Knowledge that Transforms

The cash flows of growth stocks are particularly sensitive to temporary movements in aggregate stock prices, driven by shocks to market discount rates, while the cash flows of value stocks are particularly sensitive to permanent movements, driven by shocks to aggregate cash flows. Thus, the high betas of growth (value) stocks with the market's discount-rate (cash-flow) shocks are determined by the cash-flow fundamentals of growth and value companies. Growth stocks are not merely “glamour stocks” whose systematic risks are purely driven by investor sentiment. More generally, the systematic risks of individual stocks with similar accounting characteristics are primarily driven by the systematic risks of their fundamentals.

This paper studies the impact of ambiguity and ambiguity aversion on equilibrium asset prices and portfolio holdings in competitive financial markets. It argues that attitudes toward ambiguity are heterogeneous across the population, just as attitudes toward risk are heterogeneous across the population, but that heterogeneity of attitudes toward ambiguity has different implications than heterogeneity of attitudes toward risk. In pa rticular, when some state probabilities are not known, agents who are sufficiently ambiguity averse find open sets of prices for which they refuse to hold an ambiguous portfolio. This suggests a different cross section of portfolio choices, a wider range of state price/probability ratios, and different rankings of state price/probability ratios than would be predicted if state probabilities were known. Experiments confirm all of these suggestions. Our findings contradict the claim that investors who have cognitive biases do not affect prices because they are inframarginal: ambiguity-averse investors have an indirect effect on prices because they change the per capita amount of risk that is to be shared among the marginal investors. Our experimental data also suggest a positive correlation between risk aversion and ambiguity aversion that might explain the “value effect” in historical data.

This article reports a unique analysis of private engagements by an activist fund. It is based on data made available to us by Hermes, the fund manager owned by the British Telecom Pension Scheme, on engagements with management in companies targeted by its UK Focus Fund. In contrast with most previous studies of activism, we report that the fund executes shareholder activism predominantly through private interventions that would be unobservable in studies purely relying on public information. The fund substantially outperforms benchmarks and we estimate that abnormal returns are largely associated with engagements rather than stock picking.

This article, which introduces the special issue on corporate governance cosponsored by the Review of Financial Studies and the National Bureau of Economic Research (NBER), reviews and comments on the state of corporate governance research. The special issue features seven articles on corporate governance that were presented in a meeting of the NBER’s corporate governance project. Each of the articles represents state-of-the-art research in an important area of corporate governance research. For each of these areas, we discuss the importance of the area and the questions it focuses on, how the article in the special issue makes a significant contribution to this area, and what we do and do not know about the area. We discuss in turn work on shareholders and shareholder activism, directors, executives and their compensation, controlling shareholders, comparative corporate governance, cross-border investments in global capital markets, and the political economy of corporate governance.

We test whether stock market mispricing or private investor information in stock prices affects corporate investment. We develop an econometric methodology that disentangles stock-price movements that are relevant for investment from those that are not. We combine this decomposition with proxies for private information and mispricing to devise unbiased tests for the effects of mispricing and information on investment. We depart from much of the literature by finding that stock market mispricing does not affect investment, especially that of large firms and firms subject to mispricing. In contrast, we confirm previous evidence that managers incorporate private investor information when making investment decisions.

We study the role of institutional investors in cross-border mergers and acquisitions (M&As). We find that foreign institutional ownership is positively associated with the intensity of cross-border M&A activity worldwide. Foreign institutional ownership increases the probability that a merger deal is cross-border, successful, and the bidder takes full control of the target firm. This relation is stronger in countries with weaker legal institutions and in less developed markets, suggesting some substitutability between local governance and foreign institutional investors. The results are consistent with the hypothesis that foreign institutional investors act as facilitators in the international market for corporate control; they build bridges between firms and reduce transaction costs and information asymmetry between bidder and target. We conclude that cross-border portfolio investments of institutional money managers and cross-border M&As are complements in promoting financial integration worldwide.

We study how much of the top end of the income distribution is represented by four sectors—non-financial-firm top executives (Main Street); investment bankers and hedge, private equity, and mutual fund investors (Wall Street); corporate lawyers; and athletes and celebrities. Wall Street individuals comprise a higher percentage of the top income brackets than nonfinancial executives of public companies. While top executives’ representation in the top brackets has increased from 1994 to 2004, Wall Street's representation has likely increased even more. We discuss the implications of our findings for different explanations for the increased skewness at the highest income levels.

We compare the trading performance of independent directors and other executives. The findings reveal that independent directors earn positive substantial abnormal returns when they purchase their company stock, and that the difference from the same firm's executives is relatively small at most horizons. We also find that executives and independent directors make higher returns in firms with the weakest governance, the gap between these two widens in such firms, and that independent directors sitting on the audit committee earn higher returns than other independent directors at the same firm. Independent directors also earn significantly abnormal returns when they sell the company stock in a window before bad news and around earnings restatements. The Author 2009. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: [email protected]., Oxford University Press.

Campbell, Lettau, Malkiel, and Xu (2001) document a positive trend in idiosyncratic volatility during the 1962–1997 period. We show that by 2003 volatility falls back to pre-1990s levels. Furthermore, we show that the increase and subsequent reversal is concentrated among firms with low stock prices and high retail ownership. This evidence suggests that the increase in idiosyncratic volatility through the 1990s was not a time trend but, rather, an episodic phenomenon, at least partially associated with retail investors. Results from cross-sectional regressions, conditional trend estimation, stock-split events, and “attention-grabbing” events are consistent with a retail trading effect.

I use uniquely comprehensive data on financial news events to test four predictions from an asymmetric information model of a firm's stock price. Certain investors trade on information before it becomes public; then, public news levels the playing field for other investors, increasing their willingness to accommodate a persistent liquidity shock. Empirically, I measure public information using firms' stock returns on news days in the Dow Jones archive. I find four patterns in postnews returns and trading volume that are consistent with the asymmetric information model's predictions. Some evidence is, moreover, inconsistent with alternative theories in which traders interpret news differently for rational or behavioral reasons.