A common dilemma faced by investors and portfolio managers is the tradeoff preference between risk and return. The general consensus and convention in finance and economics is that, in the aggregate, investors do not seek risk for its own sake. If so, it is reasonable to assume that returns on individual common stocks vary according to their risk. However, it is not the purpose of this paper to examine the ex post risk and return experience of various financial assets. This and related work have been treated by Sharpe [22] and by others. While some of these are studies of individual common stocks, the majority involves the ex post risk-return relationships of portfolios managed by institutional or professional investors. Although the conclusions are not totally consistent concerning the shape of the risk-return function, there is agreement that a generally positive relationship exists between risk and expected return. To date, little empiricism has been directed specifically to the ex ante risk-return preferences of individual common-stock investors. This paper takes a step in this direction by analyzing the ex ante risk-return preferences and expectations of individual common-stock investors. The purpose is two-fold: (1) to provide positive (as opposed to normative) evidence on the nature of the relationship between acceptable risk levels and expected annual rates of return; and (2) to examine the nature of this relationship between risk and the components of total return, income from dividends and capital appreciation.

The attempt to incorporate securities market imperfections other than proportional taxes within a mean-variance security valuation context has met with modest success. Lintner [5], however, has recently considered imperfections by the device of segmented markets. His paper has motivated the following taxonomy. Securities markets are defined as weakly segmented if some of the securities in at least one market are available to some investors but not to others, partially segmented if the sets containing both investors and available securities in each market are disjoint, and completely segmented if additionally the sets of firms in each market are disjoint. Segmented markets effectively relax the separation property of mean-variance equilibrium models (i.e., all investors, irrespective of differences in present wealth or preferences, divide their wealth between the same two mutual funds; one is risk-free and the other is the market portfolio of risky securities). This property unfortunately implies that each investor must hold a portion of every available risky security. This is empirically unrealistic, primarily due to restrictions on borrowing and shorting and scale economies in security analysis and brokerage. Moreover, even in the absence of these complications, ownership of nonmarketable assets, nonhomogeneous beliefs, or breakdown of the separation property due to tastes or nonnormality will motivate individuals to hold different risky portfolios. The device of segmented markets embodies in extreme form these obstacles to diversification and portfolio similarity.

This study investigates whether investors see through materially misstated earnings, and whether they anticipate earnings restatements. For firms that restate at least one annual report, we find that investors are misled by mistakes in reported earnings at the time of initial earnings announcements. Investors react positively to the component of the favorable earnings surprise that will subsequently be restated, and they attach the same valuation to it as to the true earnings surprise. We also find that investors anticipate the subsequent downward restatements and start marking stock prices down several months before a restatement announcement, so that the full impact of a restatement is about three times as large as the restatement announcement effect. Indeed, we show that investors punish restating firms because the stock price gains that shareholders enjoy when firms initially announce overstated earnings are more than reversed by the time of the restatement announcement.

We use high-frequency data to precisely estimate bond price reactions to macroeconomic announcements and the associated compensation for macro risks. We find evidence of a single factor summarizing the reaction of bond prices to different announcements. Before the financial crisis, the factor risk premium is substantial, significant, and mainly earned before announcement releases. After the crisis, the stock–bond covariance becomes negative and the preannouncement factor risk premium becomes insignificant. Our empirical results are consistent with information leakages that take place ahead of announcement releases and with the implications of a long-run risks model of bond risk premia.

We consider the estimation methods for the rank of a beta matrix corresponding to a multifactor model and study which method would be appropriate for data with a large number of assets. Our simulation results indicate that a restricted version of Cragg and Donald’s (1997) Bayesian information criterion estimator is quite reliable for such data. We use this estimator to analyze some selected asset pricing models with U.S. stock returns. Our results indicate that the beta matrix from many models fails to have full column rank, suggesting that risk premiums in these models are underidentified.

We examine the effects of chief executive officer (CEO) turnover in banks. Incoming bank CEOs face problems of information asymmetry because banks’ operations are opaque and bank risk can change dramatically in a short time. These CEOs may therefore change bank policies to manage their personal risks. Since CEO turnover is usually endogenous, we utilize a setting in which CEO turnover is based solely on retirement age and is thus exogenous to bank performance. Consistent with our thesis, incoming CEOs increase provisioning for future delinquencies and shrink lending. Bank stock prices decline following these changes. Politically motivated lending or ever-greening cannot explain our results.

