Working Paper Abstracts – 2005

Working Paper Abstracts – 2005

The Persistence and Pricing of the Cash Component of Earnings
Patricia M. Dechow, Scott A. Richardson and Richard D. Sloan

Following Sloan (1996), numerous studies show that the cash component earnings is more persistent than the accrual component of earnings. In this paper, we show that the higher persistence of the cash component of earnings is attributable to the net cash distributions to equity holders. This result holds despite the fact that net cash distributions to equity holders account for less than one third of the total variation in the cash component of earnings. We also show that investors correctly anticipate the lower persistence of the remaining cash earnings, contradicting Sloan’s hypotheses that investors naively fixate on earnings.

Information (In) Efficiency in Prediction Markets
Erik Snowberg, Justin Wolfers and Eric Zitzewitz

We analyze the extent to which simple markets can be used to aggregate dispersed information into efficient forecasts of unknown future events. From the examination of case studies in a variety of financial settings we enumerate and suggest solutions to various pitfalls of these simple markets. Despite the potential problems, we show that market-generated forecasts are typically fairly accurate in a variety of predication contexts, and that they outperform most moderately sophisticated benchmarks. We also show how conditional contracts can be sure to discover the markets belief about correlations between events, and how – with further assumptions – these correlations can be sure to make decisions.

Special Purpose Vehicles and Securitization
Gary Gorton and Nicholas S. Souleles

This paper analyzes securitization and “special purpose vehicles” (SPVs), which are now pervasive in corporate finance. The first part of the paper provides an overview of the institutional features of SPVs and securitization. The second part provides a model to analyze the motivations for using SPVs, and the conditions under which SPVs are sustainable. We argue that a key source of value to using SPVs is that they help reduce bankruptcy costs. Off-balance sheet financing involves transferring assets to SPVs, which reduces the amount of assets that are subject to bankruptcy costs, since SPVs are carefully designed to avoid bankruptcy. Off-balance sheet financing is most advantageous for sponsoring firms that are risky or face large bankruptcy costs. SPVs become sustainable in a repeated SPV game, because firms can implicitly “commit” to subsidize or “bail out” their SPVs when the SPV would otherwise not honor its debt commitments, despite legal and accounting restrictions to the contrary. The third part of the paper tests two key implications of the model using unique data on credit card securitizations. First, riskier firms should securitize more, ceteris paribus. Second, since investors know that SPV sponsors can bail out their SPVs if there is a need, in pricing the debt of the SPV investors will care about the risk of the sponsor defaulting, above and beyond the risk of SPV assets. We find evidence consistent with these implications.

Facts and Fantasies about Commodity Futures
Gary Gorton K. Geert Rouwenhorst

We construct and equally-weighted index of commodity futures monthly returns over the period between July of 1959 and December of 2004 in order to study simple properties of commodity futures as an asset class. Fully-collateralized commodity futures have historically offered the same return and Sharpe ratio as equities. While the risk premium on commodity futures is essentially the same as equities, commodity futures returns are negatively correlated with equity returns and bond returns. The negative correlation between commodity futures and other asset classes is due, in significant part, to different behavior over the business cycle. In addition, commodity futures are positively correlated with inflation, unexpected inflation, and changes in expected inflation.

The Book-to-Price Effect in Stock Returns: Accounting for Leverage
Stephen H. Penman, Scott A. Richardson and Irem Tuna

We lay out a decomposition of book-to-price (B/P) that articulates precisely how B/P “absorbs” leverage, and apply this decomposition to examine the relation between B/P and future stock returns. If net debt is carried at market value on the balance sheet, B/P can be decomposed into an enterprise book-to-price (that potentially reflects operating risk) and a financial leverage component (that reflects financing risk), with differences between the book value and the price of equity attributable only to the operating component. With this accounting for net debt, the book-to-price ratio for net debt is unity and the standard measure of “market” leverage – net debt relative to the market value of equity – is economic leverage, but only if the market prices risk appropriately. The enterprise book-to-price ratio is positively related to subsequent stock returns but, conditional upon the enterprise book-to-price, the financial leverage component of B/P is negatively associated with future stock returns. While it is difficult to interpret the result for the enterprise book-to-price as a reward for risk or a mispricing of risk, the result for financial leverage is seemingly perverse: Finance theory rather unambiguously predicts that, given operating risk, investors should be further rewarded for taking on financing risk. We find the opposite, for all levels of the enterprise book-to-price. The findings survive under controls for size, estimated beta, and default risk that may be priced in equities. They also survive after a consideration of the accounting for debt under distress, that is, conditions where the book-to-price ratio for debt may not be unity and conditions to which the B/P effect has been attributed in previous research.

