Knowledge that Transforms

This article characterizes optimal dynamic consumption and portfolio decisions in the presence of capital gains taxes and short-sale restrictions. The optimal decisions are a function of the investor’s age, initial portfolio holdings, and tax basis. Our results capture the trade-off between the diversification benefits and tax costs of trading over an investor’s lifetime. The incentive to rediversify the portfolio is inversely related to the size of the embedded gain and investor’s age. Contrary to standard financial advice, the optimal equity holding increases well into an investor’s lifetime in our model due to the forgiveness of capital gains taxes at death.

Markowitz’s portfolio theory is one of the most important theoretical developments in finance. Its elegance and theoretical appeal are illustrated by the fact that it is taught in virtually every undergraduate and MBA level course on portfolio management. Yet the Markowitz mean-variance (MV) optimization is not widely used by the investment community. In this book, Richard Michaud, a leading researcher in this area, explains why this is so. Based on his diagnosis of the problem, he advocates a “statistical view” of the MV optimization that leads to new procedures that can reduce or eliminate many practical deficiencies of the MV optimization. Using a simple global asset allocation example throughout the book, he illustrates the problems associated with a naïve implementation of the MV optimization procedure. He then describes how the new procedures can be applied, and shows how they improve the MV optimization results. The bottom line: the “statistical view” and the new procedures offer the potential of substantial improvements in the investment performance of the MV optimization. I agree with this assessment. I find this book a must-read for industry professionals and researchers who are interested in this area.

Evaluating default correlations or the probabilities of default by more than one firm is an important task in credit analysis, derivatives pricing, and risk management. However, default correlations cannot be measured directly, multiple-default modeling is technically difficult, and most existing credit models cannot be applied to analyze multiple defaults. This article develops a first-passage-time model, providing an analytical formula for calculating default correlations that is easily implemented and conveniently used for a variety of financial applications. The model also provides a theoretical justification for several empirical regularities in the credit risk literature.

Using industrial firms from the United States, Germany, and Japan, we examine the effect of bank power on cash holdings. We show that Japanese firms hold more cash than U.S. or German firms. We also document that Japanese cash balances are affected by the monopoly power of banks. During periods with powerful banks, firms’ high cash holdings are consistent with banks extracting rents. When banks weakened, Japanese cash levels became more like U.S. firms. We conclude that strong Japanese banks persuade firms to hold large cash balances. This is contrary to widely held beliefs about the Japanese governance system.

Journal Article Optimal Portfolio Choice and the Valuation of Illiquid Securities Get access Francis A. Longstaff Francis A. Longstaff University of California, Los Angeles Address correspondence to Francis A. Longstaff, Anderson School, UCLA, Box 951481, Los Angeles, CA 90095-1481, or e-mail [email protected]. Search for other works by this author on: Oxford Academic Google Scholar The Review of Financial Studies, Volume 14, Issue 2, April 2001, Pages 407–431, https://doi.org/10.1093/rfs/14.2.407 Published: 21 June 2015

This article shows how both technological and competitive risks affect the timing of private and initial public offerings in an emerging industry. Early private financing occurs in industries that are perceived to be risky, with high development costs and low probability of being displaced by technologically superior rivals. Early public financing occurs in industries perceived to be viable, with low development costs and low probability of displacement. Due to feedback effects between financial and product markets, the value of investors’ proprietary information is greater in private than in initial public offerings. This has implications for underpricing.

This article systematically examines the importance of exchange rate movements and industry competition for stock returns. Common shocks to industries across countries are more important than competitive shocks due to changes in exchange rates. Weekly exchange rate shocks explain almost nothing of the relative performance of industries. Using returns measured over longer horizons, the importance of exchange rate shocks increases slightly and the importance of industry common shocks increases more substantially. Both industry and exchange rate shocks are more important for industries that produce internationally traded goods, but the importance of these shocks is economically small for these industries as well.

Much of the empirical literature that has examined the functional relationship between firm value and managerial ownership levels assumes that managerial ownership levels are exogenous and are the only component of managerial compensation related to firm performance. This assumption is contrary to the theoretical and empirical literature wherein managerial compensation is endogenously determined and includes both shares and options. Using instruments for managerial compensation and panel data to control for unobservable heterogeneity in the firm’s contracting environment, we estimate a system of simultaneous equations. We find that firms are in equilibrium when they endogenously set their chief executive officer’s compensation.

Volatility in equity markets is asymmetric: contemporaneous return and conditional return volatility are negatively correlated. In this article I develop an asymmetric volatility model where dividend growth and dividend volatility are the two state variables of the economy. The model allows both the leverage effect and the volatility feedback effect, the two popular explanations of asymmetry. The model is estimated by the simulated method of moments. I find that both the leverage effect and volatility feedback are important determinants of asymmetric volatility, and volatility feedback is significant both statistically and economically.

In a study of the ownership of German corporations, we find a strong relation between board turnover and corporate performance, little association of concentrations of ownership with managerial disciplining, and only limited evidence that pyramid structures can be used for control purposes. The static relationship of ownership to control in Germany is therefore similar to the United Kingdom and the United States. However, there are marked differences in dynamic relations involving transfers of ownership. There is an active market in share blocks giving rise to changes in control, but the gains are limited and accrue solely to the holders of large blocks, not to minority investors. We provide evidence of low overall benefits to control changes and the exploitation of private benefits of control.