We provide a model in which a single psychological constraint, limited attention, explains both under- and overreaction to different earnings components. Investor neglect of earn-ings induces post-earnings announcement drift and the profit anomaly. Neglect of earnings components causes accrual and cash flow anomalies. The model offers empirical implica-tions relating the strength of earnings-related anomalies to the forecasting power of current earnings-related information for future earnings, investor attentiveness, and the volatilities of and correlation between accruals and cash flows. We also show that, owing to atten-tion costs, in equilibrium not all investors choose to attend to earnings or its components. (JEL G12, G14, M41, M43) Market reactions to earnings and earnings components present a striking puzzle. Stock prices on average underreact to earnings surprises (post-earnings an-nouncement drift), but overreact to the operating accruals component of earn-ings.1 Earnings- and accruals-related patterns of return predictability are often referred to as “anomalies, ” “under- ” and “overreaction, ” or reflecting investor “optimism, ” “pessimism, ” or “naı̈veté. ” Such labels offer little guidance as to

Cover Get access The Review of Asset Pricing Studies, Volume 1, Issue 1, December 2011, Page NP, https://doi.org/10.1093/rapstu/rar006 Published: 01 December 2011

We present a novel methodology for estimating/testing the Bansal and Yaron (2004) and related long-run risks (LRR) models based on the observation that the latent state variables are known functions of observables. The large standard error of the estimated elasticity of intertemporal substitution explains the controversy on its magnitude. The model requires higher persistence of consumption and dividend growth to explain the cross-section of returns than that observed in the data. The model matches the unconditional moments of consumption and dividend growth, but implies a higher risk-free rate and lower volatility of the price/dividend ratio, risk-free rate, and market return than those observed in the data. Contrary to the model implications, the conditional variance of the LRR variable fails to capture the large time variation in the equity premium.

Classical approaches to estimation and decisions requiring estimation often are at odds. When values critical to the decision are convex or concave functions of unknown parameters, the statistician's estimation error adjustments are the opposite of what is appropriate for the decision. We illustrate the conflict by studying multi-period investment problems. The proper application of Jensen's inequality to the decision turns finance intuition on its head: Multi-period investments with negative risk premia can be profitable, risk-averse investors can have infinite demand for risky securities, settings exist in which risk-averse investors should not diversify, and demand for mutual funds with negative alphas may be rational.

We show whether central clearing of a particular class of derivatives lowers counterparty risk. For plausible cases, adding a central clearing counterparty (CCP) for a class of derivatives such as credit default swaps reduces netting efficiency, leading to an increase in average exposure to counterparty default. Further, clearing different classes of derivatives in separate CCPs always increases counterparty exposures relative to clearing the combined set of derivatives in a single CCP. We provide theory as well as illustrative numerical examples of these results that are calibrated to notional derivatives position data for major banks.

This paper analyzes board independence and competence as distinct, but inextricably linked aspects of board effectiveness. Competent directors add shareholder value because they have better information about the quality of projects. While a CEO cares about shareholder value, he also wants his board to behave loyally to him by agreeing to projects that give him private benefits. Because many aspects of the CEO-board relationship are not contractible, the paper studies a model of relational contracts, a tool that has hitherto been rarely used in work on corporate governance. The analysis reveals a tradeoff: Inefficient loyalty is endogenously easier to obtain from a less competent board. The implied conflict of interest between shareholders and the CEO is particularly pronounced in difficult times. Fortunately, the tradeoff does not arise with respect to efficient loyalty. Several empirical predictions flow from the model, some of which explain existing empirical facts while others are new

Recent empirical findings by Elsas, 2005, Degryse and Ongena, 2007 document a U-shaped effect of market concentration on relationship lending which cannot be easily accommodated by the investment and strategic theories of bank lending orientation. In this paper, we suggest that this non-monotonicity can be explained by looking at the organizational structure of local credit markets. We provide evidence that marginal increases in interbank competition are detrimental to relationship lending in markets where large and out-of-market banks are predominant. By contrast, where relational lending technologies are already widely in use in the market by a large group of small mutual banks, an increase in competition may drive banks to further cultivate their extensive ties with customers

We study the impact of overconfidence on investment decisions by financial institutions. These institutions are characterized by the delegation of investment decisions to portfolio managers and the design of contracts that aim at aligning managers’ incentives with those of the institution. We show that when rational and overconfident agents acquire information of the same precision, overconfident agents trade lower quantities than rational agents. However, overconfidence also generates incentives to overinvest in information acquisition. In such cases, overconfident agents trade larger quantities and take more risk than rational agents. The direct consequence of these results is that, as far as delegated portfolio management is concerned, overconfidence generates high trading volumes only through over-acquisition of information. Based on psychological evidence that overconfidence is generated by a self-attribution bias, our results are consistent with recent empirical evidence about mutual fund managers’ portfolio-rebalancing patterns and changes in mutual funds’ advisory contracts.

We develop an incomplete contracts model to study the extent to which control rights of different financings affect corporate growth. The model admits a standard hold-up problem under equity financing; insiders may be disincentivized to do R&D because outside investors can use their control rights to expropriate large parts of the returns by hiring more efficient managers in the future. Debt financing may give rise to a double moral hazard problem; both managers and shareholders may divert corporate resources to themselves before debt is serviced. However, in many cases, these phenomena do not occur in equilibrium and control rights are irrelevant. Cross-sectional predictions are derived from those cases where control rights matter. Consistent with the empirical evidence, leverage is inversely related to growth and to profitability.

The adoption of a managed distribution policy or plan (MDP) by closed-end funds appears effective in dramatically reducing, even eliminating, fund discounts. We investigate two possible explanations: the signaling explanation proposed in the literature, that the MDP serves as a positive signal of future fund performance, and an alternative explanation based on agency costs. Our results indicate that signaling is, at best, only part of the explanation and that the evidence is generally more consistent with the agency cost hypothesis. For funds adopting aggressive payout targets of 10% (median target) and above, discounts tend to disappear, though there is no discernible improvement in NAV performance. Consistent with the agency cost hypothesis, it is often pressure from institutions/large shareholders that leads to the adoption of aggressive payout policies. Moreover, aggressive-MDPs are associated with a decrease in fund size and managerial fees. Suggestive of their activist role in MDP adoptions and/or informed trading, institutions – especially ones that are Value oriented – tend to build-up their holdings in a fund prior to the adoption of an aggressive-MDP, and liquidate their positions once the price rises.