The long and short of it
A Model of Moral-Hazard Credit Cycles
Roger Myerson
Journal of Political Economy, October 2012, Pages 847-878
Abstract:
This paper considers a simple model of credit cycles driven by moral hazard in financial intermediation. Financial agents or bankers must earn moral-hazard rents, but the cost of these rents can be efficiently spread over an agent's entire career by promising large late-career rewards if the agent has a consistently successful record. Dynamic interactions among different generations of financial agents can create credit cycles with repeated booms and recessions. In recessions, a scarcity of trusted financial intermediaries limits investment and reduces employment. Under such conditions, taxing workers to subsidize bankers may increase employment enough to make the workers better off.
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Patriotic name bias and stock returns
Evangelos Benos & Marek Jochec
Journal of Financial Markets, forthcoming
Abstract:
Companies whose names contain the words "America(n)" or "USA" earn positive abnormal returns of about 6% per annum during World War II, the Korean War, and the War on Terrorism. These abnormal returns are not realized immediately upon the outbreak of each of the wars but are accumulated gradually during wartime. Given that no such effect is observed for the Vietnam War, we hypothesize that major, victorious wars arouse investors' patriotic feelings and cause them to gradually and perhaps subconsciously gravitate toward stocks whose name has a patriotic flavor.
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Buying Beauty: On Prices and Returns in the Art Market
Luc Renneboog & Christophe Spaenjers
Management Science, forthcoming
Abstract:
This paper investigates the price determinants and investment performance of art. We apply a hedonic regression analysis to a new data set of more than one million auction transactions of paintings and works on paper. Based on the resulting price index, we conclude that art has appreciated in value by a moderate 3.97% per year, in real U.S. dollar terms, between 1957 and 2007. This is a performance similar to that of corporate bonds - at much higher risk. A repeat-sales regression on a subset of the data demonstrates the robustness of our index. Next, quantile regressions document larger average price appreciations (and higher volatilities) in more expensive price brackets. We also find variation in historical returns across mediums and movements. Finally, we show that measures of high-income consumer confidence and art market sentiment predict art price trends.
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The Inefficient Markets Hypothesis: Why Financial Markets Do Not Work Well in the Real World
Roger Farmer, Carine Nourry & Alain Venditti
NBER Working Paper, December 2012
Abstract:
Existing literature continues to be unable to offer a convincing explanation for the volatility of the stochastic discount factor in real world data. Our work provides such an explanation. We do not rely on frictions, market incompleteness or transactions costs of any kind. Instead, we modify a simple stochastic representative agent model by allowing for birth and death and by allowing for heterogeneity in agents' discount factors. We show that these two minor and realistic changes to the timeless Arrow-Debreu paradigm are sufficient to invalidate the implication that competitive financial markets efficiently allocate risk. Our work demonstrates that financial markets, by their very nature, cannot be Pareto efficient, except by chance. Although individuals in our model are rational; markets are not.
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New evidence on the first financial bubble
Rik Frehen, William Goetzmann & Geert Rouwenhorst
Journal of Financial Economics, forthcoming
Abstract:
The Mississippi Bubble, South Sea Bubble and the Dutch Windhandel of 1720 together represent the world's first global financial bubble. We hand-collect cross-sectional price data and investor account data from 1720 to test theories about market bubbles. Our tests suggest that innovation was a key driver of bubble expectations. We present evidence against the currently prevailing debt-for-equity conversion hypothesis and relate stock returns to innovations in Atlantic trade and insurance. We find evidence consistent with the innovation-driven bubble dynamics documented by Pastor and Veronesi (2009) for new economy stocks. Our evidence seems inconsistent with clientele-based theories that emphasize bubble-riding and short-sales restrictions.
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Does Religion Matter to Equity Pricing?
Sadok El Ghoul et al.
Journal of Business Ethics, December 2012, Pages 491-518
Abstract:
For a sample comprising 36,105 U.S. firm-year observations from 1985 to 2008, we find that firms located in more religious counties enjoy cheaper equity financing costs. This result is robust to a battery of sensitivity tests, including alternative assumptions and model specifications, additional controls for noise in analyst forecasts, and various approaches to addressing endogeneity. In another set of tests, we find that the equity pricing role that religion plays comes predominantly from Mainline Protestants. We also document that the effect of religiosity on firms' cost of equity capital is larger for firms (periods) lacking alternative monitoring (regulation) mechanisms as measured by lower institutional ownership (the pre-SOX era), implying that religion plays a corporate governance role. Finally, we find that the importance of religion to equity pricing is concentrated in firms that suffer lower visibility, which tend to be more sensitive to local social and economic factors. By examining the links between religiosity and valuation at the firm level, we provide strong, robust evidence supporting the perspective that religion facilitates economic development.
