enrollment continue to contribute at the default rate and invest their contributions exclusively in the default fund. The effects of automatic enrollment on asset accumulation are not straightforward. While higher participation rates promote wealth accumulation, the low default savings rate and the conservative default investment fund undercut accumulation. In our sample, these two effects are roughly offsetting on average. However, automatic enrollment does increase saving in the lower tail of the savings distribution by dramatically reducing the fraction of employees who do not participate in the 401(k) plan.
This paper provides one of the first comprehensive analyses of the household data underlying the Michigan Index of Consumer Sentiment. This data is used to test the rationality of consumer expectations and to assess their usefulness in forecasting expenditure. The results can also be interpreted as characterizing the shocks that have hit different types of households over time. Expectations are found to be biased, at least ex post, in that forecast errors did not average out even over a sample period lasting almost 20 years. People underestimated the disinflation of the early 1980’s and in the 1990’s, and generally appear to underestimate the severity of business cycles. Forecasts are also inefficient, in the people’s forecast errors are correlated with their demographic characteristics and/or aggregate shocks did not hit all people uniformly.
Further, sentiment is found to be useful in forecasting future consumption, even controlling for lagged consumption and macro variables like stock prices. This excess sensitivity is counter to the permanent income hypothesis [PIH]. Higher confidence is correlated with less saving, consistent with precautionary motives and increases in expected future resources. Some of the rejection of the PIH is found to be due to the systematic demographic components in forecast errors. But even after controlling for these components, some excess sensitivity persists. More broadly, these results suggest that empirical implementations of forward-looking models need to better account for systematic heterogeneity in forecast errors.
Packaging Liquidity: Blind Auctions and Liquidity Provision
Kenneth A. Kavajecz and Donald B. Keim
We investigate a liquidity provision mechanism whereby liquidity demanders auction a set of trades as a package directly to potential liquidity providers. A critical feature of the auction is that the identities of the securities in the package are not revealed to the bidder. We demonstrate that this mechanism provides a transactions cost savings relative to more traditional trading mechanisms for the liquidity demander as well as an efficient way for liquidity suppliers to obtain order flow. We argue that the cost savings afforded this new mechanism is due to the potential for low-cost crosses with the bidder’s existing inventory positions and through the longer trading horizon, and superior trading ability, of the bidders. This research suggests that the ability to innovate via new liquidity provision mechanisms can provide market participants with transaction cost savings that cannot be easily duplicated on more traditional exchanges.
A Simple Model of Intertemporal Capital Asset Pricing and Its Implications for the FAMA-French Three-Factor Model
Michael J. Brennan, Ashley W. Wang and Yihong Xia
Characterizing the instantaneous investment opportunity set by the real interest rate and the maximum Sharpe ratio, a simple model of time varying investment opportunities is posited in which these two variables follow correlated Ornstein-Uhlenbeck processes, and the implications for stock and bond valuation are developed. The model suggests that the prices of certain portfolios that are related tot he Fama-French HML and SMB hedge portfolios will carry information about investment opportunities, which provides a potential justification for the risk premia that have been found to be associated with these hedge portfolios. Evidence that the FF portfolios are in fact associated with variation in the investment opportunity set is found from an analysis of stock returns. Further evidence of time variation in the investment opportunity set is found by analyzing bond yields, and the time variation in investment opportunities that is identified from bond yields is shown to be associated both with the time-variation in investment opportunities that is identified from stock returns and with the returns on the Fama-French hedge portfolios. Finally, both pricing kernel and tracking portfolio approaches are used to provide estimates of the magnitude of the HML and SMB risk primia implied by our simple model.
The Structure of the US Equity Markets
Marshall E. Blume
In 1975, Congress directed the SEC to develop a national market system in which all orders to buy or sell equities would interact. A national market system abhors fragmentation and assumes that one market will best serve the needs of all investors. Such an assumption does not capture the realities of modern markets. Investors have different needs and different markets will develop to serve these needs. Markets are non anonymous, and in such markets, the very concept of “best price” is not defined. Fragmented markets are a natural result of competition. Within the US, the sharing of trade and quote information among markets helps to mitigate any deleterious effects of fragmentation. The markets of tomorrow will be global. In a global market, the SEC will have to give up its goal of a national market system and focus on other issues. For example, it will be a challenge to provide just the sharing of trade information across borders. Further, technology will allow a market center or order-gathering function to be located anywhere in the world. This threat of relocation will place constraints on US regulators, and global trading will make it more difficult for US authorities to regulate investment practices and to protect US investors.
