Can the degree of predictability found in data be explained by existing asset pricing models? We provide two theoretical upper bounds on the R2 of predictive regressions. Using data on the market portfolio and component portfolios, we find that the empirical R2s are significantly greater than the theoretical upper bounds. Our results suggest that the most promising direction for future research should aim to identify new state variables that are highly correlated with stock returns instead of seeking more elaborate stochastic discount factors.

We use variation in real estate prices as exogenous shocks to firms’ debt capacity to study the causal effect of financial flexibility on payout policy. We show that an increase in financial flexibility results in higher dividends, share repurchases, and payout flexibility. We find that a 1-standard-deviation increase in a firms’ collateral value results in 0.26- and 0.55-percentage-point increases in nondiscretionary and discretionary payouts, respectively. This effect is stronger for firms with few investment opportunities. Moreover, highly leveraged firms are more likely to cut dividends in response to a sharp decrease in their financial flexibility.

This paper analyzes the correspondence between arbitrage sector pricing efficiency and the short-term hedging costs and effectiveness of futures contracts. Reversals of initial contract mispricings by arbitrage sector trading leads to an important mispricing return component in the total return to hedge portfolios. The existence of the mispricing return has implications for initial hedge ratio selection, hedging effectiveness, and expected hedge return. The analysis is used to interpret the hedge ratio guidance and performance of short-term hedges between the Standard and Poor's 500 stock index futures contract and the underlying S&P 500 cash stock index portfolio over the 1982–1986 period.

The first part of this paper presents a general approach to valuing a financial institution's contracts when there is credit risk. The approach uses contingent claims pricing theory and is particularly appropriate for an off-balance sheet contract, such as a swap, that can have either a positive or a negative value to the counterparty. The second part of the paper extends the analysis by considering the problem, faced by bank supervisory authorities, of determining capital requirements for off-balance sheet contracts.

We construct a mortality table for U.S. public companies during 1985–2006. We find that the age-specific mortality rates of firms initially increase, peaking at age three, and then decrease with age, implying that the first 3 years of public life are critical. Financial intermediaries involved around the “public birth” of a firm (e.g., venture capitalists (VCs) and high-quality underwriters) are associated with lower firm mortality rates, sometimes for up to 7 years after the initial public offering (IPO). VCs reduce mortality rates more through natal financial care than through selection, whereas high-quality underwriters affect firm mortality more through selection.

Diversification and capital market theory in conjunction with investors' desire to quantify risk have caused the beta coefficient to receive considerable attention in recent finance literature. Results of empirical investigations of the stationarity of beta over time have been reported by Altman, Jacquillat, and Levasseur [1], Baesel [2], Blume [3], Levitz [5], and Levy [6]. Blume examined the longer-term stability of the beta coefficient, using monthly prices and successive seven-year periods, concluding that portfolio betas are very stable but individual security betas are highly unstable. Levy reported similar conclusions using weekly data and shorter-term estimates of beta; 52-week base periods; and 52-, 26-, and 13-week subsequent periods. Levitz also found portfolio betas to be stable using three-year base periods and one-year subsequent periods.

This paper is an analytic treatment of the abandonment decision in capital investment analysis. It provides a methodology which has application in obtaining better estimates for project value and risk.

We examine the relevance of informal contracting mechanisms for corporate innovation. Using social capital to capture the social costs imposed on opportunistic behavior by management, we report evidence that firms headquartered in states with higher levels of social capital are associated with more innovation. This result is more pronounced when employees are more susceptible to holdup (e.g., firms with low labor union coverage, firms located in states with weak legal protections for employees, and firms surrounded by few external employment opportunities) and when employees face higher levels of information asymmetry. Our study highlights the importance of informal contracts for innovation.

Advances in variance analysis permit the splitting of the total quadratic variation of a jump-diffusion process into upside and downside components. Recent studies establish that this decomposition enhances volatility predictions and highlight the upside/downside variance spread as a driver of the asymmetry in stock price distributions. To appraise the economic gain of this decomposition, we design a new and flexible option pricing model in which the underlying asset price exhibits distinct upside and downside semivariance dynamics driven by the model-free proxies of the variances. The new model outperforms common benchmarks, especially the alternative that splits the quadratic variation into diffusive and jump components.

I analyze the impact of competition on the risk premia of R&D ventures engaged in a multiple-stage patent race with technical and market uncertainty. After solving in closed form for the case of a two-stage race in continuous time, I show that a firm's risk premium decreases as a consequence of technical progress and increases when a rival pulls ahead. Compared to the case where firms collude, R&D competition erodes the option value to mothball a project, reduces the completion time and the failure rate of R&D, and causes higher and more volatile risk premia. Numerical simulations reveal that competition can generate risk premia up to 500 annual basis points higher and up to three times more volatility than in a collusive industry.

