• Selected
• Entire List

Abstract:
We review the theory and evidence on IPO activity: why firms go public, why they reward first-day investors with considerable underpricing, and how IPOs perform in the long run. Our perspective on the literature is three-fold: First, we believe that many IPO phenomena are not stationary. Second, we believe research into share allocation issues is the most promising area of research in IPOs at the moment. Third, we argue that asymmetric information is not the primary driver of many IPO phenomena. Instead, we believe future progress in the literature will come from non-rational and agency conflict explanations. We describe some promising such alternatives.

IPOs

Abstract:
Over the years numerous portfolio performance measures have been proposed. In general they are designed to capture some particular enhancement that might result from active management. However, if a principal uses a measure to judge an agent, then the agent has an incentive to game the measure. Our paper shows that such gaming can have a substantial impact on a number of popular measures even in the presence of extremely high transactions costs. The question then arises as to whether or not there exists a measure that cannot be gamed? As this paper shows there are conditions under which such a measure exists and fully characterizes it. This manipulation-proof measure looks like the average of a power utility function, calculated over the return history. The case for using our alternative ranking metric is particularly compelling in the hedge fund industry, in which the use of derivatives is unconstrained and manager compensation itself induces a non-linear payoff and thus encourages gaming.

Abstract:
Having seen one too many David Letterman show, I decided that it was time for me to put together my own list for the best accomplishments of my discipline, Finance. There is much subjectivity in my particular selection of subjects. Still, I would guess that most finance professors would agree that most of my final choices below represent important progress in the development of finance. Alas, I would expect none to agree with my specific rankings. Thus, my hope is that the list below is of interest to many practitioners and academics.

I then went overboard and decided that it would also be useful to put on paper what I consider to be the most important challenges of Finance to work on, as well as some failures. Necessarily, the target audience here is primarily academic researchers, not practitioners. And, naturally, however subjective the list of accomplishments, the list of challenges and failures is ten times more debatable. But, if this list manages to direct the attention of one talented PhD student towards these research issues, writing it up would have been a worthwhile exercise.

Abstract:
U.S. corporations do not issue and repurchase debt and equity to counteract the mechanistic effects of stock returns on their debt-equity ratios. Thus over one- to five-year horizons, stock returns can explain about 40 percent of debt ratio dynamics. Although corporate net issuing activity is lively and although it can explain 60 percent of debt ratio dynamics (long-term debt issuing activity being most capital structure-relevant), corporate issuing motives remain largely a mystery. When stock returns are accounted for, many other proxies used in the literature play a much lesser role in explaining capital structure.

Abstract:
U.S. corporations do not use their debt and equity issuing and repurchasing activities to counteract the mechanistic effects of stock returns on their debt equity ratios. Thus, over 1-5 year horizons, stock returns can explain about 40% of debt ratio dynamics. Although corporate (net) issuing activity is lively, and although it can explain the remaining 60% of debt ratio dynamics (long-term debt issuing activity being most capital structure relevant), corporate issuing motives remain largely a mystery. When stock returns are accounted for, taxes, bankruptcy costs, and many other proxies used in the literature, play at best a very modest role in explaining capital structure.

Abstract:
Discussants:
PETER BOSSAERTS, California Institute of Technology
JOHN COCHRANE, University of Chicago, Graduate School of Business
EUGENE FAMA, University of Chicago, Graduate School of Business
WILL GOETZMANN, Yale University, School of Management
ROBERT S. HARRIS, Darden Graduate School of Business, University of Virginia
JOHN HEATON, Northwestern University, Kellogg Graduate School of Management
ROGER IBBOTSON, Yale University, School of Management
MICHAEL J. MAUBOUSSIN, Chief U.S. Investment Strategist - Credit Suisse First Boston and Adjunct Professor - Finance and Economics - Columbia Business School
ANDRE F. PEROLD, Harvard University, Harvard Business School
JAY RITTER, University of Florida, Warrington College of Business
ROBERT WHITELAW, New York University, Stern School of Business

Organized by: PETER TUFANO, Harvard Business School


While it is sometimes difficult to teach ideas that we would all agree to be correct, it is infinitely more difficult--and more rewarding--to teach material where the "correct answer" is still very debatable. For these subjects, one challenge as an educator is to know the "state of play" in the academic community about the issue. Another challenge is deciding whether to take one point of view, or whether to try to teach the students more than one point of view. While students will press for THE right answer, if they can understand why reasonable people reach different answers, this can move a class from fixating on one rote answer to a deeper contemplation of the subtleties of the various arguments.

This new section of FEN-Educator will attempt to spotlight research areas where there is considerable disagreement in the profession. Our inaugural piece is a discussion of the equity risk premium--the long run return of stocks over riskless bonds--which is the source of much confusion in MBA classrooms and in practice. Ivo Welch has agreed to write a brief summary of the issues surrounding the market risk premium and to assemble a selected bibliography on the topic. We then invited a range of researchers, educators and practitioners to comment on how they treat this topic in the classroom. We would like to thank Ivo and the discussants for their willingness to innovate. In the spirit of innovation, we have set up a discussion board where readers can post their own observations on teaching the market risk premium and continue the conversation begun by Ivo and the discussants. (((This board can be found at http://www.???)))

This section was obviously not intended to be the definitive answer on the market risk premium, nor a large scale survey of the numbers we use in class (which can be found in Ivo's forthcoming Journal of Business piece.) Rather it is a modest attempt to move discussions from the halls of our offices (where we ask one another, "What are you going to tell them tomorrow about the risk premium?") to a more public venue, and in so doing, assist finance professors. Please let us know what you think of this concept, how it can be improved, and what other topics you might find interesting.

