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Abstract:
We survey 392 CFOs about the cost of capital, capital budgeting, and capital structure. Large firms rely heavily on net present value techniques and the capital asset pricing model, while small firms are relatively likely to use the payback criterion. Older executives without an MBA are more likely to rely on payback than are younger executives with an MBA. Surprisingly, most companies use a single company-wide discount rate to evaluate a project in a new industry and country.

In addition to market risk, firms also frequently adjust cash flows or discount rates for interest rate risk, exchange rate risk, business cycle risk, and inflation risk. Few firms adjust discount rates or cash flows for book-to-market, distress, or momentum risks.

A majority of large firms have a tight or somewhat tight target debt ratio, in contrast to only one-third of small firms. Executives rely heavily on informal rules when choosing capital structure. The most important factors affecting debt policy are maintaining financial flexibility and having a good credit rating. When issuing equity, respondents are concerned about earnings per share dilution and recent stock price appreciation.

We find some support for the pecking-order and trade-off capital structure hypotheses but little evidence that executives are concerned about asset substitution, asymmetric information, transactions costs, free cash flows, or personal taxes. If CFOs behave according to these deeper hypotheses, they apparently do so unknowingly.

Capital Structure, Cost of Capital, Cost of Equity, Capital Budgeting, Discount Rates, Project Valuation, Survey

Abstract:
We survey 384 financial executives and conduct in depth interviews with an additional 23 to determine the factors that drive dividend and share repurchase decisions. Our findings indicate that maintaining the dividend level is on par with investment decisions, while repurchases are made out of the residual cash flow after investment spending. Perceived stability of future earnings still affects dividend policy as in Lintner (1956). However, fifty years later, we find that the link between dividends and earnings has weakened. Many managers now favor repurchases because they are viewed as being more flexible than dividends and can be used in an attempt to time the equity market or to increase EPS. Executives believe that institutions are indifferent between dividends and repurchases and that payout policies have little impact on their investor clientele. In general, management views provide little support for agency, signaling, and clientele hypotheses of payout policy. Tax considerations play a secondary role. This is the final working paper version of our 2005 publication in the Journal of Financial Economics.

Payout, Dividend policy, Share repurchases, Lintner model

Abstract:
We survey 384 CFOs and Treasurers, and conduct in-depth interviews with an additional two dozen, to determine the key factors that drive dividend and share repurchase policies. We find that managers are very reluctant to cut dividends, that dividends are smoothed through time, and that dividend increases are tied to long-run sustainable earnings but much less so than in the past. Rather than increasing dividends, many firms now use repurchases as an alternative. Paying out with repurchases is viewed by managers as being more flexible than using dividends, permitting a better opportunity to optimize investment. Managers like to repurchase shares when they feel their stock is undervalued and in an effort to affect EPS. Dividend increases and the level of share repurchases are generally paid out of residual cash flow, after investment and liquidity needs are met. Financial executives believe that retail investors have a strong preference for dividends, in spite of the tax disadvantage relative to repurchases. In contrast, executives believe that institutional investors as a class have no strong preference between dividends and repurchases. In general, management views provide at most moderate support for agency, signaling, and clientele hypotheses of payout policy. Tax considerations play only a secondary role. By highlighting where the theory and practice of corporate payout policy are consistent and where they are not, we attempt to shed new light on important unresolved issues related to payout policy in the 21st century.

Abstract:
We survey 401 financial executives, and conduct in-depth interviews with an additional 20, to determine the key factors that drive decisions related to performance measurement and voluntary disclosure. The majority of firms view earnings, especially EPS, as the key metric for an external audience, more so than cash flows. We find that the majority of managers would avoid initiating a positive NPV project if it meant falling short of the current quarter's consensus earnings. Similarly, more than three-fourths of the surveyed executives would give up economic value in exchange for smooth earnings. Managers believe that missing an earnings target or reporting volatile earnings reduces the predictability of earnings, which in turn reduces stock price because investors and analysts dislike uncertainty. We also find that managers make voluntary disclosures to reduce information risk associated with their stock but at the same time, try to avoid setting a disclosure precedent that will be difficult to maintain. In general, management's views support stock price motivations for earnings management and voluntary disclosure, but provide only modest evidence consistent with other theories of these phenomena (such as debt, political cost and bonus plan based hypotheses).

Financial statement, earnings management, earnings benchmark, voluntary disclosure, information risk

Abstract:
We survey 401 financial executives, and conduct in-depth interviews with an additional 20, to determine the key factors that drive decisions related to performance measurements and voluntary disclosure. The majority of firms view earnings, especially EPS, as the key metric for an external audience, more so than cash flows. We find that the majority of managers would avoid initiating a positive NPV project if it meant falling short of the current quarter's consensus earnings. Similarly, more than three-fourths of the surveyed executives would give up economic value in exchange for smooth earnings. Managers believe that missing an earnings target or reporting volatile earnings reduces the predictability of earnings, which in turn reduces stock price because investors and analysts dislike uncertainty. We also find that managers make voluntary disclosures to reduce information risk associated with their stock but try to avoid setting a disclosure precedent that will be difficult to maintain. In general, management's views support stock price motivations for earnings management and voluntary disclosure, but provide only modest evidence consistent with other theories of these phenomena (such as debt, political cost and bonus plan based hypotheses).

financial statement, earnings management, earnings benchmark, voluntary disclosure, information risk,

Abstract:
We survey 401 financial executives, and conduct in-depth interviews with an additional 20, to determine the key factors that drive decisions related to reported earnings and voluntary disclosure. The majority of firms view earnings, especially EPS, as the key metric for outsiders, even more so than cash flows. Because of the severe market reaction to missing an earnings target, we find that firms are willing to sacrifice economic value in order to meet a short-run earnings target. The preference for smooth earnings is so strong that 78% of the surveyed executives would give up economic value in exchange for smooth earnings. We find that 55% of managers would avoid initiating a very positive NPV project if it meant falling short of the current quarter's consensus earnings. Missing an earnings target or reporting volatile earnings is thought to reduce the predictability of earnings, which in turn reduces stock price because investors and analysts hate uncertainty. We also find that managers make voluntary disclosures to reduce information risk associated with their stock but try to avoid setting a disclosure precedent that will be difficult to maintain. In general, management's views provide support for stock price motivations for earnings management and voluntary disclosure, but provide only modest evidence in support of other theories of these phenomena (such as debt, political cost and bonus plan based hypotheses).

Abstract:
We survey 401 financial executives, and conduct in-depth interviews with an additional 20, to determine the key factors that drive decisions related to performance measurement and voluntary disclosure. The majority of firms view earnings, especially EPS, as the key metric for an external audience, more so than cash flows. We find that the majority of managers would avoid initiating a positive NPV project if it meant falling short of the current quarter's consensus earnings. Similarly, more than three-fourths of the surveyed executives would give up economic value in exchange for smooth earnings. Managers believe that missing an earnings target or reporting volatile earnings reduces the predictability of earnings, which in turn reduces stock price because investors and analysts dislike uncertainty. We also find that managers make voluntary disclosures to reduce information risk associated with their stock but at the same time, try to avoid setting a disclosure precedent that will be difficult to maintain. In general, management's views support stock price motivations for earnings management and voluntary disclosure, but provide only modest evidence consistent with other theories of these phenomena (such as debt, political cost and bonus plan based hypotheses).

financial statement, earnings management, earnings benchmark, voluntary disclosure, information risk

Abstract:
Historically, commodity futures have had excess returns similar to those of equities. But what should we expect in the future? The usual risk factors are unable to explain the time-series variation in excess returns. In addition, our evidence suggests that commodity futures are an inconsistent, if not tenuous, hedge against unexpected inflation. Further, the historically high average returns to a commodity futures portfolio are largely driven by the choice of weighting schemes. Indeed, an equally weighted long-only portfolio of commodity futures returns has approximately a zero excess return over the past 25 years. Our portfolio analysis suggests that the a long-only strategic allocation to commodities as a general asset class is a bet on the future term structure of commodity prices, in general, and on specific portfolio weighting schemes, in particular. In contrast, we provide evidence that there are distinct benefits to an asset allocation overlay that tactically allocates using commodity futures exposures. We examine three trading strategies that use both momentum and the term structure of futures prices. We find that the tactical strategies provide higher average returns and lower risk than a long-only commodity futures exposure.

Abstract:
Investors face a number of challenges when seeking to estimate the prospective performance of a long-only investment in commodity futures. For instance, historically, the average annualized excess return of individual commodity futures has been approximately zero and commodity futures returns have been largely uncorrelated with one another. However, the prospective annualized excess return of a rebalanced portfolio of commodity futures can be equity-like. Certain security characteristics, such as the term structure of futures prices, and some portfolio strategies have historically been rewarded with above average returns. Avoiding naïve extrapolation of historical returns and striking a balance between dependable sources of return and possible sources of return is important. This is the unabridged version of our 2006 publication in the Financial Analysts Journal.

