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Abstract:
The separation of ownership and control allows controlling shareholders to pursue private benefits.

We develop an analytically tractable dynamic stochastic general equilibrium model to study asset pricing and welfare implications of imperfect investor protection. Consistent with empirical evidence, the model predicts that countries with weaker investor protection have more incentives to overinvest, lower Tobin's q, higher return volatility, larger risk premium, and higher interest rate. Calibrating the model to the Korean economy reveals that perfecting investor protection increases the stock market's value by 22 percent, a gain for which outside shareholders are willing to pay 11 percent of their capital stock.

Abstract:
The separation of ownership and control allows controlling shareholders to pursue private benefits. We develop an analytically tractable dynamic stochastic general equilibrium model to study asset pricing and welfare implications of imperfect investor protection. Consistent with empirical evidence, the model predicts that countries with weaker investor protection have more incentives to overinvest, lower Tobin's q, higher return volatility, larger risk premium, and higher interest rate. Calibrating the model to the Korean economy reveals that perfecting investor protection increases the stock market's value by 22 percent, a gain for which outside shareholders are willing to pay 11 percent of their capital stock.

Abstract:
The separation of ownership and control allows controlling shareholders to pursue private benefits. We develop an analytically tractable dynamic stochastic general equilibrium model to study asset pricing and welfare implications of imperfect investor protection. The model predicts that countries with weaker investor protection have more incentives to overinvest, lower Tobin's q, higher return volatility, larger risk premium, and higher interest rate, consistent with empirical evidence. Calibrating the model to the Korean economy reveals that making investor protection perfect increases the stock market value by 22%, a gain for which outside shareholders are willing to pay 11% of their capital stocks.

Asset prices, heterogeneous agents, agency, corporate governance, investor protection, volatility, overinvestment

Abstract:
This paper characterizes optimal currency hedging for a loss averse firm. Loss aversion gives rise to an incentive to hedge downside risk. Contrary to conventional wisdom we show that forwards dominate options in the presence of a concern over downside risk. The dynamic hedge ratio displays zones of inaction and behaves non-monotonically with the exchange rate.

We discuss how to reinterpret loss aversion in the context of two value-maximizing models of hedging: (i) an all equity firm that faces a convex tax schedule; and (ii) a firm that chooses its hedging policy in the presence of bankruptcy costs.

Abstract:
Evidence on international capital flows suggests that (i) foreign direct investment is less volatile than other financial flows, and that (ii) countries with lower financial ratings--and less developed countries--receive larger shares of FDI flows. We rationalize these facts in a model where international capital flows are subject to imperfect enforcement and FDI is inalienable. Inalienability means that it is not as advantageous to expropriate FDI relative to other flows. This leads to a relatively lower default premium on FDI. Hence, a financially constrained country borrows relatively more through FDI. Simultaneously, non-FDI flows respond more aggressively to changes in the country's financial constraint. The inalienability of FDI highlights its risk sharing potential.

Abstract:
This paper studies the international portfolio flows of US investors to examine the information structure of international equity markets. We use an empirical model of portfolio flows with both public and private information to extract measures of trades due to private information. We find that such trades are highly correlated across countries. In particular, a common global factor accounts for about half of the variation in trades due to private information. We show that the global factor helps explain the cross section of international equity returns, after controlling for public information. The finding that a substantial portion of trades due to private information across countries contains the same common information challenges the conventional view that domestic investors have better private information about their home market than foreign investors.

Private information, asymmetric information, portfolio choice, international equity fows and returns, home bias.

