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Abstract:
Incentive fees for money managers are frequently accompanied by high-water mark provisions that condition the payment of the performance fee upon exceeding the previously achieved maximum share value. In this paper, we show that hedge fund performance fees are valuable to money managers, and conversely, represent a claim on a significant proportion of investor wealth. The high-water mark provisions in these contracts limit the value of the performance fees. We provide a closed-form solution to the cost of the high-water mark contract under certain conditions. Our results provide a framework for valuation of a hedge fund management company.

Abstract:
Incentive or performance fees for money managers are frequently accompanied by high-water mark provisions which condition the payment of the performance fee upon exceeding the maximum achieved share value. In this paper, we show that hedge fund performance fees are valuable to money managers, and conversely represent a claim on a significant proportion of investor wealth. The high-water mark provisions in these contracts limit the value of the performance fees. We provide a closed-form solution to the high-water mark contract under certain conditions. This solution shows that managers have an incentive to take risks. Our results provide a framework for valuation of a hedge fund management company.

We conjecture that the existence of high-water mark compensation is due to decreasing returns to scale in the industry. Empirical evidence on the relationship between fund return and net money flows into and out of funds suggests that successful managers, and large fund managers are less willing to take new money than small fund managers.

Abstract:
We develop a model of optimal investment with two types of agents with different beliefs about the market dynamics. Market conformists agree with the true log-normal price distribution and rebels believe in price predictability. Depending on their exact beliefs, the rebels may follow either a momentum or a contrarian strategy. It is difficult to detect rebels' beliefs that are not far-fetched from the market perspective. The long-run investment portfolios of both conformist and rebels need not be biased towards equities.

Abstract:
We consider investing in a noisy market with incorrect beliefs about predictability. Two types of agents use subjective models to optimize their portfolios - "conformists" who happen to believe in the self-fulfilling market consensus and "rebels" who have wrong beliefs. We compare the agents' dynamic trading and their empirically observable investment performance. An agent who believes in log-normality is always a contrarian trader, who buys more shares after the price goes down, and sells shares when the price goes up. In contrast, an agent who believes in price predictability acts as a momentum trader, who buys more shares after the price goes up, for a range of subjective market mis-pricings. We show that more incorrect beliefs about predictability can lead to higher expected returns. Moreover, rebels with incorrect beliefs can have higher expected return than conformists with the same risk-aversion. We find that it is more dangerous to be a sophisticated rebel in a non-predictable world, than to be a simplistic rebel in a predictable world.

Abstract:
Milton Friedman argued that irrational traders will consistently lose money, won't survive and, therefore, cannot influence long run asset prices. Since his work, survival and price impact have been assumed to be the same. In this paper, we demonstrate that survival and price impact are two independent concepts. The price impact of irrational traders does not rely on their long-run survival and they can have a significant impact on asset prices even when their wealth becomes negligible. We also show that irrational traders' portfolio policies can deviate from their limits long after the price process approaches its long-run limit. In contrast to a partial equilibrium analysis, these general equilibrium considerations matter for the irrational traders' long-run survival.

Irrational Traders, Price Impact, Price Influence, Survival, Irrationality, Long Run Prices

Abstract:
Milton Friedman argued that irrational traders will consistently lose money, won't survive and, therefore, cannot influence long run asset prices. Since his work, survival and price impact have been assumed to be the same. In this paper, we demonstrate that survival and price impact are two independent concepts. The price impact of irrational traders does not rely on their long-run survival and they can have a significant impact on asset prices even when their wealth becomes negligible. We also show that irrational traders' portfolio policies can deviate from their limits long after the price process approaches its long-run limit. In contrast to a partial equilibrium analysis, these general equilibrium considerations matter for the irrational traders' long-run survival.

Irrational Traders, Price Impact, Price Influence, Survival, Irrationality, Long Run Prices

Abstract:
Milton Friedman argued that irrational traders will consistently lose money, won't survive and, therefore, cannot influence long run equilibrium asset prices. Since his work, survival and price influence have been assumed to be the same. Often partial equilibrium analysis has been relied upon to examine the survival of irrational traders and to make inferences on their influence on prices. In this paper, we demonstrate that survival and influence on prices are two independent concepts. The price impact of irrational traders does not rely on their long-run survival and they can have a significant impact on asset prices even when their wealth becomes negligible. In addition, in contrast to a partial equilibrium analysis, general equilibrium considerations matter since the ability of irrational traders to impact prices even when their wealth is diminishing can significantly affect their chances for long-run survival. In sum, in a long-run equilibrium, we explicitly show that price impact can occur whether or not the irrational traders survive. In related work, we show that even if the irrational traders survive they may have no price impact.