Abstract:
Our paper reexamines the forecasting regressions which predict annual aggregate stock market returns net of the risk-free rate with lagged aggregate dividend-yield ratios and dividend-price ratios. Prior to 1990, the conditional dividend yield could reliably outperform the historical equity premium mean in predicting future equity premia "in-sample." But our paper shows that the dividend ratios could not outperform the prevailing unconditional mean "out-of-sample," plus any residual power was directly related to only two years, 1974 and 1975. As of 2000, even this in-sample predictive ability has disappeared. Our paper also documents changes in the time-series processes of the dividends themselves and shows that an increasing persistence of dividend-price ratio is largely responsible for weak stock return predictability.

Abstract:
Our paper suggests a simple recursive residuals (out-of-sample) graphical approach to evaluating the predictive power of popular equity premium and stock market time-series forecasting regressions. When applied, we find that dividend-ratios should have been known to have no predictive ability even prior to the 1990s, and that any seeming ability even then was driven by only two years, 1973 and 1974. Our paper also documents changes in the time-series processes of the dividends themselves and shows that an increasing persis-tence of dividend-price ratio is largely responsible for the inability of dividend ratios to predict equity premia. Cochrane (1997)'s accounting identity—that dividend ratios have to predict long-run dividend growth or stock returns—empirically holds only over horizons longer than 5-10 years. Over shorter horizons, dividend yields primarily forecast themselves.

Abstract:
Given the historically high equity premium, is it now a good time to invest in the stock market? Economists have suggested a whole range of variables that investors could or should use to predict: dividend price ratios, dividend yields, earnings-price ratios, dividend payout ratios, net issuing ratios, book-market ratios, interest rates (in various guises), and consumption-based macroeconomic ratios (cay). The typical paper reports that the variable predicted well in an *in-sample* regression, implying forecasting ability.

Our paper explores the *out-of-sample* performance of these variables, and finds that not a single one would have helped a real-world investor outpredicting the then-prevailing historical equity premium mean. Most would have outright hurt. Therefore, we find that, for all practical purposes, the equity premium has not been predictable, and any belief about whether the stock market is now too high or too low has to be based on theoretical prior, not on the empirically variables we have explored.

Abstract:
Economists have suggested a whole range of variables that predict the equity premium: dividend price ratios, dividend yields, earnings-price ratios, dividend payout ratios, corporate or net issuing ratios, book-market ratios, beta premia, interest rates (in various guises), and consumption-based macroeconomic ratios (cay). Our paper comprehensively reexamines the performance of these variables, both in-sample and out-of-sample, as of 2005. We find that [a] over the last 30 years, the prediction models have failed both in-sample and out-of-sample; [b] the models are unstable, in that their out-of-sample predictions have performed unexpectedly poorly; [c] the models would not have helped an investor with access only to information available at the time to time the market.

Equity Premium, Prediction, Stock Market

Abstract:
We model a run on a financial market, in which each risk-neutral investor fears having to liquidate shares after a run, but before prices can recover back to fundamental values. To avoid having to possibly liquidate shares at the marginal post-run price - in which case the risk-averse market-making sector will already hold a lot of share inventory and thus be more reluctant to absorb additional shares - each investor may prefer selling today at the average in-run price, thereby causing the run itself. Liquidity runs and crises are not caused by liquidity shocks per se, but by the fear of future liquidity shocks.

Abstract:
This paper presents the results of a survey of 510 finance and economics professors. The consensus forecast for the 1-year equity premium is about 3% to 3.5%, the consensus forecast for the 30-year equity premium (arithmetic) is about 5% to 5.5%. The consensus 30-year stock market forecast is about 10%. These forecasts are considerably lower than those taken just 3 years ago.

Equity Premium

Abstract:
This paper compares investor sentiment measures based on consumer confidence surveys with measures extracted from the closed-end fund discount (CEFD). Our evidence suggests that these two kinds of sentiment measures do not correlate well with one another. For a short 2 - 4 year period in which we have direct investor sentiment survey data from UBS/Gallup, only the consumer confidence correlates well with investor sentiment. Further, only the consumer confidence based measure can robustly explain the small-firm return spread and the return spread between stocks held disproportionately by retail investors and those held by institutional investors. Surprisingly, there is even a hint that the consumer confidence measure can explain closed-end fund IPO activity, while the CEFD cannot. In sum, our evidence supports the view that sentiment plays a role in financial markets, but that the CEFD may be the wrong measure of sentiment.

Abstract:
Our paper examines two potential proxies for investor sentiment - the closed end fund discount (CEFD) and consumer confidence (CC). We can validate these proxies against a recently available more direct proxy for investor sentiment from UBS/Gallup. We find that the CEFD has no correlation with the UBS/Gallup survey, while the consumer confidence index does. The latter correlation would likely not be observed if either the consumer confidence index or the UBS/Gallup survey were not measures of some form of generic sentiment.

This direct validation is not dependent on a price role for sentiment in financial markets. Going further, our paper finds that only consumer confidence but not the closed-end fund discount plays a robust role in financial market pricing. Changes in consumer confidence can explain the excess returns on small decile stocks. The pathway does not seem to operate only through the real underlying economy (consumption and corporate profits), and it is unaffected by controlling for a measure of CEO confidence changes.

Our evidence satisfies a necessary condition for a behavioral perspective (DeLong/Shleifer/Summers/Waldmann 1990), but it is not a sufficient condition. Absent quantitative predictions by either the behavioral or the classical perspective about the exact influence of sentiment/confidence, empirical evidence cannot reject either.

investor sentiment, consumer confidence

Abstract:
This note reinterprets methods that seek to use the aggregate dividend price ratio to predict aggregate stock market returns; specifically, methods which use information about time-varying changes in the dividend-price ratio process to improve the prediction equation. It argues that the empirical evidence is still too weak to suggest practical usefulness of these estimators.

Abstract:
This paper critiques three issues that commonly arise in empirical capital structure research.

1. Capital Structure Proxies: The financial-debt-to-asset ratio is flawed as a measure of leverage, because the converse of financial debt is not equity. This is because most of the opposite of the financial-debt-to-asset ratio is the non-financial-liabilities-to-asset ratio. This problem is easy to remedy- researchers should use a debt-to-capital ratio or a liabilities-to-asset ratio. The converse of either is an equity ratio.

