# Working Paper Abstracts – 2003

**01-03**

Owner-Occupied Housing as a Hedge Against Rent Risk

*Todd Sinai and Nicholas S. Souleles*

Many people assume that the most significant risk in the housing market is that homeowners are exposed to fluctuations in house values. However, homeownership also provides a hedge against fluctuations in future rent payments. This paper finds that, even though house price risk endogenously increases with rent risk, the latter empirically dominates for most households -so housing market risk actually increases homeownership rates and house prices. Further, the net effect of rent risk on the demand for homeownership increases with a household’s expected length of stay in its home, as the cumulative rent volatility rises and the discounted house price risk falls. Using CPS data, the difference in the probability of homeownership between households with long and short expected lengths of stay is 2.9 to 5.4 percentage points greater in high rent variance places than low rent variance places. The sensitivity to rent risk is greatest for households that devote a larger share of their budgets to housing, and thus face a bigger gamble. Similarly, the elderly who live in high rent variance places are more likely to own their own homes, and their probability of homeownership fall faster with age (as their horizon shortens). This aversion to rent risk might help explain why older households do not comsume much of the housing wealth. Finally, we find that house prices capitalize not only expected future rents, but also the associated rent risk premia. At the MSA level, a one standard deviation increase in rent variance increases the house price-to-rent ration by 2 to 4 percent.

**02-03**

Do Bank-Firm Relationships Affect Bank Competition in the Corporate Bond Underwriting Market?

*Ayako Yasuda*

This paper empirically examines how bank-firm relationships affect post-deregulation competition among underwriters in the U. S. corporate bond underwriting market. I find that there is a trade-off between relationships and price in the demand equation and that this trade-off is sharply higher for junk bond issuers and first-time issuers. This finding is consistent with the certification effect of commercial bank underwriting. Commercial bank entry has increased bank competition to the extent that their client-specific relationships have increased product differentiation in the market. Since issuers with low reputation value the relationships more, the deregulation has increased competition the most in these segments.

**03-03
**External Financing and Future Stock Returns

*Scott A. Richardson and Richard Sloan*

We develop a comprehensive and parsimonious measure of the extent to which a firm is raising (distributing) capital from (to) capital market participants. We show that the relation between our measure of net external financing and future tock returns is stronger than has been documented in previous research focusing on individual categories of financing transactions. Decompositions of our measure reveal additional insights. First, the weaker results of previous research are attributable to ‘refinancing’ transactions having no change on net external financing. Second, after controlling for refinancing transactions, there is a consistently strong and negative relation between all major categories of external financing transactions and future stock returns. Third, the negative relation between external financing and future stock returns is most consistent with a combination of over-investment and aggressive accounting.

**04-03**

S&P Indexers, Delegation Costs and Liquidity Mechanisms

*Marshall E. Blume and Roger M. Edelen*

The largest S&P 500 indexers replicate the index with tracking errors of just several basis points per year. Maintaining such small errors requires a nearly exact-replication strategy and precludes profiting from trading much before or after index changes. A strategy of trading at the open following the announcement of a change, rather than at the change, adds 19.2 basis points more return per year with virtually no added risk, but with substantial tracking errors. This additional return is a measure of the delegation costs in monitoring an indexer through tracking errors. The paper then shows that less than half of indexers always follow an exact-replications strategy,consistent with the hypothesis that they are trying to recoup some of these delegation costs. Further, market mechanisms have evolved that allow some exact-replication indexers to recapture a portion of these costs.

**05-03**

Asymmetric Information and Financing with Convertibles

*Archishman Chakaborty and Bilge Yilmaz*

We analyze the problem of dilution leading to inefficient underinvestment caused by the adverse selection problem. We assume that the market obtains information about the firm over time, but that at each date the manger possesses better information about firm prospects than does the market. We show that issuing callable convertible securities with fixed conversion prices and restrictive call provisions is optimal. Such securities make the payoff to new claimholders independent of the private information of the manager. The restrictive call provision serves as a commitment device, enabling the manager to call only when the stock prices rises in the future. This benefits the new as well as the existing claim-holders so that the adverse selection problem is costlessly solved without any dissipation or underinvestment. Furthermore, we show that this efficient outcome can also be implemented by issuing optimally designed floating price convertibles.