Credibility of Management Forecasts
Jonathan L. Rogers and Phillip C. Stocken
This paper examines the credibility of management earnings forecasts. With regard to how forecast bias varies with manager incentives, we establish that when it is more difficult for market participants to detect forecast bias, financially distressed firms are more optimistic than healthy firms and firms in concentrated industries are more pessimistic than those in less concentrated industries. With regard to the stock price response to forecasts, we find that the market’s immediate response varies with the predicted bias in good news but not in bad news forecasts. The market’s subsequent response, however, is consistent with it eventually identifying the bias in bad news forecasts and modifying its valuation of the firm in the appropriate direction.
On Replicating the S&P 500 Index
Marshall E. Blume and Roger M. Edelen
To minimize tracking error, S&P 500 index funds often follow inflexible, nearly exact replication strategies. This inflexibility causes stocks with relatively low floating supply to experience abnormally high negative or positive returns upon addition or deletion on average. Moreover, the alternative of trading at the open following the announcement of a change, rather than when the change occurs, results in 25.9 basis points more return per year with virtually no incremental variance. If investment principals knew in advance of these additional returns, they may nonetheless have rationally chosen to forgo such added returns to better monitor their agents. The early-trading strategy has much higher tracking errors than the 2.7 basis-point average of the largest indexer.
Micro Effects of Macro Announcements: Real-Time Price Discovery in Foreign Exchange
Torben G. Anderson, Tim Bollerslev, Francis X. Diebold and Clara Vega
Using a new dataset consisting of six years of real-time exchange rate quotations, macroeconomic expectations, and macroeconomic realizations (announcements), we characterize the conditional means of U.S. dollar spot exchange rates versus German Mark, British Pound, Japanese Yen, Swiss Franc, and the Euro. In particular, we find that announcement surprises (that is, divergences between expectations and realizations, or “news”) produce conditional mean jumps; hence high-frequency exchange rate dynamics are linked to fundamentals. The details of the linkage are intriguing and include announcement timing and sign effects. The sign effect refers to the fact that the market reacts to news in an asymmetric fashion: bad news has greater impact than good news, which we relate to recent theoretical work on information processing and price discovery.
Modeling and Forecasting Realized Volatility
Torben G. Anderson, Tim Bollerslev, Francis X. Diebold and Paul Labys
We provide a general framework for integration of high-frequency intraday data into the measurement, modeling, and forecasting of daily and lower frequency return volatilities and return distributions. Most procedures for modeling and forecasting financial asset return volatilities, correlations, and distributions rely on potentially restrictive and complicated parametric multivariate ARCH or stochastic volatility models. Use of realized volatility constructed from high-frequency intraday returns, in contrast, permits the use of traditional time-series methods for modeling and forecasting. Building on the theory of continuous-time arbitrage-free price processes and the theory of quadratic variation, we develop formal links between realized volatility and the conditional covariance matrix. Next, using continuously recorded observations for the Deutschemark / Dollar and Yen / Dollar spot exchange rates covering more than a decade, we find that forecasts from a simple long-memory Gaussian vector autoregression for the logarithmic daily realized volatilities perform admirably compared to a variety of popular daily ARCH and more complicated high-frequency models. Moreover, the vector autoregressive volatility forecast, coupled with a parametric lognormal-normal mixture distribution implied by the theoretically and empirically grounded assumption of normally distributed standardized returns, produces well-calibrated density forecasts of future returns, and correspondingly accurate quantile predictions. Our results hold promise for practical modeling and forecasting of the large covariance matrices relevant in asset pricing, asset allocation and financial risk management applications.
Kenneth A Kavajecz and Elizabeth R. Odders-White The apparent conflict between the level of resources dedicated to technical analysis by practitioners and academic theories of market efficiency is a long-standing puzzle. We offer an alternative explanation for the value of technical analysis that is consistent with market efficiency specifically, that it reveals information about liquidity provision. We find evidence consistent with the hypotheses that support and resistance levels coincide with peaks in depth on the limit order book and that moving average forecasts reveal information about the relative position of depth on the book. These results demonstrate that technical analysis can have value even in an efficient market, and provide a practical method for estimating the level of liquidity on the book.
On the Relationship Between the Confisional Mean and the Volativity of Stock Returns: A Latent VAR APproach
Michael W. Brandt and Qiang Kang
We model the conditional mean and volatility of stock returns as a latentvector autoregressive (VAR) process to study the contemporaneous andintertemporal relationship between expected returns and risk in a flexiblestatistical framework and without relying on exogenous predictors. Wefind a strong and robust negative correlation between the innovationsto the conditional moments that leads to pronounced counter-cyclicalvariation in the Sharpe ratio. We document significant lead-lag correlationsbetween the conditional moments that also appear related to businesscycles. Finally, we show that although the conditional correlation betweenthe mean and volatility is negative, the unconditional correlation is positivedue to the lead-lag correlations.