Strategic asset allocation, Tactical asset allocation, Diversification return, Roll return, Momentum, Market timing, Convenience yield, Contango, Backwardation, Normal backwardation, Commodity correlation, Commodity risk factors, Commodity term structure, Trading strategies, Overlay strategies

Abstract:
We provide a framework for using conditioning information in the process of global asset allocation. While we discuss strategies in a global setting, the same reasoning can be applied to other asset allocation programs with different investment objectives. We examine three levels of asset allocation: unconditional or benchmark allocation, strategic asset allocation, and tactical asset allocation. We show how to use conditioning information in the process of global tactical asset allocation. An important lesson emerges. There is considerable work documenting predictability of returns using past information variables. Many of these variables are related to the stage of the business cycle, and suggest that much of the predictability in these assets, or markets, are common. The fact that returns are predictable means that active asset allocation strategies can outperform passive strategies. Uncovering the predictability is challenging as it but allows managers to beat traditional benchmarks.

Benchmarks, strategic asset allocation, tactical asset allocation, dynamic trading strategies, return predictability, trading strategies, active management, passive management, business cycle, yield curve, term structure

Abstract:
Given the cross-sectional and temporal variation in their liquidity, emerging equity markets provide an ideal setting to examine the impact of liquidity on expected returns. Our main liquidity measure is a transformation of the proportion of zero daily firm returns, averaged over the month. We find that our liquidity measures significantly predict future returns, whereas alternative measures such as turnover do not.
Consistent with liquidity being a priced factor, unexpected liquidity shocks are positively correlated with contemporaneous return shocks and negatively correlated with shocks to the dividend yield. We consider a simple asset pricing model with liquidity and the market portfolio as risk factors and transaction costs that are proportional to liquidity. The model differentiates between integrated and segmented countries and time periods. Our results suggest that local market liquidity is an important driver of expected returns in emerging markets, and that the liberalization process has not fully eliminated its impact.

Liquidity, liquidity risk, asset pricing, emerging markets, market integration, market segmentation, liquidity risk factor, local liquidity, zero returns, bid-ask spread, price impact, liquidity measures

Abstract:
Emerging markets have long posed a challenge for finance. Standard models are often ill suited to deal with the specific circumstances arising in these markets. However, the interest in emerging markets has provided impetus for the adaptation of current models to new circumstances in these markets and the development of new models. The model of market integration and segmentation is our starting point. Next, we emphasize the distinction between market liberalization and integration. We explore the financial effects of market integration as well as the impact on the real economy. We also consider a host of other issues such as contagion, corporate finance, market microstructure and stock selection in emerging markets. Apart from surveying the literature, this article contains new results regarding political risk and liberalization, the volatility of capital flows and the performance of emerging market investments.

Market liberalization, portfolio flows, market reforms, economic growth, risk sharing, contagion, privatization, capital flows, market microstructure, inequality, productivity, volatility of capital flows, performance of emerging market investments

Abstract:
In February and March of 1999, we surveyed 392 CFOs about the cost of capital, capital budgeting, and capital structure. The survey consisted of 14 main questions, most with subparts - over 100 questions in total. Although the survey was anonymous, we also collected information on 12 characteristics of the firms and management. We asked questions about firm size, foreign sales, industry, CEO education, age of the CEO, CEO tenure, ownership, whether the firm paid dividends, whether the firm was regulated, and the proportion of common stock that the top three executives owned if all their options were exercised. We also collected information on debt-equity ratios and debt ratings. The analysis, published in the 2001 Journal of Financial Economics (http://ssrn.com/abstract=220251), showed that many survey responses differed by the firm and management characteristics.

Our research left much of the data unexplored. In particular, in only one instance in the paper did we perform question-conditional analysis. That is, given a particular response to one question, how does that impact the response on another question. For example, is it the case that those CFOs that use real options analysis in project evaluation decisions also value financial flexibility in capital structure? Given the large number of inquiries we have received for the survey data, we now publicly release the raw data files so that other researchers can conduct question-conditional analysis. Using these data, researchers should be able to obtain CFO survey evidence related to specific aspects of their own research agendas, as well as perform more detailed analysis of the survey responses.

Abstract:
We propose a method for optimal portfolio selection using a Bayesian decision theoretic framework that addresses two major shortcomings of the Markowitz approach: the ability to handle higher moments and estimation error. We employ the skew normal distribution which has many attractive features for modeling multivariate returns. Our results suggest that it is important to incorporate higher order moments in portfolio selection. Further, our comparison to other methods where parameter uncertainty is either ignored or accommodated in an ad hoc way, shows that our approach leads to higher expected utility than the resampling methods that are common in the practice of finance.

Bayesian decision problem, multivariate skewness, parameter uncertainty, optimal portfolios, utility function maximization, resampling, resampled portfolios, estimation error, mean-variance portfolios, expected returns, Markowitz optimization

Abstract:
The Trouble Asset Relief Program (TARP) is an insufficient policy initiative to end the current credit crisis. The measures that I propose below call for a fundamentally different approach to dealing with troubled assets, the recapitalization of the FDIC and moves to reduce bank runs, mechanisms that the Federal Reserve and Treasury need to put in place to deal with the inevitable surge in bank failures, and a proposal for a Bank Capitalization Fund that would jump start our credit system. So far, policy makers have reacted to one crisis after another. My proposals are proactive and are guided by lessons learned in previous financial crises, in particular the Swedish banking crisis.

1. In implementing the TARP, Treasury avoid paying "hold to maturity" prices for troubled assets. The price should be set in between the firesale and hold to maturity. This insures a fair price for both the government and the financial institution. It reduces the cost of the program. In addition, the TARP should not purchase troubled assets at a premium price from any insolvent institution.

2. Establish a Bank Capitalization Fund (BCF) with the goal of purchasing amount equity of all viable financial institutions. This equity injection can be done quickly and will immediately impact the availability of loans.

3. Immediately fund the BCF investment fund with $200-$300 billion. Allow private investors to contribute capital.

4. BCF should expire in seven years.

5. Management of any government purchase of troubled assets should either not be outsourced or designed in a way so that the manager has minimum conflict of interest with their company's portfolio.

6. Recapitalize the FDIC both in anticipation of future bank failures and to instill confidence among depositors.

7. For a period of three years, guarantee all demand and savings deposits at FDIC insured institutions. Premiums that the banks pay the FDIC are frozen for three years. Afterwards, reset the FDIC maximum insured amount to $300,000. This will immediately boost confidence in the banking system.

8. Fed/Treasury needs to quickly put in place the staff to handle the potential of 750-1,000 bank failures.

9. Reestablish the Resolution Trust Corporation. This entity is mandated to dispose of assets of failed financial institutions.

10. Government incented principal resets of mortgages (cram downs). Resets determined by banks and both have the option to recover some of the reset if house price appreciates.

11. Two year moratorium on mortgage prepayment penalties.

12. Explicit quid pro quo for banks participating in TARP that credit should not be cut off from non-financial companies, particularly, small and medium sized companies that are the engine of growth and jobs in our economy.

Financial Crisis, TARP, Bank runs, FDIC, BCF, RTC

Abstract:
We present new evidence on the distribution of the ex ante risk premium based on a multi-year survey of Chief Financial Officers (CFOs) of U.S. corporations. Currently, we have responses from surveys conducted from the second quarter of 2000 through the third quarter of 2001. The results in this paper will be augmented as future surveys become available. We find direct evidence that the one-year risk premium is highly variable through time and 10-year expected risk premium is stable. In particular, after periods of negative returns, CFOs significantly reduce their one-year market forecasts, disagreement (volatility) increases and returns distributions are more skewed to the left. We also examine the relation between ex ante returns and ex ante volatility. The relation between the one-year expected risk premium and expected risk is negative. However, our research points to the importance of horizon. We find a significantly positive relation between expected return and expected risk at the 10-year horizon.

Abstract:
We present new evidence on the distribution of the ex ante risk premium based on a multi-year survey of Chief Financial Officers (CFOs) of U.S. corporations. Currently, we have responses from surveys conducted from the second quarter of 2000 through the third quarter of 2001. The results in this paper will be augmented as future surveys become available.

We find direct evidence that the 10-year expected risk premium is stable and equal to about 4%. In contrast, the one-year risk premium is highly variable through time. In particular, after periods of negative returns, CFOs significantly reduce their one-year market forecasts, disagreement (volatility) increases and returns distributions are more skewed to the left.

We also examine the relation between ex ante returns and ex ante volatility. The relation between the one-year expected risk premium and expected risk is negative. However, our research points to the importance of horizon. We find a significantly positive relation between expected return and expected risk at the 10-year horizon. Finally, our last survey was delivered September 10, 2001. We are able to measure the increase in perceived risk following the September 11, 2001 crisis.

Risk premium, cost of capital, asymmetric volatility, skewness, leverage effect, expectations, risk to reward, momentum, September 11 crisis

Abstract:
Miscalibration is a standard measure of overconfidence in both psychology and economics. Although it is often used in lab experiments, there is scarcity of evidence about its effects in practice. We test whether top corporate executives are miscalibrated, and whether their miscalibration impacts investment behavior. Over six years, we collect a unique panel of nearly 7,000 observations of probability distributions provided by top financial executives regarding the stock market. Financial executives are miscalibrated: realized market returns are within the executives' 80% confidence intervals only 38% of the time. We show that companies with overconfident CFOs use lower discount rates to value cash flows, and that they invest more, use more debt, are less likely to pay dividends, are more likely to repurchase shares, and they use proportionally more long-term, as opposed to short-term, debt. The pervasive effect of this miscalibration suggests that the effect of overconfidence should be explicitly modeled when analyzing corporate decision-making.

