Knowledge that Transforms

Abstract During the 1990s and beyond, countries around the world witnessed calls and/or mandates for more outside directors on publicly traded companies' boards even though extant studies find no significant correlation between outside directors and corporate performance. We examine the connection between changes in board composition and corporate performance in the U.K. over the interval 1989–1996, a period that surrounds publication of the Cadbury Report, which calls for at least three outside directors for publicly traded corporations. We find that companies that add directors to conform with this standard exhibit a significant improvement in operating performance both in absolute terms and relative to various peer group benchmarks. We also find a statistically significant increase in stock prices around announcements that outside directors were added in conformance with this recommendation. We do not endorse mandated board structures, but the evidence appears to be that such a mandate is associated with an improvement in performance in U.K. companies.

Abstract In this paper, we analytically derive the expected loss function associated with using sample means and the covariance matrix of returns to estimate the optimal portfolio. Our analytical results show that the standard plug-in approach that replaces the population parameters by their sample estimates can lead to very poor out-of-sample performance. We further show that with parameter uncertainty, holding the sample tangency portfolio and the riskless asset is never optimal. An investor can benefit by holding some other risky portfolios that help reduce the estimation risk. In particular, we show that a portfolio that optimally combines the riskless asset, the sample tangency portfolio, and the sample global minimum-variance portfolio dominates a portfolio with just the riskless asset and the sample tangency portfolio, suggesting that the presence of estimation risk completely alters the theoretical recommendation of a two-fund portfolio.

Abstract This paper investigates the effect of closed overnight exchanges on option prices. During the trading day, asset prices follow the literature's standard affine model that allows for stochastic volatility and random jumps. Independently, the overnight asset price process is modeled by a single jump. We find that the overnight component reduces the variation in the random jump process significantly. However, neither the random jumps nor the overnight jumps alone are able to empirically describe all features of option prices. We conclude that both random jumps during the day and overnight jumps are important in explaining option prices, where the latter account for about one quarter of total jump risk.

Abstract The forward bias anomaly implies that currency excess returns are predictable by the forward premium. Yet, recent studies suggest that statistical inference problems may spuriously account for this predictability. This article demonstrates that while currency excess returns are not predictable out of sample using a standard mean square forecast error criterion, the forward premium nonetheless has directional predictability. This directional forecasting accuracy translates into statistically significant profits from trading on the forward bias anomaly.

Abstract Legal rights of investors are recognized as an essential component of corporate governance. We assess the efficacy of these rights by examining board changes surrounding the filings of shareholder derivative lawsuits. We find that the incidence of derivative lawsuits is higher for firms with a greater likelihood of agency conflicts. We also find that derivative lawsuits are associated with significant improvements in the boards of directors. In particular, the proportion of outside representation on the board of directors increases. There is also some evidence that other board characteristics change favorably. These findings suggest that shareholder derivative lawsuits are not frivolous as is often claimed, but rather that they can serve as an effective corporate governance mechanism.

Abstract The Securities and Exchange Commission (SEC) adopted Rule 605 (formerly Rule 11Ac1–5) on November 15, 2000. The Rule requires market centers to make monthly public disclosure of execution quality. The Rule is intended to achieve a more competitive and efficient national market system by increasing the visibility of execution quality. The effective and quoted spreads for our study sample of NYSE, AMEX, and NASDAQ stocks declined significantly after implementation of the Rule. The decline cannot be attributed to a secular trend in spreads, concurrent changes in stock attributes, or the effect of decimal pricing. Although the quoted depth of NYSE stocks also declined, overall market quality is higher after implementation of the Rule. Based on these results, we conclude that the SEC's goal to improve execution quality through more transparent markets has been achieved.

Abstract This paper compares the newer uniform-price U.S. Treasury auctions to the traditional discriminatory mechanism and examines the extent to which the auction mechanisms are responsible for underpricing. Empirically, I find that even for the newer uniform-price auctions, the average price received by the Treasury is less than the price of the same securities in the concurrent secondary market although this underpricing is reduced by half relative to the older mechanism. From the summary statistics released by the Treasury, I calibrate common value auction models for the two mechanisms and predict the level of underpricing in each auction. I find that the observed magnitude of underpricing in the auctions is consistent with the model's predictions.

Abstract Many investors confine their mutual fund holdings to a single fund family either for simplicity or through restrictions placed by their retirement savings plan. We find evidence that mutual fund returns are more closely correlated within than between fund families. As a result, restricting investment to one fund family leads to a greater total portfolio risk than diversifying across fund families. We examine the sources of this increased correlation and find that it is due primarily to common stock holdings, but is also more generally related to families having similar exposures to economic sectors or industries. Fund families also show a propensity to focus on high or low risk strategies, which leads to a greater dispersion of risk across restricted investors. An investor considering adding an additional fund, either in the same family or outside the family, would need to believe the inside fund offered an extra 50 to 70 basis points to have the same Sharpe ratio.

Abstract The proliferation of electronic limit order books operating without dealers raises questions regarding the need for intermediaries with affirmative obligations to maintain markets. We develop a simple model of dealer participation and test it using a sample of less liquid firms that trade on the Paris Bourse. The results indicate that firms with designated dealers exhibit better market quality, and that younger firms, smaller firms, and less volatile firms choose a designated dealer. Around the announcement of dealer introduction, stocks experience an average cumulative abnormal return of nearly 5% that is positively correlated with improvements in liquidity. Overall, these findings emphasize the potential benefits of designing better market structures, even within electronic limit order books, and suggest that purely endogenous liquidity provision may not be optimal for all securities.