2. Non-linearity: The intrinsic non-linearity of leverage ratios can render standard linear regressions even with perfect independent variables seemingly powerless. Fortunately, researchers can easily test whether variables have a linear or non-linear influence on equity value changes, debt value changes, or leverage ratios.

3. Selection Issues: There are large survivorship biases in the CRSP/Compustat data bases. About 10% of firms appear and 10% disappear in a single year. These birth and death rates are themselves functions of capital structure and other firm characteristics. This selection makes studying long-term capital structure changes diffcult. Unfortunately, this problem is diffcult to remedy.

The paper does not claim that these three issues drive results in the existing literature. It does however claim that they are not so small as to allow ignoring them a priori.

The paper also clarifies some theoretical issues, most of which are not new, but which are suffciently often muddled that a clarification is useful. First the paper distinguishes between capital structure mechanisms and causes. Second, when it comes to causes, it clarifies that there is no dichotomy between the pecking order theory and the trade-off theory. A pecking order arises in a trade-off theory in which issuing more junior securities is relatively more expensive, or possibly prohibitively expensive. A pecking order is not synonymous with adverse selection, financial slack, or a financing pyramid, either.

capital structure

Abstract:
This paper models how imperfect memory affects the optimal continuity of policies. We examine the choices of a player (individual or firm) who observes previous actions but cannot remember the rationale for these actions. In a stable environment, the player optimally responds to memory loss with excess inertia, defined as a higher probability of following old policies than would occur under full recall. In a volatile environment, the player can exhibit excess impulsiveness (i.e., be more prone to follow new information signals). The model provides a memory-loss explanation for some documented psychological biases, implies that inertia and organizational routines should be more important instable environments than in volatile ones, and provides other empirical implications relating memory and environmental variables to the continuity of decisions.

Memory, Inertia, Amnesia, Behavioral Economics

Abstract:
The consensus of 226 academic financial economists forecasts an arithmetic equity premium of 7% per year over 10 and 30 year horizons; and 6% to 7% over 1 and 5 year horizons. Pessimistic and optimistic 30-year scenario forecasts average 2% and 13%. Respondents claim to revise their forecast downward when the stock market rises. They perceive the profession's consensus to be higher than it really is and are influenced by this perception. There is agreement that markets are efficient and lack arbitrage opportunities, and that government intervention in financial markets is detrimental.

Abstract:
The consensus of 226 academic financial economists forecasts an arithmetic equity premium of 7% per year over 10 and 30 year horizons; and 6% to 7% over 1 and 5 year horizons. Pessimistic and optimistic 30-year scenario forecasts average 2% and 13%. Respondents claim to revise their forecast downward when the stock market rises. They perceive the profession's consensus to be higher than it really is and are influenced by this perception. There is agreement that markets are efficient and lack arbitrage opportunities, and that government intervention in financial markets is detrimental.

Abstract:
The fees of experts (financial advisors, lawyers, accountants) are a substantial fraction of bankruptcy costs. Scholars have considered how best to reduce these costs, but have not considered how they should be allocated among creditors. The allocation issue is important because creditors can spend redistributionally (to violate or uphold absolute priority) and productively (to increase the value of the bankrupt firm). An efficient bankruptcy cost allocation scheme should discourage redistributional and encourage productive creditor spending.

We consider the desirability of various allocation schemes in a model in which senior and junior creditors can engage in both types of spending but the bankruptcy court cannot distinguish productive from rent seeking activities. We suppose that the senior claim is at or in the money. This implies that the seniors have an incentive to spend only to defend their position while the juniors have both good and bad incentives: to spend productively on value improvement because they are residual claimants and to spend redistributionally because they are partly or totally out of the money under absolute priority. A good bankruptcy cost allocation scheme thus should induce the seniors to spend more and the juniors to spend less.

We show: (i) The current US cost allocation system is unsatisfactory because the scheme partially reimburses junior expenses on experts but does not reimburse seniors at all; (ii) Full reimbursement schemes that imposes all costs on one set of parties, such as seniors, juniors or the government, are dominated by partial reimbursement schemes, because these can be better tailored to encourage the right and discourage the wrong kind of spending; and (iii) A cost allocation scheme that approaches first best and is implementable would delegate the issue of expert cost reimbursement to the debtor in possession. The incentive of Chapter 11 debtors to survive would induce them partly to reimburse senior spending but not to reimburse junior spending.

Abstract:
This paper explains why seemingly irrational overconfident behavior can persist. Information aggregation is poor in groups in which most individuals herd. By ignoring the herd, the actions of overconfident individuals ("entrepreneurs") convey their private information. However, entrepreneurs make mistakes and thus die more frequently. The socially optimal proportion of entrepreneurs trades off the positive information externality against high attrition rates of entrepreneurs, and depends on the size of the group, on the degree of overconfidence, and on the accuracy of individuals' private information. The stationary distribution trades off the fitness of the group against the fitness of overconfident individuals.

Evolution, Overconfidence, Behavioral Economics

Abstract:
There are situations in which dispersed creditors (e.g., public creditors) have more difficulties and higher costs when collecting their claims in financial distress than concentrated creditors (e.g., banks). Under this assumption, our model predicts that measures of debt concentration relate [a] positively to creditors' chosen aggregate debt collection expenditures; [b] positively to management's chosen expenditures to avoid paying; [c] positively to total net litigation costs/waste in financial distress; and [d] positively to accomplished claim recovery by creditors (to which we present some preliminary favorable empirical evidence). Under additional assumptions, measures of debt concentration relate [e] positively to intrinsic firm quality; [f] positively to creditor monitoring and negatively to managerial waste; [g] positively to optimal continuation/discontinuation choices; [h] negatively to issuing marketing expenses. In a signaling model, when concentration alone is not a sufficient signal, firms choose the ultimately concentrated debt (i.e., a house bank) and have to pay a high interest.