Overconfidence,Behavioral Biases,Behavioral Corporate Finance,Investment Policy,Payout Policy,Managerial Forecast,Survey Methodology,Stock Returns,Capital Structure,Executive Compensation,Risk,Volatility,Stock Market Forecasts,Debt Policy,Dividends,Behavioral Finance,Risk Premium,Managers,Forecasts

Abstract:
This paper examines the importance of political risk, the financial risk, and economic risk in portfolio and direct investment decisions. In addition, the components (from the International Country Risk Guide) of each of these risk measures are examined. The components of political risk include: Government Stability, Socioeconomic Conditions, Investment Profile, Internal Conflict, External Conflict, Corruption, Military in Politics, Religion in Politics, Law and Order, Ethnic Tensions, Democratic Accountability, and Bureaucracy Quality. The financial risk components include: Foreign Debt as a Percentage of GDP, Foreign Debt Service as a Percentage of Exports of Goods and Services, Current Account as a Percentage of Exports of Goods and Services, Net International Liquidity as Months of Import Cover, and Exchange Rate Stability. The Economic Risk category includes: Per Capita GDP, Real GDP Growth, Annual Inflation Rate, Budget Balance as a Percentage of GDP, and Current Account as a Percentage of GDP. First, I explore whether any of these measures contain information about future expected stock returns by conducting trading simulations. Second, I show the relation between these measures and implied costs of capital based on earnings forecasts. My results suggest that the country risk measures are correlated future equity returns - but only in emerging markets. These results are consistent with emerging markets being to some degree segmented from world capital markets.

Political Risk, Quality of Institutions, Law and Order, Financial Risk, Economic Risk, Country Risk Premium, Market Integration, Market Segmentation, Implied Cost of Capital

Abstract:
A large body of academic research describes the optimal decisions that corporations should make, given certain assumptions and conditions. Anecdotal evidence, however, suggests that the way that corporations actually make decisions is not always consistent with the academic decision rules. In this paper, we analyze a comprehensive survey that describes the current practice of corporate finance. This allows us to identify areas where the theory and practice of corporate finance are consistent and areas where they are not.

Capital structure, Cost of capital, Cost of equity, Capital budgeting, Discount Rates, Project valuation, Survey, Debt policy, Trade-off theory

Abstract:
How important is an understanding of country risk for investors? Given the increasingly global nature of investment portfolios, we believe it is very important. Our paper measures the economic content of five different measures of country risk: The International Country Risk Guide is political risk, the financial risk, economic risk and composite risk indices and Institutional Investoris country credit ratings. First, we explore whether any of these measures contain information about future expected stock returns by conducting trading simulations. Next, we conduct time-series-cross-sectional analysis linking these risk measures to future expected returns. Second, we investigate the relation between these measures and other, more standard, approaches to risk exposures. Finally, we analyze the linkages between fundamental attributes within each economy, such as book-to-price ratios, and the risk measures. Our results suggest that the country risk measures are correlated future equity returns. We find that the country risk measures are correlated with each other, however, financial risk measures contain the most information about future equity returns. Finally, we find that country risk measures are highly correlated with country equity valuation measures. This provides some insight into the reason why value-oriented strategies generate higher returns.

Country Risk Assessment, Mean-Reverision of Risk, Country Trading Strategies, Risk Exposure

Abstract:
This abstract describes two courses offered to full time MBA students. While different in their content, each has a self-contained hypersyllabus that includes a detailed course description, individual session assignments, references to readings, articles and other course materials, digital video clips and past student projects. Tactical Global Asset Allocation and Stock Selection delivers the theory and the quantitative tools that are necessary for global asset management. The focus of the course is on tactical rather than passive asset management. One unique feature of the course is that students are shown how to put a portfolio together from individual stocks (stock selection). Emerging Markets Finance course explores the corporate finance issues that are special to evaluating projects in emerging economies. The primary assignment in this course is for students to write a case study from scratch. A one page downloadable pdf file provides more detailed descriptions of each course and a url for each hypersyllabus.

Abstract:
The comprehensive survey reported here allowed analysis of how senior U.S. financial executives make decisions related to performance measurement and voluntary disclosure. Chief financial officers were asked what earnings benchmarks they cared about and which factors motivated executives to exercise discretion—even sacrifice economic value—to deliver earnings. These issues are crucially linked to stock market performance. The results show that the destruction of shareholder value through legal means is pervasive, perhaps even a routine way of doing business. Indeed, the amount of value destroyed by companies striving to hit earnings targets exceeds the value lost in recent high-profile fraud cases.

Financial Statement Analysis, Accounting and Financial Reporting Issues; Equity Investments, Fundamental Analysis and Valuation Models; Corporate Governance

Abstract:
We recently conducted a comprehensive survey that analyzes how senior financial executives make decisions related to performance measurement and voluntary disclosure. In particular, we ask CFOs what earnings benchmarks they care about and which factors motivate executives to exercise discretion, and even sacrifice economic value, to deliver earnings. These issues are crucially linked to stock market performance. Much of the media attention is focused on a small number of high profile firms that have engaged in earnings fraud. Our results show that the destruction of shareholder value through legal means is pervasive, if not a routine way of doing business. Indeed, we assert that the amount of value destroyed by firms striving to hit earnings targets exceeds the value lost in these high profile fraud cases.

Earnings management, earnings smoothing, consensus earnings, meeting benchmarks, value destruction, agency problems, real earnings management, unexpected earnings, earnings surprise, net present value

Abstract:
We analyze the results of the most recent survey of U.S. Chief Financial Officers (CFOs) which looks ahead to the first quarter of 2007 and beyond. We present expectations of the equity risk premium measured over a 10-year horizon relative to a 10-year U.S. Treasury bond. This multi-year survey has been conducted every quarter from June 2000 to November 2006. Each quarter the survey also provides measures of cross-sectional disagreement about the risk premium, skewness, and a measure of individual uncertainty. The individual uncertainty is deduced from the 80% confidence interval that each respondent provides for his or her risk premium assessment. We also present evidence on the determinants of the long-run risk premium. Our analysis suggests there is a positive correlation between the ex ante risk premium and real interest rates as reflected in Treasury Inflation Indexed Notes. The level of the risk premium also appears to track market volatility as reflected in the VIX index.

Cost of capital, equity premium, long-term market returns, long-term equity returns, expected excess returns, disagreement, individual uncertainty, skewness, asymmetry, survey methods, risk and reward, TIPs, VIX

Abstract:
We present expectations of the equity risk premium measured over a 10-year horizon relative to a 10-year U.S. Treasury bond based on a survey of U.S. Chief Financial Officers (CFOs). This multi-year survey has been conducted each quarter from June 2000. Each quarter the survey also provides measures of cross-sectional disagreement about the risk premium, skewness, and a measure of individual uncertainty. The individual uncertainty is deduced from the 80% confidence interval that each respondent provides for his or her risk premium assessment. We also present evidence on the determinants of the long-run risk premium. Our analysis suggests that there is a positive correlation between the ex ante risk premium and real interest rates as reflected in Treasury Inflation Indexed Notes.

Cost of capital, equity premium, long-term market returns, long-term equity returns, expected excess returns, disagreement, individual uncertainty, skewness, asymmetry, survey methods, risk and reward

Abstract:
This paper conducts powerful new tests of whether debt can mitigate the effects of agency and information problems. We focus on emerging market firms for which pyramid ownership structures create potentially extreme managerial agency costs. Our tests incorporate both traditional financial statement data and new data on global debt contracts. Our analysis is mindful of the potential endogeneity between debt, ownership structure, and value, and takes into account differences in the debt capacity of a firm's assets in place and future growth opportunities. The results indicate that the incremental benefit of debt is concentrated in firms with high expected managerial agency costs that are also most likely to have overinvestment problems resulting from high levels of assets in place or limited future growth opportunities. Subsequent internationally syndicated term loans are particularly effective at creating value for these firms. Our results support the recontracting hypothesis that equity holders value compliance with monitored covenants, particularly when firms are likely to overinvest.

capital structure, debt, agency problems, emerging markets, governance

Abstract:
The global credit crisis of 2008 provides a unique opportunity to study the effects of financing constraints on corporate behavior. Based on standard economic priors, we investigate whether this credit supply shock has a differential impact on the real and financial policies of credit constrained firms. In contrast to previous research, which has used proxies such as firm size and credit ratings to measure constraints, we survey 1,050 CFOs in the U.S., Europe, and Asia and directly assess whether their firms are credit constrained. Our evidence shows that the impact of the financial crisis is severe on credit constrained firms, leading to deeper cuts in planned R&D, employment, and capital spending. These firms also burn through more cash, draw more heavily on lines of credit for fear banks will restrict access in the future, and sell more assets to fund their operations. Using our direct measure of constraints, we also find that the inability to borrow externally causes many firms to bypass attractive investment projects, with 86% of constrained U.S. CFOs saying their investment in attractive projects has been restricted during the credit crisis of 2008 and more than half outright cancelling or postponing their investment plans. Our results also hold in Europe and Asia, and in many cases are stronger in those economies.

