This paper tests the influential hypothesis that irrational traders will be driven out of financial markets by trading losses. The paper’s main finding is that overconfident currency dealers are not driven out of the market. Dealers with extensive experience are neither more nor less overconfident than their junior colleagues. We set the stage for this investigation by providing evidence that currency dealers display two forms of overconfidence: They underestimate uncertainty, and they overestimate their professional success. This is notable because one might have expected the opposite: currency dealers face strong incentives for accuracy, they have access to comprehensive information, and they have extensive experience.

The basic idea behind the random walk hypothesis is that in a free competitive market the price currently quoted for a particular good or service should reflect all of the information available to participants in the market that influence its present price. To the extent that future conditions of the demand or supply are currently known, their effect on the current price should be properly taken into account.

We compare the volatility of 24-hour returns computed from the opening and closing prices of a diverse sample of Tokyo Stock Exchange (TSE) stocks. We find that volatility at the open is greater than volatility at the close only for the most actively traded TSE stocks. Daytime and overnight return covariances suggest that the volatility patterns are explained by the effect of implicit bid-ask spreads at the open and partial price adjustment at the close, both of which are related to the intensity of trading. Our results challenge the view that open-to-open returns are more volatile than close-to-close returns for stocks, in general, and are consistent with the hypothesis that TSE price limit rules have a significant impact on the dynamics of security prices.

This paper examines a dynamic production economy with incomplete information and shows that the set of myopic preferences, those that induce myopic decisions, depends on the representation of the information flow. For example, logarithmic preferences are nonmyopic when some of the economic state variables are unobservable. The analysis offers a broader definition of myopic behavior, termed “generalized myopia,” which is independent of the representation of the information flow. Allowing for any smooth concave utility function, logarithmic preferences endogenously emerge as necessary for generalized myopia in incomplete information economies; and when combined with restrictions on the information structure, they become sufficient.

We show that mutual funds employ portfolio strategies based on market sentiment. We build a proxy for the degree of a fund’s sentiment beta (or FSB). The low-FSB funds outperform high-FSB funds, even after controlling for standard risk factors and fund characteristics. This effect is sizable and delivers a net-of-risk performance of 3.8% per year. Funds with a lower FSB follow more idiosyncratic strategies, suggesting that FSB is a deliberate, active choice of the fund manager. A sentiment contrarian strategy leads to high flows due to its superior performance, whereas a sentiment catering strategy fails to attract significant investor flows.

The literature suggests two competing explanations for reincorporations: efforts at managerial entrenchment and attempts to improve contractual efficiency. The empirical evidence to date is inconclusive. To seek further evidence, we examine a large sample of firms that changed their state of incorporation over the period 1980–1992. We find that shareholder wealth is decreased by reincorporations that erect takeover defenses, but is increased by reincorporations that establish limits on director liability. Firms that claim they reincorporate to limit the personal liability of their board members and thereby attract better qualified outside directors do, in fact, expand the outside representation on their boards, whereas firms citing other motives do not.

This paper assesses the selection and timing abilities of 130 equity mutual funds using a conditional APT model with specified macrofactors, and time-varying risk premia and betas. For all fund categories based on investment objectives, a significant proportion of the funds exhibits negative abnormal asset selection performance based on the unconditional Jensen (1968) alpha, and a reduced proportion of the funds in each category attempts to time the realizations of the macrofactors (including those captured by the residual market factor). The average selection performance of the mutual funds improves and the proportion of funds attempting to time macrofactor realizations declines when measured using the asset selection and factor-timing models with time-varying risk premia and betas.

Firms whose human capital is concentrated in a few irreplaceable employees lack diversification in their human capital stock, exposing them to key human capital risk. Using disclosures of “key man life insurance” to measure this risk, we show that exposed firms are riskier. These younger, smaller, growth firms have abnormally high volatility, and following announcement of key employee departures, the most exposed firms lose 8% of their value. Key employees tend to be highly educated. They are four times more likely to hold PhD degrees than top managers, and firms with key human capital are more innovative.

We use an exogenous event, namely, the spillover effects of Hurricane Katrina on corporate bonds through the liquidation of bond holdings by insurance companies, to study how companies react to temporary changes in the relative availability of bond and bank financing. We find that the negative shock on bonds induces firms to shift from bond financing to bank-based borrowing and to shorten the debt maturity. This shift in debt policy does not revert in the long term. There is no significant change in capital structure, suggesting that the substitution from bonds to bank loans is sufficient for the amount of borrowing.

After Lehman’s collapse in 2008, investors ran from risky money market funds. In 27 funds, outflows overwhelmed cash inflows, thus forcing asset sales. These funds sold their safest and most liquid holdings. Funds were thus left with riskier and longer maturity assets. Over the subsequent quarter, however, the hard-hit funds reduced risk more than other funds. In contrast, money funds hit by idiosyncratic liquidity shocks before Lehman did not alter portfolio risk. The result suggests that moral hazard concerns with the Treasury Guarantee of investor claims did not increase risk taking. Funds that benefited most from the government bailout reduced risk.

