Making markets
Can Markets Discipline Government Agencies? Evidence from the Weather Derivatives Market
Amiyatosh Purnanandam & Daniel Weagley
Journal of Finance, forthcoming
Abstract:
We analyze the role of financial markets in shaping the incentives of government agencies using a unique empirical setting: the weather derivatives market. We show that the introduction of weather derivative contracts on the Chicago Mercantile Exchange improves the accuracy of temperature measurement by 13% to 20% at the underlying weather stations. We argue that temperature-based financial markets generate additional scrutiny of the temperature data measured by the National Weather Service, which motivates the agency to minimize measurement errors. Our results have broader implications: the visibility and scrutiny generated by financial markets can potentially improve the efficiency of government agencies.
---------------------
Smart money, dumb money, and capital market anomalies
Ferhat Akbas et al.
Journal of Financial Economics, forthcoming
Abstract:
We investigate the dual notions that "dumb money" exacerbates well-known stock return anomalies and "smart money" attenuates these anomalies. We find that aggregate flows to mutual funds (dumb money) appear to exacerbate cross-sectional mispricing, particularly for growth, accrual, and momentum anomalies. In contrast, hedge fund flows (smart money) appear to attenuate aggregate mispricing. Our results suggest that aggregate flows to mutual funds can have real adverse allocation effects in the stock market and that aggregate flows to hedge funds contribute to the correction of cross-sectional mispricing.
---------------------
Do Weather-Induced Moods Affect the Processing of Earnings News?
Ed DeHaan, Joshua Madsen & Joseph Piotroski
Stanford Working Paper, August 2015
Abstract:
Building on research in psychology, we predict that unpleasant weather negatively affects capital market participants' moods and activity levels, causing a muted response to information events. Exploiting within firm-quarter tests, we find that analysts experiencing unpleasant weather are less likely to update their reports following earnings announcements relative to analysts experiencing pleasant weather. At the market level, we find a muted initial price response and larger subsequent price drift for firms that announce earnings when New York City weather is unpleasant. Our tests are consistent with weather-induced bad moods impeding the efficiency of market participants' responses to earnings news.
---------------------
Can analysts pick stocks for the long-run?
Oya Altınkılıç, Robert Hansen & Liyu Ye
Journal of Financial Economics, forthcoming
Abstract:
This paper examines post-revision return drift, or PRD, following analysts' revisions of their stock recommendations. PRD refers to the finding that the analysts' recommendation changes predict future long-term returns in the same direction as the change (i.e., upgrades are followed by positive returns, and downgrades are followed by negative returns). During the high-frequency algorithmic trading period of 2003-2010, average PRD is no longer significantly different from zero. The new findings agree with improved market efficiency after declines in real trading cost inefficiencies. They are consistent with a reduced information production role for analysts in the supercomputer era.
---------------------
Investor sentiment and local bias in extreme circumstances: The case of the Blitz
Andrew Urquhart & Robert Hudson
Research in International Business and Finance, forthcoming
Abstract:
This paper treats the Blitz, the bombing of Britain during World War Two, as a natural experiment which can provide insights into the effects of investor sentiment on stock returns. The period of the Blitz is very interesting in that one of the world's major financial centres was under regular and severe air attack, as were many other industrial and commercial centres. These conditions provide a unique opportunity to study both investor sentiment and local bias effects in extreme circumstances. We show that negative investor sentiment during the Blitz as a whole was not evident. However major bombings in London generate negative investor sentiment on stock returns while major bombings outside of London generate no negative investor sentiment on stock returns, which is consistent with local bias effects.
---------------------
Elroy Dimson, Peter Rousseau & Christophe Spaenjers
Journal of Financial Economics, forthcoming
Abstract:
Using historical price records for Bordeaux Premiers Crus, we examine the impact of aging on wine prices and the long-term investment performance of fine wine. In line with the predictions of an illustrative model, young maturing wines from high-quality vintages provide the highest financial returns. Past maturity, famous châteaus deliver growing non-pecuniary benefits to their owners. Using an arithmetic repeat-sales regression over 1900-2012, we estimate a real financial return to wine investment (net of storage costs) of 4.1%, which exceeds bonds, art, and stamps. Returns to wine and equities are positively correlated. Finally, we find evidence of in-sample return predictability.
