Knowledge that Transforms

We develop an arbitrage‐free and complete framework to price options on the stocks of firms involved in a merger or acquisition deal allowing for the possibility that the deal might be called off at an intermediate time, creating discontinuous impacts on the stock prices. Our model can be a normative tool for market makers to quote prices for options on stocks involved in such deals and also for traders to control risks associated with such deals using traded options. The results of tests indicate that the model performs significantly better than the Black–Scholes model in explaining observed option prices.

This paper reports the results of experiments designed to examine whether investor selection of auditors enhances auditor independence. The experimental design enables us to explore the effect on independence of different institutional rules as to who hires and fires auditors and to directly measure independence violations. The results suggest that transferring the power to hire and fire the auditor from managers to investors significantly decreases the proportion of independence violations. Additional analysis suggests that a reduction in independence violations increases the overall economic surplus generated in the markets examined.

This paper investigates the decision by top-level executives of more than 1,200 public corporations to exercise a large number of stock option awards in the period 1992–2001. We hypothesize and find that abnormally large option exercises predict stock return future performance. We then hypothesize that this predictive ability represents private information about disappointing earnings in the post-exercise period. Consistent with this hypothesis we find that abnormally positive earnings performance in the pre-exercise period turns to disappointing earnings performance in the post-exercise period, and that this pattern comes as a surprise to even sophisticated market participants (financial analysts). We also hypothesize and find that the disappointing earnings in the post-exercise period represent a reversal of inflated earnings in the pre-exercise period. Collectively, these findings suggest that the private information used by top-level executives to time abnormally large exercises follows from earnings management so as to increase the cash payout of exercises.

This paper investigates auditors' assessments of earnings manipulation risk and corporate governance risk, and their planning and pricing decisions in the presence of these identified risks. To conduct this investigation, we use engagement partners' assessments of their existing clients made during the participating public accounting firm's client continuance risk assessment process. We find that auditors plan increased effort and billing rates for clients with earnings manipulation risk, and that the positive relationships between earnings manipulation risk and both effort and billing rates are greater for clients that also have heightened corporate governance risk. These findings provide evidence that auditors assess situations involving both an aggressive management and inadequate corporate governance, and that there is a relationship between those assessments and auditors' planning and pricing decisions.

Participants in 401(k) retirement plans violate the basic principle of diversification by investing significant fractions of their savings in their employers' equity. This paper characterizes investors' active changes to their company stock investment over time by analyzing new inflows and transfers. The average investor seems to base active changes on salient information, paying attention to past returns, volatility, and business performance. Past returns, over a three-year horizon, predict higher inflow allocations and transfers, whereas volatility and business performance only have a weak effect. The sensitivity to past returns is asymmetric, with investors reacting more strongly to positive and above-S&P500 returns.

Mergers and acquisitions improve market efficiency by capturing synergies between firms. But takeovers also impose externalities (both positive and negative) on the remaining firms in the industry. This paper describes a new equilibrium concept designed to explain and predict takeovers in this setting. We experimentally compare the new equilibrium concept to that of competing concepts in situations without and with externalities. Moreover, we examine the predicted dynamics of takeovers and outcome implications of those dynamics. Our experimental results support the predictions of the new equilibrium concept and provide implications for further empirical tests.

I conduct a time-series analysis of corporate payout policies that accounts for the dynamic nature of these decisions and for the interaction among investment decisions and payout policies. The estimation is done with a VAR model of investments, earnings, total payout, and the split of the total payout between dividends and share repurchases. I control for changes in the legal treatment of share repurchases in 1982 and for changes in the relative taxation of dividends and capital gains. I find that: (i) an increase in the taxation of capital gains relative to dividends shifts the split of total payout away from share repurchase and toward dividends; (ii) corporate investment decisions lead payout policies and not the other way around; (iii) increases in corporate total payout are associated with long-term subsequent increases in earnings; (iv) changes in the composition of corporate payout away from share repurchases and toward dividends are associated with subsequent increases in earnings.

We report on two sets of large-scale financial markets experiments that were designed to test the central proposition of modern asset pricing theory, namely, that risk premia are solely determined by covariance with aggregate risk. We analyze the pricing within the framework suggested by two theoretical models, namely, the (general) Arrow and Debreu's complete-markets model, and the (more specific) Sharpe-Lintner-Mossin Capital Asset Pricing Model (CAPM). Completeness of the asset payoff structure justifies the former; the small (albeit non-negligible) risks justifies the latter. We observe swift convergence towards price patterns predicted in the Arrow and Debreu and CAPM models. This observation is significant, because subjects always lack the information to deliberately set asset prices using either model. In the first set of experiments, however, equilibration is not always robust, with markets temporarily veering away. We conjecture that this reflects our failure to control subject' beliefs about the temporal independence of the payouts. Confirming this conjecture, the anomaly disappears in a second set of experiments, where states were drawn without replacement. We formally test whether CAPM and Arrow–Debreu equilibrium can be used to predict price movements in our experiments and confirm the hypothesis. When multiplying the subject payout tenfold (in real terms), to US $ 500 on average for a 3-h experiment, the results are unaltered, except for an increase in the recorded risk premia.

This paper presents empirical evidence that accounting for heterogeneity in financial market participation is important for evaluating the empirical performance of the Consumption-based Capital Asset Pricing Model (C-CAPM). Using the U.S. Consumer Expenditure Survey as a common testing ground, I re-assess three well-known characterizations of the “equity premium puzzle”: (i) the inconsistency of the representative agent's IMRS with Hansen and Jagannathan bounds; (ii) Mehra and Prescott's calibration of a large representative agent's risk aversion; (iii) Hansen and the Singleton's large structural estimates of the preference parameters based on aggregate data. In all three cases, the estimates of risk aversion conditional upon financial market participation are not as far from reasonable values as the corresponding unconditional ones. The differences suggest that part of the “equity premium puzzle” can be accounted for by the use of a “representative agent” assumption rather than a more appropriate “representative stockholding agent” assumption.

Traders with short horizons and privately known loss limits interact in a market for a risky asset. Risk-averse, long horizon traders generate a downward sloping residual demand curve that faces the short-horizon traders. When the price falls close to the loss limits of the short horizon traders, selling of the risky asset by any trader increases the incentives for others to sell. Sales become mutually reinforcing among the short term traders, and payoffs analogous to a bank run are generated. A “liquidity black hole” is the analogue of the run outcome in a bank run model. Short horizon traders sell because others sell. Using global game techniques, we solve for the unique trigger point at which the liquidity black hole comes into existence. Empirical implications include the sharp V-shaped pattern in prices around the time of the liquidity black hole.