Knowledge that Transforms

As the usual normality assumption is firmly rejected by the data, investors encounter a data-generating process (DGP) uncertainty in making investment decisions. In this paper, we propose a novel way to incorporate uncertainty about the DGP into portfolio analysis. We find that accounting for fat tails leads to nontrivial changes in both parameter estimates and optimal portfolio weights, but the certainty–equivalent losses associated with ignoring fat tails are small. This suggests that the normality assumption works well in evaluating portfolio performance for a mean-variance investor.

Floating-priced convertibles, known as death spirals, are privately held convertible securities with a conversion price set at a discount from the average of past stock prices in a look-back period. The issuance of floating-priced convertibles is followed by significant negative abnormal returns. The results are consistent with the faulty contract hypothesis that argues that the contract design encourages short-selling by the convertible holders and other professional short sellers. However, the results are also consistent with the last-resort financing hypothesis that argues that the stock price declines because the stock is overvalued at the time of the issue.

We investigate whether security analysts exhibit persistence in their stock picking ability. We find that analysts whose recommendation revisions earned the most (least) excess returns in the past continue to outperform (underperform) in the future. Further, the market recognizes these performance differences in the five-day period surrounding the recommendation revision. This market reaction, however, is incomplete. Excess returns in the one and three trading months following the revision are significant and positively associated with analysts’ prior performance. However, a trading strategy taking long (short) positions in recommendation upgrades (downgrades) conditional on analysts’ prior performance is unprofitable.

This study provides evidence that links institutional trading behavior directly to anomalous turn-of-the-year return patterns of small stocks. We find that turn-of-the-year trading patterns of institutions reflect strategies generally consistent with window-dressing and risk-shifting behaviors. Institutions sell more loser small stocks in the last quarter of the year, but buy more small stocks, winners and losers, in the first quarter. Institutional buying (selling) of loser stocks at year-end weakens (strengthens) the turn-of-the-year effect. Buying of winner stocks after year-end causes a statistically significant, though weaker, effect.

This paper introduces the concept of statistical arbitrage, a long horizon trading opportunity that generates a riskless profit and is designed to exploit persistent anomalies. Statistical arbitrage circumvents the joint hypothesis dilemma of traditional market efficiency tests because its definition is independent of any equilibrium model and its existence is incompatible with market efficiency. We provide a methodology to test for statistical arbitrage and then empirically investigate whether momentum and value trading strategies constitute statistical arbitrage opportunities. Despite adjusting for transaction costs, the influence of small stocks, margin requirements, liquidity buffers for the marking-to-market of short-sales, and higher borrowing rates, we find evidence that these strategies generate statistical arbitrage.

Despite the widely held belief that order preferencing affects market quality, no hard evidence exists on the extent and determinants of order preferencing and its impact on dealer competition and execution quality. This study shows that the bid-ask spread (dealer quote aggressiveness) is positively (negatively) related to the proportion of internalized volume during both the pre- and post-decimalization periods. Although decimal pricing led to lower order preferencing on NASDAQ, the extent of order preferencing after decimalization is higher than what prior studies had predicted. The price impact of preferenced trades is smaller than that of unpreferenced trades and preferenced trades receive greater (smaller) size (price) improvements than unpreferenced trades.

Firm investment activity and firm characteristics, particularly the market-to-book ratio or q, are functions of the state of the economy and therefore contain information about the dynamic behavior of stock returns. This paper develops a model of a production economy in which real investment is irreversible and subject to convex adjustment costs. During low-q (high-q) periods when the irreversibility constraint (constraint on the rate of investment) is binding, conditional volatility and expected returns on one hand, and market-to-book ratios on the other, should be negatively (positively) related. Empirical tests based on industry portfolios support these predictions for conditional volatility but not for expected returns.

We document that seasoned equity issuers experiencing the greatest increase in institutional investment around the offer date outperformed their benchmark portfolios in the year following the issue by a statistically and economically significant margin relative to those experiencing the greatest decrease. No such relationship exists for a control sample of matched non-issuers. Issuers with the greatest institutional investment are also found to have the highest ratio of sell-side analyst upgrades less downgrades to total forecasts in the two quarters following the issue. Again, no such relationship is found for matched non-issuers. We interpret our results as evidence that institutions are able to identify above-average seasoned equity offering SEO firms at the time of equity issuance and increase their holdings in these potential outperformers.

This paper examines the relationship between banking market structure and financial stability. Using data on thrifts, a type of banking institution specializing in residential mortgage lending, I test two related hypotheses. First, competition reduces franchise value. Second, reduced franchise value induces risk taking. Testing the second hypothesis exploits predictions that when hit by an exogenous shock, the slope of risk with respect to franchise value becomes more negative because thrifts adopt “bang-bang” strategies and choose minimal or maximal risk. Using the Texas real estate collapse in the 1980s as a natural experiment, I find evidence supporting both hypotheses.

Using a windstorm simulation model developed by Applied Insurance Research, we analyze the effectiveness of catastrophic-loss index options in hedging hurricane losses for Florida insurers. The results suggest that insurers in the two largest size quartiles can hedge losses almost as effectively using contracts based on four intrastate indices as they can using contracts that settle on their own losses. Many insurers in the third largest size quartile also can hedge effectively using the intrastate indices, but most insurers in the smallest quartile would encounter significant basis risk. Hedging using a statewide loss index is effective only for the largest insurers.