A Consumption-Based Explanation of Expected Stock Returns
Motohiro Yogo

When utility is nonseparable in nondurable and durable consumption and the elasticity of substitution between the two consumption goods is sufficiently high, marginal utility rises when durable consumption falls. The model explains both the cross-sectional variation in expected stock returns and the time variation in the equity premium. Small stocks and value stocks deliver relatively low returns during recessions, when durable consumption falls, which explains their high average returns relative to big stocks and growth stocks. Stock returns are unexpectedly low at business cycle troughs, when durable consumption falls sharply, which explains countercyclical variation in the equity premium.

07-05 (Revision of paper 24-04)
Analyst Reputation, Conflict of Interest, and Forecast Accuracy
Lily Fang and Ayako Yasuda

We study the effect of analyst reputation on earnings forecast accuracy using the 1983-2002 U.S. data. We find that All-American analysts are significantly more accurate than non-All-Americans. We also find that analysts who work at top-tier investment banks (large underwriters) are more accurate than others but become inaccurate in boom IPO markets, which is consistent with conflict of interest. Finally, we find that All-Americans do not become inaccurate in boom IPO markets. Personal reputation, as measured by All-American status, apparently mitigates the conflict of interest that becomes particularly acute for analysts employed at top-tier investment banks during boom years.

Passive Decisions and Potent Defaults
James J. Choi, David Laibson, Brigitte C. Madrian and Andrew Metrick

Default options have an enormous impact on household “choices.” Defaults matter because opting out of a default is costly and these costs change over time, generating an option value of waiting. In addition, people have a tendency to procrastinate. We develop a theory of optimal defaults based on these considerations. We find that it is sometimes optimal to set extreme defaults, which are far away from the mean optimal savings rate. A default that is far away from a consumer’s optimal savings rate may make that consumer better off since such a “bad” default will lead procrastinating consumers to more quickly opt out of the default. We calibrate our model and use it to calculate optimal defaults for employees at four different companies. Our work suggests that optimal defaults are likely to be at one of three savings rates: the minimum savings rate (0%), the employer matched threshold (typically 5% or 6%), or the maximum savings rate.

Saving for Retirement on 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.

Large Blocks of Stock: Prevalence, Size and Measurement
Jennifer Dlugosz, Rudiger Fahlenbrah, Paul Gompers, Andrew Metrick

Large blocks of stock play an important role in many studies of corporate governance and finance. Despite this important role, there is no standardized data set for these blocks, and the best available data source, Compact Disclosure, has many mistakes and biases. In this paper, we document these mistakes and show how to fix them. The mistakes and biases tend to increase with the level of reported blockholdings: in firms where Compact Disclosure reports that aggregate blockholdings are greater than 50 percent, these aggregate holdings are incorrect more than half the time and average holdings for these incorrect firms are overstated by almost 30 percentage points. For researchers using uncorrected blockholder data as a dependent variable, these errors will increase the standard error of coefficient estimates but do not appear to cause bias. However, we find that if blockholders are used as an independent variable, economically significant errors-in-variables biases can occur. We demonstrate these biases using a representative analysis of the relationship between firm value and outside blockholders. An online appendix to our paper provides a “clean” data set for out sample firms and time period. For researchers who need to work outside of this sample, we also test the efficacy of alternative (cheaper) fixes to this data problem, and find that truncating or winsorizing the sample can reduce about half the bias in out representative application.

