Knowledge that Transforms

We argue that arbitrage is limited if rational traders face uncertainty about when their peers will exploit a common arbitrage opportunity. This synchronization risk—which is distinct from noise trader risk and fundamental risk—arises in our model because arbitrageurs become sequentially aware of mispricing and they incur holding costs. We show that rational arbitrageurs “time the market” rather than correct mispricing right away. This leads to delayed arbitrage. The analysis suggests that behavioral influences on prices are resistant to arbitrage in the short and intermediate run.

Regulatory changes that appear comprehensive will have little impact on the functioning of a developing market if they fail to lead to foreign portfolio inflows. We specify a reduced-form model for a number of financial time series and search for a common, endogenous break in the data generating process. We also estimate a confidence interval for the break. Our endogenous break dates are accurately estimated but do not always correspond closely to dates of official capital market reforms. Indeed, the endogenous dates are usually later than official dates, highlighting the important distinction between market liberalization and market integration.

This paper combines the use of portfolio holdings data and conditioning information to create a new performance measure. Our conditional weight-based measure has several advantages. Using conditioning information avoids biases in weight-based measures as discussed by Grinblatt and Titman (J. Business 60 (1993)). When conditioning information is used, returns-based measures face a bias if managers can trade between observation dates. The new measures avoid this interim trading bias. We use the new measures to provide fresh insights about performance in a sample of U.S. equity pension fund managers.

Traditionally, volume has provided the link between trading activity and returns. We focus on a hitherto unexplored but intuitive measure of trading activity: the aggregate daily order imbalance, buy orders less sell orders, on the New York Stock Exchange. Order imbalance increases following market declines and vice versa, which reveals that investors are contrarians on aggregate. Order imbalances in either direction, excess buy or sell orders, reduce liquidity. Market-wide returns are strongly affected by contemporaneous and lagged order imbalances. Market returns reverse themselves after high-negative-imbalance, large-negative-return days. Even after controlling for aggregate volume and liquidity, market returns are affected by order imbalance.

We examine how mutual fund flows that are correlated with subsequent fund returns can have a dilution impact on the performance of open-end funds. Active trading of open-end funds has a meaningful economic impact on the returns of passive, nontrading shareholders, particularly in U.S.-based international funds. The overall sample of domestic equity funds shows no dilution impact, but we find an annualized negative impact of 0.48% in international funds (and nearly 1% for a subsample of funds whose daily flows are particularly large). The exchange and pricing policies of mutual funds can thus have important performance-related implications.

This paper examines the valuation effects associated with the incentive structures of different types of institutional investors using the ownership levels of public and private pension funds in a firm. The results suggest that institutional monitoring is associated with valuation effects when both observable and unobservable aspects of the relationship between institutions and firms are taken into account. Moreover, the valuation effects vary according to the objective functions of institutions’ administrators. Thus, other shareholders do not necessarily benefit from relationships between institutions and managers, and they could be hurt when the institutional agents watching firm agents have conflicts of interest with other shareholders.

We use new fully functional methods to describe and study the dynamics of the short-term interest rate process in continuous-time. The suggested procedure exploits the spatial properties, embodied in the local time process, of the diffusion of interest, and is robust against deviations from stationarity. Our results indicate that the misspecification of a standard constant elasticity of variance model with linear mean-reverting drift cannot be attributed to the nonlinear behavior of the infinitesimal first moment of the short-term interest rate process at high rates. Rather, it should be attributed to the martingale nature of the process over most of its empirical range (i.e., between 3% and about 15%).

This paper studies multi-line pricing and capital allocation by insurance companies when solvency matters to consumers, capital is costly to hold, and the average loss is uncertain. In this environment, product quality concerns lead firms to diversify across markets and charge high prices for risk that threatens company solvency, even if the risk is unrelated to other asset risk. Price differences across markets are traced to differences in capital required at the margin to maintain solvency. Finally, the paper shows that capital costs have significant effects on catastrophe insurance markets because of high marginal capital requirements.

We examine the relation between risk and IPO underpricing and test two aspects of the litigation-risk hypothesis: (1) firms with higher litigation risk underprice their IPOs by a greater amount as a form of insurance (insurance effect) and (2) higher underpricing lowers expected litigation costs (deterrence effect). To adjust for the endogeneity bias in previous studies, we use a simultaneous equation framework. Evidence provides support for both aspects of the litigation-risk hypothesis.

This paper examines the hypothesis that non-US firms cross-list in the United States to increase protection of their minority shareholders. Cross-listing on the NYSE or Nasdaq subjects a non-US firm to a number of provisions of US securities law, and requires the firm to conform to US GAAP. It therefore increases the expected cost to managers of extracting private benefits, and commits the firm to protect minority shareholders’ interests. The expected relation between the quantity of cross-listings and shareholder protection in the home country is ambiguous, because managers will consider both expected private benefits and the public value of their shares. However, there are clear predictions about the relation between subsequent equity issues, shareholder protection, and cross-listings:(1)Equity issues increase following all cross-listings, regardless of shareholder protection.(2)The increase should be larger for cross-listings from countries with weak protection.(3)Equity issues following cross-listings in the US will tend to be in the US for firms from countries with strong protection and outside the US for firms from countries with weak protection.We find evidence consistent with each of these predictions. Overall, the desire to protect shareholder rights appears to be an important reason why some non-US firms cross-list in the United States.