The real effect of the initial enforcement of insider trading laws
Zhihong Chen et al.
Journal of Corporate Finance, August 2017, Pages 687-709
Based on a difference-in-differences approach, we find strong evidence that the initial enforcement of insider trading laws improves capital allocation efficiency. The effect is concentrated in developed markets and manifests shortly after the enforcement year. Further analysis shows that the improvement is positively associated with the increase in liquidity around the enforcement year and the opaqueness of the information environment before the enforcement year. The improvement is more pronounced for firms operating in more competitive markets, being more financially constrained, and with more severe agency problems. Finally, we find increased accounting performance after the enforcement and the increase is positively associated with the improvement in capital allocation efficiency. Overall, our evidence suggests that the initial enforcement of insider trading laws improves capital allocation efficiency by providing more information to guide managerial decisions and by reducing market frictions arising from information asymmetry and agency problems.
Politics and liquidity
Ben Marshall et al.
Journal of Financial Markets, forthcoming
The equity market is more liquid under Democratic than Republican presidencies. This is apparent at the market level but is stronger in small, value stocks and in industries that are more sensitive to Democratic presidents. The effect is robust to different liquidity measures and time periods and is not solely driven by variation in the business cycle or macroeconomic variables. A number of factors that influence liquidity, including information asymmetry, volatility, and economic policy uncertainty, are all lower during Democratic presidencies. We also show that liquidity increases in the months following a Democratic president replacing a Republican president.
An Empirical Analysis of the Effects of the Dodd-Frank Act on Determinants of Credit Ratings
Anwer Ahmed, Dechun Wang & Nina Xu
Texas A&M University Working Paper, June 2017
We study the effects of the Dodd-Frank Act ("Dodd-Frank") on determinants of credit ratings. We predict that the increase in regulatory oversight and litigation risk prompted by Dodd-Frank, as well as requirements for improved disclosures and governance, motivated credit rating agencies (CRAs) to increase the weight on firm-specific, quantitative fundamental information in making rating decisions. We find that CRAs place a higher weight on firm-specific fundamentals in determining ratings, and the power of the fundamentals in explaining credit rating variation increases significantly after the passage of Dodd-Frank. Additionally, we find that the greater reliance on firm fundamentals at least partially drives the improvement in credit ratings' ability to predict future defaults. Finally, we show that Dodd-Frank has an incremental effect beyond the financial crisis on the determinants of credit ratings. Our results are robust to a battery of sensitivity analyses. Collectively, our evidence suggests that Dodd-Frank incentivizes CRAs to use more quantitative information in making rating decisions, which in turn helps improve credit rating quality.
President Life Cycle and Stock Market Outcomes
University of Colorado Working Paper, June 2017
We show that stock market performance (volatility) comoves concavely (convexly) with President Seniority. There is increasing (decreasing) excess return (volatility) until the end of the fifth year in office, and then the trend reverses. Standard asset pricing theory of risk and behavioral perspective explains the excess return comovement, but faces challenges in explaining the volatility comovement, which is explained using intuition from political science, where each President faces political stages (honeymoon, midterm, reelection, lame duck) with implications for stock market outcomes. Collectively, President Seniority is a determinant of stock market outcomes, a phenomenon that can be understood by aligning asset pricing theory with political science.
In the Red: The Effects of Color on Investment Behavior
William Bazley, Henrik Cronqvist & Milica Mormann
University of Miami Working Paper, June 2017
Financial decisions in today's society are made in environments that involve color stimuli. In this paper, we perform an empirical analysis of the effects of color on investment behavior. First, we find that when investors are displayed potential losses in red, risk taking is reduced. Second, when investors are shown past negative stock price paths in red, expectations about future stock returns are reduced. Consistent with red causing "avoidance behavior," red color reduces investors' propensity to purchase stocks. The findings are robust to a series of checks involving colorblind investors and alternative colors to control for salience effects. Finally, the effects are muted in a cultural setting, e.g., China, where red is not used to visualize financial losses. A contribution of this study is to introduce hypotheses from color psychology and visual science to enhance our understanding of the behavior of individual investors.
Price dynamics and speculative trading in Bitcoin
Research in International Business and Finance, October 2017, Pages 493-499
Few innovations in the money markets have brought more attention by regulators and policy makers than the digital currency Bitcoin. However, few studies in the literature have examined the price dynamics of Bitcoin. Besides providing an exploratory glance at the value and volatility of the Bitcoin across time, we also test whether the unusual level of Bitcoin's volatility is attributable to speculative trading. Results in this study do not find that, during 2013, speculative trading contributed to the unprecedented rise and subsequent crash in Bitcoin's value nor do we find that speculative trading is directly associated with Bitcoin's unusual level of volatility.