For firms that adopted economic profit plans between 1983 and 1996, we document changes in investment behavior that lead to improvements in operating performance and growth opportunities relative to these firms' past performance. The improvements, however, are similar to those realized by a set of non-adopting control firms that are selected on the basis of a logistic regression model of adoption choice. We then consider the possibility that some firms are better candidates for economic profit plans than others and classify adopters according to whether they make anticipated or surprising choices based on the adoption choice model. We find that anticipated adopters make changes in investment behavior that reduce invested capital and allow them to become more profitable than a sample of control firms that were expected to adopt but chose to continue using a traditional plan. A similar analysis of surprise adopters does not reveal significant performance differences relative to a sample of anticipated non-adopters. The classification analysis suggests that economic profit plans work best for firms that are expected to adopt such plans based on pre-adoption operating, organizational, financial, and compensation characteristics.

Most of the recent empirical tests of the Black-Scholes option-pricing formula have been joint tests of three types of hypotheses:

1) mathematical structure of the formula,

2) measurement of formula inputs and outputs, and

3) the efficiency of the listed option market.

The model presented here shows that extreme uncertainty between an entrepreneur and potential investors can lead to the exclusive use of equity and riskless debt for small business financing. The paper derives these results without any restrictions on the available contract space, the distribution function governing a project's payoff, or the risk aversion of most potential entrepreneurs. In addition, the model produces predictions regarding the “under-pricing”; of securities to outside financiers, the order in which firms will issue securities, and the relationship between the types of securities a firm will issue and its available collateral.

This study tests whether belief differences affect the cross-sectional variation of risk-neutral skewness using data on firm-level stock options traded on the Chicago Board Options Exchange from 2003 to 2006. We find that stocks with greater belief differences have more negative skews, even after controlling for systematic risk and other firm-level variables known to affect skewness. Factor analysis identifies latent variables linked to risk and belief differences. The belief factor explains more variation in the risk-neutral skewness than the risk-based factor. Our results suggest that belief differences may be one of the unexplained firm-specific components affecting skewness.

We examine how analysts establish target prices for IPO firms and whether comparable firms used to support target prices are helpful in explaining IPO offer prices. During the bubble period of 1999 to 2000, the average offer price was set at a discount relative to comparable firm valuations. In contrast, the average offer price was set at a small premium relative to comparables in the pre-bubble period. This shift appears to hold even after controlling for the differences in the types of firms going public during the bubble period. Moreover, target prices of IPO firms were set at a higher premium relative to comparables during the bubble period. While our results suggest that underwriters systematically discounted offer prices during the bubble period, an alternative explanation is that the shift arose because underwriters and analysts faced different incentives and legal exposures during the bubble period.

This paper investigates the relation between the form of compensation and the manager's decision horizon. It finds that while all-cash contracts induce managers to underinvest in the long term, all-stock contracts induce overinvestment in the long term. It shows that compensation contracts consisting of both cash and restricted stock can produce efficient investment, thereby providing a rationale for the existence of both cash and stock incentive schemes in executive compensation packages. This explains why the adoption of either type of incentive scheme results in a positive stock price reaction. In addition, the paper derives the following testable hypotheses: i) the proportion of the stock compensation is decreasing in the precision of the manager's ability and increasing in the precision of the firm's cash flows; ii) firms compensate their managers with proportionately more stock in profitable years and proportionately more cash in leaner years; and iii) the greater the growth opportunities, the higher the proportion of stock compensation.

In acquisitions, target chief executive officers (CEOs) face a moral hazard: Any personal gain from the deal could be offset by the loss of the future compensation stream associated with their jobs. Larger, more important parachutes provide greater relief for these losses. To explicitly measure the moral hazard target CEOs face, we standardize the parachute payment by the expected value of their acquisition-induced lost compensation. We examine 851 acquisitions from 1999–2007, finding that more important parachutes benefit target shareholders through higher completion probabilities. Conversely, as parachute importance increases, target shareholders receive lower takeover premia, while acquirer shareholders capture additional rents from target shareholders.

This paper examines the potential benefits of security fungibility by conducting the first comprehensive analysis of global bonds. Unlike other debt securities, global bonds' fungibility allows them to be placed simultaneously in bond markets around the world; they trade, clear, and settle efficiently within as well as across markets. We test the impact of issuing these securities on firms' cost of capital, issuing costs, liquidity, and shareholder wealth. Using a sample of 230 global bond issues by 94 companies from the U.S. and abroad over the period 1996–2003, we find that firms lower their cost of (debt) capital by issuing these fungible securities. We also document that the stock price reaction to the announcement of global bond issuance is positive and significant, while comparable domestic and eurobond issues over the same time period are associated with insignificant changes in shareholder wealth.

We use a proprietary data set to test the implications of several asymmetric information models on how short-lived private information affects trading strategies and liquidity provision. Our identification rests on information acquisition before analyst recommendations are publicly announced. We provide the first empirical evidence supporting theoretical predictions that early-informed traders “sell the news” after “buying the rumor.” Further, we find distinct profit-taking patterns across different classes of institutions. Uninformed institutions, but not individuals, emerge as de facto liquidity providers to better-informed institutions. Placebo tests confirm that these trading patterns are unique to situations in which some investors have a short-lived informational advantage.

This paper studies the diffusion of regional macroeconomic information into stock prices. I identify all U.S. states that are economically relevant for a company through textual analysis of annual reports and find that economic activity forecasts of company-relevant regions positively predict cross-sectional stock returns. Information arising from all relevant states is more important than that relating to the headquarter state alone. These forecasts also predict firms’ performance and earnings surprises, suggesting that the return predictability stems from future cash flows that are gradually reflected in prices. Finally, regional information takes longer to be incorporated into prices among difficult-to-arbitrage stocks.