Financial crisis, financing constraints, investment spending, liquidity management, matching estimators

Abstract:
The global credit crisis of 2008 provides a unique opportunity to study the effects of financial constraints on real corporate actions. In contrast to previous research which has used proxies such as firm size and credit ratings to measure constraints, we survey 1,050 CFOs in the U.S., Europe and Asia and directly assess whether firms are credit constrained. Our evidence shows that the impact of the credit crisis was severe on constrained firms, leading to deep cuts in R&D, employment, and capital spending. These firms burn through more cash, draw more heavily on lines of credit for fear banks will restrict access in the future, and sell more assets to fund their operations. Among other results, we find that a greater proportion of unconstrained firms resist using lines of credit in order to preserve their reputation in the financial markets. Using our direct measure of constraints, we also find that the inability to borrow externally causes many financially constrained firms to bypass attractive investment projects, with 86% of U.S. CFOs saying their investment has been restricted during the credit crisis of 2008 and more than half outright cancelling or postponing their investment plans. Our results also hold in Europe and Asia, and in many cases are stronger in those economies.

Financial crisis, financing constraints, investment spending, liquidity management

Abstract:
We show that equity market liberalizations, on average, lead to a one percent increase in annual real economic growth over a five-year period. The liberalization effect is not spuriously accounted for by macro-economic reforms and does not reflect a business cycle effect. Although financial liberalizations further financial development, measures of financial development fail to fully drive out the liberalization effect. The investment/GDP ratio increases post liberalization, with the investment partially financed by foreign capital inducing worsened trade balances. Differentiating across liberalizing countries, a large secondary school enrollment, a small government sector and an Anglo-Saxon legal system tend to enhance the liberalization effect. Finally, the conditional convergence effect is larger once financial liberalization is accounted for.

Abstract:
We show that equity market liberalizations, on average, lead to a one percent increase in annual real economic growth. The effect is robust to alternative definitions of liberalization and does not reflect variation in the world business cycle. The effect also remains intact when an exogenous measure of growth opportunities is included in the regression. We find that capital account liberalization also plays a role in future economic growth, but, importantly, it does not subsume the contribution of equity market liberalizations. Other simultaneous reforms only partially account for the equity market liberalization effect. Finally, the largest growth response occurs in countries with high quality institutions.

Equity Market Liberalization, Capital Account Openness, Quality of Institutions, GDP Growth, Shareholder Protection, Growth Opportunities, Legal Systems, Political Risk

Abstract:
Traditional mean-variance efficient portfolios do not capture the potential wealth creation opportunities provided by predictability of asset returns. We propose a simple method for constructing optimally managed portfolios that exploits the possibility that asset returns are predictable. We implement these portfolios in both single and multi-period horizon settings. We compare alternative portfolio strategies which include both buy-and-hold and fixed weight portfolios. We find that managed portfolios can significantly improve the mean-variance trade-off, in particular, for investors with investment horizons of three to five years. Also, in contrast to popular advice, we show that the buy-and-hold strategy should be avoided.

Abstract:
Traditional mean-variance efficient portfolios do not capture the potential wealth creation opportunities provided by predictability of asset returns. We propose a simple method for constructing optimally managed portfolios that exploits the possibility that asset returns are predictable. We implement these portfolios in both single and multi-period horizon settings. We compare alternative portfolio strategies which include both buy-and-hold and fixed weight portfolios. We find that managed portfolios can significantly improve the mean-variance trade-off, in particular, for investors with investment horizons of three to five years. Also, in contrast to popular advice, we show that the buy-and-hold strategy should be avoided.

Dynamic strategies, mean-variance optimization, multiperiod choice, efficient frontier, buy-and-hold investment

Abstract:
People are more willing to bet on their own judgments when they feel skillful or knowledgeable (Heath and Tversky (1991)). We investigate whether this "competence effect" influences trading frequency and home bias. We find that investors who feel competent trade more often and have a more internationally diversified portfolio. We also find that male investors, and investors with higher income or more education, are more likely to perceive themselves as competent investors than are female investors, and investors with lower income or less education. Our results are unlikely to be explained by other hypotheses, such as overconfidence or information advantage. Finally, we separately establish a link between optimism towards the home market and international portfolio diversification.

Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Abstract:
People are more willing to bet on their own judgments when they feel skillful or knowledgeable (Heath and Tversky, 1991). We investigate whether this 'competence effect' influences trading frequency and home bias. We find that investors who feel competent trade more often and have more internationally diversified portfolios. We also find that male investors, and investors with larger portfolios or more education, are more likely to perceive themselves as competent than are female investors, and investors with smaller portfolios or less education. Our paper also contributes to understanding the theoretical link between overconfidence and trading frequency. Existing theories on trading frequency have focused on one aspect of overconfidence, i.e., miscalibration. Our paper offers a potential mechanism for the 'better-than-average' aspect of overconfidence to influence trading frequency. In the context of our paper, overconfident investors tend to perceive themselves to be more competent, and thus are more willing to act on their beliefs, leading to higher trading frequency.

Behavioral Finance, Investment, Competence, Ambiguity, Stock Trading Frequency, Home Bias

Abstract:
Contagion is usually defined as correlation between markets in excess of what would be implied by economic fundamentals; however, there is considerable disagreement regarding the definitions of the fundamentals, how the fundamentals might differ across countries, and the mechanisms that link the fundamentals to asset returns. Our research takes, as a starting point, a two-factor model with time-varying betas that accommodates various degrees of market integration between different markets. We apply this model to stock returns in three different regions: Europe, South-East Asia, and Latin America. In addition to providing new insights on contagion during crisis periods, we document patterns through time in world and regional market integration and measure the proportion of volatility driven by global, regional, and local factors.

Abstract:
Contagion is usually defined as correlation between markets in excess of what would be implied by economic fundamentals. However, there is considerable disagreement regarding the definitions of the fundamentals, how the fundamentals might differ across countries and the mechanisms that link the fundamentals to asset returns. Our research takes as a starting point, a two-factor model with time-varying betas that accommodates various degrees of market integration between the different markets. We apply this model to stock returns in three different regions, Europe, South-East Asia and Latin America. In addition to providing new insights on contagion during crisis periods, we document patterns through time in world and regional market integration and measure the proportion of volatility driven by global, regional, as well as, local factors.

Abstract:
In early 2002, we surveyed 384 financial executives, to determine the factors that drive dividend and share repurchase decisions. Our survey was supplemented by in-depth interviews with an additional 23 executives. The survey consisted of 11 main questions, most with subparts - over 100 questions in total. Although the survey was anonymous, we also collected information on 20 characteristics of the firms and management. We asked questions about firm size, number of employees, industry, CEO education, age of the CEO, CEO tenure, ownership, the proportion of common stock owned by insiders, credit ratings, debt/equity ratios, dividend payout, earnings per share, average price to earnings ratio over the past few years, and the current price of the stock. The analysis was recently published in the September 2005 Journal of Financial Economics (http://ssrn.com/abstract=571046).

Our findings indicate that maintaining the dividend level is on par with investment decisions, while repurchases are made out of the residual cash flow after investment spending. Perceived stability of future earnings still affects dividend policy as in Lintner (1956). However, 50 years later, we find that the link between dividends and earnings has weakened. Many managers now favor repurchases because they are viewed as being more flexible than dividends and can be used in an attempt to time the equity market or to increase earnings per share. Executives believe that institutions are indifferent between dividends and repurchases and that payout policies have little impact on their investor clientele. In general, management views provide little support for agency, signaling, and clientele hypotheses of payout policy. Tax considerations play a secondary role.

We provide new analysis of the survey responses which are conditional on the firm and CEO characteristics. In addition, we provide the codebook and original survey data. This allows researchers to conduct question-conditional analysis. It is now possible to address questions like: given the set of respondents that answered one set of questions in a particular way, what are their responses to other questions? We hope that these data spur future research on payout policy.

Payout, Dividend policy, Share repurchases, Survey, Survey data

Abstract:
Local Asian and international capital markets have been branded as culprits in the recent Asian financial crisis. Unfortunately, much of our understanding of the crisis stems from macro level analysis. We provide a micro level approach to understanding the Asian financial crisis that focuses on understanding the development of capital markets throughout the region as well as deciphering the performance of Asian corporations. We find that Asian capital markets were successful at fostering new capital mobilization as well as offering a high degree of liquidity to investors. Asian capital markets also pursued gradual liberalization and privatization programs during the 1990s. Despite these successes, Asian equity markets were characterized by a high degree of asset and industry based concentration. Both forms of concentration help to explain the high correlation among individual stock returns in Asia. Stock market investment performance in Asian failed to achieve returns comparable to less risky investments made in the US and the rest of the world. The only exception to this poor investment performance resulted from dynamic trading strategies designed to capture the price appreciation associated with capital market integration. We argue that corporate managers bet their companies by taking greatly increased leverage in the face of declining profitability. In addition, much of the debt was foreign denominated. This added an extra dimension to the gamble. Asian managers were betting that the exchange rate would remain stable. We argue that the crisis was heightened by the extra risk exposure that Asian managers induced by their leverage policies. This all points to a failure in corporate governance with respect to risk management and control.