The Congruence of Shareholder and Bondholder Governance
K. J. Martjin Cremers, Vinay B. Nair and Chenyang Wei

We document the effect of shareholder governance mechanisms on bondholder risk. We find that shareholder control (proxied by the presence of an institutional blockholder) is associated with higher (lower) yields if the firm is exposed (protected) to takeovers. In the presence of shareholder control, the difference in bond yields due to differences in takeover vulnerability can be as high as 139 basis points. Also, suggestive of risk differences due to shareholder governance, we find that a bond portfolio that buys issues of firms with both strong shareholder control and high takeover vulnerability and shorts issues of firms without either shareholder control or takeover vulnerability generates an annual return of 1.5%. Finally, to investigate the importance of the takeovers, we show that the issues with event risk protection always consider stronger shareholder control beneficial, especially as takeover vulnerability increases. Therefore, in the presence of event risk covenants, shareholder governance and bondholder interests converge.

The Role of Banks in Takeovers
Victoria Ivashina, Vinay B. Nair, Anthony Saunders, Nadia Massoud and Roger Stover

To transfer loans from one debtor to another debtor, banks might transmit borrower information which is collected in the lending process to potential acquirers. In this paper, we investigate the importance of banks in the effectiveness of the takeover mechanism and hence in corporate governance. Using unsolicited takeovers between 1992 and 2003, we find that bank lending intensity and bank client network (the number of firms that the bank deals with) have a significant and positive effect on the probability of a borrower firm becoming a target. We find that this effect is enhanced in cases where the target and acquirer have a relationship with the same bank and is robust to the inclusion of several firm characteristics including the presence of large external shareholders. Moreover, takeover completion rates are positively related to bank lending intensity. Finally, we find that the equity market views takeovers where the target and the acquirer deal with the same bank more positively relative to takeovers with no bank involvement. Overall, the evidence supports the view that banks increase the disciplining role of the market for corporate control.

Corporate Governance and Internal Organization
Vinay B. Nair

This paper jointly designs the level of external control that financial claimants have; characterized as likelihood of performance-based CEO dismissals, and the internal organization of firms. While the internal organization of a firm affects competition between lower-level managers to become the CEO, performance-based CEO dismissal and replacement alters the incentives due to this competition. I show CEO dismissals are more likely to be accompanied by an outside replacement and that such governance mechanisms reduce the counterproductive activities (“power struggles”) and can increase the productive activities that arise due to managerial competition. This enables the CEO to directly access more managers and increase managerial competition. However, strong governance may also reduce managerial incentives to acquire skill to become the CEO. As lower level managers have a greater impact on firm performance, strong governance, flatter firms and greater pay inequality is optimal.

Why Do Public Firms Issue Private and Public Securities?
Armando Gomes and Gordon Phillips

We examine a comprehensive set of private and public security issuance decisions by publicly traded companies. We study private and public issues of debt, convertibles and common equity securities – a total of 6 different security-market choices. The market for public firms issuing private securities is large. Of the over 13,000 issues we examine, more than half are in the private market. We find that asymmetric information and moral hazard problems play a large role in the public versus private market choice and the security type choice. Our findings show that asymmetric information impacts security choice in a particular pattern: Conditional on issuing in the public market we find a pecking order of security issuance holds, firms with higher measures of asymmetric information are less likely to issue equity. We find a reversal of this pecking order in the private market, firms with higher measure of asymmetric information are more likely to issue equity and convertibles. Second, we find risk and investment opportunities are important in determining which security type a firm issues. Firms with high risk, low profitability and good investment opportunities are more likely to choose equity and convertibles and to issue privately. The results support models of security issuance where private securities give investors more incentives to produce information and monitor the firm.

