Knowledge that Transforms

Abstract In this paper we examine the relation between equity mispricing and arbitrage risk and find that stocks with high arbitrage risk have higher estimated mispricing than stocks with low arbitrage risk. These results are not limited to high book-to-market or small capitalization stocks, and they are not sensitive to transaction and short-selling costs. In addition, they remain robust to alternative multifactor return generating specification models and mispricing measures. Overall, our empirical results are consistent with the conjecture that mispricing is a manifestation of the inability of arbitrageurs to hedge idiosyncratic risk, a major deterrent to arbitrage activity.

Abstract This paper argues that, contrary to the conventional wisdom, stock return synchronicity (or R 2 ) can increase when transparency improves. In a simple model, we show that, in more transparent environments, stock prices should be more informative about future events. Consequently, when the events actually happen in the future, there should be less “surprise” (i.e., less new information is impounded into the stock price). Thus a more informative stock price today means higher return synchronicity in the future. We find empirical support for our theoretical predictions in 3 settings: namely, firm age, seasoned equity offerings (SEOs), and listing of American Depositary Receipts (ADRs).

Abstract This paper investigates whether comovements between euro area equity returns at national and industry level changed after the introduction of the euro. By adopting a regression quantile-based methodology, we find that after 1999 the degree of comovements among euro area national equity markets was augmented. By explicitly controlling for the impact of global factors, we show that this result cannot be explained by recent worldwide trends. A more refined analysis based on an industry breakdown suggests that the increase in national index comovements is mainly driven by financial, industrial, and consumer services sectors.

Abstract The decline of average stock return volatility in the 2001–2006 period provides an opportunity to test various theories on why the average return volatility increased in the pre-2000 period. This paper compares fundamentals-based theories with trading volume-based theories. While both fundamentals-based and trading volume-based theories explain the upward trend in the average volatility in U.S. stocks from 1976 to 2000 and international stocks from 1990 to 2000, only the fundamentals-based theories explain the volatility pattern for 2001–2006. Much of the variation in the stock return volatilities can be explained by the variation in the earnings volatilities and proxies for growth options, but not by trading-related variables. Evidence also shows that the explanatory power of the fundamentals variables is time varying.

Abstract This paper shows that prospect theory is unlikely to explain the disposition effect. Prospect theory predicts that the propensity to sell a stock declines as its price moves away from the purchase price in either direction. Trading data, on the other hand, show that the propensity to sell jumps at zero return, but it is approximately constant over a wide range of losses and increasing or constant over a wide range of gains. Further, the pattern of realized returns does not seem to stem from optimal after-tax portfolio rebalancing, a belief in mean-reverting returns, or investors acting on target prices.

Abstract Motivated by the effect on valuation of stopped or reduced debt coupon payments from a company in financial distress, we value a level-dependent annuity contract where the annuity rate depends on the value of an underlying asset process. The range of possible values of this asset is divided into a finite number of regions, with constant annuity rates within each region. We present closed-form formulas for the market value of level-dependent annuities contracts when the market value of the underlying asset is assumed to follow a geometric Brownian motion. Such annuities occur naturally in models of debt with credit risk in financial economics. Our results are applied for valuing both corporate debt with suspended interest payments under the U.S. Chapter 11 provisions and loans with contractual level-dependent interest rates.

Abstract Disagreement, a key factor inducing trading, has been receiving ever increasing attention in recent years. Most research has focused on disagreement about the expected returns. Several authors have shown that if the average belief coincides with the true expected return, in the portfolio context prices are unaffected by disagreement. In this paper we study the pricing effects of disagreement about return variances. We show that i) disagreement about variances has systematic and significant pricing effects—more disagreement leads to higher prices, and ii) prices are very sensitive to the degree of disagreement: Even if the average belief about the variance is constant, tiny fluctuations in the disagreement about the variance lead to substantial price fluctuations. This second result may offer an explanation for the excess volatility puzzle: When small changes in the degree of disagreement occur, they induce relatively large price changes. Yet, the changes in disagreement may be hard to directly detect empirically, leading to apparent “excess volatility.”

Abstract This paper numerically solves the decision problem of a multiperiod constant relative risk aversion individual who faces transaction costs and has access to two risky assets, both with predictable returns. With proportional transaction costs and independent and identically distributed returns, we numerically find the rebalancing rule to be a no-trade region for the portfolio weights with rebalancing to the boundary. The shape of the no-trade region depends on the correlation between the two risky assets. With predictable returns, there is instead a no-trade region for each state. We also examine several important economic questions, including the utility cost of not being able to buy on margin or short stock.

Abstract We study the effects of investor protection on stock returns and portfolio allocation decisions. In our theoretical model, if investor protection is weak, wealthy investors have an incentive to become controlling shareholders. In equilibrium, the stock price reflects the demand from both controlling shareholders and portfolio investors. Due to the high demand from controlling shareholders, the price of weak corporate governance stocks is not low enough to fully discount the extraction of private benefits. Thus, stocks have lower expected returns when investor protection is weak. This has implications for domestic and foreign investors’ stockholdings. In particular, we show that portfolio investors’ participation in the domestic stock market and home equity bias are positively related to investor protection and provide original evidence in their support.

Abstract We integrate appealing features of Markowitz’s mean-variance portfolio theory (MVT) and Shefrin and Statman’s behavioral portfolio theory (BPT) into a new mental accounting (MA) framework. Features of the MA framework include an MA structure of portfolios, a definition of risk as the probability of failing to reach the threshold level in each mental account, and attitudes toward risk that vary by account. We demonstrate a mathematical equivalence between MVT, MA, and risk management using value at risk (VaR). The aggregate allocation across MA subportfolios is mean-variance efficient with short selling. Short-selling constraints on mental accounts impose very minor reductions in certainty equivalents, only if binding for the aggregate portfolio, offsetting utility losses from errors in specifying risk-aversion coefficients in MVT applications. These generalizations of MVT and BPT via a unified MA framework result in a fruitful connection between investor consumption goals and portfolio production.