Knowledge that Transforms

I demonstrate that ratings-based capital rules, including both the current Basel Accord and its proposed revision, can be reconciled with the general class of credit value-at-risk models. Each exposure's contribution to VaR is portfolio-invariant only if (a) dependence across exposures is driven by a single systematic risk factor, and (b) no exposure accounts for more than an arbitrarily small share of total portfolio exposure. Analysis of rates of convergence to asymptotic VaR leads to a simple and accurate portfolio-level add-on charge for undiversified idiosyncratic risk. There is no similarly simple way to address violation of the single factor assumption.

We study asset prices in an economy where some investors categorize risky assets into different styles and move funds among these styles depending on their relative performance. In our economy, assets in the same style comove too much, assets in different styles comove too little, and reclassifying an asset into a new style raises its correlation with that style. We also predict that style returns exhibit a rich pattern of own- and cross-autocorrelations and that while asset-level momentum and value strategies are profitable, their style-level counterparts are even more so. We use the model to shed light on several style-related empirical anomalies.

IPO volume fluctuates substantially over time. This paper compares the extent to which the aggregate capital demands of private firms, the adverse-selection costs of issuing equity, and the level of investor optimism can explain these fluctuations. Empirical tests include both aggregate and industry-level time-series regressions using proxies for the above factors and an analysis of the relation between post-IPO stock returns and IPO volume. Results indicate that firms’ demands for capital and investor sentiment are important determinants of IPO volume, in both statistical and economic terms. Adverse-selection costs are also statistically significant, but their economic effect appears small.

Major events often trigger abrupt changes in stock prices and volatility. We study the implications of jumps in prices and volatility on investment strategies. Using the event‐risk framework of Duffie, Pan, and Singleton (2000) , we provide analytical solutions to the optimal portfolio problem. Event risk dramatically affects the optimal strategy. An investor facing event risk is less willing to take leveraged or short positions. The investor acts as if some portion of his wealth may become illiquid and the optimal strategy blends both dynamic and buy‐and‐hold strategies. Jumps in prices and volatility both have important effects.

This paper examines the relation between the institutional structures of advanced OECD countries and the comparative growth and investment of 27 industries in those countries over the period 1970 to 1995. The paper reports a strong relation between the structure of countries’ financial systems, the characteristics of industries, and the growth and investment of industries in different countries.

We present a model of mergers and acquisitions based on stock market misvaluations of the combining firms. The key ingredients of the model are the relative valuations of the merging firms and the market's perception of the synergies from the combination. The model explains who acquires whom, the choice of the medium of payment, the valuation consequences of mergers, and merger waves. The model is consistent with available empirical findings about characteristics and returns of merging firms, and yields new predictions as well.

We develop an approximate solution method for the optimal consumption and portfolio choice problem of an infinitely long-lived investor with Epstein–Zin utility who faces a set of asset returns described by a vector autoregression in returns and state variables. Empirical estimates in long-run annual and post-war quarterly U.S. data suggest that the predictability of stock returns greatly increases the optimal demand for stocks. The role of nominal bonds in long-term portfolios depends on the importance of real interest rate risk relative to other sources of risk. Long-term inflation-indexed bonds greatly increase the utility of conservative investors.

This paper studies how an optimal wage contract can be implemented using stock options, and derives the properties of the optimal contract with stock options. Specifically, we show how the exercise price and the size of the option grant should change in response to changes in exogenous parameters. First, for a fixed exercise price of executive stock options, the size of the option grant decreases in the riskiness of a desired investment policy, decreases in the volatility of return from the risky project, and increases in leverage. Second, for a fixed size of the option grant, the optimal exercise price of managerial stock options increases in the riskiness of a desired investment policy, increases in the volatility of return from the risky project, and decreases in leverage. Several empirical predictions are drawn from these conclusions regarding the pay-performance sensitivity of management compensation.

This paper examines whether the stock market valuation impact is consistent with subsequent operating performance of firms. We use data for equity rights offerings—the widely adopted flotation method in the Netherlands. We first examine the stock market announcement effect of rights issues and observe that a statistically significant stock price decline takes place when companies announce rights issues. Further stock price decline is also observed during the subscription period. We then analyze post-rights issue operating performance of firms and find that, consistent with the announcement period decline in stock price, rights issuing firms subsequently exhibit a statistically significant decline in their operating performance. Additional investigation of both stock and operating performance declines provides full support for the information asymmetry hypothesis, partial support for the free cash flow hypothesis but no support for the window of opportunity hypothesis.

This study investigates the relationship between underpricing, ownership structure and post-listing liquidity of initial public offerings (IPOs). It is argued that higher underpricing induces both broader investor participation and creates a more diffuse ownership structure. These two factors are in turn positively associated with the level of post-listing trading, and therefore offer an explanation of how underpricing can influence liquidity. Using a sample of Australian IPOs, we provide evidence of statistically significant relationship between underpricing and various proxies for shareholding distribution and liquidity. This result remains robust after controlling for a number of potential underlying factors that may drive both underpricing and ownership allocation decisions. Overall, our analysis suggests that liquidity is a partial but important benefit of underpricing an IPO.