---------------------
Does Academic Research Destroy Stock Return Predictability?
David McLean & Jeffrey Pontiff
Journal of Finance, forthcoming
Abstract:
We study the out-of-sample and post-publication return predictability of 97 variables shown to predict cross-sectional stock returns. Portfolio returns are 26% lower out-of-sample and 58% lower post-publication. The out-of-sample decline is an upper bound estimate of data mining effects. We estimate a 32% (58%-26%) lower return from publication-informed trading. Post-publication declines are greater for predictors with higher in-sample returns, and returns are higher for portfolios concentrated in stocks with high idiosyncratic risk and low liquidity. Predictor portfolios exhibit post-publication increases in correlations with other published-predictor portfolios. Our findings suggest that investors learn about mispricing from academic publications.
---------------------
Home Bias in Online Investments: An Empirical Study of an Online Crowdfunding Market
Mingfeng Lin & Siva Viswanathan
Management Science, forthcoming
Abstract:
An extensive literature in economics and finance has documented home bias, the tendency that transactions are more likely to occur between parties in the same geographical area rather than outside. Using data from a large online crowdfunding marketplace and employing a quasi-experimental design, we find evidence that home bias still exists in this virtual marketplace for financial products. Furthermore, through a series of empirical tests, we show that rationality-based explanations cannot fully explain such behavior and that behavioral reasons at least partially drive this remarkable phenomenon. As crowdfunding becomes an alternative and increasingly appealing channel for financing, a better understanding of home bias in this new context provides important managerial, practical, and policy implications.
---------------------
Looking for Someone to Blame: Delegation, Cognitive Dissonance, and the Disposition Effect
Tom Chang, David Solomon & Mark Westerfield
Journal of Finance, forthcoming
Abstract:
We analyze brokerage data and an experiment to test a cognitive dissonance based theory of trading: investors avoid realizing losses because they dislike admitting that past purchases were mistakes, but delegation reverses this effect by allowing the investor to blame the manager instead. Using individual trading data, we show that the disposition effect - the propensity to realize past gains more than past losses - applies only to nondelegated assets like individual stocks; delegated assets, like mutual funds, exhibit a robust reverse-disposition effect. In an experiment, we show increasing investors' cognitive dissonance results in both a larger disposition effect in stocks and a larger reverse-disposition effect in funds. Additionally, increasing the salience of delegation increases the reverse-disposition effect in funds. Cognitive dissonance provides a unified explanation for apparently contradictory investor behavior across asset classes and has implications for personal investment decisions, mutual fund management, and intermediation.
---------------------
Disclosure Standards and the Sensitivity of Returns to Mood
Brian Bushee & Henry Friedman
Review of Financial Studies, forthcoming
Abstract:
We provide evidence that higher-quality disclosure standards are associated with stock returns that are less sensitive to noise driven by investors' moods. We identify return-mood sensitivity (RMS) based on the association between index returns and urban cloudiness, a source of short-term variation in mood. Based on a stylized model, we predict and find evidence consistent with higher-quality disclosure standards reducing RMS by tilting susceptible investors' trades toward information and by facilitating sophisticated investors' arbitrage. Our findings suggest that disclosure standards play an important role in enhancing price efficiency by reducing noise in returns, particularly noise related to investors' short-term moods.
---------------------
Does individual investor trading impact firm valuation?
Qin Wang & Jun Zhang
Journal of Corporate Finance, December 2015, Pages 120-135
Abstract:
Motivated by recent evidence of informed trading by individual investors (Kaniel, Liu, Saar and Titman, 2012; Kelley and Tetlock, 2013; Wang and Zhang, 2015), we posit that individual investor trading enhances firm performance. Consistent with the conjecture, we find that individual investor trading positively impacts firm value. The results are robust to inclusion of year, industry and firm fixed effects, alternative model specifications, a control for endogeneity, Granger causality test, matched sample analysis and subsample analyses. The positive effect of individual investor trading on firm value is stronger for firms with higher information production and stocks with higher spread, consistent with the information and spread channel mechanism. Our results suggest that trading by individual investors enhances firm value by improving stock price informativeness and reducing spread.