Abstract:
Our model assumes that creditors need to expend resources to collect on
claims. Consequently, because diffuse creditors suffer from mutual
free-riding (Holmstrom (1982)), they fare worse than
concentrated creditors (e.g. a house bank). The model predicts that
measures of debt concentration relate positively to creditors'
(aggregate) debt collection expenditures and positively to management's
chosen expenditures to resist paying. However, collection activity is
purely redistributive, so social waste is larger when creditors are
concentrated. If borrower quality is not known, the best firms choose
the most concentrated creditors and pay higher expected yields.

Banking, Capital Structure

Abstract:
A sample of about 400 finance professors estimates the 1-year equity premium and the 30-year geometric equity premium to be about 5%, as of year-end 2007. The sample interquartile range is 4% to 6%. The typical range recommended in their classes is a little higher (from 4% to 7%, with a mean of 6%). Since 2001, participants have become more bearish (by about 0.5%).

The participants estimate the 30-year arithmetic equity premium estimate to be about 75 basis points higher than its geometric equivalent; and they estimate the 30-year geometric expected rate of return on the stock market to be about 9%.

75% of finance professors recommend using the CAPM for corporate capital budgeting purposes; 10% recommend the Fama-French model; 5% recommend an APT model.

equity premium

Abstract:
Our paper explores a comprehensive sample of small and large corporate bankruptcies in Arizona and New York from 1995-2001. We find that bankruptcy costs are very heterogeneous and sensitive to measurement method. Still, Chapter 7 liquidations appear no faster or cheaper (in terms of direct expense) than Chapter 11 bankruptcies. But Chapter 11 seems to preserve assets better, and thereby allows creditors to recover relatively more. Our paper also provides a large number of further empirical regularities.

Abstract:
Many papers in the empirical finance literature implement tests of asset pricing models either via Fama-French time-series regressions or via Fama-Macbeth cross-sectional regressions. This short paper explains their conceptual relationships. There is a time-series equivalent method to implementing Fama-Macbeth regressions (in a stable world). This correspondence also helps to clarify the interpretation of the estimates from the two methods: The Fama-Macbeth test is better suited for APT tests, while the plain Fama-French test is better suited for equilibrium tests. (Of course, all equilibrium model must be arbitrage-free, but not vice-versa.) It is possible to test not only whether factors can price portfolios in an equilibrium framework, but also the less restrictive requirement that the factors should not allow for arbitrage. For example, this short paper shows that the Fama-French 3-factor model fails the weaker arbitrage pricing restriction for the the 2x3 Fama-French portfolios, and not just the stronger equilibrium pricing restriction.

Asset Pricing, Fama-French, Fama-Macbeth, APT, CAPM

Abstract:
Our paper explores a comprehensive sample of both small and large corporate bankruptcies in Arizona and New York from 1995-2001. We find that bankruptcy costs are very heterogeneous and sensitive to measurement method. Still, Chapter 7 liquidations seem more expensive in direct and equally expensive in indirect costs, than Chapter 11 bankruptcies. The paper provides a large number of further empirical regularities.

Abstract:
This article analyzes how legal presumptions can mediate between costly litigation and ex ante incentives. We augment a moral hazard model with a redistributional litigation game in which a presumption parameterizes how a court 'weighs' evidence offered by the opposing sides. Strong prodefendant presumptions foreclose lawsuits altogether, but also engender shirking. Strong proplaintiff presumptions have the opposite effects. Moderate presumptions give rise to equilibria in which both shirking and suit occur probabilisitically. The socially optimal presumption trades off agency costs against litigation costs, and could be either strong or moderate, depending on the social importance of effort, the costs of filing suit, and the comparative advantage that diligent agents have over their shirking counterparts in mounting a defense. We posit three applications of our model: the litigation rate effects of the 1995 Private Securities Litigation Reform Act, the business judgment rule in corporations law, and fiduciary duties in financially distressed firms.

Abstract:
This paper develops a theoretical account of presumptions, focusing on their capacity to mediate between costly litigation and ex ante incentives. We augment a standard moral hazard model with a redistributional litigation game in which a legal presumption parameterizes how a court "weighs" evidence offered by the opposing sides. Strong pro-defendant presumptions can foreclose lawsuits altogether, but also lead to shirking. Strong pro-plaintiff presumptions have the opposite effects. Moderate presumptions give rise to equilibria in which productive effort and suit occur probabilistically. The socially-optimal presumption trades off litigation costs against agency costs, and could be either strong or moderate, depending on the social importance of effort, the costs of filing suit, and the comparative advantage that diligent agents have over their shirking counterparts in mounting a defense. We posit three applications of the model: the business judgment rule in corporations law, fiduciary duties in financially-distressed firms, and the doctrine of res ipsa loquitur in accident law.

Abstract:
This paper provides a theory why bank debt is universally senior, consistent with the presence of conflict (lawyers) and absolute priority violations in financial distress: banks would more strongly contest the priority structure in financial distress if they were junior, because they are both better organized than public debt and more appreciative of a toughness reputation in repeat relationships with other clients. This paper identifies the conditions under which firms find it efficient to award the ex-post stronger lobbyist/litigant ex-ante priority, because "deterrence" can reduce total creditors' expenses associated with a priority contest. For equivalent reasons, the theory can advise when public debt should be senior to trade credit and/or implicit contracts, and can even suggest one rationale for the absolute priority rule (APR). The paper further shows that overall creditors' contest expenses can be lower when the firm pays, thus providing a rationale for Chapter 11 creditor reimbursement procedures.

Abstract:
In a one-factor model, such as the CAPM, it takes two assets to pin down the expected rates of return on every other asset in the economy. The risk-free rate is one. The market is traditionally the second. However, this numeraire can be switched to other assets. If we use long-term Treasuries, and believe earlier empirical evidence in Fama-Bliss (1987) that the long-term yield spread is entirely due to a risk premium and not at all due to a forecast of future yields, then the Treasury yield spread and the market-beta of the long-term Treasury pin down an estimate of the equity premium. For the period from 1962 to 2007, it was 8 er year.