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Wall Street and the Housing Bubble
Ing-Haw Cheng, Sahil Raina & Wei Xiong
University of Michigan Working Paper, September 2012
Abstract:
We analyze whether mid-level managers in securitized finance were aware of the housing bubble in 2004-2006 using their personal home transaction data. We find little evidence of them timing the bubble or exercising cautious behavior in purchasing homes on average, relative to two uninformed control groups: one composed of non-real estate lawyers and the other of non-housing equity analysts. Our findings cast doubt on the popular "inside job" view of the recent financial crisis that Wall Street employees knowingly ignored warning signs of the housing bubble.
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U.S. presidential elections and implied volatility: The role of political uncertainty
John Goodell & Sami Vähämaa
Journal of Banking & Finance, forthcoming
Abstract:
This paper focuses on the effects of political uncertainty and the political process on implied stock market volatility during U.S. presidential election cycles. Using monthly Iowa Electronic Markets data over five elections, we document that stock market uncertainty, as measured by the VIX volatility index, increases along with positive changes in the probability of success of the eventual winner. The association between implied volatility and the election probability of the eventual winner is positive even after controlling for changes in overall election uncertainty. These findings indicate that the presidential election process engenders market anxiety as investors form and revise their expectations regarding future macroeconomic policy.
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Lauren Cohen, Karl Diether & Christopher Malloy
Review of Financial Studies, forthcoming
Abstract:
We demonstrate that a firm's ability to innovate is predictable, persistent, and relatively simple to compute, and yet the stock market appears to ignore the implications of past successes when valuing future innovation. We show that two firms that invest the exact same in research and development (R&D) can have quite divergent, but predictably divergent, future paths. Our approach is based on the simple premise that while future outcomes associated with R&D investment are uncertain, the past track records of firms may give insight into their potential for future success. We show that a long-short portfolio strategy that takes advantage of the information in past track records earns abnormal returns of roughly 11 percent per year. Importantly, these past track records also predict divergent future real outcomes in patents, patent citations, and new product innovations.
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Political Climate, Optimism, and Investment Decisions
Yosef Bonaparte, Alok Kumar & Jeremy Page
University of Miami Working Paper, February 2012
Abstract:
We show that people's optimism towards financial markets and the macroeconomy is dynamically influenced by their political affiliation and the existing political climate. Individuals become more optimistic and perceive the markets to be less risky and more undervalued when their own party is in power. These shifts in perceptions of risk and reward affect investors' portfolio decisions. Specifically, when the political climate is aligned with their political identity, investors increase allocations to risky assets and exhibit a stronger preference for high market beta, small-cap, and value stocks. Due to these portfolio reallocations, investors improve their raw portfolio performance when their own party is in power, but the improvement in risk-adjusted performance is economically small.
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Danling Jiang, Alok Kumar & Kelvin Law
University of Miami Working Paper, September 2011
Abstract:
Using a unique dataset tracking the personal political contributions of sell-side equity analysts from 1993 to 2009, this paper shows that personal political preferences of sell-side equity analysts are reflected in their professional decisions and market prices. Specifically, we find that Republican analysts who are conservative in their personal decisions issue more conservative earnings forecasts and stock recommendations. Further, Republican forecasts are more accurate because their conservatism partially mitigates the adverse effects of known optimism biases in analyst forecasts. Sophisticated market participants are aware of the superior abilities of Republican analysts as they receive greater media coverage and are more likely to be voted as all-star analysts. In contrast, the market reaction to their revisions is weaker, particularly among stocks that are more actively traded by retail investors. Thus, less sophisticated retail investors are unable to identify the positive relation between personal conservatism and forecasting skill.
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Emotion regulation and trader expertise: Heart rate variability on the trading floor
Mark Fenton-O'Creevy et al.
Journal of Neuroscience, Psychology, and Economics, November 2012, Pages 227-237
Abstract:
We describe a psychophysiological study of the emotion regulation of investment bank traders. Building on work on the role of emotions in financial decision making, we examined the relationship between market conditions, trader experience, and emotion regulation while trading, as indexed by high-frequency heart rate variability (HF HRV). We found a significant inverse relationship between HF HRV and market volatility and a positive relationship between HF HRV and trader experience. We argue that this suggests that emotion regulation may be an important facet of trader expertise, and that learning effects demonstrated in financial markets may include improved emotion regulation as an important component of that learning. Our results also suggest the value of investigating the role of effective emotion regulation in a broader range of financial decision-making contexts.