---------------------
Do analysts understand the economic and reporting complexities of derivatives?
Hye Sun Chang, Michael Donohoe & Theodore Sougiannis
Journal of Accounting and Economics, forthcoming
Abstract:
We investigate whether and how the complexity of derivatives influences analysts' earnings forecast properties. Using a difference-in-differences design, we find that, relative to a matched control sample of non-users, analysts' earnings forecasts for new derivatives users are less accurate and more dispersed after derivatives initiation. These results do not appear to be driven by the economic complexity of derivatives, but rather the financial reporting of such economic complexity. Overall, despite their financial expertise, analysts routinely misjudge the earnings implications of firms' derivatives activity. However, we find evidence that a series of derivatives accounting standards has helped analysts improve their forecasts over time.
---------------------
The Sovereign Wealth Fund Discount: Evidence from Public Equity Investments
Bernardo Bortolotti, Veljko Fotak & William Megginson
Review of Financial Studies, November 2015, Pages 2993-3035
Abstract:
We document that announcement-period abnormal returns of sovereign wealth fund (SWF) equity investments in publicly traded firms are positive but lower than those of comparable private investments. Further, SWF investment targets suffer from declining return on assets and sales growth over the following three years. Our results are robust to controls for target and deal characteristics and are not driven by SWF target selection criteria. Larger discounts are associated with SWFs taking seats on boards of directors and with SWFs under strict government control acquiring greater stakes, supporting the hypothesis that political influence negatively affects firm value and performance.
---------------------
Target revaluation after failed takeover attempts: Cash versus stock
Ulrike Malmendier, Marcus Opp & Farzad Saidi
Journal of Financial Economics, forthcoming
Abstract:
Cash- and stock-financed takeover bids induce strikingly different target revaluations. We exploit detailed data on unsuccessful takeover bids between 1980 and 2008, and we show that targets of cash offers are revalued on average by +15% after deal failure, whereas stock targets return to their pre-announcement levels. The differences in revaluation do not revert over longer horizons. We find no evidence that future takeover activities or operational changes explain these differences. While the targets of failed cash and stock offers are both more likely to be acquired over the following eight years than matched control firms, no differences exist between cash and stock targets, neither in the timing nor in the value of future offers. Similarly, we cannot detect differential operational policies following the failed bid. Our results are most consistent with cash bids revealing prior undervaluation of the target. We reconcile our findings with the opposite conclusion in earlier literature (Bradley, Desai, and Kim, 1983) by identifying a look-ahead bias built into their sample construction.
---------------------
Who Should Pay for Credit Ratings and How?
Anil Kashyap & Natalia Kovrijnykh
University of Chicago Working Paper, August 2015
Abstract:
This paper analyzes a model where investors use a credit rating to decide whether to finance a firm. The rating quality depends on the unobservable effort exerted by a credit rating agency (CRA). We analyze optimal compensation schemes for the CRA that differ depending on whether a social planner, the firm, or investors order the rating. We find that rating errors are larger when the firm orders it than when investors do. However, investors ask for ratings inefficiently often. Which arrangement leads to a higher social surplus depends on the agents' prior beliefs about the project quality. We also show that competition among CRAs causes them to reduce their fees, put in less effort, and thus leads to less accurate ratings. Rating quality also tends to be lower for new securities. Finally, we find that optimal contracts that provide incentives for both initial ratings and their subsequent revisions can lead the CRA to be slow to acknowledge mistakes.
---------------------
Institutional Investors and the Information Production Theory of Stock Splits
Thomas Chemmanur, Gang Hu & Jiekun Huang
Journal of Financial and Quantitative Analysis, June 2015, Pages 413-445
Abstract:
We make use of a large sample of transaction-level institutional trading data to test an extended version of Brennan and Hughes' (1991) information production theory of stock splits. We compare brokerage commissions paid by institutional investors before and after a split, assess the private information held by them, and relate the informativeness of their trading to brokerage commissions paid. We show that institutions make abnormal profits net of brokerage commissions by trading in splitting stocks. We also show that the information asymmetry faced by firms goes down after stock splits. Overall, our empirical results support the information production theory.