Abstract:
Local Asian and international capital markets have been branded as culprits in the recent Asian financial crisis. Unfortunately, much of our understanding of the crisis stems from macro level analysis. We provide a micro level approach to understanding the Asian financial crisis that focuses on understanding the development of capital markets throughout the region as well as deciphering the performance of Asian corporations. We find that Asian capital markets were successful at fostering new capital mobilization as well as offering a high degree of liquidity to investors. Asian capital markets also pursued gradual liberalization and privatization programs during the 1990s. Despite these successes, Asian equity markets were characterized by a high degree of asset and industry based concentration. Both forms of concentration help to explain the high correlation among individual stock returns in Asia. Stock market investment performance in Asian failed to achieve returns comparable to less risky investments made in the US and the rest of the world. The only exception to this poor investment performance resulted from dynamic trading strategies designed to capture the price appreciation associated with capital market integration. We argue that corporate managers "bet" their companies by taking greatly increased leverage in the face of declining profitability. In addition, much of the debt was foreign denominated. This added an extra dimension to the gamble. Asian managers were betting that the exchange rate would remain stable. We argue that the crisis was heightened by the extra risk exposure that Asian managers induced by their leverage policies. This all points to a failure in corporate governance with respect to risk management and control.

Abstract:
We study the interrelationship between capital flows, returns, dividend yields and world interest rates in 20 emerging markets. We estimate a vector autoregressionn with these variables to measure the degree to which lower interest rates contribute to increased capital flows and shocks in flows affect the cost of capital among other dynamic relations. We precede the VAR analysis by a detailed examination of endogenous break points in capital flows and the other variables. These structural breaks are traced to the liberalization of emerging equity markets. Our evidence of structural breaks call into question past research which estimates VAR models over the full sample. After a liberalization, we find that equity flows increase by 1.4% of market capitalization. We also show that shocks in equity flows initially increase returns which is consistent with a price pressure hypothesis. While the effect is diminished over time, there also appears to be a permenant impact. This is consistent with our finding that our proxy for the cost of capital, dividend yields, decreases. Finally, our analysis of the transitition dynamics from pre-liberalization to post-liberalization suggests that when capital leaves, it leaves faster than it came in. These results may help us understand the dynamics of the recent crises in Latin America and East Asia.

Abstract:
We study the interrelationship between capital flows, returns, dividend yields and world interest rates in 20 emerging markets. We use a structural VAR framework to examine the impact of shocks in interest rates and net capital flows on asset returns and the cost of capital. In contrast to previous research, we explicitly take into account a fundamental nonstationarity in the data - structural breaks induced by liberalizations. We estimate our VARs in both the full sample, pre-break and the post-break sample, with the breaks endogenously determined. We find significant differences, in particular, between the pre-break analysis and the post-break analysis. We revisit a number of important hypotheses within the VAR framework. First, the "push effect" from world interest rates to capital flows appears consistently when we cumulate impulse responses whereas contemporaneously interest rates and capital flows show no consistent correlation pattern. Second, unexpected shocks to equity flows have a strongly positive contemporaneous effect on returns, in line with the findings of Clark and Berko (1997), and Froot et al. (1998). The effect immediately dies out but there is only incomplete reversal suggesting some of the effect is permanent. This is consistent with our finding that positive shocks in net equity capital flows lead to lower dividend yields -- our proxy for expected returns. Following Bekaert and Harvey's (1999) argument that dividend yield changes reveal information about the cost of equity capital, the equity capital flow shocks lead to lower cost of capital in many countries. We find that this relation is dramatically strengthened if we estimate our VARs on the post break sample. Although part of the initial effect may be due to "price pressure", our results suggest part of the response is near permanent and beneficial. Third, we revisit the Bohn and Tesar (1996) argument that capital flows are more likely driven by "return chasing" than portfolio rebalancing. We find evidence that positive returns shocks are followed by increased short-term equity capital flows. Finally, we provide interesting new results on the transition from pre-break to post-break systems. In almost all the countries we examine, our transition analysis of equity flows suggests that when capital leaves it leaves faster than it came. These intriguing results may shed light on the recent crises in Latin America and Asia and the role of capital flight.

Abstract:
Previous studies have identified predetermined variables that have some power to explain the time series of stock and bond returns. This paper shows that loadings on the same variables also provide significant cross-sectional explanatory power for stock portfolio returns. These loadings are important, over and the above the variables advocated by Fama and French (1993) in their three factor model,' and also the four factors of Elton, Gruber and Blake (1995). The explanatory power of the loadings on lagged variables is robust to various portfolio grouping procedures and other considerations. The lagged variables reveal information about the cross-section of expected returns that is not captured by popular asset pricing factors. These results carry implications for risk analysis, performance measurement, cost-of-capital calculations and other applications.

Abstract:
Previous studies have identified predetermined variables that have some power to explain the time series of stock and bond returns. This paper shows that loadings on the same variables also provide significant cross-sectional explanatory power for stock portfolio returns. These loadings are important, over and the above the variables advocated by Fama and French (1993) in their three factor "model," and also the four factors of Elton, Gruber and Blake (1995). The explanatory power of the loadings on lagged variables is robust to various portfolio grouping procedures and other considerations. The lagged variables reveal information about the cross-section of expected returns that is not captured by popular asset pricing factors. These results carry implications for risk analysis, performance measurement, cost-of-capital calculations and other applications.

Abstract:
The emergence of new equity markets in Europe, Latin America, Asia, the Mideast and Africa provides a new menu of opportunities for investors. These markets exhibit high expected returns as well as high volatility. Importantly, the low correlations with developed countries' equity markets significantly reduce the unconditional portfolio risk of a world investor. However, standard global asset pricing models, which assume complete integration of capital markets, fail to explain the cross-section of average returns in emerging countries. An analysis of the predictability of the returns reveals that emerging market returns are more likely than developed countries to be influenced by local information.

This is the final working paper version of my 1995 publication in the Review of Financial Studies.

Emerging markets, cost of capital, performance evaluation, non-normality, market integration, market segmentation, capital market reforms, market liberalization, financial openness, predictable returns

Abstract:
The emergence of new equity markets in Europe, Latin America, Asia, the Mideast and Africa provides a new menu of opportunities for investors. These markets exhibit high expected returns as well as high volatility. Importantly, the low correlations with developed countries' equity markets significantly reduces the unconditional portfolio risk of a world investor. However, standard global asset pricing models, which assume complete integration of capital markets, fail to explain the cross-section of average returns in emerging countries. An analysis of the predictability of the returns reveals that emerging market returns are more likely than developed countries to be influenced by local information.

Abstract:
The emergence of new equity markets in Europe, Latin America, Asia, the Mideast and Africa provides a new menu of opportunities for investors. These markets exhibit high expected returns as well as high volatility. Importantly, the low correlations with developed countries' equity markets significantly reduces the unconditional portfolio risk of a world investor. However, standard global asset pricing models, which assume complete integration of capital markets, fail to explain the cross-section of average returns in emerging countries. An analysis of the predictability of the returns reveals that emerging market returns are more likely than developed countries to be influenced by local information.

Abstract:
We measure a country's growth opportunities by investigating how its industry mix is priced in global capital markets, using price earnings ratios of global industry portfolios. We derive three sets of empirical results. First, these exogenous growth opportunities strongly predict future changes in real GDP and investment in a large panel of countries. This relation is strongest in countries that have liberalized their capital accounts, equity markets, and banking systems. Second, we re-examine the link between financial development, investor protection, capital allocation, and growth. We find that financial development and investor protection measures are much less important in aligning growth opportunities with growth than is capital market openness. Third, we formulate new tests of market integration and segmentation. Under integration, the difference between a country's local PE ratio and its global counterpart should not predict relative growth, but the difference between its "exogenous" global PE ratio and the world market PE ratio should predict relative growth.

Abstract:
We propose an exogenous measure of a country's growth opportunities by interacting the country's local industry mix with global price to earnings (PE) ratios. We find that these exogenous growth opportunities predict future changes in real GDP and investment in a large panel of countries. This relation is strongest in countries that have liberalized their capital accounts, equity markets, and banking systems. We also find that financial development, external finance dependence, and investor protection measures are much less important in aligning growth opportunities with growth than is capital market openness. Finally, we formulate new tests of market integration and segmentation by linking local and global PE ratios to relative economic growth.

Growth Opportunities, Market Integration, Finance and Growth, Capital Allocation, Capital Account Openness, Financial Liberalization

Abstract:
We analyze the history of the equity risk premium from surveys of U.S. Chief Financial Officers (CFOs) conducted every quarter from June 2000 to March 2009. The risk premium is the expected 10-year S&P 500 return relative to a 10-year U.S. Treasury bond yield. The last two surveys were conducted during the darkest parts of a global financial crisis and our results show that the equity premium sharply increased during the crisis. The survey also provides measures of cross-sectional disagreement about the risk premium, skewness, and a measure of individual uncertainty. The level of disagreement in late 2008 and early 2009 is 64% higher than 2007 levels. We also present evidence on the determinants of the long-run risk premium. Our analysis suggests the level of the risk premium closely tracks both market volatility (reflected in the VIX index) as well as credit spreads.