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The Real Effects of Financial Markets
Philip Bond, Alex Edmans & Itay Goldstein
Annual Review of Financial Economics, 2012, Pages 339-360
Abstract:
A large amount of activity in the financial sector occurs in secondary financial markets, where securities are traded among investors without capital flowing to firms. The stock market is the archetypal example, which in most developed economies captures a lot of attention and resources. Is the stock market just a sideshow or does it affect real economic activity? In this review, we discuss the potential real effects of financial markets that stem from the informational role of market prices. We review the theoretical literature and show that accounting for the feedback effect from market prices to the real economy significantly changes our understanding of the price formation process, the informativeness of the price, and speculators' trading behavior. We make two main points. First, we argue that a new definition of price efficiency is needed to account for the extent to which prices reflect information that is useful for the efficiency of real decisions (rather than the extent to which they forecast future cash flows). Second, incorporating the feedback effect into models of financial markets can explain various market phenomena that otherwise seem puzzling. Finally, we review empirical evidence on the real effects of secondary financial markets.
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Short-Selling Bans Around the World: Evidence from the 2007-09 Crisis
Alessandro Beber & Marco Pagano
Journal of Finance, forthcoming
Abstract:
Most regulators around the world reacted to the 2007-09 crisis by imposing bans on short selling. These were imposed and lifted at different dates in different countries, often targeted different sets of stocks, and featured varying degrees of stringency. We exploit this variation in short-sales regimes to identify their effects on liquidity, price discovery, and stock prices. Using panel and matching techniques, we find that bans (i) were detrimental for liquidity, especially for stocks with small capitalization and no listed options; (ii) slowed price discovery, especially in bear markets, and (iii) failed to support prices, except possibly for U.S. financial stocks.
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Paying Attention: Overnight Returns and the Hidden Cost of Buying at the Open
Henk Berkman et al.
Journal of Financial and Quantitative Analysis, August 2012, Pages 715-741
Abstract:
We find a strong tendency for positive returns during the overnight period followed by reversals during the trading day. This behavior is driven by an opening price that is high relative to intraday prices. It is concentrated among stocks that have recently attracted the attention of retail investors, it is more pronounced for stocks that are difficult to value and costly to arbitrage, and it is greater during periods of high overall retail investor sentiment. The additional implicit transaction costs for retail traders who buy high-attention stocks near the open frequently exceed the effective half spread.
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Out of the Dark: Hedge Fund Reporting Biases and Commercial Databases
Adam Aiken, Christopher Clifford & Jesse Ellis
Review of Financial Studies, forthcoming
Abstract:
We examine the potential for selection bias in voluntarily reported hedge fund performance data. We construct a set of hedge fund returns that have never been reported to a commercial hedge fund database. These returns allow a direct comparison of performance between funds that choose to report to commercial databases and funds that do not. We find that funds that report their performance to commercial databases significantly outperform nonreporting funds. Our results suggest that the voluntarily reported performance in commercial databases suffers from a selection bias that may exaggerate the average skill of the universe of hedge fund managers.
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On the Size of the Active Management Industry
Luboš Pástor & Robert Stambaugh
Journal of Political Economy, August 2012, Pages 740-781
Abstract:
We argue that active management's popularity is not puzzling despite the industry's poor track record. Our explanation features decreasing returns to scale: As the industry's size increases, every manager's ability to outperform passive benchmarks declines. The poor track record occurred before the growth of indexing modestly reduced the share of active management to its current size. At this size, better performance is expected by investors who believe in decreasing returns to scale. Such beliefs persist because persistence in industry size causes learning about returns to scale to be slow. The industry should shrink only moderately if its underperformance continues.
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Wall Street occupations: An equilibrium theory of overpaid jobs
Ulf Axelson & Philip Bond
London School of Economics Working Paper, June 2012
Abstract:
We develop an optimal dynamic contracting theory of overpay for jobs in which moral hazard is a key concern, such as investment banking. Overpaying jobs feature up-or-out contracts and long work hours, yet give more utility to workers than their outside option dictates. Labor markets feature "dynamic segregation," where some workers are put on fast-track careers in overpaying jobs and others have no chance of entering the overpaying segment. Entering the labor market in bad economic times has life-long negative implications for a worker's career both in terms of job placement and contract terms. Moral hazard problems are exacerbated in good economic times, which leads to countercyclical productivity. Finally, workers whose talent would be more valuable elsewhere can be lured into overpaying jobs, while the most talented workers might be unable to land these jobs because they are "too hard to manage."
