Knowledge that Transforms

We examine the relation between implied cost of capital and expected returns under an assumption that expected returns are stochastic, a property supported by theory and empirical evidence. We demonstrate that implied cost of capital differs from expected return, on average, by a function encompassing volatilities of, as well as correlation between, expected returns and cash flows, growth in cash flows, and leverage. These results provide alternative explanations for findings from empirical studies employing implied cost of capital on the magnitude of the market risk premium; predictability of future returns; and the relations between cost of capital and a host of firm characteristics, such as growth, leverage, idiosyncratic risk and the firm’s information environment.

We conduct a field survey to investigate whether current mid-level and future entry-level managers (collectively managers) subjectively value stock options and restricted stock consistent with economic theory. We find that managers, on average, subjectively value stock options at greater than their Black-Scholes value and greater than fair-value equivalent restricted stock. This result contrasts with conventional economic wisdom that risk-averse employees discount the Black-Scholes value of an option. With respect to stock options, our results also reveal that managers, on average, have a lottery ticket mentality when subjectively valuing options, they value shorter vesting periods, and they value longer terms to maturity. With respect to stock options and restricted stock, we find that managers tend to extrapolate recently rising stock price trends to arrive at their subjective values. Overall, our results suggest that in some cases standard economic theory does not accurately reflect how managers appear to subjectively value stock options and restricted stock.

Bayesian theory predicts an increase in market participants' reliance on reported current earnings to revise their expectations of future earnings when the uncertainty in future earnings is higher. Prior studies focus on price reactions and find negative associations between measures of earnings uncertainty and investors' reliance on reported current earnings. This study examines analysts' forecast revisions (of future earnings) around the announcements of current period earnings and finds positive associations between measures of earnings uncertainty and analysts' reliance on reported current earnings. The findings suggest that uncertainty measures and discount rates are correlated, and cross-sectional differences in the discount rate taint the interpretation of price reactions as evidence of expectation revisions under uncertainty. This study sheds additional light on the complex relationships among earnings uncertainty measures, price reactions to earnings surprise, and cost of capital.

This paper investigates a little studied but common mechanism that firms use to obtain state favors: business owners themselves seeking election to top office. Using Thailand as a research setting, we find that the more business owners rely on government concessions or the wealthier they are, the more likely they are to run for top office. Once in power, the market valuation of their firms increases dramatically. Surprisingly, the political power does not influence the financing strategies of their firms. Instead, business owners in top office use their policy-decision powers to implement regulations and public policies favorable to their firms. Such policies hinder not only domestic competitors but also foreign investors. As a result, these politically connected firms are able to capture more market share.

One can consider the concept of market neutrality for hedge funds as having breadth and depth: "breadth" reects the number of market risks to which a fund is neutral, while "depth" reects the "completeness" of the neutrality of the fund to market risks. We focus on market neutrality depth, and propose ve different neutrality concepts. "Mean neutrality" nests the standard correlation-based denition of neutrality. "Variance neutrality", "Value-at-Risk neutrality" and "tail neutrality" all relate to the neutrality of the risk of the hedge fund to market risks. Finally, "complete neutrality" corresponds to independence of the fund to market risks. We suggest statistical tests for each neutrality concept, and apply the tests to a combined database of monthly "market neutral" hedge fund returns from the HFR and TASS hedge fund databases. We nd that around one-quarter of these funds exhibit some signicant exposure to market risk.