Abstract:
We study the determinants of private benefits of control in negotiated block transactions. We estimate the block pricing model in Burkart, Gromb, and Panunzi (2000) explicitly dealing with the existence of both block premia and block discounts in the data. We find evidence that the occurrence of block premia and block discounts depends on the controlling block holder's ability to fight a potential tender offer for the target's stock. Private benefits represent 3% of the target firm's stock market value. Private benefits increase with the target's cash holdings and decrease with its short term debt providing evidence in favor of Jensen's free cash flow hypothesis. A counterfactual policy evaluation of the Mandatory Bid Rule suggests that it fails to add value to shareholders because it fails to prevent welfare decreasing transactions and, by forcing inefficient tender offers, it deters welfare increasing transactions.

block pricing, block trades, control transactions, private benefits of control, market rule, mandatory bid rule, structural estimation

Abstract:
We develop a general dynamic model in which borrowing constraints arise endogenously as part of a constrained- efficient contract when borrowers face limited liability and debt repayment cannot be perfectly enforced. The model is qualitatively consistent with the some stylized facts on the growth and survival, and on the dividend and capital structure policies of firms. We derive new implications for the study of financing constraints and the behavior of small versus large firms.

Financial constraints, imperfect enforcement, long term debt, capital structure, firm dynamics.

Abstract:
We develop a general model of lending in the presence of endogenous borrowing constraints. Borrowing constraints arise because borrowers face limited liability and debt repayment cannot be perfectly enforced. In the model, the dynamics of debt are closely linked with the dynamics of borrowing constraints. In fact, borrowing constraints must satisfy a dynamic consistency requirement: the value of outstanding debt restricts current access to short-term capital, but is itself determined by future access to credit. This dynamic consistency is not guaranteed in models of exogenous borrowing constraints, where the ability to raise short-term capital is limited by some prespecified function of debt. We characterize the optimal default-free contract - which minimizes borrowing constraints at all histories - and derive implications for firm growth, survival, leverage and debt maturity. The model is qualitatively consistent with stylized facts on the growth and survival of firms. Comparative statics with respect to technology and default constraints are derived.

Abstract:
We develop a general dynamic model in which borrowing constraints arise endogenously as part of a constrained-efficient contract when borrowers face limited liability and debt repayment cannot be perfectly enforced. The model is qualitatively consistent with some stylized facts on the growth and survival of firms. We derive implications for the study of financing constraints and the capital structure choices of constrained firms.

Financial constraints, imperfect enforcement, firm dynamics, capital structure, debt maturity.

Abstract:
This paper presents a contracting model of governance based on the premise that CEOs are the main promoters of governance change. CEOs use their power to extract higher pay or private benefits, and different governance structures are preferred by different CEOs as they favor one or the other type of compensation. The model explains why good country-wide investor protection breeds good firm governance and predicts a race to the top in firm-governance quality after the Sarbanes-Oxley Act. However, such governance changes may be associated with higher rather than lower CEO pay as CEOs substitute away from private benefits. The model also provides an explanation for the observed correlation of CEO pay and firm governance as driven by CEO power.

CEO power, moral hazard, CEO compensation, corporate governance, investor protection

Abstract:
Albuquerque, Loayza, and Serven analyze the unparalleled increase in foreign direct investment to emerging market economies in the past 25 years. Using a large cross-country timeseries data set, the authors evaluate the dependence of foreign direct investment on global factors or worldwide sources of risk (that is, factors that drive foreign direct investment across several countries). They construct a globalization measure that equals the share of explained variation in direct investment attributable to global factors. The authors show that the globalization measure has increased steadily for industrial and developing countries. For the full sample of countries, the globalization measure rose eightfold from 1985 to 1999. Furthermore, in recent years developing countries' exposure to global factors has approached that of industrial countries, particularly for Latin America. Finally, the globalization measure correlates strongly with measures of capital market liberalization. Overall, the authors find strong support for the hypothesis of increased market integration which implies a greater role for worldwide sources of risk. They discuss the implications of the results for public policies regarding capital market liberalization and policies directed at attracting foreign investment.

This paper - a product of Macroeconomics and Growth, Development Research Group - is part of a larger effort in the group to understand international capital flows.

Capital Market Integration, Emerging Economies, Global Factors, Foreign Direct Investment

Abstract:
This paper considers the role of foreign investors in developed country equity markets. It presents a quantitative model of trading that is built around two new assumptions about investor sophistication: (i) both the foreign and domestic populations contain investors with superior information sets; and (ii) these knowledgeable investors have access to both public equity markets and private investment opportunities. The model delivers a unified explanation for three stylized facts about U.S. investors' international equity trades: (i) trading by U.S. investors occurs in waves of simultaneous buying and selling; (ii) U.S. investors build and unwind foreign equity positions gradually; and (iii) U.S. investors increase their market share in a country when stock prices there have recently been rising. The results suggest that heterogeneity within the foreign investor population is much more important than heterogeneity of investors across countries.