However, this method also fails often, specifically in times when the market beta estimate of the long-term Treasury is close to zero. Moreover, given that the CAPM performs so poorly, the author recommends using the resulting estimate only as an internally consistent estimate within the context of the model itself.

Beta, Capital Budgeting, CAPM

Abstract:
Governments and vocal institutional shareholders have been exerting pressure on companies they deem to have objectionable operations (such as tobacco or chemical producers). This paper studies the effect of the most important legislative and shareholder boycott to date, the boycott of the South Africa's apartheid regime. We find that the announcement of legislative/shareholder pressure of voluntary divestment from South Africa had little discernible effect either on the valuation of banks and corporations with South African operations or on the South African financial markets. There is weak evidence that institutional shareholdings increased when corporations divested. In sum, despite the public significance of the boycott and the multitude of divesting companies, financial markets seem to have perceived the boycott to be merely a "sideshow."

Abstract:
This paper studies institutions, such as firms, in which multiple projects can require attention at unpredictable times. Firms respond optimally by limiting the number of projects they simultaneously undertake (medium-term) and by acquiring attention capacity (long-term). The most interesting implications relate to a variable that would otherwise be interpreted as the sign of an agency conflict: idleness (operational slack). In our full-information model, it is optimal for the institution to be idle some of the time. In the medium-term and long-term, when firms respond optimally, they tend to idle *more* when projects require "more" attention and when they have "less" attention capacity. Moreover, natural model extensions suggest that managers who want to signal higher quality or who are overly optimistic take on too many projects. This can explain overinvestment and the diversification discount even when managers are not agency-conflicted.

Attention, Project Choice, Slack, Overinvestment, Diversification Discount

Abstract:
It is now well known that the Sharpe ratio and other related reward-to-risk measures may be manipulated with option-like strategies. In this paper we derive the general conditions for achieving the maximum expected Sharpe ratio. We derive static rules for achieving the maximum Sharpe ratio with two or more options, as well as a continuum of derivative contracts. The optimal strategy rules for increasing the Sharpe ratio. Our results have implications for performance measurement in any setting in which managers may use derivative contracts. In a performance measurement setting, we suggest that the distribution of high Sharpe ratio managers should be compared with that of the optimal Sharpe ratio strategy. This has particular application in the hedge fund industry where use of derivatives is unconstrained and manager compensation itself induces a non-linear payoff. The shape of the optimal Sharpe ratio leads to further conjectures. Expected returns being held constant, high Sharpe ratio strategies are, by definition, strategies that generate regular modest profits punctunated by occasional crashes. Our evidence suggests that the 'peso problem' may be ubiquitous in any investment management industry that rewards high Sharpe ratio managers.

Abstract:
This paper seeks to reconcile the different results from prominent estimators of the speed of adjustment (SOA) of firms' leverage ratios. Previous papers overlooked the simple fact that leverage ratios less than 0% or greater than 100% are not possible. This made some of them find mean reversion, which they mistakenly considered as readjustment. When corrected, the best reconciled estimate for the SOA is not positive: On average, firms do not seem to adjust. Moreover, the data is so plentiful that SOA estimates can be extremely accurate even when the firm-specific target is not known. Finally, our paper suggests both a method of reconciling estimators from prior research and a better way of modeling the underlying leverage ratio process.

capital structure, leverage ratios, speed of adjustment, dynamic tradeoff theories

Abstract:
This is a chapter on ethics, that will be a supplementary part of my introductory corporate finance textbook. The chapter seeks to ask interesting questions and to provoke students. These questions asked have no clear answers and are generally not politically correct. The chapter can serve as the basis for a class session or as the basis for an entire class.

The chapter is 'not' representative of the remainder of the book. However, I believe that the subject is important - and too often simply ignored by us finance professors - so even after the book will be formally published by Addison-Wesley-Pearson, this chapter will remain freely available.

Abstract:
We review the theory and evidence on IPO activity: why firms go public, why they reward first-day investors with considerable underpricing, and how IPOs perform in the long run. Our perspective is threefold: First, we believe that many IPO phenomena are not stationary. Second, we believe research into share allocation issues is the most promising area of research in IPOs at the moment. Third, we argue that asymmetric information is not the primary driver of many IPO phenomena. Instead, we believe future progress in the literature will come from nonrational and agency conflict explanations. We describe some promising such alternatives.

Abstract:
We review the theory and evidence on IPO activity: why firms go public, why they reward first-day investors with considerable underpricing, and how IPOs perform in the long run. Our perspective on the literature is three-fold: First, we believe that many IPO phenomena are not stationary. Second, we believe research into share allocation issues is the most promising area of research in IPOs at the moment. Third, we argue that asymmetric information is not the primary driver of many IPO phenomena. Instead, we believe future progress in the literature will come from non-rational and agency conflict explanations. We describe some promising such alternatives.

Abstract:
An informational cascade occurs when it is optimal for an individual, having observed the actions of those ahead of him, to follow the behavior of the preceding individual without regard to his own information. We argue that localized conformity of behavior and the fragility of mass behaviors can be explained by informational cascades.

Abstract:
Market-beta, momentum, and 1-month-reversal are statistics computed from historical stock-returns. However, when a stock has experienced unusually noisy rates of return (e.g., a rare extreme stock return), ignoring this noise should yield a better estimate of the future statistic than the actual historical statistic. The standard method to do this, at least in the context of market-betas, is Stein shrinkage (vasicek:1973).