Cost of capital, financial crisis, equity premium, long-term market returns, long-term equity returns, expected excess returns, disagreement, individual uncertainty, skewness, asymmetry, survey methods, risk and reward, TIPs, VIX, Credit spreads

Abstract:
We analyze the results of a recent survey of U.S. Chief Financial Officers (CFOs) conducted in 2008. We present expectations of the equity risk premium measured over a 10-year horizon relative to a 10-year U.S. Treasury bond. This multi-year survey has been conducted every quarter from June 2000 to March 2008. Each quarter the survey also provides measures of cross-sectional disagreement about the risk premium, skewness, and a measure of individual uncertainty. The individual uncertainty is deduced from the 80% confidence interval that each respondent provides for his or her risk premium assessment. Using our time series of risk premia, we explore the link between these premia and real interest rates implied in Treasury Inflation Indexed Notes, stock market volatility represented by the VIX index, past stock market returns and equity valuation reflected in price to earnings ratios.

cost of capital, equity premium, long-term market returns, long-term equity returns, expected excess returns, disagreement, individual uncertainty, skewness, asymmetry, survey methods, risk and reward, TIPs, VIX

Abstract:
We propose a new, valuation-based measure of world equity market segmentation. While we observe decreased levels of segmentation in many developing countries, the level of segmentation is still significant. In contrast to previous research, we characterize the factors that account for variation in market segmentation both through time as well as across countries. While a country's regulation with respect to foreign capital flows is important in determining its level of segmentation, we find that non-regulatory factors are also related to the cross-sectional and time-series variation in the level of segmentation. We identify a country's political risk profile and its stock market development as two additional local segmentation factors as well as the U.S. corporate credit spread as a global segmentation factor.

Abstract:
Much has been learned about emerging markets finance over the past 20 years. These markets have attracted a unique interdisciplinary interest that bridges both investment and corporate finance with international economics, development economics, law, demographics and political science. Our paper focuses on the research areas that are ripe for exploration. We provide new evidence on how emerging market returns, volatility, betas, correlations, skewness and kurtosis have changed as these markets become more financially open.

Emerging markets, International Cost of Capital, Financial openness, dating integration, market segmentation, market integration, capital flows, contagion, market correlations, emerging market volatility, emerging return skewness, emerging return kurtosis

Abstract:
We replay an investment game that compares the performance of a player using Bayesian methods for determining portfolio weights with a player that uses the Monte Carlo based resampling approach advocated in Michaud (1998). Markowitz and Usmen (2003) showed that the Michaud player always won. However, in the original experiment, the Bayes player was handicapped because the algorithm that was used to evaluate the predictive distribution of the portfolio provided only a rough approximation. We level the playing field by allowing the Bayes player to use a more standard algorithm. Our results sharply contrast with those of the original game. The final part of our paper proposes a new investment game that is much more relevant for the average investor - a one-period ahead asset allocation. For this game, the Bayes player always wins.

Bayesian decision problem, parameter uncertainty, optimal portfolios, utility function maximization, resampling

Abstract:
Understanding volatility in emerging capital markets is important for determining the cost of capital and for evaluating direct investment and asset allocation decisions. We provide an approach that allows the relative importance of world and local information to change through time in both the expected returns and conditional variance processes. Our time-series and cross-sectional models analyze the reasons that volatility is different across emerging markets, particularly with respect to the timing of capital market reforms. We find that capital market liberalizations often increase the correlation between local market returns and the world market but do not drive up local market volatility.

Emerging markets, volatility, capital market reforms, asymmetric volatility, country risk, market liberalization, financial openness, market integration, market segmentation

Abstract:
Returns in emerging capital markets are very different from returns in developed markets. While most previous research has focused on average returns, we analyze the volatility of the returns in emerging equity markets. We characterize the time-series of volatility in emerging markets and explore the distributional foundations of the variance process. Of particular interest is evidence of asymmetries in volatility and the evolution of the variance process after periods of capital market reform. We shed indirect light on the question of capital market integration by exploring the changing influence of world factors on the volatility in emerging markets. Finally, we investigate the cross-section of volatility. We use measures such as asset concentration, market capitalization to GDP, size of the trade sector, cross-sectional volatility of individual securities within each country, turnover, foreign exchange variability and national credit ratings to characterize why volatility is different across emerging markets.

Abstract:
We analyze expected returns and volatility in 135 different markets. We argue that country credit risk is a proxy for the ex-ante risk exposure of, particularly, segmented developing countries. We fit a time-series cross-sectional regression using data on the 47 countries which have equity markets. These regressions predict both expected returns and volatility using credit risk as a single explanatory variable. We then use the credit rating data on the other 88 countries to project hurdle rates and volatility into the future. Finally, we calculate for each country, the expected time in years, given the forecasted country risk premium and volatility, for an investor to break even and double the initial investment - with 90% probability. This is the final working paper version of our 1996 Journal of Portfolio Management paper.

International cost of capital, country hurdle rates, forecasting volatility, forecasting correlation, country rate of return, country risk, political risk, credit ratings, risk ratings, hitting time

Abstract:
We provide an analysis of real economic growth prospects in emerging markets after financial liberalizations. In contrast with previous research, we identify the financial liberalization dates and examine the influence of liberalizations while controlling for a number of other macroeconomic and financial variables. Our work also introduces an econometric methodology that allows us to use extensive time-series as well as cross-sectional information for our tests. We find across a number of different specifications that financial liberalizations are associated with significant increases in real economic growth. The effect is larger for countries with high education levels.

Abstract:
This paper proposes tests of asset pricing models that allow for time variation in conditional covariances. The evidence indicates that the conditional covariances do change through time. Estimates of the expected excess return on the market divided by the variance of the market (reward-to-risk ratio) are presented for the Sharpe-Lintner CAPM, as well as a number of tests of the model specification. The patterns of the pricing errors through time suggest the model's inability to capture the dynamic behavior of asset returns. This is the working paper version of my 1989 Journal of Financial Economics article.

CAPM, asset pricing tests, market efficiency, time-varying risk, dynamic risk, predicting returns, forecasting stock returns

Abstract:
Based on a multi-year survey of U.S. Chief Financial Officers (CFOs), we present expectations of the risk premium measured over a 10-year horizon relative to a 10-year U.S. Treasury bond. Our survey also provides measures of the disagreement over the risk premium. We also provide a measure of individual uncertainty in that we ask for each respondent's 80% confidence interval for their risk premium assessment. We combine the June 2005 survey data with 20 historical quarterly surveys that date back to June 2000. We also collect demographic information about our survey participants. Finally, we present the results of other questions on the survey in June 2005 which include assessments of both economy-wide and firm optimism.

Cost of capital, equity premium, hurdle rate, long-term market returns, long-term equity returns, expected excess returns, disagreement, individual uncertainty, skewness, asymmetry, survey methods, risk and reward

Abstract:
We analyze the results of the most recent survey of U.S. Chief Financial Officers (CFOs) which looks ahead to the first quarter of 2006 and beyond. We present expectations of the equity risk premium measured over a 10-year horizon relative to a 10-year U.S. Treasury bond. This multi-year survey has been conducted every quarter from June 2000 to November 2005. Each quarter the survey also provides measures of cross-sectional disagreement about the risk premium, skewness, and a measure of individual uncertainty. The individual uncertainty is deduced from the 80% confidence interval that each respondent provides for his or her risk premium assessment. We also present evidence on the determinants of the long-run risk premium. Our analysis suggests there is a positive correlation between the ex ante risk premium and real interest rates as reflected in Treasury Inflation Indexed Notes. The level of the risk premium also appears to track market volatility as reflected in the VIX index.

Cost of capital, equity premium, long-term market returns, long-term equity returns, expected excess returns, disagreement, individual uncertainty, skewness, asymmetry, survey methods, risk and reward, TIPs, VIX

Abstract:
We examine the effects of both equity market liberalization and capital account openness on real consumption growth variability. We show that financial liberalization is mostly associated with lower consumption growth volatility. Our results are robust, surviving controls for business-cycle effects, economic and financial development, the quality of institutions, and other variables. Countries that have more open capital accounts experience a greater reduction in consumption growth volatility after equity market openings. The results hold for both total and idiosyncratic consumption growth volatility. We also find that financial liberalizations are associated with declines in the ratio of consumption growth volatility to GDP growth volatility, suggesting improved risk sharing. Our results are weaker for liberalizing emerging markets but we never observe an increase in real volatility. Moreover, we demonstrate significant differences in the volatility response depending on the size of the banking and government sectors and certain institutional factors.

Abstract:
We examine the effects of both equity market liberalization and capital account openness on real consumption growth variability. We show that financial liberalization is mostly associated with lower consumption growth volatility. Our results are robust, surviving controls for business-cycle effects, economic and financial development, the quality of institutions, and other variables. Countries that have more open capital accounts experience a greater reduction in consumption growth volatility after equity market openings. The results hold for both total and idiosyncratic consumption growth volatility. We also find that financial liberalizations are associated with declines in the ratio of consumption growth volatility to GDP growth volatility, suggesting improved risk sharing. Our results are weaker for liberalizing emerging markets but we never observe a significant increase in real volatility. Moreover, we demonstrate significant differences in the volatility response depending on the size of the banking and government sectors and certain institutional factors.

