We show that if true returns are independently distributed and a manager fully reports gains but delays reporting losses, then reported returns will feature conditional serial correlation. We use conditional serial correlation as a measure of conditional return smoothing. We estimate conditional serial correlation in a large sample of hedge funds. We find that the probability of observing conditional serial correlation is related to the volatility and magnitude of investor cash flows, consistent with conditional return smoothing in response to the risk of capital flight. We also present evidence that conditional serial correlation is a leading indicator of fraud.

Two alternate hypotheses, the stable Paretian and mixture of normals, have been proposed to explain the observed thick-tailed distributions of futures price movements. The two hypotheses are tested by applying the stability-under-addition test of stable distribution parameters to twenty lengthy time series of changes in daily closing futures prices. Tests are conducted on both the original data series and randomized data. The results offer support for the mixture of normals hypothesis.

Corporate bond returns exhibit predictability in a manner consistent with efficient pricing. Many equity characteristics, such as accruals, standardized unexpected earnings, and idiosyncratic volatility, do not impact bond returns. Profitability and asset growth are negatively related to corporate bond returns. Because firms that are profitable or have high asset growth (and hence more collateral) should be less risky, with lower required returns, the evidence accords with the risk–reward paradigm. Past equity returns are positively related to bond returns, indicating that equities lead bonds. Cross-sectional bond return predictors generally do not provide materially high Sharpe ratios after accounting for trading costs.

A conditional asset pricing model with risk and uncertainty implies that the time-varying exposures of equity portfolios to the market and uncertainty factors carry positive risk premia. The empirical results from the size, book-to-market, momentum, and industry portfolios indicate that the conditional covariances of equity portfolios with market and uncertainty predict the time-series and cross-sectional variation in stock returns. We find that equity portfolios that are highly correlated with economic uncertainty proxied by the variance risk premium (VRP) carry a significant annualized 8% premium relative to portfolios that are minimally correlated with VRP.

Individual and institutional investors can trade German initial public equity offerings on an as-if/when-issued basis before the start of secondary trading. Using actual when-issued trades made by a sample of clients at a large German retail broker during 1999 and 2000, the paper documents that retail buyers consistently overpay for initial public offerings (IPOs) in the when-issued market relative to the immediate aftermarket. The observed willingness to overpay points to sentiment as a driver of retail trading decisions. Consistent with this interpretation and with sentiment affecting prices, IPOs that are aggressively bought by individuals in the when-issued market exhibit high first-day returns as well as poor aftermarket returns relative to benchmarks of similar stocks.

We show that firms with more illiquid real assets have a higher cost of capital. This effect is stronger when real illiquidity arises from lower within-industry acquisition activity. Real asset illiquidity increases the cost of capital more for firms that face more competition, have less access to external capital, or are closer to default, and for those facing negative demand shocks. The effect of real asset illiquidity is distinct from that of firms’ stock illiquidity or systematic liquidity risk. These results suggest that real asset illiquidity reduces firms’ operating flexibility and through this channel their cost of capital.

We test the relevance of technical and fundamental variables in forming currency portfolios. Carry, momentum, and value reversal all contribute to portfolio performance, whereas the real exchange rate and the current account do not. The resulting optimal portfolio produces out-of-sample returns that are not explained by risk and are valuable to diversified investors holding stocks and bonds. Exposure to currencies increases the Sharpe ratio of diversified portfolios by 0.5 on average, while reducing crash risk. We argue that besides risk, currency returns reflect the scarcity of speculative capital.