Our paper exploits the wedge between the two statistics: If investors care about the forward-looking aspect of a measure, then it is the shrunk statistic that should predict future stock returns. If investors care about the backward-looking "characteristics" aspect of a measure, then it is the unshrunk actual historical statistic that should predict future stock returns. We find: [1] Market-beta contains a backward-looking aspect that has a negative influence on future stock returns. This distorts the positive signal in the forward-looking (likely hedging-related) aspect of market-beta. [2] 2-to-13 month momentum is principally a forward-looking effect. [3] The 1-month return reversal effect arises principally from some backward-looking characteristic.

Abstract:
This paper shows that managers fail to readjust their capital structure in response to external stock returns. Thus, the typical firm's capital structure is not caused by attempts to time the market, by attempts to minimize taxes or bankruptcy costs, or by any other attempts at firm-value maximization. Instead, capital structure is almost entirely determined by lagged stock returns (which, when applied to ancient equity values, predict current equity value and with it debt equity ratios). Consequently, one should conclude that capital structure is determined primarily by external stock market influences, and not by internal corporate optimizing decisions.

Abstract:
Our paper studies an economy in which each financial institution takes into account that if it has to sell its assets after others have already sold, the price will be lower. This causes preemptive selling, driven not by actual margin calls, but by the fear of future margin calls. Financial institutions cannot determine their optimal capitalizations in isolation, but need to know the aggregate capitalization. The resulting equilibrium is fragile: Small changes in model parameters can cause large changes in the equilibrium allocation of risk. Our model is a natural complement to Allen and Gale (2004).

Leverage, Banks, Financial Institutions, Preemptive Selling, Fire Sales

Abstract:
Our paper offers a minimalist model of a run on a financial market. The prime ingredient is that each risk-neutral investor fears having to liquidate after a run, but before prices can recover back to fundamental values. During the urn, only the risk-averse market-making sector is willing to absorb shares. To avoid having to possibly liquidate shares at the marginal post-run price in which case the market-making sector will already hold a lot of share inventory and thus be more reluctant to absorb additional shares all investors may prefer selling their shares into the market today at the average run price, thereby causing the run itself. Consequently, stock prices are low and risk is allocated inefficiently. Liquidity runs and crises are not caused by liquidity shocks per se, but by the fear of future liquidity shocks.

Abstract:
Our article comprehensively reexamines the performance of variables that have been suggested by the academic literature to be good predictors of the equity premium. We find that by and large, these models have predicted poorly both in-sample (IS) and out-of-sample (OOS) for 30 years now; these models seem unstable, as diagnosed by their out-of-sample predictions and other statistics; and these models would not have helped an investor with access only to available information to profitably time the market.

G12, G14

Abstract:
Suggests a model to explain underpricing at the IPO by high-quality firms as a signal to investors at the expense of low-quality firms. In contrast to Rock's (1986) equilibrium model suggesting firms underprice reluctantly, this model follows in the vein of more recent models (Nanda 1989 and Grinblatt & Hwang 1989), suggesting that high-quality firms underprice strategically as a signaling device. Consequently, low-quality firms are forced to either invest in substantial imitation expenses or reveal their quality. Using data from a sample of 1,028 IPO firms from 1977-1982 in Going Public: The IPO Reporter, empirical evidence shows that IPO firms reissue substantially, and moreover that they choose a timing for seasoned offerings (SO) that is related to the IPO. The model implies that firms are eventually compensated for low IPO prices by a higher price at a seasoned offering. High-quality firm owners are able to achieve higher SO prices because their marginal cost of underpricing is less than that incurred by low-quality firms attempting to imitate high-quality firms. Ultimately, strategic underpricing at the IPO is possible because of an information asymmetry between firm owners and investors. (CJC)

Seasoned offerings, Signaling, Underpricing, Valuation, Business conditions, Stock offerings, Information asymmetry, Initial public offerings (IPO)

Abstract:
Considering that roughly 75 percent of new businesses fail within the first five years, it is difficult to account for entrepreneurs' irrationally overconfident behavior.One explanation is that overconfident entrepreneurs are less likely to imitate their peers and more likely to explore their environment.When groups compete and inferior groups disappear, groups with some entrepreneurial activity may gain enough of an evolutionary advantage to permit entrepreneurs to survive in equilibrium; in other words, groups with some overconfident individuals have an evolutionary advantage over groups without such individuals. A model illustrates the idea that overconfidence imposes only small costs on entrepreneurs (who put too much weight on their own information) but provides large benefits in revealing their private information to their groups.The presentation of the model is followed by a discussion of factors influencing the trade-off between the positive information externality and the high rate of entrepreneurial attrition.This trade-off results in an optimal proportion of entrepreneurs and depends on the size of the group, the degree of overconfidence, and the accuracy of individuals' private information. What follows is a discussion of the trade-off between intergroup and intragroup selection, as well as arguments pro and con group selection.One alternative explanation for overconfidence exists: when trying to deceive others that they are of higher ability, individuals' credibility is enhanced if they are themselves convinced of this ability.(SAA)

Theoretical, Overconfidence, Self-efficacy, Management decisions, Startups, Groups, Risk orientation, Survival rates

Abstract:
Learning by observing the past decisions of others can help explain some otherwise puzzling phenomena about human behavior. For example, why do people tend to converge on similar behavior? Why is mass behavior prone to error and fads? The authors argue that the theory of observational learning, and particularly of informational cascades, has much to offer economics, business strategy, political science, and the study of criminal behavior.

Abstract:
This paper models how imperfect memory affects the optimal continuity of policies. We examine the choices of a player (individual or firm) who observes previous actions but cannot remember the rationale for these actions. In a stable environment, the player optimally responds to memory loss with excess inertia, defined as a higher probability of following old policies than would occur under full recall. In a volatile environment, the player can exhibit excess impulsiveness (i.e., be more prone to follow new information signals). The model provides a memory-loss explanation for some documented psychological biases, implies that inertia and organizational routines should be more important in stable environments than in volatile ones, and provides other empirical implications relating memory and environmental variables to the continuity of decisions.

