Knowledge that Transforms

Previous tests of stock index arbitrage models have rejected the no-arbitrage constraint imposed by these models. This paper provides a detailed analysis of actual S&P 500 arbitrage trades and directly relates these trades to the predictions of index arbitrage models. An analysis of arbitrage trades suggests that i) short-sale rules are unlikely to affect the cashfutures mispricing, ii) the opportunity cost of arbitrage funds exceeds the Treasury bill rate, and iii) the average price discrepancy captured by arbitrage trades is small. Tests of the models provide some support for a version ofthe arbitrage model that incorporates an early liquidation option. The ability of these models to explain arbitrage trades, however, is surprisingly low.

Stijn Claessens, George Pennacchi, Estimating the Likelihood of Mexican Default from the Market Prices of Brady Bonds, The Journal of Financial and Quantitative Analysis, Vol. 31, No. 1 (Mar., 1996), pp. 109-126

Robert G. Hansen, John R. Lott, Jr., Externalities and Corporate Objectives in a World with Diversified Shareholder/Consumers, The Journal of Financial and Quantitative Analysis, Vol. 31, No. 1 (Mar., 1996), pp. 43-68

This paper investigates the relation between the form of compensation and the manager's decision horizon. It finds that while all-cash contracts induce managers to underinvest in the long term, all-stock contracts induce overinvestment in the long term. It shows that compensation contracts consisting of both cash and restricted stock can produce efficient investment, thereby providing a rationale for the existence of both cash and stock incentive schemes in executive compensation packages. This explains why the adoption of either type of incentive scheme results in a positive stock price reaction. In addition, the paper derives the following testable hypotheses: i) the proportion of the stock compensation is decreasing in the precision of the manager's ability and increasing in the precision of the firm's cash flows; ii) firms compensate their managers with proportionately more stock in profitable years and proportionately more cash in leaner years; and iii) the greater the growth opportunities, the higher the proportion of stock compensation.

This paper studies the efficacy of pension fund activism by examining all firms targeted by nine major funds from 1987 to 1993. I document a movement away from takeover-related proxy proposal targetings in the late 1980s to governance-related proxy proposal and nonproxy proposal targetings in the 1990s. For the vast majority of firms, there are no significant abnormal returns at the time of targeting. The subset of firms subject to nonproxy proposal targeting, however, experiences a significant positive wealth effect. There is no evidence of significant long-term improvement in either stock price or accounting measures of performance in the post-targeting period. Collectively, these results cast doubt on the effectiveness of pension fund activism as a substitute for an active market for corporate control.

The concept of multifactor portfolio efficiency plays a role in Merton's intertemporal CAPM (the ICAPM), like that of mean-variance efficiency in the Sharpe-Lintner CAPM. In the CAPM, the relation between the expected return on a security and its risk is just the condition on security weights that holds in any mean-variance-efficient portfolio, applied to the market portfolio M. The risk-return relation of the ICAPM is likewise just the application to M of the condition on security weights that produces ICAPM multifactor-efficient portfolios. The main testable implication of the CAPM is that equilibrium security prices require that M is mean-variance-efficient. The main testable implication of the ICAPM is that securities must be priced so that M is multifactor-efficient. As in the CAPM, building the ICAPM on multifactor efficiency exposes its simplicity and allows easy economic insights.

Kee H. Chung, Hoje Jo, The Impact of Security Analysts' Monitoring and Marketing Functions on the Market Value of Firms, The Journal of Financial and Quantitative Analysis, Vol. 31, No. 4 (Dec., 1996), pp. 493-512

Previous empirical research has established that dividend changes are associated with significant abnormal returns. This association is rationalized on the basis that the dividend announcement acts as a signal of future earnings. Another body of research has documented the existence of intra-industry transfers of information where news about one firm is extrapolated to other companies in the same industry. Earnings information transfers have been found to be positive in nature, with good news about one company leading to stock price increases for rival firms. Linking dividend signaling and information transfer, tests were constructed to ascertain whether the dividend change of one firm is associated with the stock price performance of other companies in the same industry. The results indicate there is some small positive information transfer. The magnitude of information transfer is related to the degree of the dividend surprise, the recent dividend history of the other companies, and correlations in stock returns between the dividend announcer and the other companies. Information transfer is found to affect earnings and earnings growth estimates of the other firms and this leads to revisions in their stock prices.

This paper analyzes the tradeoff between cost and risk of discretely rebalanced option hedges in the presence of transactions costs. I present closed form solutions for expected hedging error, transactions costs, and variance of the cash flow from a time-based hedging strategy similar to that analyzed by Leland (1985). Furthermore, I characterize the cost and risk of a move-based hedging strategy without resorting to Monte Carlo simulations. All results are sufficiently general to accommodate the use of a transactions costs adjusted hedging volatility and an asset rate of return that differs from the risk-free rate of return.

Traditional measures of interest rate risk assume that prices of financial assets and liabilities are set in perfectly competitive markets. However, evidence suggests that many retail financial markets do not follow the competitive paradigm. In this paper, we employ a general contingent claims framework to value rents earned by banks in demandable retail deposit markets. Our analysis provides a natural and economically meaningful measure of interest rate risk for these imperfectly competitive markets. Using monthly survey data on NOW accounts and MMDAs, we estimate the value of retail deposit rents and deposit durations for more than 200 commercial banks.