Consumption growth, equity market liberalization, capital account liberalization, consumption growth volatility, economic volatility, capital account openness, risk sharing, emerging markets

Abstract:
We present a framework for modeling and estimating dynamics of variance and skewness from time-series data using a maximum likelihood approach assuming that the errors from the mean have a non-central conditional t distribution. We parameterize conditional variance and conditional skewness in an autoregressive framework similar to that of GARCH models and estimate the parameters in a conditional noncentral t distribution. The likelihood function has two time-varying parameters, the degrees of freedom and the noncentrality parameter. We apply this methodology to daily and monthly equity returns data from the U.S., Germany and Japan, concurrently estimating conditional mean, variance and skewness. We find that there is significant conditional skewness.

We then use this model to understand how the inclusion of conditional skewness affects some of the well-known stylized facts about conditional variance and the relation between returns and conditional variance. Two important stylized facts about conditional variance we examine are persistence and asymmetry in variance. Persistence refers to the tendency where high conditional variance is followed by high conditional variance. Asymmetry in variance, i.e., the observation that conditional variance depends on the sign of the innovation to the conditional mean has been documented in asymmetric variance models used in Glosten, Jagannathan, and Runkle (1993) and Engle and Ng (1993). We find that the evidence of asymmetric variance is really just conditional skewness. Inclusion of conditional skewness also impacts the persistence in conditional variance. However, we also find that there are significant seasonalities in variance and the results also depend on how the seasonal effects are accommodated in the estimation methodology. We also examine the relation between expected returns and volatility.

Time-varying skewness, GARCH, non-central t-distribution, leverage effect

Abstract:
A number of countries have delayed the opening of their capital markets to international investment because of reservations about the impact of foreign speculators on both expected returns and market volatility. We propose a cross-sectional time-series model that attempts to assess the impact of market liberalizations, in the form of the offering of depositary receipts country funds and other financial instruments, in an extranational market and market volatility in emerging equity markets. We also examine the impact of capital market liberalizations on the correlation of emerging equity market returns and the world market return. Our empirical approach is designed to control for other economic events which might confound the impact of foreign speculators on local equity markets. Whatever the empirical specification the cost of capital always decreases after a capital market liberalization but the effect is economically and statistically weak. The effects on volatility and correlation are less robust.

Abstract:
A number of countries have delayed the opening of their capital markets to international investment because of reservations about the impact of foreign speculators on both expected returns and market volatility. We propose a cross-sectional time-series model that attempts to assess the impact of market liberalizations, in the form of the offering of depositary receipts, country funds and other financial instruments, in an extranational market, on the cost of capital and market volatility in emerging equity markets. We also examine the impact of capital market liberalizations on the correlation of emerging equity market returns and the world market return. Our empirical approach is designed to control for other economic events which might confound the impact of foreign speculators on local equity markets. Whatever the empirical specification, the cost of capital always decreases after a capital market liberalization with the effect varying between 5 and 90 basis points depending on the specification. There is little impact on volatility. While correlation with world markets increases after liberalizations, it is unlikely that this higher correlation will impact global investors looking to diversify their international portfolios.

Equity Market Liberalization, Cost of Capital, Investment Growth, Economic Growth, Liberalization and Risk, Country Correlations, Country Betas, Country Volatility

Abstract:
Measuring the integration of world capital markets is notoriously difficult. For example, regulatory changes which appear comprehensive may have little impact on the functioning of the capital market if they fail to lead to foreign portfolio inflows. In contrast to the usual practice of documenting the timing of regulatory changes, we specify a reduced-form model for a number of financial time-series (for example, equity returns and dividend yields) and search for a common break in the process generating the data. In addition, we estimate a confidence interval for the break. Information on a variety of financial and macroeconomic indicators is employed to interpret the results and to identify the likely date the equity market becomes financially integrated with world capital markets. We find endogenous break dates that are very accurately estimated but do not always correspond closely to dates of official capital market reforms. After the break, stock markets are on average larger and more liquid than before; returns are more volatile and more highly correlated with the world market return, dividend yields are lower and credit ratings improve.

Abstract:
Measuring the integration of world capital markets is notoriously difficult. For example, regulatory changes which appear comprehensive may have little impact on the functioning of the capital market if they fail to lead to foreign portfolio inflows. In contrast to the usual practice of documenting the timing of regulatory changes, we specify a reduced-form model for a number of financial time-series (for example, equity returns and dividend yields) and search for a common break in the process generating the data. In addition, we estimate a confidence interval for the break. Information on a variety of financial and macroeconomic indicators is employed to interpret the results and to identify the likely date the equity market becomes financially integrated with world capital markets. We find endogenous break dates that are very accurately estimated but do not always correspond closely to dates of official capital market reforms. After the break, stock markets are on average larger and more liquid than before; returns are more volatile and more highly correlated with the world market return, dividend yields are lower and credit ratings improve.

Abstract:
We survey 328 financial executives to determine the effects of the May 2003 dividend tax cut on corporate payout policy. We find that the tax cut led to initiations and dividend increases at some firms, weakly more so at firms for which retail investors are particularly important. However, financial executives say that the tax rate reduction ranks behind stability of future cash flows and cash holdings (and for firms already paying dividends, taxes also rank behind the historic level of dividends) in a list of factors that affect dividend policy. Tax effects are of roughly the same importance as attracting institutional investors and the availability of profitable investments. We also search press releases and find that the dividend tax cut is only occasionally mentioned as the reason for an initiation, especially from 2004 onward. Overall, the evidence indicates that dividend tax rates are a second-order concern in setting payout policy.

Payout, Dividend policy, Share repurchases, Tax cut, Press Release

Abstract:
We examine the effects of both equity market liberalization and capital account openness on real consumption growth variability. We show that financial liberalization is mostly associated with lower consumption growth volatility. Our results are robust, surviving controls for business-cycle effects, economic and financial development, the quality of institutions, and other variables. Countries that have more open capital accounts experience a greater reduction in consumption growth volatility after equity market openings. The results hold for both total and idiosyncratic consumption growth volatility. We also find that financial liberalizations are associated with declines in the ratio of consumption growth volatility to GDP growth volatility, suggesting improved risk sharing. Our results are weaker for liberalizing emerging markets but we never observe a significant increase in real volatility. Moreover, we demonstrate significant differences in the volatility response depending on the size of the banking and government sectors and certain institutional factors.

Economic volatility, risk sharing, financial openness, equity market liberalization, capital account openness, GDP volatility, consumption volatility

Abstract:
We propose a measure of capital market integration arising from a conditional regime-switching model. Our measure allows us to describe expected returns in countries that are segmented from world capital markets in one part of the sample and become integrated later in the sample. We find that a number of emerging markets exhibit time-varying integration. Some markets appear more integrated than one might expect based on prior knowledge of investment restrictions. Other markets appear segmented even though foreigners have relatively free access to their capital markets. While there is a perception that world capital markets have become more integrated, our country-specific investigation suggests that this is not always the case.

Emerging markets, cost of capital, market integration, market segmentation, capital market reforms, market liberalization, financial openness, regime switching

Abstract:
We propose a conditional measure of capital market integration that allows us to characterize both the cross-section and time-series of expected returns in developed and emerging markets. Our measure, which arises from a conditional regime-switching model, allows us to describe expected returns in countries that are segmented from world capital markets in one part of the sample and become integrated later in the sample. Our results suggest that a number of emerging markets exhibit time-varying integration. Interestingly, some markets appear to be more integrated than one might expect based on prior knowledge of investment restrictions. Other markets appear segmented even though foreigners have relatively free access to their capital markets.

Abstract:
We propose a measure of capital market integration arising from a conditional regime-switching model. Our measure allows us to describe expected returns in countries that are segmented from world capital markets in one part of the sample and become integrated later in the sample. We find that a number of emerging markets exhibit time-varying integration. Some markets appear more integrated than one might expect based on prior knowledge of investment restrictions. Other markets appear segmented even though foreigners have relatively free access to their capital markets. While there is a perception that world capital markets have become more integrated, our country-specific investigation suggests that this is not always the case.

Abstract:
The focus of the current credit crisis is on the immediate implications, such as reduced profits and increased unemployment. In contrast, we show that there are worrisome long-term economic consequences of the crisis through its effect on financially constrained firms. Using a survey of over 1,000 CFOs in the United States, Europe and Asia, we show that firms are cutting back or canceling projects that they know add to firm value. The elimination of profitable projects is especially acute for firms that face financial constraints. One of the basic tenets of finance is that projects that enhance firm value should be pursued. Financial constraints potentially prevent the funding of these projects. The current credit crisis is an ideal setting to measure the impact of constraints on value creation. Turning down or canceling profitable projects is a lesser known cost of the current financial crisis. Our evidence suggests that in the scramble for short-term cash flow, firms are sacrificing long-term value. This implies lower future growth opportunities and lower future employment growth.

Financial crisis, financing constraints, investment spending, liquidity management, matching estimators

Abstract:
One version of the consumption-based asset pricing model implies a linear relation between expected returns and expected consumption growth. This paper provides evidence that the expected real term structure contains information that can be used to forecast consumption growth. The evidence is strongest for the 1970's and 1980's. The real term structure contains more information than two alternative measures: lagged consumption growth and lagged stock returns. Further, the real term structure appears to have slightly more forecasting power than the leading commercial econometric models. This is the working paper version of my 1988 Journal of Financial Economics article.