Is the stock market boom a result of the baby boom? This paper develops an overlapping generations model in which a baby boom is modeled as a high realization of a random birth rate, and the price of capital is determined endogenously by a convex cost of adjustment. A baby boom increases national saving and investment and thus causes an increase in the price of capital. The price of capital is meanreverting so the initial increase in the price of capital is followed by a decrease. Social Security can potentially a.ect national saving and nvestment, though in the long run, it does not a.ect the price of capital.
Price Discovery in the U.S. Treasury Market: The Impact of Orderflow and Liquidity on the Yield Curve
Michael W. Brandt and Kenneth A. Kavajecz
We examine the role of price discovery in the U.S. Treasury market through the empirical relationship between orderflow, liquidity, and the yield curve. We find that orderflow imbalances (excess buying or selling pressure) can account for as much as 26 percent of the day-to-day variation in yields on days without major macroeconomic announcements. The effect of orderflow on yields is permanent and strongest when liquidity is low. All of the evidence points toward an important role of price discovery in understanding the behavior of the yield curve.
The Positive Role of Overconfidence and Optimism in Investment Policy
Simon Gervais, J. B. Heaton and Terrance Odean
We use a simple capital budgeting problem to contrast the decisions of overconfident, optimistic managers with those of rational managers. We reach the surprising conclusion that managerial overconfidence and optimism can increase the value of the firm. Risk averse rational managers will postpone the decision to exercise real options longer than is in the best interest of shareholders. Overconfident managers underestimate the risk of potential projects and are therefore less likely to postpone the decision to undertake. Optimistic manager, too, undertake projects too quickly. Thus, moderately overconfident or optimistic managers make decisions that are in the better interest of shareholders than do rational managers. Overly confident or optimistic managers may be too eager to undertake projects. This tendency can sometimes be controlled by increasing hurdle rates for risky projects. While compensation contracts that increase the convexity of manager payoffs can be used to realign the decisions of a rational manager with those of shareholders, it is less expensive to simply hire a moderately overconfident manager. The gains from overconfidence and optimism will at times be sufficient that shareholders actually prefer an overconfident, optimistic manager with less ability to a rational manager with greater ability.
Asset Pricing Implications of Firms’ Financing Constraints
Joao Gomes, Amir Yaron and Lu Zhang.
We incorporate costly external finance in an investment-based asset pricing model and investigate whether financing frictions are quantitatively important for pricing a cross-section of expected returns. We show that common assumptions about the nature of the financing frictions are captured by a simple “financing cost” function, equal to the product of the financing premium and the amount of external finance. This approach provides a tractable framework for empirical analysis. Using GMM, we estimate a pricing kernel that incorporates the effects of financing constraints on investment behavior. The key ingredients in this pricing kernel depend not only on “fundamentals,” such as profits and investment, but also on the financing variables, such as default premium and the amount of external financing. Our findings, however, suggest that the role played by financing frictions is fairly negligible, unless the premium on external funds is procyclical, a property not evident in the data and not satisfied by most models of costly external finance.
Asset Pricing and Business Cycles with Costly External Finance
Joao Gomes, Amir Yaron and Lu Zhang.
This paper asks whether the asset pricing fluctuations induced by the presence of costly external finance are empirically plausible. To accomplish this, we incorporate costly external finance into a dynamic stochastic general equilibrium model and explore its implications for the properties of the returns on key financial assets, such as stocks, bonds and risky loans. We find that the mean and volatility of the equity premium, although small, are significantly higher than those in comparable adjustment cost models. However, we also show that these results require a procyclical financing premium, a property that seems at odds with the data.
Corporate Bankruptcy Reorganizations: Estimates from a Bargaining Model
In this paper I estimate a bargaining model of Chapter 11 bankruptcies. I use the estimated structural model to conduct policy experiments aimed at evaluating the impact of institutional rules on the creditor recoveries, distribution to shareholders and deviations from absolute priority rule.
Weather Forecasting for Weather Derivatives
Sean D. Campbell and Francis X. Diebold
We take a nonstructural time-series approach to modeling and forecasting daily average temperature in ten U.S. cities, and we inquire systematically as to whether it may prove useful from the vantage point of participants in the weather derivatives market. The answer is, perhaps surprisingly, yes. Time series modeling reveals both strong conditional mean dynamics and conditional variance dynamics
in daily average temperature, and it reveals sharp differences between the distribution of temperature and the distribution of temperature surprises. Most importantly, it adapts readily to produce the long-horizon forecasts of relevance in weather derivatives contexts. We produce and evaluate both point and
distributional forecasts of average temperature, with some success. We conclude that additional inquiry into nonstructural weather forecasting methods, as relevant for weather derivatives, will likely prove useful.