Knowledge that Transforms

This paper resolves the disagreement between Longstaff et al. [2001. Journal of Finance Economics 62, 39–66] and Andersen and Andreasen [2001. Journal of Financial Economics 62, 3–37] over the effectiveness of the common business practice of using best-fit single-factor term structure models to deduce exercise strategies of Bermudan swaptions. I examine the cost of using recalibrated single-factor models to determine the exercise strategy for Bermudan swaptions in a multifactor world. I show that single-factor exercise strategies applied in a multifactor world only give rise to economically insignificant losses. Furthermore, I find that the conditional model risk as defined in Longstaff et al. [2001. Journal of Finance Economics 62, 39–66] is statistically insignificant given the number of observations. Additional tests using the Primal–Dual algorithm of Andersen and Broadie [2004. Management Science 50(9)] indicate that losses found in Longstaff et al. [2001. Journal of Finance Economics 62, 39–66] cannot, as claimed, be ascribed to the number of factors.

Aggregate merger waves could be due to market timing or to clustering of industry shocks for which mergers facilitate change to the new environment. This study finds that economic, regulatory and technological shocks drive industry merger waves. Whether the shock leads to a wave of mergers, however, depends on whether there is sufficient overall capital liquidity. This macro-level liquidity component causes industry merger waves to cluster in time even if industry shocks do not. Market-timing variables have little explanatory power relative to an economic model including this liquidity component. The contemporaneous peak in divisional acquisitions for cash also suggests an economic motivation for the merger activity.

The average level and cross-sectional variability of fund alphas are estimated from a large sample of mutual funds. This information is incorporated, along with the usual regression estimate of alpha, in a (roughly) precision-weighted average measure of individual fund performance. Substantial “learning across funds” is documented, with significant effects on investment decisions. In a Bayesian framework, this form of learning is inconsistent with the assumption, made in the past literature, of prior independence across funds. Independence can be viewed as an extreme scenario in which the true cross-sectional distribution of alphas is presumed to be known a priori.

We examine the wealth effects of horizontal takeovers on rivals of the merging firms, and on firms in the takeover industry's supplier and customer industries. Inconsistent with the collusion and buyer power motives, we find significant positive abnormal returns to rivals, suppliers, and corporate customers for the subsample of takeovers with positive combined wealth effect to target and bidder shareholders. Overall, our findings suggest that the average takeover in our sample is driven by efficiency considerations. However, we find evidence suggesting that horizontal takeovers increase the buyer power of the merging firms if suppliers are concentrated.

Theories based on incomplete contracting suggest that small organizations have a comparative advantage in activities that make extensive use of “soft” information. We provide evidence consistent with small banks being better able to collect and act on soft information than large banks. In particular, large banks are less willing to lend to informationally “difficult” credits, such as firms with no financial records. Moreover, after controlling for the endogeneity of bank-firm matching, we find that large banks lend at a greater distance, interact more impersonally with their borrowers, have shorter and less exclusive relationships, and do not alleviate credit constraints as effectively.

We study dealer behavior in the foreign exchange spot market using detailed observations on all the transactions of four interbank dealers. There is strong support for an information effect in incoming trades. The direction of trade is most important, but we also find that the information effect increases with trade size in direct bilateral trades. All four dealers control their inventory intensively. Inventory control is not, however, manifested through a dealer's own prices in contrast to findings by Lyons (J. Financial Econ. 39(1995) 321). Furthermore, we document differences in trading styles, especially how they actually control their inventories.

This study develops a model in which rational issuers maximize the expected surplus from going public by choosing an offer price that weighs the benefit of higher proceeds if the offer is completed against the cost of foregone surplus if the offer fails. Increases in the market valuation of comparable firms during the waiting period imply higher surplus associated with going public; issuers respond with a partial revision in the offer price to elevate the probability of completion. The model offers insights into many facts associated with initial public offering pricing, including partial adjustment to market returns, the inverse relation between withdrawal and market returns, the asymmetric price adjustment to up versus down market returns, hot-issue markets, and unconditional underpricing.

This paper examines the interaction between momentum in the returns of equities and corporate bonds. We find that investment grade corporate bonds do not exhibit momentum at the three- to 12-month horizons. Instead, the evidence suggests that they exhibit reversals. However, significant evidence exists of a momentum spillover from equities to investment grade corporate bonds of the same firm. Firms earning high (low) equity returns over the previous year earn high (low) bond returns the following year. The spillover results are stronger among firms with lower-grade debt and higher equity trading volume, seem robust to various risk and liquidity controls, and hold even after controlling for past earnings surprises. In examining the source of the spillover, we find that the bond ratings of firms with positive (negative) equity momentum continue to improve (deteriorate) in the future, suggesting underreaction to the information in past equity prices about changing default risk is a likely source of the spillover effect. Overall, our results suggest that both equity and debt underreact to firm fundamentals, but past equity returns is a better proxy of firm fundamentals than past bond returns.

Emerging markets are characterized by volatile, but substantial returns that can easily exceed 75% per annum. Balancing these lofty returns are liquidity costs that, using the bid–ask spread as a basis, range from 1% for the Taiwanese market to over 47% for the Russian market. However, the paucity of bid–ask spread information across countries and time requires the use of liquidity estimates in emerging markets even though little is known about the efficacy of these estimates in measuring bid–ask spread costs. Using firm-level quoted bid–ask spreads as a basis, I find that price-based liquidity measures of Lesmond et al. [Review of Financial Studies 12 (1999) 1113] and Roll [Journal of Finance 39 (1984) 1127] perform better at representing cross-country liquidity effects than do volume based liquidity measures. Within-country liquidity is best measured with the liquidity estimates of either Lesmond, Ogden, and Trzcinka or, to a lesser extent, Amihud (2002). Examining the impact of legal origin and political institutions on liquidity levels shows that countries with weak political and legal institutions have significantly higher liquidity costs than do countries with strong political and legal systems, even to the exclusion of legal origin or insider trading enforcement. Higher incremental political risk is associated with a 10 basis point increase in transaction costs, using the Lesmond, Ogden, and Trzcinka estimate, or a 1.9% increase in price impact costs, using the Amihud estimate.

Stocks are short-sale constrained when there is a strong demand to sell short and a limited supply of shares to borrow. Using data on both short interest (a proxy for demand) and institutional ownership (a proxy for supply) we find that constrained stocks underperform during the period 1988–2002 by a significant 215 basis points per month on an equally weighted basis, although by only an insignificant 39 basis points per month on a value-weighted basis. For the overwhelming majority of stocks, short interest and institutional ownership levels make short selling constraints unlikely.