Abstract:
This paper reconsiders the role of foreign investors in developed country equity markets. It presents a quantitative model of trading that is built around two new assumptions about investor sophistication: (i) both the foreign and domestic populations contain investors with superior information sets; and (ii) these knowledgeable investors have access to both public equity markets and private investment opportunities. The model delivers a unified explanation for three stylized facts about US investors' international equity trades: (i) trading by US investors occurs in waves of simultaneous buying and selling; (ii) US investors build and unwind foreign equity positions gradually; and (iii) US investors increase their market share in a country when stock prices there have recently been rising. The results suggest that heterogeneity within the foreign investor population is much more important than heterogeneity of investors across countries.

Asymmetric information, heterogenous investors, asset pricing, international equity flows, international equity returns

Abstract:
This paper considers the role of foreign investors in developed-country equity markets. It presents a quantitative model of trading that is built around two new assumptions: (i) both the foreign and domestic investor populations contain investors of different sophistication, and (ii) investor sophistication matters for performance in both public equity and private investment opportunities. The model delivers a unified explanation for three stylized facts about US investors' international equity trades: (i) trading by US investors occurs in bursts of simultaneous buying and selling, (ii) Americans build and unwind foreign equity positions gradually and (iii) US investors increase their market share in a country when stock prices there have recently been rising. The results suggest that heterogeneity within the foreign investor population is much more important than heterogeneity of investors across countries.

Asymmetric information, heterogenous investors, asset pricing, international equity flows, international equity returns.

Abstract:
This paper studies the forward premium puzzle in an environment where private agents do not perfectly observe the shocks that drive monetary policy. Private agents optimally update their conditional expectations by means of the Kalman filter. The transition dynamics associated with Kalman filtering lead to fixed time-effects and conditional heteroskedasticity in the forward premium regression. We provide evidence for some of the theoretical properties of the model and find that our empirical specification significantly weakens the forward premium puzzle. In particular, a 1 percent increase in the 1-month interest differential is expected to be accompanied by an additional 0.34 percent depreciation of the currency in the following month.

Abstract:
This paper provides an explanation for momentum and reversal in stock returns within a rational expectations framework in which investors are heterogeneous in their information and investment opportunities. We assume that informed agents privately receive advance information about company earnings that materializes into the future. While this information is immediately incorporated into prices, stock prices underreact to it causing short-run momentum. Stock prices may appear to move in ways unrelated to current fundamentals. When the information materializes, the stock price reverts back to its long run mean mimicking an overreaction pattern.

advance information, momentum and reversal effects, overreaction, rational expectations equilibrium, underreaction

Abstract:
This paper provides an explanation for momentum and reversal in stock returns within a rational expectations equilibrium framework in which investors have heterogeneous information and investment opportunities. We assume that informed investors privately receive advance information about company earnings that materializes into the future. This information is immediately partially incorporated into prices, and thus stock prices may move in ways unrelated to current fundamentals. Investors' speculative and rebalancing trades in response to advance information generate short-run momentum, mimicking an underreaction pattern. When this information materializes, the stock price reverts back to its long-run mean, mimicking an overreaction pattern.

advance information, momentum and reversal effects, underreaction, overreaction, rational expectations equilibrium

Abstract:
This paper provides an explanation for momentum and reversal in stock returns within a rational expectations framework in which investors are heterogeneous in their information and investment opportunities. We assume that informed investors privately receive advance information about company earnings that materializes into the future. While this information is immediately incorporated into prices, stock prices underreact to it causing short-run momentum. Stock prices may appear to move in ways unrelated to current fundamentals. When the information materializes, the stock price reverts back to its long run mean mimicking an overreaction pattern.

advance information, momentum and reversal effects, underreaction, overreaction, rational expectations equilibrium

Abstract:
We analyze the effects that real-time domestic and foreign news about fundamentals have on the co-movement between stock returns of a small, open economy, Portugal, and a large economy, the United States. Consistent with our theoretical model, we find that US macroeconomic news and Portuguese earnings news do not affect stock market co-movement, whereas Portuguese macroeconomic news lowers stock market co-movement. We find that US news affects Portuguese stock market returns, though less so when US stock market returns are included in the regression. We provide evidence, contrary to common wisdom, that this last result does not derive from contagion.