Abstract:
This FAQ provides an analysis of the causes and of some remedies of the financial crisis of 2008. Subprime and Alt-A mortgage losses were just a trigger - they could not possibly be responsible alone for the steep drop in the value of banks, financial institutions, and companies. The FAQ decomposes causes into those that are shallow (e.g., defaulting bonds), mid-level (e.g., fall in real estate values) and deep (e.g., poor corporate governance and tax systems).

Financial Crisis 2008

Abstract:
An information cascade occurs when individuals, having observed the actions and possibly payoffs of those ahead of them, take the same action regardless of their own information signals. Informational cascades may realize only a fraction of the potential gains from aggregating the diverse information of many individuals, which helps explain some otherwise puzzling aspects of human and animal behaviour. For example, why do individuals tend to converge on similar behaviour? Why is mass behaviour prone to error and fads? The theory of observational learning, and particularly of information cascades, has much to offer economics and other social sciences.

Abstract:
Numerous measures have been proposed to gauge the performance of active management. Unfortunately, these measures can be gamed. Our article shows that gaming can have a substantial impact on popular measures even in the presence of high transactions costs. Our article shows there are conditions under which a manipulation-proof measure exists and fully characterizes it. This measure looks like the average of a power utility function, calculated over the return history. The case for using our alternative ranking metric is particularly compelling for hedge funds whose use of derivatives is unconstrained and whose managers' compensation itself induces a nonlinear payoff.

G11, G23, G24

Abstract:
An information cascade occurs when it is optimal for an individual, having observed the actions and possibly payoffs of those ahead of him, to take the same action regardless of his own information. When there are informational cascades, society may reap only a modest fraction of the potential gains from aggregating the diverse information of many individuals. As a result, information cascades can help explain some otherwise puzzling aspects of human and animal behavior. For example, why do individuals tend to converge on similar behavior? Why is mass behavior prone to error and fads? We suggest that the theory of observational learning, and particularly of information cascades, has much to offer economics and other social sciences.

Abstract describes an entry written for: S. N. Durlauf and L. E. Blume, The New Palgrave Dictionary of Economics, forthcoming, Palgrave Macmillan. This abstract has not been reviewed or edited. The definitive published version of the entry may be found in the complete New Palgrave Dictionary of Economics in print and online, forthcoming.

information cascades, information aggregation, social learning, cultural evolution

Abstract:
This study predicts cross-sectional investment (asset-normalized capital expenditures) innovations within the United States, Canada, Great Britain, (mainland) Europe, and Japan. We find that lagged stock returns are the most important cross-sectional predictors of investment increases - except in mainland Europe. American firms tend to react more than Japanese firms but less than Canadian and British firms. However, the differences between Japanese firms and U.S. firms are small. In contrast, European firms appear to conduct their investment policy without much regard for their own lagged stock performance.

Abstract:
The paper shows that the buy or sell recommendations of security analysts have a significant positive influence on the recommendations of the next two analysts. This influence can be traced to short-lived information in the most recent revisions. In contrast, the influence of the prevailing consensus is not stronger if the consensus accurately forecasts subsequent stock price movements. This indicates consensus herding consistent with models in which analysts herd based on little information. The consensus also has a stronger influence when market conditions are favorable. The resulting poorer information aggregation could cause bull markets to be intrinsically more "fragile" (e.g., Bikhchandani et al., J. Political Economy 100(5) (1992) 992-1026).

Herding, Imitation, Informational Cascades, Analysts

Abstract:
Theories of banks as efficient monitors would suggest that bank debt should be junior to other creditors in order to precipitate bankruptcy when other creditors are still in- the-money. This paper provides an explanation why bank debt is usually senior: banks would more strongly contest the priority structure in financial distress if they were junior, because they are both better organized than public debt and more appreciative of a toughness reputation in repeat relationships with other clients. This paper identifies the conditions under which it can be efficient to award the ex-post stronger litigant ex-ante priority, because it reduces the creditors' expenses associated with a priority contest. For equivalent reasons, the theory can advise when public debt should be senior to trade credit and/or implicit contracts, and even suggests one rationale for the absolute priority rule (APR).This paper is available for print via anonymous ftp: Postscript: next.agsm.ucla.edu: ~/academic.finance/bankdebt.ps HP LJ (binary/no figures): next.agsm.ucla.edu: ~/academic.finance/bankdebt.hp

Abstract:
This paper examines how imperfect institutional memory affects organizational decisions. In our model, new managers are aware of their firm's previous actions but not the rationale for these actions. If the environment is stable, we find that a firm that has followed an old investment policy long enough and then changes management generally exhibits greater INERTIA, that is a greater tendency to follow old actions than a firm in which the old manager with full memory would have continued. On the other hand, if the environment is volatile or if the old manager has followed a policy only briefly, previous investment decisions are not very informative, and new managers can be excessively IMPULSIVE (prone to follow their latest information with less regard to history). The model implies relationships among various variables, such as the frequency of policy changes (e.g., reversal of project choices), managerial turnover, the quality of record-keeping, the history of the project, and the stability of the underlying environment.

Abstract:
Issuers of Initial Public Offerings (IPOs) face numerous decisions, of which the selection and compensation of experts---the legal counsel, the auditor and the investment banker---are among the most important. Using new data, our paper investigates the role of the entire IPO coalition (including the legal counsel). We examine how expert compensation, IPO underpricing, IPO underpricing uncertainty, and subsequent performance are related to: [1] expert quality; [2] legal caution and liability; [3] non- legal risk signals; and [4] one another.

Abstract:
This article studies the most important legislative and shareholder boycott to date, the boycott of South Africa's apartheid regime. We find that corporate involvement with South Africa was so small that the announcement of legislative/shareholder pressure or voluntary corporate divestment from South Africa had little discernible effect either on the valuation of banks and corporations with South African operations or on the South African financial markets. There is weak evidence that institutional shareholdings increased when corporations divested. In sum, despite the publicity of the boycott and the multitude of divesting companies, political pressure had little visible effect on the financial markets.

