We show that banks expand mortgage lending in the home states of Senate Banking Committee chairs, and the effect is more pronounced in counties where the incumbent senator faces a competitive re-election race. Banks strategically target politically active borrowers. Consequently, banks’ profitability increases after favoring the incumbent politicians’ constituents, but they suffer a deterioration in mortgage asset quality in the long run. Our findings imply that political power could distort private capital allocation beyond conventional political contribution channels.

The decline of average stock return volatility in the 2001–2006 period provides an opportunity to test various theories on why the average return volatility increased in the pre-2000 period. This paper compares fundamentals-based theories with trading volume-based theories. While both fundamentals-based and trading volume-based theories explain the upward trend in the average volatility in U.S. stocks from 1976 to 2000 and international stocks from 1990 to 2000, only the fundamentals-based theories explain the volatility pattern for 2001–2006. Much of the variation in the stock return volatilities can be explained by the variation in the earnings volatilities and proxies for growth options, but not by trading-related variables. Evidence also shows that the explanatory power of the fundamentals variables is time varying.

This paper explores the reasons behind the discrepancy between interest rates in China’s two repurchase agreement (repo) markets, the interbank repo market and the exchange-traded repo market. The repo rates in the exchange market are at times, significantly higher than those in the interbank market, especially in the first three years of the 2000–2005 sample period. While market segmentation clearly hinders arbitrage, the causes of the repo rate discrepancy are related to the alternative investment opportunities available to market participants and to the volatility differences in the repo rates.

We propose an explanation for why corporate investment used to be sensitive to cash flow and why the sensitivity declined over time. The sensitivity stems from the informational role of cash flow in inferring the productivity of tangible capital in the old economy. Over time, however, more new-economy firms enter the market. These firms have reduced tangible capital productivity and reduced cash-flow predictability, which drives the decline in the average investment–cash flow sensitivity. Theoretical and empirical analyses support this explanation.

Derivative warrants typically have higher prices than do otherwise identical options. Using data from the Hong Kong market during 2002–2007, we show that the price difference reflects the liquidity premium of derivative warrants over options. Newly issued derivative warrants are much more liquid than options with similar terms. As a result, long-term derivative warrants are preferred by traders who trade frequently. In spite of their higher prices, short-term returns on long-term derivative warrants are, in fact, higher than the hypothetical short-term returns on options. The differences in price and liquidity measures decline as the contracts get closer to maturity.

This paper studies generalized method of moments tests for the stochastic discount factor representation of asset pricing models when one of the proposed factors is in fact useless, defined as being independent of the asset returns. Analytic results on asymptotic distributions and simulation results on finite sample distributions both show that (i)the Wald test tends to overreject the hypothesis of a zero factor premium for a useless factor when the model is misspecified, (ii)with the presence of a useless factor, the power of the over-identifying restriction test in rejecting misspecified models is reduced, and in some cases a misspecified model with a useless factor is more likely to be accepted than the true model.

Many evaluation techniques typically measure performance as deviations of average returns on actively managed funds from those predicted by some asset pricing model. Empirical evidence, however, has so far suggested that all asset pricing models lack empirical support, implying that the models contain mis-specification errors to various degrees. Evaluating mutual fund performance relative to any of these models thus becomes problematic. In this paper, we propose an approach to performance measurement that emphasizes minimizing explicitly the pricing error associated with an asset pricing function which is employed to compute performance measures. This approach is henceforth called the minimum specification-error (MSE) method. We also discuss the statistical properties for implementing MSE performance measure. To demonstrate the significance of the pricing error confounded in evaluation measurement, we contrast our methodology with the Grinblatt and Titman (1989) period weighting approach and with the empirical implementation of Chen and Knez (1996). We find that the greater the pricing error of passive assets, the larger the performance measures. Given the average pricing error generated from a collection of 163 diverse passive portfolios used in this analysis the performance values assigned to a large number of the funds become statistically and economically insignificant.

A recent study by Goyal and Santa-Clara [J. Finance 58 (2003) 975] finds a significantly positive relationship between average stock returns and pre-determined average return volatility measures, while finding no relationship between the average return and its own volatility. The result is interpreted as evidence that idiosyncratic risk matters in asset pricing. We re-examine the issue in extended sample periods and find the proclaimed positive relationship is not substantiated. Our analysis indicates that the above-mentioned positive relationship is mainly driven by the data in the 1990s. The trading strategy suggested by Goyal and Santa-Clara to exploit the return predictability by pre-determined volatility does not yield sustained economic gains.

It is well documented that the time-varying bond excess returns can be explained by predetermined variables such as information in the term structure and macro economic variables. Recent studies suggest that demand and supply of bonds influence bond excess returns. We extend the literature and find that monetary system attributes affect return dynamics in the bond market. By introducing a theoretical model to forecast excess returns on Treasury bonds in the context of China’s unique monetary system, this paper attributes the predicted components of bond excess returns mainly to the inflexible term structures of official interest rates set by China’s central bank.