The Neoclassical Theory of Investment in Speculative Markets
Stavros Panageas

In this paper I investigate whether firms’ physical investments should react to the speculative over-pricing of securities. I introduce investment subject to quadratic adjustment costs (along the lines of Abel and Eberly [1994]) in an infinite horizon continuous time model with short sale constraints and heterogeneous beliefs (along the lines of Scheinkman and Xiong [2003]). Under standard assumptions, I show that the neoclassical “q” theory of investment will continue to hold despite the presence of (endogenous) speculative mispricing in the stock market. Strikingly, the welfare implications of the theory will also continue to hold, despite the presence of a speculative bubble. I show how the model provides new formalization of the notions of “short-termist” and “long-termist” investment policies and also how the behavior of investment can be used to disentangle rational and behavioral approaches to so-called pricing anomalies.

Dequity: The Blurring of Debt and Equity in Securitized Real Estate Financing
Georgette Chapman Poindexter

This paper explores the legal differentiation of equity and debt in subordinate real estate financing. Various financing vehicles that occupy a gray space between true debt and true equity have replaced traditional asset secured debt lending. This paper investigates the legal rights and responsibilities of parties functioning in the grey area. The goal of this is to identify potential conflicts and unforeseen consequences of investment processing attributes of both equity and debt in the event of default.

Bank Credit Cycles
Gary B. Gorton and Ping He

Private information about prospective borrowers produced by a bank can affect rival lenders due to a “winner’s curse” effect. Strategic interaction between banks with respect to the intensity of costly information production results in endogenous credit cycles, periodic “credit crunches.” Empirical tests are constructed based on parameterizing public information about relative bank performance that is at the root of banks’ beliefs about rival banks’ behavior. Consistent with the theory, we find that the relative performance of rival banks has predictive power for a subsequent lending in the credit market, where we can identify the main competitors. At the macroeconomic level, we show that the relative bank performance of commercial and industrial loans is an autonomous source of macroeconomic fluctuations. We also find that the relative bank performance is a priced risk factor for both banks and nonfinancial firms. The factor-coefficients for non-financial firms are decreasing with size.

Eat or Be Eaten: A Theory of Mergers and Merger Waves
Gary B. Gorton, Matthias Kahl and Richard Rosen

In this paper, we present a model of defensive merger and merger waves. We argue that mergers and merger waves can occur when managers prefer that their firms remain independent rather than be acquired. We assume that managers can reduce their chance of being acquired by acquiring another firm and hence increasing the size of their own firm. We show that if managers value private benefits of control sufficiently, they may engage in unprofitable defensive acquisitions. A technological or regulatory change that makes acquisitions profitable in some future states of the world can induce a preemptive wave of unprofitable, defensive acquisitions. The timing of mergers, the identity of acquirers and targets, and the profitability of acquisitions depend on the size of the private benefits of control, managerial equity ownership, the likelihood of a regime shift that makes some mergers profitable, and the distribution of firm sizes within an industry.

Vote Trading and Information Aggregation
Susan E. K. Christoffersen, Christopher C. Geczy, David K. Musto and Adam V. Reed

The standard analysis of corporate governance is that shareholders vote in the ratio that firms choose, such as one-share-one-vote. But if the cost of unbundling and trading votes is sufficiently low, then shareholders vote in the ratios that they themselves choose. We document an active market for votes within the equity-loan market, where we find that the average vote sells for zero. We hypothesize that asymmetric information motivates these vote reallocations, and we find support for this view in the cross section votes: there is more trade for higher -spread firms and more for poor performers, especially when the vote is close. We also find that the vote reallocations correspond to support for shareholder proposals and opposition to management proposals.

Interpretable Asset Markets?
Ravi Bansal, Varoujan Khatchatrian and Amir Yaron

In this paper we show that measures of economic uncertainty (conditional volatility of consumption) predict and are predicted by valuation ratios at long horizons. Further we document that asset valuations drop as economic uncertainty rises – that is, financial markets dislike economic uncertainty. Moreover, future earnings growth rates are sharply predicted by current price-earnings ratios. It seems that much of the variation in asset prices can be attributed to fluctuations in economic uncertainty and expected cash-flow growth. This empirical evidence is consistent with the implications of existing parametric general equilibrium models. Hence, the channels of fluctuating economic uncertainty and expected growth seem important for interpreting asset markets.