Intraday online investor sentiment and return patterns in the U.S. stock market
Journal of Banking & Finance, November 2017, Pages 25-40
We implement a novel approach to derive investor sentiment from messages posted on social media before we explore the relation between online investor sentiment and intraday stock returns. Using an extensive dataset of messages posted on the microblogging platform StockTwits, we construct a lexicon of words used by online investors when they share opinions and ideas about the bullishness or the bearishness of the stock market. We demonstrate that a transparent and replicable approach significantly outperforms standard dictionary-based methods used in the literature while remaining competitive with more complex machine learning algorithms. Aggregating individual message sentiment at half-hour intervals, we provide empirical evidence that online investor sentiment helps forecast intraday stock index returns. After controlling for past market returns, we find that the first half-hour change in investor sentiment predicts the last half-hour S&P 500 index ETF return. Examining users' self-reported investment approach, holding period and experience level, we find that the intraday sentiment effect is driven by the shift in the sentiment of novice traders. Overall, our results provide direct empirical evidence of sentiment-driven noise trading at the intraday level.
Noisy Active Management
University of Pennsylvania Working Paper, June 2017
Lower skill of the active management industry can imply greater fee revenue, value added, and investor performance. Such outcomes arise in a competitive equilibrium in which portfolio choices of active managers partially echo those of noise traders and also contain manager-specific noise. Both sources of noise reduce managers' skill to identify mispriced securities and thereby produce alpha. However, lower skill also means a given amount of active management corrects prices less and thus competes away less alpha. The latter effect can outweigh managers' poorer portfolio choices, so that investors rationally allocate more to active management when its skill is lower.
The impact of portfolio disclosure on hedge fund performance
Journal of Financial Economics, forthcoming
Consistent with the argument that portfolio disclosure reveals trade secrets, a difference-in-differences estimation suggests a drop in fund performance after a hedge fund begins filing Form 13F as well as an increase in return correlations with other funds in the same investment style. The drop in performance is concentrated among funds with larger expected proprietary costs of disclosure, for instance, funds that disclose a greater fraction of their assets or hold more illiquid stocks. The drop in performance cannot be fully explained by alternative explanations such as decreasing returns to scale or mean reversion in fund returns.
It's all in the name: Mutual Fund Name Changes after SEC Rule 35d-1
Susanne Espenlaub, Imtiaz ul Haq & Arif Khurshed
Journal of Banking & Finance, forthcoming
We study how investors respond to 'superficial' mutual-fund name changes that occur for no fundamental reasons. We find that such name changes remain widespread even after regulation to curb potentially misleading name changes (SEC Rule 35d-1). Superficial changes are more widespread than previously studied 'misleading' changes that are not accompanied by corresponding portfolio adjustments reflecting the investment style suggested by the new name. Superficial changes appear to be driven by managerial incentives. Investors react to superficial changes with increased fund flows but appear to gain no benefit through improved performance or lower fees. On the contrary, name-change funds underperform as a group. Our findings highlight inefficiencies in the mutual-fund market and hold important implications for the stakeholders involved.
Presidential Candidates, Political Speeches and Stock Market Returns
University of Miami Working Paper, June 2017
Using data on political speeches, I demonstrate that presidential candidates influence stock market returns. Political speeches that contain economic information increase aggregate market returns and decrease market volatility, while speeches with negative linguistic tone have the opposite effect. The magnitude of the effect becomes stronger during the first months of the campaigns, and varies upon the prevailing market conditions. Using industry-level data, I show that industries with high government exposure are more sensitive to government-spending information, but I find no evidence that politically sensitive industries react stronger to candidate speeches. Overall, my findings suggest that political speeches act as a source of information to investors, and in turn affect asset prices.
Production Networks and Stock Returns: The Role of Creative Destruction
Michael Gofman, Gill Segal & Youchang Wu
University of Wisconsin Working Paper, June 2017
We establish a novel return spread based on the distance between firms and final consumers in a production network. An investment strategy that longs firms with the longest distance and shorts firms with the shortest distance to consumers earns a monthly return of 105 basis points. We explain this spread quantitatively using a general equilibrium model with multiple layers of production. The driving force behind the spread is creative destruction. The spread is smaller for firms that belong to supply chains with lower competition. Overall, our results provide empirical and theoretical support for creative destruction based on financial markets.