Investment decision making under conditions of uncertainty, and in particular portfolio selection, is carried out mainly in the Mean-Variance framework which has been developed by Markowitz [29], [30] and Tobin [42]. By assuming the lending and borrowing of money at a given riskless interest rate, Sharpe [39], [40], Lintner [27], [28], Mossin [34], and others derived and extended the Capital Asset Pricing Model, under which an equilibrium price of each risky asset is determined. However, though the mean variance rule is quite convenient to apply, its limitations are well known, i.e., one must assume either normal probability distributions with risk aversion or quadratic utility functions.

This article presents a unique test of the effectiveness of technical analysis in different sentiment environments by focusing on its usage by perhaps the most sophisticated and astute investors, namely, hedge fund managers. We document that during high-sentiment periods, hedge funds using technical analysis exhibit higher performance, lower risk, and superior market-timing ability than nonusers. The advantages of using technical analysis disappear or even reverse in low-sentiment periods. Our findings are consistent with the view that technical analysis is relatively more useful in high-sentiment periods with larger mispricing, which cannot be fully exploited by arbitrage activities because of short-sale impediments.

A family of jump process models is derived by applying Gauss-Hermite quadrature to the recursive integration problem presented by a compound option model. The result is jump processes of any order with known efficiency properties in valuing options. In addition, these processes arise in the replication of options over finite periods of time with two or more assets where they again have known efficiency properties. A “sharpened” trinomial process is designed that accounts for the first-derivative discontinuity in option valuation functions at critical exercise points. It is shown to have accuracy superior to that of conventional binomial and trinomial processes and is nearly identical to the trinomial process optimized by Boyle (1988) through trial and error.

This paper examines trading volume on the Tokyo Stock Exchange. Traditional theory suggests that taxes create strong incentives to delay realization of capital gains and accelerate realization of losses. Contrary to the theory, we find strong evidence that turnover is higher for stocks with gains (winners) than for stocks with losses (losers). In particular, the winner stocks of keiretsu firms tend to have high end-of-fiscal-year turnover. This is true even when realizing gains could result in higher tax liabilities. We conclude that capital gains taxes have only a small impact on turnover in Japan. Other non-tax-related motives, especially window dressing, appear to dominate investor behavior. We find strong evidence that this window dressing is concentrated in the stock of keiretsu firms.

The Markowitz model for the efficient diversification of investments [12] has, over the years since its original formulation, provided the basis for many investigations into the question of portfolio selection. Amongst the more notable contributions to the theory are the works of Fama [6] and Mandelbrot [11], Smith [17], Latané [10], Arditti [1], and Blume [2].

Short sellers are known to have private information about security prices. Empirical evidence of short selling, however, is based on only half of short sellers’ trading activity; specifically, the opening of the position. Using disclosed large-short-position data from the Japanese stock market, we provide the first detailed evidence of covering trades and find a positive reaction to short covering that only partially reverses. Although these results are consistent with substantial transaction costs for closing large short positions, they also reveal that some short sellers are privately informed about positive future events and have timing ability in covering positions.

An approximate method is developed for computing the values of European options on the maximum or the minimum of several assets. The method is very fast and is accurate for parameter ranges that are often of the most interest. The approach casts the problem in terms of order statistics and can be used to handle situations where the initial asset prices, the asset variances, and the covariances are all unequal. Numerical values are given to illustrate the accuracy of the method.

Do threats of pharmaceutical price regulation affect subsequent research and development (R&D) spending? This study uses the Clinton administration’s Health Security Act (HSA) of 1993 as a natural experiment to study this issue. We link events surrounding the HSA to pharmaceutical stock price changes and then examine the cross-sectional relation between firms’ stock price changes and their subsequent unexpected R&D spending changes. Results show that the HSA had significant negative effects on stock prices and firm-level R&D spending. Conservatively, the HSA reduced R&D spending by about $1 billion even though it never became law.

This paper examines cash management bill announcements in an event study framework and finds that segmentation in the Treasury bill market is widespread and not limited to bills maturing across month-ends. Announcements of cash management bills, which represent unexpected additional supplies of outstanding Treasury bills, cause the yields on these bills to rise significantly relative to yields on adjacent maturity bills. This paper also finds, consistent with other studies, that segmentation is greater at the short end of the bill market.

This paper tests the null hypothesis of no difference in the probability of a trade occurring at the ask using a new database containing intraday bid-ask quotes and transaction prices on both U.S. and Canadian Exchanges. We use LOGIT analysis to test the hypothesis across days of the week, price-stratified portfolios, and times of the day. We find systematic patterns in the probability of a trade at the ask resembling previously documented returns anomalies and conclude that the findings of previous weekend and intraday returns studies may be overstated. The significance of this conclusion substantially increases as one moves from the use of interday to intraday data.