Knowledge that Transforms

We test whether the profitability of HML, SMB, and WML can be linked to future Gross Domestic Product (GDP) growth. Using data from ten countries, we find that HML and SMB contain significant information about future GDP growth. This information is to a large degree independent of that in the market factor. Even in the presence of popular business cycle variables, HML and SMB retain their ability to predict future economic growth in some countries. Our results support a risk-based explanation for the performance of HML and SMB. Little evidence is found to support such an explanation in the case of WML.

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This paper examines the effect of several factors on the market share of investment banks that act as book managers in initial public offerings (IPOs) between 1984 and 1995. For established banks, IPO first-day returns, one-year abnormal performance, abnormal compensation, industry specialization, analyst reputation, and association with withdrawn offers have a significant impact on changes in market share. These factors have a more significant effect on market share changes in low-volume IPO markets. These factors have a less significant effect on market share, statistically and economically, for less established banks, consistent with the notion that less reputation is placed at risk.

We develop and test the Acquisition Probability Hypothesis, which asserts that rivals of initial acquisition targets earn abnormal returns because of the increased probability that they will be targets themselves. On average, rival firms earn positive abnormal returns regardless of the form and outcome of acquisition. These returns increase significantly with the magnitude of surprise about the initial acquisition. Moreover, the cross-sectional variation of rival abnormal returns in the announcement period is systematically related to variables associated with the probability of acquisition. In addition, rivals that subsequently become targets earn significantly higher abnormal returns in the announcement period.

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).

We examine a sample of firms that reset the exercise prices on their executive options. These repricings follow a period of about one year of poor firm-specific performance in which the average firm loses one-fourth of its value. No other offsetting changes to option terms or compensation are made, and many firms reprice more than once. Without repricing, a majority of the options would have been at-the-money within two years. We find that when faced with circumstances in which repricing might be chosen, firms with greater agency problems, smaller size, and insider- dominated boards are more likely to reprice.

We develop a model of the mutual fund industry in which the management fees and loads charged by actively managed open-end funds and average fund returns are determined endogenously in a competitive market setting. It is shown that heterogeneity in managerial skills at investing and minimizing costs, and the existence of investor clienteles with differing liquidity and marketing needs, gives rise to a variety of open-end fund structures that differ in the average return delivered to investors. Managers choose a fund's structure to maximize the rents they capture from their ability, taking into account the effect on investor flows. In equilibrium, funds that constrain liquidity withdrawals may have to charge lower fees and share some profits in the form of higher investor returns, when there is relative scarcity of investors with low liquidity needs.

This paper examines the convexity bias, caused by the non-linearity of payoffs, in the pricing of interest rate swaps off the Eurocurrency futures curve. The evidence from four major currencies – $, £, DM and ¥ – during 1987–1996 suggests that swaps were initially being priced off the futures curve (ignoring the convexity adjustment); subsequently, the market swap rates drifted below the rates implied by futures prices. After rejecting alternative explanations, we use alternative term structure models to show that the convexity bias is related to the empirically observed swap-futures differential. We interpret these results as evidence of mispricing of swap contracts during the early years, which was eliminated over time.

We investigate pricing relations and the potential for arbitrage in the U.S. Treasury STRIPS market, stressing the importance of reconciling quoted Treasury data with actual market pricing conventions. We document that stripping and reconstitution profits in the STRIPS market are fleeting and rarely economically significant; that matched-maturity principal and coupon STRIPS generally have different prices due, at least in part, to richness or cheapness in the underlying note or bond; and that apparent negative forward rates in the STRIPS market are concentrated in certain long-maturity STRIPS that do not actually exist at the time.

The regulations governing asset distributions from many retirement plans give participants the option to time retirement or rollovers from the plan strategically. They possess a long-lived put option, whose exercise price resets periodically to the current value of the assets in the plan. I derive a recursive closed-form valuation formula for the option and develop a numerical algorithm for implementing the result. I find that, for reasonable assumptions about volatility and life expectancy, the option's value may approach 40% of the value of the assets in the plan, financed entirely by those still contributing. This wealth transfer can, however, be easily avoided by making a simple change to the current regulations governing valuation and payout of these retirement plans.