F3, G12, G14, G15

Abstract:
We analyze the effects that real-time domestic and foreign news about fundamentals have on the co-movement between stock returns of a small, open economy, Portugal, and a large economy, the United States. Studying co-movement between the US and a small, open economy helps overcome significant potential issues in the literature: (i) we avoid endogeneity biases; (ii) we increase the statistical power to reject the null hypothesis in favor of the alternative that US macroeconomic news are drivers of co-movement; and (iii) our results are less likely to suffer from omitted variable biases. Consistent with our theoretical model, we find that US macroeconomic news and Portuguese earnings news do not affect cross-country stock market co-movement, whereas Portuguese macroeconomic news lowers cross-country stock market co-movement. We also find that US public information affects Portuguese stock market returns; however, this effect is much reduced when US stock market returns are included in the regression. We provide evidence, contrary to common wisdom, that this result does not derive from contagion. Finally, public information is associated with increased liquidity in the United States, while the effect in Portugal depends on the type of news released.

Private information, public news announcements, information spillovers, international equity returns, contagion

Abstract:
We analyze the effects that real-time domestic and foreign news about fundamentals have on the co-movement between stock returns of a small, open economy, Portugal, and a large economy, the United States. Studying co-movement between the US and a small, open economy helps overcome significant potential issues in the literature: (i) we avoid endogeneity biases; (ii) we increase the statistical power to reject the null hypothesis in favor of the alternative that US macroeconomic news are drivers of co-movement; and (iii) our results are less likely to suffer from omitted variable biases. Consistent with our theoretical model, we find that US macroeconomic news and Portuguese earnings news do not affect cross-country stock market co-movement, whereas Portuguese macroeconomic news lowers cross-country stock market co-movement. We also find that US public information affects Portuguese stock market returns; however, this effect is much reduced when US stock market returns are included in the regression. We provide evidence, contrary to common wisdom, that this result does not derive from contagion. Finally, public information is associated with increased liquidity in the United States, while the effect in Portugal depends on the type of news released.

Private information, public news announcements, information spillovers, international equity returns, contagion

Abstract:
We present a model of equity trading with informed and uninformed investors where informed investors act upon firm-specific private information and marketwide private information. The model is used to structurally identify the component of order flow that is due to marketwide private information. Trades driven by marketwide private information display very little or no correlation with the first principal component of order flow. This finding implies that a simple statistical factor is a poor measure of marketwide private information. Moreover, the model suggests that the previously documented comovement in order flow captures mostly common variation in liquidity trades. We find that marketwide private information obtained from equity market data forecasts industry stock returns and foreign exchange returns consistent with Evans and Lyons' (2004a) model of exchange rate determination.

Marketwide private information, firm-specific private information, order flow, principal components, currency returns, equity returns

Abstract:
We present a model of equity trading with informed and uninformed investors where informed investors act upon firm-specific private information and marketwide private information. The model is used to structurally identify the component of order flow that is due to marketwide private information. Estimated trades driven by marketwide private information display very little or no correlation with the first principal component in order flow. This finding implies that a simple statistical factor of order flow is a poor measure of marketwide private information. Moreover, the model suggests that the previously documented co-movement in order flow captures mostly variation in liquidity trades. Marketwide private information obtained from equity market data forecasts industry stock returns. It also forecasts foreign exchange returns consistent with Evans and Lyons' (2004a) model of exchange rate determination.