Term structure, yield curve, forecasting economic growth, predicting consumption growth

Abstract:
We explore the different factors that drive expected returns in world markets. Our research offers two innovations. First, the introduction of the Euro currency unit greatly reduces the complexity of including foreign exchange risk in asset pricing models. We use a synthetic Euro excess return along with a Yen excess return to assess country equity sensitivities to currency risk factors. Second, when combining the currency factors with a group of economic factors, we measure the incremental information in the factor proposed in Fama and French (1998). We find that a global price-to-book factor offers little additional explanatory power over and above a model that includes economic risk factors.

Abstract:
This paper examines a comprehensive list of 18 different risk factors that potentially impact international equity returns. These factors include systematic risk, idiosyncratic risk, size, semi-variance, downside betas, value-at-risk, skewness, coskewness, kurtosis, political risk and country risk. I investigate whether these risk factors explain the cross-section of average returns in 47 countries. I also analyze whether the same risk factors influence developed and emerging market returns. I find evidence that an asset pricing framework that incorporates skewness has success in explaining average returns.

Global risk factors, beta, cross-section of returns, systematic risk, idiosyncratic risk, size, semi-variance, downside betas, value-at-risk, skewness, coskewness, kurtosis, political risk, country risk

Abstract:
Is there information in the commonly used indicators of country risk for expected global fixed income returns and volatility? We examine the information content in publicly available measures of political, financial and economic risk. We find that these ex-ante measures contain important information about the cross-section of expected fixed income and currency returns. Trading strategies based on the change in, and level of, these risk measures produce positive risk-adjusted returns. We find that the country risk measures are significantly correlated with international bond metrics, such as real yields. This is the final working paper version of our 1996 Journal of Fixed Income publication.

global bond strategies, predicting bond returns, trading strategies, interest rates, political risk, economic risk, financial risk, country risk, trading strategies, active management

Abstract:
Foreign portfolio flows may reflect deep changes in the functioning of an emerging market economy and its capital markets. Using a database of monthly net U.S. equity flows, we investigate the relation of these flows to the behavior of equity returns, the structural characteristics of the capital markets, exchange rates, and the strength of the economy. We find that increases in equity flows are associated with a lower cost of capital, higher correlation with world market returns, lower asset concentration, lower inflation, larger market size relative to GDP, more trade, and slightly higher per capita economic growth.

Abstract:
Foreign portfolio flows may reflect deep changes in the functioning of an emerging market economy and its capital markets. Using a database of monthly net U.S. equity flows, we investigate the relation of these flows to the behavior of equity returns, the structural characteristics of the capital markets, exchange rates, and the strength of the economy. We find that increases in equity flows are associated with a lower cost of capital, higher correlation with world market returns, lower asset concentration, lower inflation, larger market size relative to GDP, more trade and slightly higher per capita economic growth.

Capital Markets, U.S. Equity Flows, Distribution of Equity Returns, Economic Growth

Abstract:
We analyze the results of the September 2005 survey of U.S. Chief Financial Officers (CFOs). We present expectations of the equity risk premium measured over a 10-year horizon relative to a 10-year U.S. Treasury bond. This multi-year survey has been conducted every quarter from June 2000 to September 2005. Each quarter the survey also provides measures of cross-sectional disagreement about the risk premium, skewness, and a measure of individual uncertainty. The individual uncertainty is deduced from the 80% confidence interval that each respondent provides for his or her risk premium assessment. We also present evidence on the determinants of the long-run risk premium. Our analysis suggests there is a positive correlation between the ex ante risk premium and real interest rates as reflected in Treasury Inflation Indexed Notes. The level of the risk premium also appears to track market volatility as reflected in the VIX index.

Cost of capital, equity premium, long-term market returns, long-term equity returns, expected excess returns, disagreement, individual uncertainty, skewness, asymmetry, survey methods, risk and reward, TIPs, VIX

Abstract:
Single factor asset pricing models face two major hurdles: the problematic time-series properties of the ex ante market risk premium and the inability of the risk measure to account for a substantial degree of the cross-sectional variation of expected excess returns. We provide an explanation for the first failure using the following intuition: if investors know that the asset returns have conditional skewness given the information known today, the expected excess returns should include rewards for accepting skewness. We formalize this intuition with an asset pricing model which incorporates conditional skewness. We decompose the expected excess returns into components due to conditional variance and skewness. Our results show that conditional skewness is important and, when combined with the economy-wide reward for skewness, helps explain the time-variation of the ex ante market risk premiums. Conditional skewness has greater success in explaining the ex ante risk premium for the world portfolio than for the U.S. portfolio.

Risk premium, reward to risk, volatility, skewness, risk premium puzzle, reward for skewness

Abstract:
We analyze the advice contained in a sample of 237 investment strategies over the 1980-1992 period. Each newsletter strategy recommends a mix of equity and cash. We construct portfolios based on these recommendations and find that only a small number of the newsletters appear to have higher average returns than passive portfolios constructed to have the same returns variance. We test the timing abilities of newsletters by examining how often newsletters correctly change their equity weights. Our evidnece shows that the newsletters offer unimpressive asset allocation advice. Knowledge of the asset allocation weights also implies knowledge of the exact conditional betas. As a result, we present direct tests of market timing ability that bypass beta estimation problems. Assuming that different letters cater to investors with different risk aversions, we are able to infer each newsletter's forecasted market returns. The standard deviation of newsletters' forecasts provides a natural measure of disagreement in the market. We find that the degree of disagreement contains information about both market volatility and trading activity.

Newsletter performance, market timing

Abstract:
Equity market liberalizations, if effective, lead to important changes in both the financial and real sectors as the economy becomes integrated into world capital markets. The study of market integration is complicated because there are many ways one can liberalize and many countries have taken different routes. To study the effectiveness of particular liberalization policies, the sequencing of liberalizations, and the impact on the real economy, systematic methods must be developed to 'date' the liberalization of emerging equity markets. We provide a synthesis of the current methods, and also show the impact of liberalization on the real sector.

Financial openness, economic growth, equity liberalization, economic volatility, dating integration, market segmentation, market integration, GDP growth, GDP volatility

Abstract:
As liquidity became scarce and internal profits plunged, many firms were forced to rely on bank lines of credit during the 2008-9 financial crisis. Surprisingly, little is known about these credit facilities in general, let alone about their importance during a crisis. This paper investigates a unique dataset that describes how public and private firms in the U.S. and abroad use lines of credit during early 2009. Our analysis emphasizes the interaction between internal funds, external funds, and real decisions such as corporate investment and employment. Among other things, we find that firms that are "credit constrained" (small, private, non-investment grade, and unprofitable) have larger credit lines (as a proportion of assets) than their large, public, investment-grade, profitable counterparts both before and during the crisis. Constrained firms draw more funds from their credit lines and are more likely to face difficulties in renewing or initiating new lines during the crisis. The terms of credit line facilities changed significantly with the crisis: maturities declined; and commitment fees and interest spreads went up for all firms, but particularly for constrained firms. Our evidence suggests that while being profitable helps firms establish credit lines, it does not monotonically lead to increased use. Instead, lines of credit are used when internal funds (cash stocks and cash flows) decline. Looking at real-side decisions, our estimates suggest that lines of credit provide the liquidity "edge" firms need to invest during the crisis.

Financial crisis, investment, liquidity management, lines of credit

Abstract:
We explore the cross-sectional determinants of emerging equity market returns. We find that the behavior of emerging market returns differs substantially from the behavior of developed equity market returns and that these differences have persisted in the period ending June 1996. While there are some similarities between the cross-sectional determinants of emerging and developed market equity returns, emerging market strategies must take into account the special characteristics of these markets. In particular, the degree of integration of these markets with world equity markets has changed through time. This time-varying integration must be taken into account in asset allocation strategies.

This is the final working paper version of a chapter we wrote for a book published in 1997.

emerging market returns, predicting equity returns, factors, active management, market integration, asset allocation, emerging markets, time-varying integration

Abstract:
We reflect on China's economic performance from the perspective of the experiences of a broad panel of countries. We formulate an econometric framework building on standard growth regressions that allows us to measure the impact of various factors on economic growth and growth variability. As China has become more and more integrated into the world's economic and financial landscape, we devote special attention to measures of (de jure) financial openness. We also document how the real effects of openness are impacted by financial development, political risk, and the quality of institutions. Standard growth regressions cannot explain China's extraordinary growth experience and we fail to find an important role for foreign trade and foreign direct investment. In contrast, the sheer volume of investment has played a significant role in China's growth. As China's per capita GDP continues to grow, it must find sustainable sources of growth. We identify a more efficient financial sector, less state ownership higher quality of government institutions and full financial openness as important factors. Interaction analysis suggests that the beneficial effects of financial openness first require further financial and institutional development. China is less of an outlier in its growth variability experience but achieved high growth with surprisingly low growth volatility.

Abstract:
This paper compares forecasts of real economic growth from models based on the stock market and bond market data. Although both contain information relevant for predicting GNP growth, the bond market delivers more accurate predictions. The bond market predictions are compared to the forecasts of seven leading econometric forecasting services. None of these services is able to provide a lower root mean squared error than the bond market model. This is the working paper version of my 1989 Financial Analysts Journal article.

structure, yield curve, forecasting GDP, predicting GDP