Knowledge that Transforms

We develop a multi-period learning model to examine the relation between analysts’ forecasting behavior and their performance. In a competitive market for banking services, the surplus and the analyst's payoff, which is determined through bargaining, are convex in her reputation. The convexity of her payoff structure and the presence of employment risk lead to a U-shaped relation between the analyst's forecast boldness and prior performance and a positive relation between forecast boldness and experience. We find support for these predictions in our empirical analysis. Significant underperformers (outperformers) face higher (lower) employment risk and are more likely to issue bolder forecasts.

Unlike in the U.S., the initial price range for European IPOs is seldom revised, although issues are often priced at the upper bound. We develop a model that explains this seemingly inefficient pricing behavior. As in Europe, but not in the U.S., underwriters in the model obtain information from investors before establishing the indicative price range. A commitment to stay within the range is necessary to extract private information from investors. Ours is therefore the first treatment in which the bookbuilding range has a clear economic role. The model has important implications for empirical research based on European primary market data.

We analyze the relationship between conglomerates’ internal capital markets and the efficiency of economy-wide capital allocation, and we identify a novel cost of conglomeration that arises from an equilibrium framework. Because of financial market imperfections engendered by imperfect investor protection, conglomerates that engage in winner-picking (Stein, 1997 [Internal capital markets and the competition for corporate resources. Journal of Finance 52, 111–133]) find it optimal to allocate scarce capital internally to mediocre projects, even when other firms in the economy have higher-productivity projects that are in need of additional capital. This bias for internal capital allocation can decrease allocative efficiency even when conglomerates have efficient internal capital markets, because a substantial presence of conglomerates might make it harder for other firms in the economy to raise capital. We also argue that the negative externality associated with conglomeration is particularly costly for countries that are at intermediary levels of financial development. In such countries, a high degree of conglomeration, generated, for example, by the control of the corporate sector by family business groups, could decrease the efficiency of the capital market. Our theory generates novel empirical predictions that cannot be derived in models that ignore the equilibrium effects of conglomerates. These predictions are consistent with anecdotal evidence that the presence of business groups in developing countries inhibits the growth of new independent firms because of a lack of finance.

This paper shows for 1929–2003 U.S. data and also for international G-7 data that the ratio of share prices to GDP tracks a large fraction of the variation over time in expected returns on the aggregate stock market, capturing more of that variation than do price–earnings and price–dividend ratios and often also providing additional information about excess returns. The price–output ratio tracks long-term U.S. cumulative stock returns almost as well as the cay-ratio of Lettau and Ludvigson [2001a. Journal of Finance 56, 815–849, 2005. Journal of Financial Economics 76, 583–626], although the cay-ratio tracks variation in U.S. excess returns better. The price–output ratio, however, involves no parameter estimation and is easily constructed for non-U.S. countries.

Integrated risk management for financial institutions requires an approach for aggregating risk types (market, credit, and operational) whose distributional shapes vary considerably. We construct the joint risk distribution for a typical large, internationally active bank using the method of copulas. This technique allows us to incorporate realistic marginal distributions that capture essential empirical features of these risks such as skewness and fat-tails while allowing for a rich dependence structure. We explore the impact of business mix and inter-risk correlations on total risk. We then compare the copula-based method with several conventional approaches to computing risk.

We investigate an economy of heterogeneous agents that cannot specify all exogenous welfare-relevant events and consequently view the impact of unforeseen contingencies as utility shocks. In this setting we characterize an appropriate market equilibrium concept when securities can trade only on demand- and price-contingent events. We establish the existence of an equilibrium for a class of parametric models in which aggregating taste shocks across agents can lead to nonconsumption pricing factors. To fit the stylized facts, (i) non consumption factors must dominate the pricing kernel and contribute to the variation of the wealth-consumption ratio, (ii) markets must be incomplete and the set of claims that are traded endogenously determined, (iii) agents’ preferences with respect to unforeseen contingencies must be non-expected utility, and, (iv) although non-consumption pricing factors can be conditionally uncorrelated with aggregate consumption shocks, they must be correlated with shocks to expected consumption growth.

Fernandez [2004b. The value of tax shields is not equal to the present value of tax shields. Journal of Financial Economics 73, 145–165] argues that the present value effect of the tax saving on debt cannot be calculated as simply the present value of the tax shields associated with interest. This contradicts standard results in the literature. It implies that, even though the capital market is complete, value-additivity is violated. As a consequence, adjusted present value formulae of a standard sort cannot be used. Also, Fernandez's argument implies that the value of the tax saving differs from conventional estimates by a considerable amount. We reconcile Fernandez's results with standard valuation formulae for the tax saving from debt. We show that, as one would expect, the value of the debt tax saving is the present value of the tax savings from interest. The apparent violation of value-additivity in the Fernandez paper comes from mixing the Miles and Ezzell and Miller and Modigliani leverage policies.

This paper examines the effect of CEO compensation contracts on misreporting. We find that the sensitivity of the CEO's option portfolio to stock price is significantly positively related to the propensity to misreport. We do not find that the sensitivity of other components of CEO compensation, i.e., equity, restricted stock, long-term incentive payouts, and salary plus bonus have any significant impact on the propensity to misreport. Relative to other components of compensation, stock options are associated with stronger incentives to misreport because convexity in CEO wealth introduced by stock options limits the downside risk on detection of the misreporting.

This paper develops a framework for analyzing the impact of macroeconomic conditions on credit risk and dynamic capital structure choice. We begin by observing that when cash flows depend on current economic conditions, there will be a benefit for firms to adapt their default and financing policies to the position of the economy in the business cycle phase. We then demonstrate that this simple observation has a wide range of empirical implications for corporations. Notably, we show that our model can replicate observed debt levels and the countercyclicality of leverage ratios. We also demonstrate that it can reproduce the observed term structure of credit spreads and generate strictly positive credit spreads for debt contracts with very short maturities. Finally, we characterize the impact of macroeconomic conditions on the pace and size of capital structure changes, and debt capacity.

This paper examines whether earnings momentum and price momentum are related. Both in time-series as well as in cross-sectional asset pricing tests, we find that price momentum is captured by the systematic component of earnings momentum. The predictive power of past returns is subsumed by a zero-investment portfolio that is long on stocks with high earnings surprises and short on stocks with low earnings surprises. Further, returns to the earnings-based zero-investment portfolio are significantly related to future macroeconomic activities, including growth in GDP, industrial production, consumption, labor income, inflation, and T-bill returns.