Price Informativeness and Investment Sensitivity to Stock Price
Qi Chen, Itay Goldstein and Wei Jiang

Stock prices and real investments are highly correlated. Previous literature has offered two main explanations for this high correlation. The first explanation relies on price being informative about investment opportunities, the second one is based on financing constraints. In this paper we empirically examine the effect of price informativeness on the sensitivity of investment to stock price. Using price non-synchronicity and PIN as measures of price informativeness, we find that the degree of informativeness is positively correlated with the sensitivity of investment to stock price. Since, according to previous literature, there measures reflect private information, the result suggests that prices perform an active role, i.e. that managers learn from stock price when making investment decisions. This result is robust to the inclusion of various control variables (such as controls for managerial information) and to changes in specification.

Human Capital and Earnings Distribution Dynamics
Mark Huggett, Gustavo Ventura and Amir Yaron

Earnings heterogeneity plays a crucial role in modern macroeconomics. We document that mean earnings and measures of earnings dispersion and skewness all increase in US data over most of the working life-cycle for a typical cohort as the cohort ages. We show that (i) a human capital model can replicate these properties from the right distribution of initial human capital and learning ability, (ii) differences in learning ability are essential to produce an increase in earnings dispersion over the life cycle and (iii) differences in learning ability account for the bulk of the variation in the present value of earnings across agents. These findings emphasize the need to further understand that role and origins of initial conditions.

Debt Restructuring and Voting Rules
Philip Bond and Hulya Eraslan

The voting arrangements used by creditors during debt restructuring are prespecified, often by statute. For example, U.S. law stipulates unanimous agreement outside bankruptcy, but allows for a supermajority vote in Chapter 11 bankruptcy. We analyze the effect of voting rules on the welfare of debtors and their creditors in restructuring negotiations. When markets are liquid, the “toughness” engendered by a requirement of unanimous agreement benefits creditors by more than the rise in the probability of disagreement hurts them. Conversely, if markets are illiquid (or creditors non-Bayesian), a unanimity requirement makes successful restructurings almost impossible, hurting creditors and the debtor alike. We apply our results to the choice of securities issued in exchange offers, to U.S. regulations governing debt restructuring, and to the current debate on the desirability of a sovereign debt restructuring mechanism. On a more technical level, our analysis extends the existing strategic voting literature (see especially Feddersen and Pesendorfer 1997) to the case in which the issue being voted over is endogenous to the voting rule used.

Futures Prices in a Production Economy with Investment Constraints
Leonid Kogan, Dimitry Livdan and Amir Yaron

We document a new stylized fact regarding the term-structure of futures volatility. We show that the relationship between volatility of futures prices and the slope of the term structure of prices is non-monotone and has a “V-shape”. This aspect of the data cannot be generated by basic models that emphasize storage while this fact is consistent with models that emphasize investment constraints or, more generally, time-varying supply-elasticity. We develop an equilibrium model in which futures prices are determined endogenously in a production economy in which investment is both irreversible and is capacity constrained. Investment constraints affect firms investment decisions, which in turn determine the dynamic properties of their output and consequently imply that the supply-elasticity of the commodity changes over time. Since demand shocks must be absorbed either by changes in prices, or by changes in supply, time-varying supply-elasticity results in time-varying volatility of futures prices. Calibrating this model, we show it is quantitatively consistent with the aforementioned “V-shape” relationship between the volatility of futures prices and the slope of the term-structure.

Persistence, Predictability and Portfolio Planning
Michael J. Brennan and Yihong Xia

We use a model stock price behavior in which the expected return on stocks follows an Ornstein-Uhlenbeck process to show that levels of return predictability that cause large variation in valuation ratios and offer significant benefits to dynamic portfolio strategies are hard to detect or measure by standard regression techniques, and that the R2 from standard short run predictive regressions carry little information about either long run predictability or value of dynamic portfolio strategies. We propose a new approach to portfolio planning that uses forward-looking estimates of long run expected rates of return from dividend discount models. We show how such long run expected rates of return can be used to estimate the instantaneous expected rate of return under the assumption that the latter follows an Ornstein-Uhlenbeck process. Simulation results using four different estimates of long run rates of return on US common stocks suggest that this approach may be valuable for long horizon investors.

