Knowledge that Transforms

Abstract 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.

Abstract 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.

Abstract This paper provides a unifying framework for the modeling of various types of credit risks such as contagion effects. We argue that Markov chains can efficiently be used to tackle these problems. However, our approach is not limited to pricing problems with contagion. On the theoretical side, we derive pricing formulas for three building blocks that are generalizations of contingent claims studied in Lando (1998). These claims can be thought of as atoms forming the basis for all credit risk payments. Furthermore, we demonstrate that, in general, all contingent claims exposed to credit risk satisfy a system of partial differential equations. This is the key result to calculate prices of credit risk claims explicitly and efficiently.

Abstract 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.

Abstract We study a firm in which the marginal productivity of agents' effort increases with the effort of others. We show that the presence of an agent who overestimates his marginal productivity may make all agents better off, including the biased agent himself. This Pareto improvement is obtained even when compensation contracts are set endogenously to maximize firm value. We show that the presence of a leader improves coordination, but self-perception biases can never be Pareto-improving when they affect the leader. Self-perception biases are also shown to affect job assignments within firms and the likelihood and value of mergers.

Abstract This paper presents a continuous time model of a firm that can dynamically adjust both its capital structure and its investment choices. In the model we endogenize the investment choice as well as firm value, which are both determined by an exogenous price process that describes the firm's product market. Within the context of this model we explore cross-sectional as well as time-series variation in debt ratios. We pay particular attention to interactions between financial distress costs and debtholder/equityholder agency problems and examine how the ability to dynamically adjust the debt ratio affects the deviation of actual debt ratios from their targets. Regressions estimated on simulated data generated by our model are roughly consistent with actual regressions estimated in the empirical literature.

Abstract 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.

Abstract We fully characterize the equilibria in a gme between a fund manager of unknown ability who control the riskiness of his portfolio and investors who only observe realized returns. We derive two types of equilibria. The first one is such that (i) investors invest in the fund if the realized return falls within some interval, i.e., is neither too low nor too high, (ii) a good manager picks a portfolio of minimal riskiness and (iii) a bad manager picks a portfolio with higher risk, “gambling” on a lucky outcome. The second type of equilibrium is more traditional: (i) investors invest in the fund if the observed return is larger than some threshold, and (ii) good and bad managers choose the same risk level.

Abstract 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.

Abstract 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.