Knowledge that Transforms

This paper examines the costs and benefits of the EU/IMF rescue package for Ireland, on November 29, 2010. We analyze the costs of the intervention and the subsequent increase in value of debt and/or equity issued by Irish banks, the Irish government, and European banks with substantial holdings of Irish debt. The total initial value increase around the announcement amounts to €5.59bln at a realized taxpayers’ cost of €4.23bln. While the value increase depends on somewhat generous assumptions, it further increases by €2.8bln up to Ireland’s exit in December 2013. About €3.1bln of the value created indirectly supports the European banking sector, indicating that substantial benefits arise from systemic risk containment.

As a consequence of the 2008 financial crisis, the Australian regulator mandated daily reporting and disclosure of both short flow and short interest at an individual stock level. This provides a unique opportunity to study the nature and source of information embedded in each metric. Our empirical findings are consistent with short sellers being heterogeneous with respect to their information. Short flow is strongly related to recent returns and buy-order imbalance, and both anticipates and reacts to price-relevant announcements. In contrast, short interest is related to the mispricing of firm fundamentals. The distinct differences in the nature of information embedded in the two metrics provide an economic rationale for both the unique ability of each metric to predict returns and the future horizons over which the information is relevant.

We study association between macroeconomic news and stock market returns using the statistical theory of copulas, and a new comprehensive measure of news based on textual review and classification of news wires. We find the impact of economic news on equity returns to be nonlinear and asymmetric. In particular, controlling for economic conditions and surprises associated with releases of economic data, we find that the market reacts strongly and negatively to the most unfavourable macroeconomic news, but appears to largely discount the good news. Further, the most-unfavorable news creates price drift, and we document that selling stocks short in the wake of unusually-bad news yields annual abnormal gross returns greater than four percent.

In this study, we propose a new semi-nonparametric (SNP) density model for describing the density of portfolio returns. This distribution, which we refer to as the multivariate moments expansion (MME), admits any non-Gaussian (multivariate) distribution as its basis because it is specified directly in terms of the basis density’s moments. To obtain the expansion of the Gaussian density, the MME is a reformulation of the multivariate Gram–Charlier (MGC), but the MME is much simpler and tractable than the MGC when positive transformations are used to produce well-defined densities. As an empirical application, we extend the dynamic conditional equicorrelation (DECO) model to an SNP framework using the MME. The resulting model is parameterized in a feasible manner to admit two-stage consistent estimation and it represents the DECO as well as the salient non-Gaussian features of portfolio return distributions. The in- and out-of-sample performance of a MME–DECO model of a portfolio of 10 assets demonstrate that it can be a useful tool for risk management purposes.

We analyze the optimal portfolio policy for a multiperiod mean–variance investor facing multiple risky assets in the presence of general transaction costs. For proportional transaction costs, we give a closed-form expression for a no-trade region, shaped as a multi-dimensional parallelogram, and show how the optimal portfolio policy can be efficiently computed for many risky assets by solving a single quadratic program. For market impact costs, we show that at each period it is optimal to trade to the boundary of a state-dependent rebalancing region. Finally, we show empirically that the losses associated with ignoring transaction costs and behaving myopically may be large.

We provide evidence that sophisticated investors like short sellers, option traders, and financial institutions are more informed when trading stocks of companies with more connected board members. For firms with large director networks, the annualized return difference between the highest and lowest quintile of informed trading ranges from 4% to 7.2% compared to the same return difference in firms with less connected directors. Sophisticated investors better predict outcomes of upcoming earnings surprises and firm-specific news sentiment for companies with more connected directors. Changes in board connectedness are positively associated with changes in measures of adverse selection.

We examine whether directors׳ and officers׳ (D&O) liability insurance affects a firm’s cost of equity. We find a positive association between D&O insurance and the cost of equity. Information quality and risk-taking appear to be two underlying channels through which D&O insurance affects the cost of equity. Further tests suggest that this positive association is not due to optimal risk-taking, as evidenced by a negative market reaction to an increase in D&O insurance coverage, a lack of improvement in firms׳ cash flow and a low valuation associated with high D&O insurance. Overall, our evidence is consistent with the notion that D&O insurance weakens the disciplining effect of shareholder litigation, leading to an increase in the cost of equity.

Economic theory suggests that the industry-wide component of firm performance is more persistent than the firm-specific component. This paper provides evidence on this assertion and tests whether investors misprice these components of earnings. Consistent with predictions, we find greater persistence in the industry-wide component of earnings that is not fully recognized in stock prices. We show that these effects are partially driven by the market׳s inability to recognize the differential persistence of industry-wide earnings in homogenous industries or in the presence of a large business shock. Finally, we show that industry-wide cash flows is the most persistent component of earnings while firm-specific accruals is the least persistent, suggesting that economic fundamentals and accounting constructs are jointly informative about firms׳ future earnings. The market predictably misprices these components, however, significantly underweighting the persistence of industry-wide cash flows and overweighting the persistence of firm-specific accruals.

We argue that conservatism improves investment efficiency. In particular, we predict that it resolves debt-equity conflicts, facilitating a firm׳s access to debt financing and limiting underinvestment. This permits the financing of prudent investments that otherwise might not be pursued. Our empirical results confirm these predictions. We find that more conservative firms invest more and issue more debt in settings prone to underinvestment and that these effects are more pronounced in firms characterized by greater information asymmetries. We also find that conservatism is associated with reduced overinvestment, even for opaque investments such as research and development.

We identify connected auditors as those who attended the same university as the executives of their clients. Using manually collected data from China, we find that connected auditors are more likely to issue favorable audit opinions, especially for financially distressed clients. Moreover, companies audited by connected auditors report significantly higher discretionary accruals, are more likely to subsequently restate earnings downward, and have lower earnings response coefficients. Lastly, connected auditors earn higher audit fees. Collectively, our evidence suggests the impairment of audit quality when auditors and client executives have school ties and the presence of social reciprocity derived from school ties.