Knowledge that Transforms

Confirming predictions shared by the trade-off and pecking order models, more profitable firms and firms with fewer investments have higher dividend payouts. Confirming the pecking order model but contradicting the trade-off model, more profitable firms are less levered. Firms with more investments have less market leverage, which is consistent with the trade-off model and a complex pecking order model. Firms with more investments have lower long-term dividend payouts, but dividends do not vary to accommodate short-term variation in investment. As the pecking order model predicts, short-term variation in investment and earnings is mostly absorbed by debt.

Correlations between international equity market returns tend to increase in highly volatile bear markets, which has led some to doubt the benefits of international diversification. This article solves the dynamic portfolio choice problem of a U.S. investor faced with a time-varying investment opportunity set modeled using a regime-switching process which may be characterized by correlations and volatilities that increase in bad times. International diversification is still valuable with regime changes and currency hedging imparts further benefit. The costs of ignoring the regimes are small for all-equity portfolios but increase when a conditionally risk-free asset can be held.

Using a unique dataset based on daily and hourly high-yield bond transaction prices, we find the informational efficiency of corporate bond prices is similar to that of the underlying stocks. We find that stocks do not lead bonds in reflecting firm-specific information. We further examine price behavior around earnings news and find that information is quickly incorporated into both bond and stock prices, even at short return horizons. Finally, we find that measures of market quality are no poorer for the bonds in our sample than for the underlying stocks.

We examine the impact deciding to route limit orders away from the New York Stock Exchange (NYSE) has on three dimensions of execution quality with methodologies controlling for market conditions and order submission strategies. Overall differences in limit order execution quality between regional stock exchanges and the NYSE are small, suggesting that the order routing decision may not affect retail limit order traders substantively. Conditioning on the distance between the limit order's price and prevailing quotes, however, reveals systematic differences in execution quality. This implies that brokers can strategically route limit orders to improve retail limit order execution quality.

We compare two competing theories of financial anomalies: "behavioral" theories built on investor irrationality, and "rational structural uncertainty" theories built on incomplete information about the structure of the economic environment. We find that although the theories relax opposite assumptions of the rational expectations ideal, their mathematical and predictive similarities make them difficult to distinguish. Even if irrationality generates financial anomalies, their disappearance still may hinge on rational learning-that is, on the ability of rational arbitrageurs and their investors to reject competing rational explanations for observed price patterns.

Attempts to characterize stock return predictability have resulted in little consensus on the important conditioning variables, giving rise to model uncertainty and data snooping fears. We introduce a new methodology that explicitly incorporates model uncertainty by comparing all possible models simultaneously and in which the priors are calibrated to reflect economically meaningful information. Our approach minimizes data snooping given the information set and the priors. We compare the prior views of a skeptic and a confident investor. The data imply posterior probabilities that are in general more supportive of stock return predictability than the priors for both types of investors.

We show an isomorphism between optimal portfolio selection or competitive equilibrium models with utilities incorporating linear habit formation, and corresponding models without habit formation. The isomorphism can be used to mechanically transform known solutions not involving habit formation to corresponding solutions with habit formation. For example, the Constantinides (1990) and Ingersoll (1992) solutions are mechanically obtained from the familiar Merton solutions for the additive utility case, without recourse to a Bellman equation or first-order conditions. More generally, recent solutions to portfolio selection problems with recursive utility and a stochastic investment opportunity set are readily transformed to novel solutions of corresponding problems with utility that combines recursivity with habit formation. The methodology also applies in the context of Hindy-Huang-Kreps (1992) preferences, where our isomorphism shows that the solution obtained by Hindy and Huang (1993) can be mechanically transformed to Dybvig's (1995) solution to the optimal consumption-investment problem with consumption ratcheting.