Marketwide private information, firm-specific private information, order flow, principal components, currency returns, equity returns

Abstract:
This paper studies international equity markets when some investors have private information that is valuable for trading in many countries simultaneously. We use a dynamic model of equity trading to show that 'global' private information helps understand US investors' trading behaviour and performance. In particular, the model predicts global return chasing - positive comovement of US investors' net purchases with returns in many countries - which we show to be present in the data. Return chasing in our model can be due to superior performance of US investors, not inferior knowledge or naive trend-following. We also show that trades due to private information are strongly correlated across countries: a common 'global' factor accounts for about half their variation.

Private information, global private information, asymmetric information, portfolio choice, international equity flows and returns, home bias, return chasing

Abstract:
This paper studies international equity markets when some investors have private information that is valuable for trading in many countries simultaneously. We use a dynamic model of equity trading to show that "global" private information helps understand US investors' trading behavior and performance. In particular, the model predicts global return chasing -- positive comovement of US investors' net purchases with returns in many countries -- which we show to be present in the data. Return chasing in our model can be due to superior performance of US investors, not inferior knowledge or naive trend-following. We also show that trades due to private information are strongly correlated across countries: a common "global" factor accounts for about half their variation.

Private information, global private information, asymmetric information, portfolio choice, international equity flows and returns, home bias, return chasing

Abstract:
This paper presents a contracting model of governance based on the premise that CEOs are the main promoters of governance change. CEOs use their power to extract higher pay or private benefits, and different governance structures are preferred by different CEOs as they favour one or the other type of compensation. The model explains why good countrywide investor protection breeds good firm governance and predicts a 'race to the top' in firm-governance quality after the Sarbanes-Oxley Act. However, such governance changes may be associated with higher rather than lower CEO pay as CEOs substitute away from private benefits. The model also provides an explanation for the observed correlation of CEO pay and firm governance based on CEO power. Finally, we discuss the optimality of introducing randomness in CEO hiring, for example, by evaluating CEOs based on qualitative characteristics, or soft skills, that are prone to diverse judgements.

CEO power, moral hazard, CEO compensation, investor protection

Abstract:
We study the determinants of private benefits of control in negotiated block transactions. We estimate the block pricing model in Burkart, Gromb, and Panunzi (2000) explicitly accounting for both block premia and block discounts in the data. The evidence suggests that the occurrence of a block premium or discount depends on the controlling block holder's ability to fight a potential tender offer for the target's stock. We find evidence of large private benefits of control and of associated deadweight losses, but also of value creation by controlling shareholders. Finally, we provide evidence consistent with Jensen's free cash flow hypothesis.

Block pricing, block trades, control transactions, deadweight loss, private benefits of control, structural estimation

Abstract:
We study the determinants of private benefits of control in negotiated block transactions. We estimate the block pricing model in Burkart, Gromb, and Panunzi (2000) explicitly accounting for both block premia and block discounts in the data. The evidence suggests that the occurrence of a block premium or discount depends on the controlling block holder's ability to fight a potential tender offer for the target's stock. We find evidence of large private benefits of control and of associated deadweight losses, but also of value creation by controlling shareholders. Finally, we provide evidence consistent with Jensen's free cash flow hypothesis.

block pricing, block trades, control transactions, deadweight loss, private benefits of control and structural estimation

Abstract:
Corporations in most countries are run by controlling shareholders whose cash flow rights are substantially smaller than their control rights in the firm. This separation of ownership and control allows the controlling shareholders to pursue private benefits at the cost of outside minority investors by diverting resources away from the firm and distorting corporate investment and payout policies. We develop a dynamic stochastic general equilibrium asset-pricing model that acknowledges the implications of agency conflicts through imperfect investor protection on security prices. We show that countries with weaker investor protection have more overinvestment, lower market-to-book equity values, larger expected equity returns and return volatility, higher dividend yields, and higher interest rates. These predictions are consistent with empirical findings. We develop new predictions: countries with high investment-capital ratios have both higher variance of GDP growth and higher variance of stock returns. We provide evidence consistent with these hypotheses. Finally, we show that weak investor protection causes significant wealth redistribution from outside shareholders to controlling shareholders.

