Knowledge that Transforms

Recent research has documented large differences among countries in ownership concentration in publicly traded firms, in the breadth and depth of capital markets, in dividend policies, and in the access of firms to external finance. A common element to the explanations of these differences is how well investors, both shareholders and creditors, are protected by law from expropriation by the managers and controlling shareholders of firms. We describe the differences in laws and the effectiveness of their enforcement across countries, discuss the possible origins of these differences, summarize their consequences, and assess potential strategies of corporate governance reform. We argue that the legal approach is a more fruitful way to understand corporate governance and its reform than the conventional distinction between bank-centered and market-centered financial systems.

We hypothesize that firms choose dividend increases to distribute relatively permanent cash-flow shocks and repurchases to distribute more transient shocks. As predicted, we find that post-shock cash flows of dividend increasing firms exhibit less reversion to pre-shock levels compared with repurchasing firms. We also examine whether the stock market uses the announcement of the payout method to update its beliefs about the permanence of cash-flow shocks. Controlling for payout size and the market's expectation about the permanence of the cash-flow shock, the stock price reaction to dividend increases is more positive than the reaction to repurchases.

We investigate the portfolio choices of mean-variance-optimizing investors who use sample evidence to update prior beliefs centered on either risk-based or characteristic-based pricing models. With dogmatic beliefs in such models and an unconstrained ratio of position size to capital, optimal portfolios can differ across models to economically significant degrees. The differences are substantially reduced by modest uncertainty about the models’ pricing abilities. When the ratio of position size to capital is subject to realistic constraints, the differences in portfolios across models become even less important and are nonexistent in some cases.

In this paper, I develop a theory of bid–ask quotes provided by foreign exchange dealers in the inter-bank market based on their beliefs and their inventory positions. I then build an agent-based model of the inter-dealer market where dealers learn in a Bayesian manner from quotes from other dealers. Using simulations, I find that the resulting intra-day spreads and between-quote returns largely conform to the empirically observed intra-day U-shaped pattern – a feature that has not been satisfactorily explained in the literature. I also study the factors that determine this U-shape.

Stock prices move together more in poor economies than in rich economies. This finding is not due to market size and is only partially explained by higher fundamentals correlation in low-income economies. However, measures of property rights do explain this difference. The systematic component of returns variation is large in emerging markets, and appears unrelated to fundamentals co-movement, consistent with noise trader risk. Among developed economy stock markets, higher firm-specific returns variation is associated with stronger public investor property rights. We propose that strong property rights promote informed arbitrage, which capitalizes detailed firm-specific information.

We examine the practice of resetting the terms of previously-issued executive stock options. We identify properties of reset options, develop a model for valuing resettable options, and characterize the firms that have reset options. We find the vast majority of options are reset at-the-money, resulting, on average, in the strike price dropping 40%. Our valuation model suggests that resetting has only a small impact on the ex-ante value of an option award, but the ex-post gain can be substantial. Finally, we find resetting has a strong negative relation with firm performance even after correcting for industry performance.

This paper provides an empirical description of the relationship between the trading system operated by a stock exchange and the trading behaviour of heterogeneous investors who use the exchange. The recent introduction of SETS in the London Stock Exchange provides an excellent opportunity to study the impact of an electronic trading system upon traders who use the exchange. Using the cost-of-carry model of futures prices we estimate (non-linearly) the transaction costs and trade speeds faced by arbitragers who take advantage of mispricing of FTSE100 futures contracts relative to the spot prices of the stocks that make up the FTSE100 stock index. We divide the sample period into pre-SETS and post-SETS sample periods and conduct a comparative study of arbitrager behaviour under different trading systems. The results indicate that there has been a significant reduction in the level of transaction costs faced by arbitragers and in the degree of transaction cost heterogeneity. Finally, generalised impulse response functions show that both spot and futures prices adjust more quickly in the post-SETS period. These results suggest that both spot and futures markets have become more efficient under SETS.

This paper examines how corporate control is exerted in companies listed on the Brussels Stock Exchange. There are several alternative corporate governance mechanisms which may play a role in disciplining poorly performing management: blockholders (holding companies, industrial companies, families and institutions), the market for partial control, debt policy, and board composition. Even if there is redundancy of substitute forms of discipline, some mechanisms may dominate. We find that top managerial turnover is strongly related to poor performance measured by stock returns, accounting earnings in relation to industry peers and dividend cuts and omissions. Tobit models reveal that there is little relation between ownership and managerial replacement, although industrial companies resort to disciplinary actions when performance is poor. When industrial companies increase their share stake or acquire a new stake in a poorly performing company, there is evidence of an increase in executive board turnover, which suggests a partial market for control. There is little relation between changes in ownership concentration held by institutions and holding companies, and disciplining. Still, high leverage and decreasing solvency and liquidity variables are also followed by increased disciplining, as are a high proportion of non-executive directors and the separation of the functions of CEO and chairman.

We study the rationality of learning and the biases in expectations in the Iowa Experimental Markets. Using novel tests developed in (Bossaerts, P., 1996. Martingale restrictions on equilibrium security prices under rational expectations and consistent beliefs. Caltech working paper; Bossaerts, P., 1997. The dynamics of equity prices in fallible markets. Caltech working paper), learning in the Iowa winner-take-all markets is found to be in accordance with the rules of conditional probability (Bayes' law). Hence, participants correctly update their beliefs using the available information. There is evidence, however, that beliefs do not satisfy the restrictions of rational expectations that they reflect the factual distribution of outcomes.

This paper demonstrates that the use of GARCH-type models for the calculation of minimum capital risk requirements (MCRRs) may lead to the production of inaccurate and therefore inefficient capital requirements. We show that this inaccuracy stems from the fact that GARCH models typically overstate the degree of persistence in return volatility. A simple modification to the model is found to improve the accuracy of MCRR estimates in both back- and out-of-sample tests. Given that internal risk management models are currently in widespread usage in some parts of the world (most notably the USA), and will soon be permitted for EC banks and investment firms, we believe that our paper should serve as a valuable caution to risk management practitioners who are using, or intend to use this popular class of models.