Knowledge that Transforms

Studies analyzing return expectations of financial market participants like fund managers, CFOs or individual investors are highly influential in academia and practice. We argue and show that the results in these surveys above are easily influenced by the elicitation mode of return expectations. Surveys that ask for future stock price levels are more likely to produce mean reverting expectations than surveys that directly ask for future returns. Furthermore, we conduct a questionnaire study that explicitly analyzes whether the specific elicitation mode affects return expectations in the above direction. In our study, subjects were asked to state mean forecasts for seven time series. Using a between subject design, one half of the subjects was asked to state future price levels, the other group was directly asked for returns. We observe a highly significant framing effect. For upward sloping time series, the return forecasts stated by investors in the return forecast mode are significantly higher than those derived for investors in the price forecast mode. For downward sloping time series, the return forecasts given by investors in the return forecast mode are significantly lower than those derived for investors in the price forecast mode. We argue that this finding is consistent with behavioral theories of investor expectation formation based on the representativeness heuristic.

This paper examines the determinants of the time it takes for an index options market to return to no arbitrage values after put-call parity deviations, using intraday transactions data from the French index options market. We employ survival analysis to characterize how limits to arbitrage influence the expected duration of arbitrage deviations. After controlling for conventional limits to arbitrage, we show that liquidity-linked variables are associated with a faster reversion of arbitrage profits. The introduction of an Exchange Traded Fund also affects the survival rates of deviations, but this impact essentially stems from the reduction in the level of potential arbitrage profits.

This paper proposes a simple back testing procedure that is shown to dramatically improve a panel data model's ability to produce out of sample forecasts. Here the procedure is used to forecast mutual fund alphas. Using monthly data with an OLS model it has been difficult to consistently predict which portfolio managers will produce above market returns for their investors. This paper provides empirical evidence that sorting on the estimated alphas populates the top and bottom deciles not with the best and worst funds, but with those having the greatest estimation error. This problem can be attenuated by back testing the statistical model fund by fund. The back test used here requires a statistical model to exhibit some past predictive success for a particular fund before it is allowed to make predictions about that fund in the current period. Another estimation problem concerns the use of a single statistical model for all available mutual funds. Since no one statistical model is likely to fit every fund, the result is a great deal of misspecification error. This paper shows that the combined use of an OLS and Kalman filter model increases the number of funds with predictable out of sample alphas by about 60%. Overall, a strategy that uses very modest ex-ante filters to eliminate funds whose parameters likely derive primarily from estimation error produces an out of sample risk-adjusted return of over 4% per annum.

Why is the issuer's reservation price not disclosed in bookbuilding? We analyze the differential effect of reservation price disclosure on the underpricing required to elicit truthful indications of interest from investors. We find that a policy of disclosure would increase proceeds for firms with a reservation price sufficiently high relative to possible investor valuations of the shares, but would decrease proceeds for issuers with lower reservation prices. The former group is likely to be absent from the IPO market, explaining why secrecy in reservation prices is the norm.

A wide range of empirical biases hampers hedge fund databases. In this paper we focus upon survival-related biases and disentangle look-ahead biases due to self-selection of funds and due to fund termination. Self-selection arises because funds voluntarily report their information to data vendors and may decide to stop doing so. By extending existing methodology, we analyze persistence in hedge fund performance over the period 1994–2000, taking into account the above biases. The results show that look-ahead biases due to liquidation and self-selection enforce each other and may lead to overestimating expected returns by as much as 8% per year. Overall, the results are consistent with positive persistence in hedge fund returns at horizons of two and four quarters.

This paper analyzes the relation between agency conflicts and risk management. In contrast to previous contributions, our analysis incorporates not only stockholder-debtholder conflicts but also manager–stockholder conflicts. We show that the costs of both underinvestment and overinvestment are essential in determining the firm's hedging policy. In particular, firms that derive more of their value from assets in place (lower market-to-book ratios), although having lower costs of underinvestment, generally display larger costs of overinvestment. Thus, they may be more likely to hedge to control these overinvestment incentives. Our analysis explains why large profitable firms with fewer growth opportunities tend to hedge more (Bartram et al., 2004). It also provides a number of new predictions relating the benefits associated with risk management to various dimensions of the firm's economic environment.

This paper studies a unique buyback method allowing firms to reacquire their own shares on a separate trading line where only the firm is allowed to buy shares. This share repurchase method is called the Second Trading Line and has been extensively used by Swiss companies since 1997. This type of repurchase is unique for two reasons. First, unlike open market programs, the repurchasing company does not trade anonymously. Second, all transactions made by the repurchasing firm are publicly available in real time to every market participant. This is a case of instantaneous disclosure which contrasts sharply with other markets characterized by delayed or no disclosure. We document that the daily repurchase decision is statistically associated with short-term price changes and the release of firm-specific news. We also find that repurchases on the second trading line have a beneficial impact on the liquidity of repurchasing firms. Exchanges and regulators may consider the second trading line an attractive share reacquisition mechanism because of its transparency and positive liquidity effects.

To simultaneously account for the properties of interest-rate term structure and foreign exchange rates within one arbitrage-free framework, we propose a class of multi-currency quadratic models (MCQM) with an (m + n) factor structure in the pricing kernel of each economy. The m factors model the term structure of interest rates. The n factors capture the portion of the exchange rate movement that is independent of the term structure. Our modeling framework represents the first in the literature that not only explicitly allows independent currency movement, but also guarantees internal consistency across all economies without imposing any artificial constraints on the exchange rate dynamics. We estimate a series of multi-currency quadratic models using U.S. and Japanese LIBOR and swap rates and the exchange rate between the two economies. Estimation shows that independent currency factors are essential in releasing the tension between the currency movement and the term structure of interest rates.

This paper analyzes explicit buy recommendations for stocks published by German Personal Finance Magazines from 1995 to 2003. These recommendations earn significant abnormal returns of 2.58% within the five days around the publication day. Both the price-pressure hypothesis and the information hypothesis can be confirmed by our data. The price-pressure effect is most evident for small stocks and glamour stocks. However, whereas the initial price reaction to small stocks is additionally driven by permanent information value, this does not hold true for glamour stocks. In contrast, value stocks are associated with high cumulative abnormal returns that are solely driven by information value.

We derive equilibrium restrictions on the range of the transaction prices of American options on the stock market index and index futures. Trading over the lifetime of the options is accounted for, in contrast to earlier single-period results. The bounds on the reservation purchase price of American puts and the reservation write price of American calls are tight. We allow the market to be incomplete and imperfect due to the presence of proportional transaction costs in trading the underlying security and due to bid-ask spreads in option prices. The bounds may be derived for any given probability distribution of the return of the underlying security and admit price jumps and stochastic volatility. We assume that at least some of the traders maximize a time- separable utility function. The bounds are derived by applying the weak notion of stochastic dominance and are independent of a trader's particular utility function and initial portfolio position.