Asset prices, heterogeneous agents, agency, corporate governance, investor protection, volatility, overinvestment

Abstract:
We analyze the effect that real-time domestic and foreign news about fundamentals have on the correlation of stock returns of a small open economy, Portugal, and a large open economy, the U.S. We also study the role of public and private information in the price formation process in the U.S. and Portuguese stock markets. First, and consistent with our theoretical model, we find that U.S. macroeconomic news and Portuguese earnings news do not affect the cross-country stock market correlation, whereas Portuguese macroeconomic news lowers the cross-country stock market correlation. Second, we find that U.S. public information affects Portuguese stock market returns, but this effect is diminished when U.S. stock market returns are included in the regression; we provide evidence in the paper that this effect does not derive from contagion as commonly accepted. Finally, public information news in the U.S. is associated with increased liquidity, while the effect in Portugal depends on the type of news releases.

Private information, public news announcements, information spillovers, international equity returns, contagion

Abstract:
The empirical evidence on trade reforms suggests that these have a surprisingly small impact on the country's industrial configuration. This industrial structure inertia is difficult to rationalize in standard trade models. This paper develops a two-sector industry dynamics model in which industrial composition inertia arises naturally. The model is then used to study the consequences of different types of trade reforms (e.g. permanent, temporary, gradual, pre-announced) on investment, employment composition, and income distribution.

Abstract:
When a controlling blockholder of a public corporation has a liquidity shock and is forced to sell, he or she may sell to a party that generates a lower security value. The possibility of a liquidity shock induces a 'marketability discount' on the price of shares owned by the blockholder relative to the price of the shares traded in the stock market. In addition, the possibility that the new blockholder generates a lower security value induces an 'illiquidity discount' on shares traded in the stock market relative to shares of otherwise similar stocks without a blockholder. We model the implications of liquidity shocks and estimate their effect on both the price of shares owned by the blockholder (i.e., the marketability discount) and the price of shares owned by the dispersed shareholders (i.e., the illiquidity discount).

There is an obvious practical value of the project which is the ability to guide investors in pricing large blocks. Large blocks are especially hard to price because of the nature of the trades and their infrequency. Moreover, most of the contribution of the literature toward this goal has been via calibrated models, not via estimation.

Because of the nature of majority block trades, these events represent a natural setting to study the impact of liquidity shocks. We thus expect to contribute to the literature on illiquidity in asset markets by estimating the determinants of liquidity shocks using information from block trades.

In addition, understanding the costs associated with controlling shareholders is critical - even in markets like the US where dispersed shareholders tend to be dominant - if one is to advocate controlling shareholders as a substitute for weak corporate governance, in the US or elsewhere.

Abstract:
We study the determinants of private benefits of control in negotiated block transactions. We estimate the block pricing model in Burkart, Gromb, and Panunzi (2000) explicitly dealing with the existence of both block premia and block discounts in the data. We find evidence that the occurrence of block premia and block discounts depends on the controlling block holder's ability to fight a potential tender offer for the target's stock. Private benefits represent 3% of the target firm's stock market value. Private benefits increase with the target's cash holdings and decrease with its short term debt providing evidence in favour of Jensen's free cash flow hypothesis. A counterfactual policy evaluation of the Mandatory Bid Rule suggests that it fails to add value to shareholders because it fails to prevent welfare decreasing transactions and, by forcing inefficient tender offers, it deters welfare increasing transactions.

Block pricing, block trades, control transactions, mandatory bid rule, market rule, private benefits of control, structural estimation

Abstract:
This paper analyzes the asset pricing implications of periodic cash payouts within the context of a stationary rational expectations model with heterogeneous investors. The periodicity of cash payouts provides a natural motivation for time-varying conditional volatility in stock returns. I show that the unconditional distribution of returns is a mixture of normals distribution, which has non-trivial skewness properties. I examine how conditional volatility, trading volume and skewness in stock returns are related to information dispersion and liquidity in the stock market. The model provides a rationale for why firm returns have positive skewness while market returns have negative skewness.

Skewness, investor heterogeneity, period cash payouts, turnover