Knowledge that Transforms

An emerging literature looking at self-selected, corporate news events concludes that markets appear to underreact to news. Recent theoretical articles have explored why or how underreaction might occur. However, the notion of underreaction is contentious. We revisit this issue by focusing on one of the most simple of corporate transactions, the stock split. Prior studies that report abnormal return drifts subsequent to splits do not appear to be spurious, nor a consequence of misspecified benchmarks. Using recent cases, we report a drift of 9% in the year following a split announcement. We consider fundamental operating performance as a source of the underreaction and find that splitting firms have an unusually low propensity to experience a contraction in future earnings. Further, analysts' earnings forecasts are comparatively low at the time of the split announcement and revise sluggishly over time. Together these results are consistent with the notion of market under reaction to the information in corporate news events.

We provide empirical evidence on the economic benefits of negotiating trades in the upstairs trading room of brokerage firms relative to the downstairs market. Using Helsinki Stock Exchange data, we find that upstairs trades tend to have lower information content and lower price impacts than downstairs trades. This is consistent with the hypotheses that the upstairs market is better at pricing uninformed liquidity trades and that upstairs brokers can give better prices to their customers if they know the unexpressed demands of other customers. We find that these economic benefits depend on price discovery occurring in the downstairs market.

We find that analysts' forecast errors are predicted by past accounting accruals (adjustments to cash flows to obtain reported earnings) among both equity issuers and nonissuers. Analysts are more optimistic for the subsequent four years for issuers reporting higher issue-year accruals. The predictive power is greater for discretionary accruals than nondiscretionary accruals and is independent of the presence of an underwriting affiliation. Predicted forecast errors from accruals significantly explain the long-term under performance of new issuers. The predictability of forecast errors among nonissuers suggests that analysts' credulity about accruals management more generally contributes to market inefficiency.

We examine the effect of bargaining power and informational asymmetry on the design of international cooperative ventures in the presence of restrictions on equity participation and investment. When the bargaining advantage rests with the multinational, equity participation restrictions can increase the profits to domestic firms and encourage sub-optimal investment policies. Overinvestment occurs when the multinational's bargaining advantage is reinforced by an informational advantage, while underinvestment occurs when the domestic firm possesses the informational advantage. In contrast, when the bargaining advantage rests with the domestic firm, equity participation restrictions do not affect investment levels.

This paper analyzes corporate bond valuation and optimal call and default rules when interest rates and firm value are stochastic. It then uses the results to explain the dynamics of hedging. Bankruptcy rules are important determinants of corporate bond sensitivity to interest rates and firm value. Although endogenous and exogenous bankruptcy models can be calibrated to produce the same prices, they can have very different hedging implications. We show that empirical results on the relation between corporate spreads and Treasury rates provide evidence on duration, and we find that the endogenous model explains the empirical patterns better than do typical exogenous models.

One of the puzzles regarding initial public offerings (IPOs) is that issuers rarely get upset about leaving substantial amounts of money on the table, defined as the number of shares sold times the difference between the first-day closing market price and the offer price. The average IPO leaves $9.1 million on the table. This number is approximately twice as large as the fees paid to investment bankers and represents a substantial indirect cost to the issuing firm. We present a prospect theory model that focuses on the covariance of the money left on the table and wealth changes. Our reasoning also provides an explanation for a second puzzling pattern: much more money is left on the table following recent market rises than after market falls. This results in an explanation of hot issue markets. We also offer a new explanation for why IPOs are underpriced.

This article studies access regulation to international large-value payment systems when banking supervision is national. We focus on the choice between net and real-time gross settlement. As a novel feature, the communication between the public authorities is endogenized. It is shown that the national authorities' incentives are not perfectly aligned concerning the settlement method. Therefore public regulation fails to implement the first-best access criteria. Banks prefer net settlement too often due to limited liability. Still, if banks have superior information about their counterparties, private involvement in access regulation is desirable as it reveals information to the public authorities.

The fee structure used to compensate investment advisers is central to the study of fund design, and affects investor welfare in at least three ways: (i) by influencing the portfolio-selection incentives of the adviser, (ii) by affecting risk-sharing between adviser and investor, and (iii) through its use as a signal of quality by superior investment advisers. In this paper, we describe a model in which all of these features are present, and use it to compare two popular and contrasting forms of fee contracts, the "fulcrum" and the "incentive" types, from the standpoint of investor welfare. While the former has some undeniably attractive features (that have, in particular, been used by regulators to justify its mandatory use in a mutual fund context), we find surprisingly that it is the latter that is often more attractive from the standpoint of investor welfare. Our model is a flexible one; our conclusions are shown to be robust to many extensions of interest. The results are also extended to consider unrestricted fee structures and competitive markets for fund managers.

Stock market returns are significantly correlated with inflation and money growth. The impact of real macroeconomic variables on aggregate equity returns has been difficult to establish, perhaps because their effects are neither linear nor time invariant. We estimate a GARCH model of daily equity returns, where realized returns and their conditional volatility depend on 17 macro series' announcements. We find six candidates for priced factors: three nominal (CPI, PPI, and a Monetary Aggregate) and three real (Balance of Trade, Employment Report, and Housing Starts). Popular measures of overall economic activity, such as Industrial Production or GNP are not represented.