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:
The hypothesis that financial markets punish traders who make relatively inaccurate forecasts and eventually eliminate the effect of their beliefs on prices is of fundamental importance to the standard modeling paradigm in asset pricing. We establish necessary and sufficient conditions for agents making inferior forecasts to survive and to affect prices in the long run in a general setting with minimal restrictions on endowments, beliefs, or utility functions. We show that the market selection hypothesis is valid for economies with bounded endowments or bounded relative risk aversion, but it cannot be substantially generalized to a broader class of models. Instead, survival is determined by a comparison of the forecast errors to risk attitudes. The price impact of inaccurate forecasts is distinct from survival because price impact is determined by the volatility of traders' consumption shares rather than by their level. Our results also apply to economies with state-dependent preferences, such as habit formation.

Market Selection, Heterogeneous Beliefs, State-Dependent Utility, Survival, Price Impact

Abstract:
Brown, Goetzmann and Ross (1995) document that ex-post conditioning can significantly bias empirical results based on observed rates of return. These results have interesting implications for cross-sectional cumulated excess return measures [CAR s] that are commonly used in the context of event studies (see Brown and Warner, 1981). Ball and Brown [1968] note an upward drift in cumulated excess returns subsequent to a positive earnings announcement surprise. Subsequent work by Foster [1977] and Foster et al [1984] among others has documented that this drift is related to size of the firm in question. The current state of this literature is summarized in Ball [1992].

Abstract:
Empirical analysis of rates of return in Finance implicitly condition on the security surviving into the sample. We investigate the implications of such conditioning on the time series of rates of return. In general this conditioning induces a spurious relationship between observed return and total risk for those securities that survive to be included in the sample. This result has immediate implications for the equity premium puzzle. We show how these results apply to other outstanding problems of empirical Finance. Long term autocorrelation studies focus on the statistical relation between successive holding period returns, where the holding period is of possibly extensive duration. If the equity market survives, then we find that average return in the beginning is higher than average return near the end of the time period. For this reason, statistical measures of long-term dependence are typically biased towards the rejection of a random walk. The result also has implications for event studies. There is a strong association between the magnitude of an earnings announcement and the post-announcement performance of equity. This might be explained in part as an artifact of the stock price performance of firms in financial distress that survive an earnings announcement. The final example considers stock split studies. In this analysis we implicitly exclude securities whose price on announcement is less than the prior average stock price. We apply our results to this case, and find that the condition that the security forms part of our positive stock split sample suffices to explain the upward trend in event-related cumulated excess return in the pre-announcement period.

Abstract:
No abstract available.

Abstract:
Incentive fees for money managers are frequently accompanied by high water mark provisions which condition the payment of the incentive upon exceeding the maximum achieved share value. In this paper, we show that these high water mark contracts are valuable to money managers, and conversely represent a claim on a significant proportion of investor wealth. We provide a closed-form solution to the high water mark contract under certain conditions. This solution shows that managers have an incentive to take risks. We conjecture that the existence of high water mark compensation is due to decreasing returns to scale in the industry. Empirical evidence on the relationship between fund return and net money flows into and out of funds suggests that successful managers, and large fund managers are less willing to take new money than small fund managers.

Abstract:
This article provides an intertemporal synthesis of the basic neoclassical theory of capital structure as a tradeoff between tax effects and bankruptcy costs. The latter is partially endogenized as the loss of future tax benefits and the stationary reorganization policy is considered.

Abstract:
Implicit government obligations represent the lion's share of government liabilities in the U.S. and many other countries. Yet these liabilities are rarely measured, let alone properly adjusted for their risk. This paper shows, by example, how modern asset pricing can be used to value implicit fiscal debts taking into account their risk properties. The example is the U.S. Social Security System's net liability to working-age Americans. Marking this debt to market makes a big difference; its market value is 23 percent larger than the Social Security trustees' valuation method suggests.

Abstract:
No abstract is available for this paper.

Abstract:
The hypothesis that financial markets punish traders who make relatively inaccurate forecasts and eventually eliminate the effect of their beliefs on prices is of fundamental importance to the standard modeling paradigm in asset pricing. We establish necessary and sufficient conditions for agents making inferior forecasts to survive and to affect prices in the long run in a general setting with minimal restrictions on endowments, beliefs, or utility functions. We show that the market selection hypothesis is valid for economies with bounded endowments or bounded relative risk aversion, but it cannot be substantially generalized to a broader class of models. Instead, survival is determined by a comparison of the forecast errors to risk attitudes. The price impact of inaccurate forecasts is distinct from survival because price impact is determined by the volatility of traders’ consumption shares rather than by their level. Our results also apply to economies with state-dependent preferences, such as habit formation.

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:
In frictionless markets having no arbitrage, the asymptotic zero-coupon rate never falls. The same is true of the long forward rate. The long par-coupon rate can rise and fall due to forward rate movements at short maturities. This paper relates the three types of interest rate and formalizes and proves the impossibility results for falling asymptotic rates. These results can be tested in a parametric term structure specification that is rich enough to identify a time series of long rates. The results show that it is not possible to specify arbitrarily the long forward or zero-coupon rate process.