Abstract:
Loughran and Ritter (1995) document that firms issuing seasoned equity offerings (SEOs) severely underperform the stock market for three to five years after the offering. Our paper examines the hypothesis that SEO investors are too optimistic because they naively extrapolate earnings trends without fully adjusting for observable discretionary managerial reporting choices. We find that aggressive firms, which report high pre-SEO earnings at the expense of post-SEO earnings by taking high discretionary pre-issue accruals, subsequently perform worse (abnormal stock returns and industry-adjusted net income). Aggressive quartile firms earned a highly significant-50% four-year cumulative abnormal return; conservative quartile firms earn an insignificant-7% four-year cumulative abnormal return. In contrast with discretionary accruals, pre-issue non-discretionary accruals did not predict post-SEO returns.

Abstract:

SUBJECT AREAS: Initial Public Offerings, Valuation, Earnings Management, Securities Underwriting.
CASE SETTING: Late 1989, apparel manufacturer and distributor located in NY, with production in Korea. IPO selling $26 million of an $80 million company.

REQUEST FOR COPIES: http://linux.agsm.ucla.edu/giii/. There are four versions of the case, ranging from 13 pages to 25 pages, according to desired level of detail. This includes 3 pages from the prospectus itself. A very detailed instructors guide is available upon request. It tries to link the case and discussion to findings in the academic literature (with full citations and references).


Situation:
The case presents the initial public offering (IPO) of G-III, a leather apparel producer. Unlike biotech or computer IPOs, the G-III company is not in a sexy growth industry, but in an "almost-commodity" industry. G-III has operated for a good number of years and has revenue-generating operations. Furthermore, apparel is relatively comparable across different companies, which presumably allows students to evaluate the relative potential of G-III.

The case illustrates how difficult it is to value even established companies off of comparables. In addition, most IPOs manage their reported earnings rather aggressively, and G-III is no exception. A naive application of comparables thus misleads and later unpleasantly surprises investors/students. The instructor's note details how this is done and what its consequences are. (In my opinion, the "surprise factor" is of great didactic use: the instructor adds value by pointing out the mistakes in most students' analyses of what is the most standard/common IPO that I could find.)

The case also contains some detail about the IPO and underwriting process, and lends itself to a discussion of many IPO related issues (such as the role and selection of the underwriter) and IPO and apparel market conditions. Smaller versions (progressively) exclude details on industry, market, company, comparables, and IPO market conditions.

The case is geared towards a second or third course in corporate finance, or a valuation course. It can be taught either over one or two class sessions. It has been used in my own and others' classes. I expect to refine the teaching note and perhaps change some minor parts of the case in the next year, but the case is fairly stable by now.

Abstract:
Loughran and Ritter (1995) document that firms issuing seasoned equity offerings (SEOs) severely underperform the stock market for three to five years after the offering. Our paper examines the hypothesis that SEO investors are too optimistic because they naively extrapolate earnings trends without fully adjusting for observable discretionary managerial reporting choices. We find that aggressive firms, which report high pre-SEO earnings at the expense of post-SEO earnings by taking high discretionary pre-issue accruals, subsequently performed worse (abnormal stock returns and industry-adjusted net income). Aggressive quartile firms earned a highly significant-48% four-year cumulative abnormal return; conservative quartile firms earned an insignificant-7% four-year cumulative abnormal return. In contrast with discretionary accruals, pre-issue non-discretionary accruals did not predict post SEO returns. This paper is also available at the following web address: ftp://next.agsm.ucla.edu/academic.finance/mngseo.ps ftp://next.agsm.ucla.edu/academic.finance/mngseo.hp If you have any questions concerning downloading, please contact Professor Teoh.

Abstract:
This paper briefly describes recent papers on economics of rational herding in financial markets. Some models can predict perfect herding, in which rational agents all act alike without any counterveiling force. Such herding typically arises either from direct payoff externalities (negative externalities in bank runs; positive externalities in the generation of trading liquidity or in information acquisition), principal-agent problems (based on managerial desire to protect or signal reputation), or informational learning (cascades). The paper also provides a few pointers to related literature and suggests issues to be addressed in future research.

Abstract:
This paper offers a novel explanation for why some firms prefer to pay dividends rather than repurchase shares. It is well-known that institutional investors are relatively less taxed than individual investors, and that this induces "dividend clientele" effects. We argue that these clientele effects are the very reason for the presence of dividends, because institutions have a relative advantage in monitoring firms or in detecting firm quality. Firms paying dividends attract relatively more institutions and perform better. The theory is consistent with some documented regularities, such as a reluctance of firms to cut dividends, and offers novel empirical implications, such as a prediction that is the tax difference between institutions and retail investors that determines dividend payments, not the absolute tax payments.

Abstract:
We show that discrimination can occur even when it is common knowledge that underlying group characteristics do not differ and when employers do not prefer same-group candidates. When employers can judge job applicants' unknown qualities better when candidates belong to the same group and hire the best prospect from a large pool of applicants, the top applicant is likely to be from the same background as the employer. The model has policy, empirical and experimental implications. For example, the model predicts that "screening discrimination" is more likely to occur and persist in sectors in which underlying quality is important but difficult to observe, in which there are numerous applicants, in which interviewing (screening) is relatively cheap, and in which applicants have to acquire job-specific skills.

Abstract:
We show that discrimination can occur even when it is common knowledge that underlying group characteristics do not differ and when employers do not prefer same-group candidates. When employers can judge job applicants' unknown qualities better when candidates belong to the same group and hire the best prospect from a large pool of applicants, the top applicant is likely to have the same background as the employer. The model has policy, empirical, and experimental implications. For example, the model predicts that "screening discrimination" is more likely to occur and persist in sectors in which underlying quality is important but difficult to observe, there are numerous applicants, interviewing (screening) is relatively cheap, and applicants have to acquire job-specific skills.