Knowledge that Transforms

This paper examines expected option returns in the context of mainstream asset‐pricing theory. Under mild assumptions, expected call returns exceed those of the underlying security and increase with the strike price. Likewise, expected put returns are below the risk‐free rate and increase with the strike price. S&P index option returns consistently exhibit these characteristics. Under stronger assumptions, expected option returns vary linearly with option betas. However, zero‐beta, at‐the‐money straddle positions produce average losses of approximately three percent per week. This suggests that some additional factor, such as systematic stochastic volatility, is priced in option returns.

This study examines how client risk factors and the provision of additional services affect engagement planning and bid pricing for a set of initial engagement proposals that a single firm submitted to its prospective clients in 1997–1998. We find little effect of risk on planned personnel hours, but show that the firm responds to fraud and error risk factors by applying engagement-planning strategies such as assigning more high-risk specialist personnel, assigning more industry expert personnel, applying more intensive testing, and/or performing additional review. Analyzing proposed fees while controlling for planned personnel hours, we find risk premia for both fraud and error risk factors. Supplemental analysis of accepted vs. rejected bids shows that the risk premia are detectable for bids accepted by clients (i.e., the engagements the firm will actually perform), implying that risk premia are not bid away in the market. We also find that for clients purchasing additional services, the firm plans more hours and uses industry experts more often. Results reveal a relatively small fee premium for additional services clients across all bids, but analysis of accepted vs. rejected bids implies that this premium is bid away in the market.

This study provides evidence that hyperlinking a firm's audited financial statements to unaudited information in a web-based environment leads investors to blend the unaudited information with the audited statements. I obtain evidence of this blending effect using an experiment where investors assessed a firm's earnings potential by evaluating the firm's audited financial statements and a subsequent optimistic unaudited letter to shareholders from the firm's management. Investors who viewed hyperlinked materials on the Web misclassified more unaudited information as audited and assessed the credibility of the unaudited information as higher than did investors who viewed hardcopy materials. Those investors who assessed the unaudited information as more credible also judged the firm's earnings potential to be higher. Notifying users with an “AUDITED/NOT AUDITED” label attenuated these effects. This evidence suggests that firms can influence financial report users' perceptions by hyperlinking unaudited information to information in their audited financial statements, and that a simple disclosure rule reduces this influence.

Prior research suggests that the earnings expectations of a segment of the market can be described by the seasonal random-walk model. Prior research also provides evidence that less wealthy and less informed investors tend to make smaller trades (small traders) than wealthier and betterinformed investors (large traders). I hypothesize that it is the earnings expectations of small traders that are associated with predictions from the seasonal random-walk model. By directly analyzing the trading activities of small and large traders, this study provides evidence that is largely consistent with the hypotheses. Specifically, small traders' trading response around earnings announcements is increasing in the magnitude of seasonal random-walk forecast errors, even after controlling for absolute analyst forecast errors, contemporaneous price changes, and market-wide trading. Supplementary analysis reveals that this effect is largely confined to firms with relatively impoverished information environments (i.e., smaller firms and firms with little to moderate analyst following).

This paper solves numerically the intertemporal consumption and portfolio choice problem of an infinitely-lived investor who faces a time-varying equity premium. The solutions we obtain are very similar to the approximate analytical solutions of Campbell and Viceira (1999), except at the upper extreme of the state space where both the numerical consumption and portfolio rules flatten out. We also consider a constrained version of the problem in which the investor faces borrowing and short-sales restrictions. These constraints bind when the equity premium moves away from its mean in either direction, and are particularly severe for risk-tolerant investors. The constraints have substantial effects on optimal consumption, but much more modest effects on optimal portfolio choice in the region of the state space where they are not binding.

This study extends research on earnings conservatism – the degree to which the accounting system recognizes bad news regarding future cash flows in a more timely manner than good news – by arguing that heterogeneous executives' risk attitudes will influence the degree of conservatism. Prior research has demonstrated that differences in earnings conservatism are mainly the result of differences in institutional factors (Basu (1997) and Ball et al. (2000a)). We hypothesize that more risk-averse managers, who demand a risk premium that offsets the effects of the variance in their compensation, will report more conservative earnings. Earnings conservatism will temper expectations among stakeholders about the future cash flows to be distributed thereby diminishing the likelihood of disappointing outcomes and potential litigation or threats for executives of being fired. The more risk-averse manager would be more inclined to reduce such conflicts, since they will have a destabilizing effect on his future compensation. The empirical results for a sample of Dutch companies over the period of 1983 to 1995 confirm our hypothesis: more risk-averse managers report earnings more conservatively than do less risk-averse managers.

We empirically compare Libor and Swap Market Models for the pricing of interest rate derivatives, using panel data on prices of US caplets and swaptions. A Libor Market Model can directly be calibrated to observed prices of caplets, whereas a Swap Market Model is calibrated to a certain set of swaption prices. For both models we analyze how well they price caplets and swaptions that were not used for calibration. We show that the Libor Market Model in general leads to better prediction of derivative prices that were not used for calibration than the Swap Market Model. Also, we find that Market Models with a declining volatility function give much better pricing results than a specification with a constant volatility function. Finally, we find that models that arechosen to exactly match certain derivative prices are overfitted; more parsimonious models lead to better predictions for derivative prices that were not used for calibration.

Loans are illiquid when a lender needs relationship-specific skills to collect them. Consequently, if the relationship lender needs funds before the loan matures, she may demand to liquidate early, or require a return premium, when she lends directly. Borrowers also risk losing funding. The costs of illiquidity are avoided if the relationship lender is a bank with a fragile capital structure, subject to runs. Fragility commits banks to creating liquidity, enabling depositors to withdraw when needed, while buffering borrowers from depositors' liquidity needs. Stabilization policies, such as capital requirements, narrow banking, and suspension of convertibility, may reduce liquidity creation.

This paper argues that a principal cause of the 1997 Asian currency crisis was large prospective deficits associated with implicit bailout guarantees to failing banking systems. The expectation that these future deficits would be at least partially financed by seigniorage revenues or an inflation tax on outstanding nominal debt led to a collapse of the fixed exchange rate regimes in Asia. We articulate this view using a simple model whose key feature is that a speculative attack is inevitable once the present value of future government deficits rises. We present empirical evidence in support of the key assumptions underlying our interpretation of the crisis.