The form of the Pareto optimal general insurance contract has been investigated by Borch [5], Arrow [3], and Raviv [16]. This paper extends their work to the consideration of the optimal investment portfolio insurance contract. This is a contract whose payoff depends upon the investment performance of some specified portfolio of common stocks. Portfolio insurance differs from general insurance in two important ways. First, investment portfolio insurance lacks the property of stochastic independence between losses on different contracts which is characteristic of general insurance, and this has led some actuaries to question whether portfolio insurance contracts should be sold in view of the risks they pose for the solvency of insurance companies. Recent developments in the theory of option pricing suggest, however, that under certain assumptions an insurance company will be able to eliminate the risks associated with portfolio insurance contracts by following an appropriately defined investment strategy. Secondly, there exists a market for the pricing of investment risks, the securities market; and, under appropriate assumptions, the equilibrium price of portfolio insurance contracts may be determined without specification of the preferences of insurance companies. This permits consideration of insurance company preference functions to be dispensed with, in marked contrast to the earlier literature concerned with general insurance, which treats insurance company preferences symmetrically with those of the insurance purchaser. In addition, since the characteristics of the insured portfolio are known to the insurer, and the performance of the portfolio is beyond the control of the insured, portfolio insurance is not prone to the problems of adverse selection and moral hazard which are liable to arise in general insurance.

This study constructs a firm-level measure of large foreign ownership (LFO) and investigates its impact on stock return volatility in 31 emerging markets. We find a negative relationship between LFO and volatility, even after controlling for potential endogeneity and the impact of major domestic shareholders. This suggests a stabilizing role of LFO in emerging markets, which is consistent with previous suggestions in the literature on the strong commitments and potential monitoring role of large foreign shareholders. Overall, our study highlights the importance of recognizing the heterogeneity among foreign investors and the benefits of large foreign shareholders to emerging stock markets.

Using a large loan sample from 1990 to 2006, we examine why firms form new banking relationships. Small public firms that do not have existing relationships with large banks are more likely to form new banking relationships. On average, firms obtain higher loan amounts when they form new banking relationships, while small firms also experience an increase in sales growth, capital expenditure, leverage, analyst coverage, and public debt issuance subsequently. Our findings suggest that firms form new banking relationships to expand their access to credit and capital market services, and highlight an important cost of exclusive banking relationships.

The purpose of this paper is to compare a variety of approximation techniques for valuing contingent contracts when analytic solutions do not exist. The comparison is made with respect to the differences in both the approximation theory and the efficiency of the computation algorithms. The focus of the computational comparison is upon binomial and finite difference methods applied to option valuation models with one stochastic variable. However, many of the results would generalize to pricing corporate securities, and also to certain aspects of problems involving multiple stochastic variables.

We examine the extent to which investment opportunities and/or mispricing motivate equity issuance and contribute to post-issue stock underperformance. We decompose market-to-book ratios into misvaluation and growth option components and find that issuing firms are both overvalued and have greater growth opportunities relative to nonissuers. Firms with greater growth opportunities invest more in capital expenditures and research and development (R&D) after issuance but do not experience lower post-issue stock returns. In contrast, issuing firms with greater mispricing tend to decrease long-term debt and/or increase cash holdings and do earn lower returns. Our findings are consistent with behavioral explanations for post-issue stock price underperformance.

The FTC reported 22,517 corporate acquisitions during the 1960s compared with 7200 for the period, 1940–1959. The increased employment of this method of corporate growth has generated a number of studies explaining certain segments of the merger movement. Attempts have been made to explain why firms merge, how firms merge, and how mergers have affected subsequent performance of firms. Mergers have been described as consummated to avoid bankruptcy (for the acquired firm), to capitalize upon managerial inefficiencies, to gain from valuation discrepancies, to achieve portfolio diversification, and for synergistic purposes and many other reasons.

This paper is an event-time study of OTC stocks that listed on the New York Stock Exchange (NYSE) over the period 1966–1977. This period was chosen because it spans the introduction of the National Association of Securities Dealers Automatic Quotation (NASDAQ) communications system in the OTC market. In the pre-NASDAQ period, stocks, on average, earn significant positive abnormal returns in response to listing announcements. In the post-NASDAQ period, abnormal returns in response to listing announcements are statistically significantly lower than those for the pre-NASDAQ period. These results are consistent with the hypothesis that NASDAQ has reduced the benefits associated with listing on a major stock exchange. Additionally, in both the pre- and post- NASDAQ periods, stocks, on average, earn significant positive abnormal returns following the initial announcement of listing before listing actually occurs, and they earn significant negative returns immediately after listing. These anomalies are explored and the results are shown to be insensitive to variations in empirical methodology.