An International Examination of Affine Term Structure Models and the Expectations Hypothesis
Huarong Tang and Yihong Xia

We examine the yield curve behavior and the relative performance of affine term structure models using government bond yield data from Canada, Germany, Japan, UK, and US. We find strong predictability of forward rates for excess bond returns and reject the expectations hypothesis across all five countries. A three-factor model is sufficient to capture movements in the yield curve of Canada, Japan, UK, and US, but may not be enough for Germany. An exhaustive comparison among affine term structure models with no more than three factors reveals that the three-factor essential affine model (A1 (3) E) with only one factor affecting the volatility of the short rate but with all three factors affecting price of risk performs best in all five countries. Simulations provide inconclusive evidence on whether this best affine model can successfully generate the rich yield curve behavior observed in the data.

Are Stars’ Opinions Worth More? The Relation between Analyst Reputation and Recommendation Values
Lily H. Fang and Ayako Yasuda

We study the effect of personal reputation on the values analysts’ stock recommendations using the 1994-2003 U.S. data. All-American (AA) analysts’ buy recommendations earn significantly positive abnormal returns over the 10-year period. Buy recommendations of analysts at top-tier banks also earn significantly positive abnormal returns, but only AAs contribute to this out-performance; top-tier non-AAs’ buy recommendations do not provide positive abnormal returns.

Interestingly, sell recommendations made by all four sub-groups of analysts (top-tier AA, top-tier non-AA, lower-status AA, lower-status non AA) have significant investment value. Among them, top-tier bank analysts out-perform lower-status-bank analysts.

Comparing investment performance across groups, we find that top-tier AAs out-perform all other groups in both buy and sell category. The value of their recommendation is economically significant. For buys, they out-perform the market by 6.12% per year in raw returns, and by 4.35% and 2.59% per year in market-and Fama-French three-factor adjusted returns, respectively. For sells, their market- and three-factor-adjusted returns are 3.56% and 6.9% per year, respectively. These results indicate that active sell-side research has value, and that personal reputation is positively related to recommendation value.

We document evidence consistent with the existence of conflict of interest in top-tier investment banks. We find that buy recommendations made by top-tier non-AAs out-perform all other groups in the peak year of 1999, but they yield the negative and the lowest abnormal returns in the subsequent trough of 2000. Since top-tier analysts generally have superior skill, this volatile performance pattern is consistent with top-tier non-AAs aggressively touting “glamour” stock during market booms and subsequently being reluctant to downgrade their former champion stocks in the following bear market. In contrast, since top-tier AAs’ recommendations remain valuable during the troughs of the market, our results indirectly suggest that personal reputation , as indicated by the AA status, can play a mitigating role in the conflict of interest problem and this has a net positive effect on the value of analysts’ stock recommendations.

The Effects of Biased Self Perception in Teams
Simon Gervais and Itay Goldstein

Several finance and economics problems involve a team of agents in which the marginal productivity of any one agent increases with the effort of others on the team. Because the effort of each agent is not observable to any other agents, the performance of the team is negatively affected by a free-rider problem and by a lack of effort coordination across agents. In this context, we show that an agent who mistakenly overestimates her own marginal productivity works harder, thereby increasing the marginal productivity of her teammates who then work harder as well. This not only enhances team performance but may also create a Pareto improvement at the individual level. Indeed, although the biased agent overworks, she benefits from the positive externality that other agents working harder generates. The presence of a team leader improves coordination and team value, but self-perception biases can never be Pareto-improving when they affect the leader. Because self-perception biases naturally make agents work harder, monitoring, even when it is costless, may hurt the team by causing an overinvestment in effort. Interestingly, the benefits of self-perception biases may be long-lived even if agents learn from team performance, as the biased agent attributes the team’ s success to her own ability, and not to the better coordination of the team.

