Knowledge that Transforms

Economists have long recognized that investors care differently about downside losses versus upside gains. Agents who place greater weight on downside risk demand additional compensation for holding stocks with high sensitivities to downside market movements. We show that the cross section of stock returns reflects a downside risk premium of approximately 6% per annum. Stocks that covary strongly with the market during market declines have high average returns. The reward for beasring downside risk is not simply compensation for regular market beta, nor is it explained by coskewness or liquidity risk, or by size, value, and momentum characteristics.

This article develops a framework that applies to single securities to test whether asset pricing models can explain the size, value, and momentum anomalies. Stock level beta is allowed to vary with firm-level size and book-to-market as well as with macroeconomic variables. With constant beta, none of the models examined capture any of the market anomalies. When beta is allowed to vary, the size and value effects are often explained, but the explanatory power of past return remains robust. The past return effect is captured by model mispricing that varies with macroeconomic variables.

This article uses transactions data for all NYSE/AMEX stocks in the period 1983-2002 to study how investors trade in Jegadeesh and Titman's (1993) momentum portfolios. Among small trades, there is an extremely sluggish reaction to the past returns. For instance, an initial small-trade buying pressure exists for loser stocks, and it gradually converts into an intense selling pressure over the following year. The results are consistent with initial underreaction followed by delayed reaction among small traders. Moreover, small-trade imbalances during the formation period significantly affect momentum returns, suggesting that underreaction among small traders contributes to the momentum effect. Large traders, by contrast, show no evidence of underreaction, and large-trade imbalances have little impact on subsequent returns. Overall, the results suggest that momentum could partly be driven by the behavior of small traders.

Target firms often face bidders that are not equally well informed, which reduces competition, because bidders with less information fear the winner's curse more. We analyze how targets should be sold in this situation. We show that a sequential procedure can extract the highest possible transaction price. The target first offers an exclusive deal to a better-informed bidder, without considering a less well-informed bidder. If rejected, the target offers either an exclusive deal to the less well-informed bidder, or a modified first-price auction. Deal protection devices can be used to enhance a target's commitment to the procedure.

Prior work on leverage implicitly assumes capital availability depends solely on firm characteristics. However, market frictions that make capital structure relevant may also be associated with a firm's source of capital. Examining this intuition, we find firms that have access to the public bond markets, as measured by having a debt rating, have significantly more leverage. Although firms with a rating are fundamentally different, these differences do not explain our findings. Even after controlling for firm characteristics that determine observed capital structure, and instrumenting for the possible endogeneity of having a rating, firms with access have 35% more debt.

We explore the time-series relationship between investor sentiment and the small-stock premium using consumer confidence as a measure of investor optimism. We estimate the components of consumer confidence related to economic fundamentals and investor sentiment. After controlling for the time variation of beta, we study the time-series variation of the pricing error with sentiment. Over the last 25 years, investor sentiment measured using consumer confidence forecasts the returns of small stocks and stocks with low institutional ownership in a manner consistent with the predictions of models based on noise-trader sentiment. Sentiment does not appear to forecast time-series variation in the value and momentum premiums.

We study whether differences in access to credit cause focused firms to perform differently from diversified firms in the product market. Prior work has identified binding credit constraints for bank-dependent firms during recessions. We assess whether corporate diversification alleviates these constraints. We find that during recessions sales growth rates drop more for bank-dependent focused firms than for rival segments of bank-dependent diversified firms. We also find that during recessions inventory growth rates drop more for bank-dependent focused firms than for bank-dependent diversified firms even after we control for contemporaneous sales growth. Consistent with a credit constraint explanation, we find no difference in the sensitivities to recessions of bank-independent focused and bank-independent diversified firms.

We test a Wall Street investment strategy, "pairs trading," with daily data over 1962-2002. Stocks are matched into pairs with minimum distance between normalized historical prices. A simple trading rule yields average annualized excess returns of up to 11% for self-financing portfolios of pairs. The profits typically exceed conservative transaction-cost estimates. Bootstrap results suggest that the "pairs" effect differs from previously documented reversal profits. Robustness of the excess returns indicates that pairs trading profits from temporary mispricing of close substitutes. We link the profitability to the presence of a common factor in the returns, different from conventional risk measures.

This article illustrates an incentive-aligning role of debt in the presence of optimal compensation contracts. Owing to information asymmetry, value-maximizing compensation contracts allow managerial rents following high investment outcomes. The manager has an incentive to increase these rents by choosing investments that generate greater information asymmetry. An aptly chosen debt level mitigates this incentive, because investments that generate greater information asymmetry have more volatile outcomes. The greater volatility would make the debt risky, causing the shareholders to focus on high outcomes and therefore compensation contracts that reduce managerial rents. At the optimum, the manager avoids opportunistic investments, and the shareholders offer value-maximizing compensation contracts. Empirically, the analysis predicts a negative relationship between leverage and market-to-book that is reversed at extreme market-to-book ratios, a negative relationship between leverage and profitability, a negative relationship between leverage and pay-for-performance, and a positive relationship between pay-for-performance and investment opportunities.

We develop an equilibrium model in which exchange rates, stock prices, and capital flows are jointly determined under incomplete foreign exchange (forex) risk trading. Incomplete hedging of forex risk, documented for U.S. global mutual funds, induces the following price and capital flow dynamics: Higher returns in the home equity market relative to the foreign equity market are associated with a home currency depreciation. Net equity flows into the foreign market are positively correlated with a foreign currency appreciation. The model predictions are strongly supported at daily, monthly, and quarterly frequencies for 17 OECD countries vis-à-vis the United States. Correlations are strongest after 1990 and for countries with higher equity market capitalization relative to GDP, suggesting that the observed exchange rate dynamics is indeed related to equity market development.