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Causes and Consequences of Linguistic Complexity in Non-U.S. Firm Conference Calls
Francois Brochet, Patricia Naranjo & Gwen Yu
Harvard Working Paper, October 2012
Abstract:
We examine the determinants and capital market consequences of linguistic complexity in conference calls held in English by non-U.S. firms. We find that linguistic complexity is positively associated with the language barrier in the firms' home country. Also, linguistic complexity in firms' conference calls affects the extent to which the capital market reacts to the information releases. Firms with more linguistic complexity in their conference calls show less trading volume and price movement following the information releases, after controlling for the actual earnings news. Further, the capital market's response to linguistic complexity is more pronounced when there is greater implicit (as captured by the presence of foreign investors) or explicit (as captured by how actively analysts ask questions) demand for the English conference calls. This suggests that the form in which financial information is presented can impose additional processing costs by limiting investors' ability to interpret the reported financials.
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The Impact of Social and Conventional Media on Firm Equity Value: A Sentiment Analysis Approach
Yang Yu, Wenjing Duan & Qing Cao
Decision Support Systems, forthcoming
Abstract:
This study aims to investigate the effect of social media and conventional media, their relative importance, and their interrelatedness on short term firm stock market performances. We use a novel and large-scale dataset that features daily media content across various conventional media and social media outlets for 824 public traded firms across 6 industries. Social media outlets include blogs, forums, and twitter. Conventional media includes major newspapers, television broadcasting companies, and business magazines. We apply the advanced sentiment analysis technique that goes beyond the number of mentions (counts) to analyze the overall sentiment of each media resource toward a specific company on the daily basis. We use stock return and risk as the indicators of companies' short-term performances. Our findings suggest that overall social media has stronger relationship with firm stock performance than conventional media while social and conventional media have strong interaction effect on stock performance. More interestingly, we find the impact of different types of social media varies significantly. Different types of social media also interrelate with conventional media to influence stock movement in various directions and degrees. Our study is among the first to examine the effect of multiple sources of social media along with the effect of conventional media and to investigate their relative importance and their interrelatedness. Our findings suggest the importance for firms to differentiate and leverage the unique impact of various sources of media outlets in implementing their social media marketing strategies.
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Gilles Hilary & Charles Hsu
Journal of Finance, forthcoming
Abstract:
We show empirically that analysts who display more consistent forecast errors have greater ability to affect prices, and that this effect is larger than that of stated accuracy. These results lead to three implications. First, consistent analysts are less likely to be demoted and are more likely to be nominated All Star analysts. Second, analysts strategically deliver downward-biased forecasts to increase their consistency (if at the expense of stated accuracy). Finally, the benefits of consistency and of "lowballing" (accuracy) are increasing (decreasing) in institutional investors' presence.
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Do Less Regulated Markets Attract Lower Quality Firms? Evidence from the London AIM Market
Ulf Nielsson
Journal of Financial Intermediation, forthcoming
Abstract:
The paper examines whether the moderately regulated London AIM market is at a disadvantage in attracting high quality firms. The results show that firms listed on AIM are of the same quality level as firms listed in the U.S. and in Continental Europe, albeit smaller in size. Furthermore, the delisting and valuation pattern is the same across markets, whereas AIM listed firms raise relatively more capital. Thus, rather than catering to low quality firms seeking to conceal their type, the AIM market attracts small firms that - due to size - face disproportional regulatory costs, but are otherwise equivalent to firms listing in more regulated markets.
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Thomas Chemmanur & Xuan Tian
Journal of Financial and Quantitative Analysis, September/October 2012, Pages 933-972
Abstract:
This paper presents the first theoretical analysis of the choice of firms between "preparing" and not preparing the equity market in advance of a possible dividend cut. In our model, insiders have private information about their firm's intermediate cash flow as well as about the net present value of its growth opportunity. We show that, in equilibrium, firms in temporary financial difficulties but with good long-term growth prospects are more likely to prepare the market in advance of dividend cuts, while those with permanently declining earnings are less likely to prepare the market. Our model generates several new testable predictions.