Solving Models with External Habit
Jessica A. Wachter

Habit utility has been the focus of a large and growing body of literature in financial economics. This study investigates ways of accurately and efficiently solving the Campbell and Cochrane (1999) external habit model. Solutions for this model based on a grid of values for the state variable are shown to converge as the grid becomes increasingly fine. Convergence is substantially faster if the price-dividend ratio is computed as a series of “zero-coupon equity” claims rather than as the fixed-point of the Euler equation. Fitting the model to the term structure as well as to equity moments (as in Wachter (2005)) also results in faster convergence.

Let us Trade Pension Claims
Bernard Dumas and Juerg Syz

Trading pension claims would kill many birds with one stone: an accurate valuation of pension liabilities would provide a measurable yardstick for plan managers; beneficiaries would be able to diversify the idiosyncratic risk of their plan sponsors; systematic risk could be reallocated to comply with individual risk/return preferences. The consequence would be an alignment of incentives to fully fund plans, lower agency and governmental bail-out costs, and an increase in general welfare.

Asymmetric Information and Financing with Convertibles
Archishman Chakraborty and Bilge Yilmaz

Asymmetric information regarding project prospects causes dilution, leading to adverse selection and inefficiencies in the market for new investments. However, if the market obtains information about the firm over time, issuing callable convertible securities with restrictive call provisions is optimal. Even when the market’s information is noisy, such securities can be designed to 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 price rises in the future. This solves the dilution and adverse selection problem costlessly. The same first-best efficient outcome can also be implemented by issuing floating price and mandatory convertibles.

Stock Returns and Expected Business Conditions: Half a Century of Direct Evidence
Sean D. Campbell and Francis X. Diebold

We explore the macro/finance interface in the context of equity markets. In particular, using half a century of Livingston expected business conditions data we characterize directly the impact of expected business conditions on expected excess stock returns. Expected business conditions consistently affect expected excess returns in a statistically and economically significant counter-cyclical fashion: depressed expected business conditions are associated with high expected excess returns. Moreover, inclusion of expected business conditions in otherwise-standard predictive return regression substantially reduces the explanatory power of the conventional financial predictors, including the dividend yield, default premium, and term premium, while simultaneously increasing R2 . Expected business conditions retain predictive power even after controlling for an important and recently introduced non-financial predictor, the generalized consumption/wealth ratio, which accords with the view that expected business conditions play a role in asset pricing different from and complementary to that of the consumption/wealth ratio. We argue that time-varying expected business conditions likely capture time-varying risk, while time-varying consumption/wealth may capture time-varying risk aversion.

The Pecking Order, Debt Capacity, and Information
Mark T. Leary and Michael R. Roberts

We examine the pecking order hypothesis using a new empirical model and testing strategy. After illustrating how our approach provides a more powerful test relative to earlier attempts, we show that approximately 36% of firms adhere to the pecking order’s prediction that firms issue debt before equity. Further investigation reveals that violations of the pecking order do not appear to be a consequence of variation in information asymmetry or attempts by firms to issue less information-sensitive securities. Similarly, using a database of private loans, we show that equity issuers are strikingly similar to private debt issuers along many dimensions, suggesting that the propensity to issue equity in violation of the pecking order is not fully explained by debt capacity concerns. When we relax the assumption of a strict financing hierarchy by incorporating alternative considerations (e.g., tradeoff) into the model, its predictive accuracy more than doubles, correctly classifying the debt and equity issuance decisions of almost 80% of our sample. Thus, a perhaps more accurate characterization of issuance behavior is that firms select the least costly source of financing but the costs are not limited to those emphasized by the pecking order.

A Dynamic Model for the Forward Curve
Choong Tze Chang, Dean Foster, Krishna Ramaswamy and Robert Stine

This paper develops and estimates a dynamic arbitrage-free model for the current forward curve as the sum of (i) an unconditional component, (ii) a maturity-specific component and (iii) a date-specific component. The model combines features of the Preferred Habitat model, the Expectation Hypothesis and affine yield curve models. We show how to construct alternative parametric examples of the three components from a sum of exponential functions, verify that the resulting forward curves satisfy the Heath-Jarrow-Morton conditions, and derive the risk-neutral dynamics for the purpose of pricing interest rate derivatives. We select a model from alternative affine examples that are fitted to the Fama-Bliss Treasury data over an initial training period and use it to generate out-of-sample forecasts for forward rates and yields. For forecast horizons of 6-months or longer, the forecasts of this model significantly outperform forecasts from common benchmark models.