Previous empirical studies on the “rationality” of economic and financial forecasts generally test for generic properties such as bias or autocorrelated errors but provide only limited insight into the behavior behind inefficient forecasts. This paper tests for a specific form of forecast bias. In particular, we examine whether expert consensus forecasts of monthly economic releases are systematically biased toward the value of previous months’ releases. Such a bias would be consistent with the anchoring and adjustment heuristic described by Tversky and Kahneman (1974) or could arise from professional forecasters’ strategic incentives. We find broad-based and significant evidence for this form of bias, which in some cases results in sizable predictable forecast errors. To investigate whether market participants’ expectations are influenced by this bias, we examine interest rate reactions to economic news. We find that bond yields react only to the residual, or unpredictable, component of the forecast error and not to the component induced by anchoring, suggesting that expectations of market participants anticipate this bias embedded in expert forecasts.

Using a large sample of hedge fund manager characteristics, we provide one of the first comprehensive studies on the impact of manager characteristics, such as education and career concern, on hedge fund performances. We document differential ability among hedge fund managers in either generating risk-adjusted returns or running hedge funds as a business. In particular, we find that managers from higher-SAT (Scholastic Aptitude Test) undergraduate institutions tend to have higher raw and risk-adjusted returns, more inflows, and take fewer risks. Unlike mutual funds, we find a rather symmetric relation between hedge fund flows and past performance, and that hedge fund flows do not have a significant negative impact on future performance.

This paper provides further evidence of the holiday effect in stock returns and additional insight into the effect. This paper reports abnormally high returns on the trading day before holidays in all three of the major stock markets in the U.S.: the NYSE, AMEX, and NASDAQ. The holiday effect is also present in the U.K. and Japanese stock markets, even though each country has different holidays and institutional arrangements. This study finds that the holiday effects in the U.K. and Japanese stock markets are independent of the holiday effect in the U.S. stock market. Unlike the other seasonal patterns in stock returns, such as January and weekend effects, this investigation of size decile portfolios shows that the size effect is not present in mean returns on preholidays.

This study directly tests the ability of several competing methods to identify market buy and sell orders using intra-day quote and trade prices, and identifies factors that affect the accuracy of the methods. Lee and Ready's (1991) algorithm performs about the same as the tick test, but the performance of both methods is worse than expected. The results show that the use of either algorithm to classify trades can lead to significantly biased estimates of effective spreads and signed volume, but the tick test provides better estimates of effective spreads and signed volume than Lee and Ready's method.

This paper tests whether the persistence of the momentum and reversal effects is the result of idiosyncratic risk limiting arbitrage. Idiosyncratic risk deters arbitrage, regardless of the arbitrageur’s diversification. Reversal is prevalent only in high idiosyncratic risk stocks, suggesting that idiosyncratic risk limits arbitrage in reversal mispricing. This finding is robust to controls for transaction costs, informed trading, and systematic relations between idiosyncratic risk and subsequent returns. Momentum is not related to idiosyncratic risk. Momentum generates a smaller aggregate return than reversal, so the findings along with those in related studies suggest that transaction costs are sufficient to prevent arbitrageurs from eliminating momentum mispricing.

This paper analyzes the relationship between tax heterogeneity and the behavior of stock prices and trading volume around the ex-dividend day within an equilibrium framework. We conclude that, even in a world without transaction costs, the price drop on the ex-day need not be equal to the dividend amount. Our model accounts for the higher market trading volume around the ex-day, and shows this to be a function of tax heterogeneity among traders. We show that the volume of trade around the ex-day contains information about investors' tax preferences above and beyond the information contained in the ex-day price alone. Consistent with the model's predictions, our empirical analysis reveals that as the risk associated with the ex-dividend day increases, or tax heterogeneity decreases, trading volume decreases.