Knowledge that Transforms

Abstract This paper examines differences between risk-neutral and objective probability densities of future interest rates. The identification and quantification of these differences are important when risk-neutral densities (RNDs), such as option-implied RNDs, are used as indicators of actual beliefs of investors. We employ a multi-factor essentially affine modeling framework applied to German time-series and cross-section term structure data in order to identify both the risk-neutral and the objective term structure dynamics. We find important differences between risk-neutral and objective distributions due to risk premia in bond prices. Moreover, the estimated premia vary over time in a quantitatively significant way, which implies that the differences between the objective and the risk-neutral distributions also vary over time. We therefore conclude that one should be cautious in interpreting RNDs in terms of expectations. The method used in this paper provides an alternative approach to identifying objective probabilities of future interest rates.

Abstract Dollar Cost Averaging is a strategy for purchasing equity securities that is widely recommended by professional investment advisors and commentators, but which has been virtually ignored by academic theorists and textbook writers. In this paper we explore whether the strategy is but another instance of irrational behavior by individual investors, or whether it is an investment heuristic that has survival value in an environment in which security prices exhibit mean reversion behavior that has only belatedly been recognized by academic theorists. Our evidence supports the view that the uninformed individual investors who follow this strategy in purchasing individual stocks to add to an existing portfolio are better off than if they followed the ‘rational’ strategies traditionally recommended by academics.

Abstract Popular investment advice recommends that stock/bond and stock/wealth ratios should rise with investor risk tolerance and investment horizon respectively, prescriptions that are difficult to reconcile with the simple mean-variance model. We show that extending the mean-variance model to include human capital, without any other modifications, can simultaneously justify both recommendations, so long as the correlation between labour income and stock returns falls within a range determined by market and investor-specific parameters. Aggregate labour income data from 11 countries generally satisfy this requirement, as do plausible individual income processes. We also consider the implications of human capital for the optimal bond/wealth ratio over the investment horizon, and examine the sensitivity of the stock/bond mix to the volatility of labour income.

Abstract This study uses data that offers the unique opportunity to analyze how an unprecedented crisis suchas the September 11 tragedy influences expected returns and volatility forecasts of individual investors. Via e-mail, we asked a randomly selected group of individual investors with accounts at a German online broker to answer an internet questionnaire at the beginning of August 2001. A second e-mail to the investors who had not yet answered, scheduled five weeks later, was postponed due to the terror attacks until September 20, which was exactly the day with the lowest share prices in Germany in the year 2001. Based on the answers to questions concerning stock market predictions, we find that return forecasts of the investors in our sample are significantly higher after September 11, suggesting a belief in mean reversion. Our results show that investors interpret the largedrop in share prices during the ten day period after September 11 mainly as temporary rather than permanent. After the terror attacks, volatility forecasts are higher than before September 11. In two out of four cases, historical volatilities are overestimated. Therefore, investors are not generally overconfident in the way that they underestimate the variance of stock returns. Differences of opinion with regard to return forecasts are lower after the terror attacks whereas differences of opinion concerning volatility forecasts are mainly unaffected.

A fundamental unresolved issue is whether information asymmetries underlie investors' predisposition to invest close to home (i.e., domestically or locally). We conduct experiments in the United States and Canada to investigate agents' portfolio allocation decisions, controlling for the availability of information. Providing participants with information about a firm's home base, without disclosing its specific identity, is not sufficient to change investment behavior. Rather, participants need to know a firm's name and home base. Additional evidence indicates that participants have a greater perceived familiarity with local and domestic securities and, in turn, invest more in such securities.

Abstract We provide a model of bookbuilding in IPOs, in which the issuer can choose to ration shares. Before informed investors submit their bids, they know that, in the aggregate, winning bidders will receive only a fraction of their demand. We demonstrate that this mitigates the winner's curse, that is, the incentive of bidders to shade their bids. It leads to more aggressive bidding, to the extent that rationing can be revenue-enhancing. In a parametric example, we characterize bid and revenue functions, and the optimal degree of rationing. We show that, when investors’information is diffuse, maximal rationing is optimal. Conversely, when their information is concentrated, the seller should not ration shares. We provide testable predictions on bid dispersion and the degree of rationing. Our model reconciles the documented anomaly that higher bidders in IPOs do not necessarily receive higher allocations.