A Portfolio of Consumer Credit
David K. Musto and Nicholas Souleles

This paper takes a portfolio view of consumer credit. Default models (credit-risk scores) estimate the probability of default of individual loans. But to compute risk-adjusted returns, lenders also need to know the covariances of the returns on their loans with aggregate returns. Covariances are independently relevant for lender who care directly about the volatility of their portfolios, e.g. because of Value-at-Risk considerations or the structure of the securitization market. Cross-sectional differences in these covariances also provide insight into the nature of the shocks hitting different types of consumers.

We use a unique panel dataset of credit bureau records to measure the ‘covariance risk’ of individual consumers, i.e., the covariance of their default risk with aggregate consumer default rates, and more generally to analyze the cross-sectional distribution of credit, including the effects of credit scores. We obtain two key sets of results. First, there is significant systematic heterogeneity in covariance risk across consumers with different characteristics. Consumers with high covariance risk tend to also have low credit scores (high default probabilities). Second, the amount of credit obtained by consumers significantly increases with their credit scores, and significantly decreases with their covariance risk (especially revolving credit), though the effect of covariance risk is smaller in magnitude. It appears that some lenders take covariance risk into account, at least in part, in determining the amount of credit they provide.

Do Consumers Choose the Right Credit Contracts?
Sumit Agarwal, Souphala Chomsisengphet, Chunlin Liu and Nicholas Souleles

A number of studies have pointed to various mistakes that consumers might make in their consumption-saving and financial decisions. We utilize a unique market experiment conducted by a large U.S. Bank to assess how systematic and costly such mistakes are in practice. The bank offered a choice between two credit card contracts, one with an annual fee but a lower interest rate and one with no annual fee but a higher interest rate. To minimize their total interest costs net of the fee, consumers expecting to borrow a sufficiently large amount should choose the contract with the fee, and vice-versa.

We find that on average consumers chose the contract that ex post minimized their net costs. A substantial fraction of consumers (about 40%) still chose the ex post sub-optimal contract, with some incurring hundreds of dollars of avoidable interest costs. Nonetheless, the probability of choosing the sub-optimal contract declines with the dollar magnitude of the potential error, and consumers with larger errors were more likely to subsequently switch to the optimal contract. Thus most of the errors appear not to have been very costly, with the exception that a small minority of consumers persists in holding substantially sub-optimal contracts without switching.

What Can Rational Investors Do About Excessive Volatility and Sentiment Fluctuations?
Bernard Dumas, Alexander Kurshev, and Raman Uppal

Our objective is to understand the trading strategy that would allow an investor to take advantage of “excessive” stock price volatility and “sentiment” fluctuations. We construct a general equilibrium model of sentiment. In it, there are two classes of agents and stock prices are excessively volatile because one class is overconfident about a public signal. As a result, this class of irrational agents changes its expectations too often, sometimes being excessively optimistic, sometimes being excessively pessimistic. We determine and analyze the trading strategy of the rational investors who are not overconfident about the signal. We find that because irrational traders introduce an additional source of risk, rational investors reduce the proportion of wealth invested into equity except when they are extremely optimistic about future growth. Moreover, their optimal portfolio strategy is based not just on a current price divergence but also a model of irrational behavior and a prediction concerning the speed of convergence. Thus, the portfolio strategy includes a protection in case there is a deviation from that prediction. We find that long maturity bonds are an essential accompaniment of equity investment, as they serve to hedge this “sentiment risk.” Even though rational investors find it beneficial to trade on their belief that the market is excessively volatile, the answer to the question posed in the title is: “There is little that rational investors can do optimally to exploit, and hence, eliminate excessive volatility, except in the very long run.”