**06-03**

Time-Consistent No-Arbitrage Models of the Term Structure

*Michael W. Brandt and Amir Yaron*

We present an econometric procedure for calibrating no-arbitrage term structure models in a way that is time-consistent and robust to measurement errors. Typical no-arbitrage models are time-inconsistent because their parameters are assumed constant for pricing purposes despite the fact that the parameters change whenever the model is recalibrated. No-arbitrage models are also sensitive to measurement errors because the fit exactly each potentially contaminated bond price in the cross-section. We overcome both problems by evaluating bond prices using the joint dynamics of the factors and calibrated parameters and by locally averaging out the measurement errors. Our empirical application illustrates the trade-off between fitting as well as possible and overfitting the cross-section of bond prices due to measurement errors. After optimizing this trade-ff, our approach fits almost exactly the cross-section of bond prices at each date and produces out-of-sample forecast errors that beat a random walk benchmark and are comparable to the results in the affine term structure literature. We find that non-linearities in the pricing kernel are important, lending support to quadratic term structure models.

**07-03**

A No-Arbitrage Approach to Range-Based Estimation of Return Covariances and Correlations

*Michael W. Brandt and Francis X. Diebold*

We extend range-based volatility estimation to the multivariance case. In particular, we propose a range-based covariance estimator motivated by a key financial economic consideration, the absence of arbitrage, in addition to statistical considerations. We show that this estimator is highly efficient yet robust to market microstructure noise arising from bid-ask bounce and asychronous trading.

**08-03**

The Limits to Dividend Arbitrage: Implications for Cross-Border Investment

*Susan E. K. Christoffersen, Christopher C. Geczy, David K. Musto and Adam V. Reed*

The economic significance of the tax on cross-border dividends depends on the limits to dividend arbitrage. In the case of Canadian payments to the U.S. we observe these limits exactly because we see the actual pricing of the dividend-arbitrage transactions. These transactions recover only some withholding, so that Canadian and non-tax U.S. accounts perceive different expected returns from Canadian stocks, where the difference increases with dividend yield. The resulting difference in expected utility of wealth is small but the difference in efficient portfolio weights is potentially large and increasing in yield, and the actual difference between Canadian and U.S. holdings of Canadian stocks is large and increasing in yield. Governments may thus take advantage of robust financial markets to boost domestic governance of domestic firms at a low utility cost, though this may be more preferable for zero-dividend firms, whose governance moves abroad.

**09-03**

Risk and Valuation Under an Intertemporal Capital Asset Pricing Model

*Michael J. Brennan and Yihong Xia*

We analyze the risk characteristics and the valuation of assets in an economy in which the investment opportunity set is described by the real interest rate and the maximum Sharpe ratio. It is shown that, holding constant the beta of the underlying cash flow, the beta of a security is a function of the maturity of the cash flow. For parameter values estimated from U. S. data, the security beta is always increasing with the maturity of the underlying cash flow, while the discount rates for risky cash flows can be increasing, decreasing or non-monotone functions of the maturity of the cash flow. The variation in discount rates and present value factors that is due to variation in the real interest rate and the Sharpe ratio is shown to be large for long maturity cash flows, and the component of the volatility that is due to variation in the Sharpe ratio is more important than that due to variation in the real interest rate.

**10-03**

The Effect of Macroeconomic News on Beliefs and Preferences: Evidence from the Options Market

*Alessandro Beber and Michael W. Brandt*

We examine the effect of regularly schedules macroeconomic announcements on the beliefs and preferences of participants in the U. S. Treasury market by comparing the option-implied state-price density (SPD) of bond prices shortly before and after the announcements. We find that the announcements reduce the uncertainty implicit in the second moment of the SPD regardless of the content of the news. The changes in the higher-order moments, in contrast, depend on whether the news is good or bad for economic prospects. Using a standard model for interest rates to disentangle changes in beliefs and changes in preferences, we demonstrate that our results are consistent with the time-varying risk aversion in the spirit of habit formation.