Firms modify their payout policy in anticipation of future litigation costs. We examine a comprehensive sample of U.S. corporate lawsuits and find that firms facing significant litigation risk pay lower dividends, and in some cases omit dividends while distributing more cash through share repurchases. Litigation risk changes the distribution of payouts but not the total payout yield as the increase in share repurchases offsets the decrease in dividends. Cash-poor firms cut share repurchases when settlement costs are incurred. The results suggest that firms at a higher risk of litigation increase their payout flexibility.

Option pricing models and longer-term value-at-risk (VaR) models generally require volatility forecasts over horizons considerably longer than the data frequency. The typical recursive procedure for generating longer-term forecasts keeps the relative weights of recent and older observations the same for all forecast horizons. In contrast, we find that older observations are relatively more important in forecasting at longer horizons. We find that the Ederington and Guan (2005) model and a modified EGARCH (exponential generalized autoregressive conditional heteroskedastic) model in which parameter values vary with the forecast horizon forecast better out-of-sample than the GARCH (generalized autoregressive conditional heteroskedastic), EGARCH, and Glosten, Jagannathan, and Runkle (GJR) models across a wide variety of markets and forecast horizons.

This paper examines management’s motives for rejecting takeover bids and the associated shareholder wealth effects. We develop measures of initial bid quality and find a significant negative correlation between the quality of a bid and rejection. The likelihood of higher follow-on offers decreases with bid quality and is greater when targets have classified boards and chief executive officers (CEOs) with significant personal wealth tied to the transaction. Target CEOs who fail to close high-quality offers experience a significant rate of forced turnover. Overall, the results support a price improvement motive for contested bids.

If the “smart money” was out of Franklin before its financial difficulties became public knowledge, just what elements of Franklin's balance sheet were the sagacious analysts reading and why weren't the banking authorities aware of this information? The purpose of this paper is to determine what balance-sheet and income-statement figures, if any, could have been arrayed in an ex post early-warning system to spotlight Franklin's developing problems.

Formal models for portfolio analysis, such as Markowitz [13], are frequently based upon mean-variance analyses and involve the estimation of a mean vector and a variance-covariance matrix describing expected returns and variability of returns for all securities under consideration. These parameter estimates play a major role in the selection of a single, optimal portfolio. Kalymon [9] and Barry [1] have considered the effects of parameter uncertainty upon individual investors' inferences and decisions in the context of portfolio selection, and Barry and Winkler [2] have similarly considered the impact of nonstationary means upon portfolio selection decisions by individual investors.

Previous literature documents significant seasonalities in stock market returns. One explanation is seasonality in earnings information. If true, a return index comprised solely of firms reporting earnings should exhibit stronger intertemporal seasonalities than a return index comprised of firms not reporting earnings. Employing all New York and American Stock Exchange firms over six years, this study examines the seasonality of stock returns. Generally, seasonal patterns for reporting returns are found to be similar to or slightly weaker than for nonreporting returns. Thus, it is doubtful that earnings news seasonality induces stock return seasonality.

Numerous hedge funds stop reporting each year to commercial databases, wreaking havoc with analyzing investment strategies that incur the unobserved delisting return. We use estimated portfolio holdings for funds-of-funds to back out estimated hedge-fund delisting returns. For all exiting funds, the estimated mean delisting return is insignificantly different from the average monthly return for live hedge funds. However, funds with poor prior performance and no clearly stated delisting reason had a significantly negative estimated mean delisting return of -5.97%, suggesting that a shock to their returns “tips them over the edge” and leads to delisting.

We consider a broad class of dynamic portfolio optimization problems that allow for complex models of return predictability, transaction costs, trading constraints, and risk considerations. Determining an optimal policy in this general setting is almost always intractable. We propose a class of linear rebalancing rules and describe an efficient computational procedure to optimize with this class. We illustrate this method in the context of portfolio execution and show that it achieves near optimal performance. We consider another numerical example involving dynamic trading with mean-variance preferences and demonstrate that our method can result in economically large benefits.

The Securities and Exchange Commission (SEC) adopted Rule 605 (formerly Rule 11Ac1–5) on November 15, 2000. The Rule requires market centers to make monthly public disclosure of execution quality. The Rule is intended to achieve a more competitive and efficient national market system by increasing the visibility of execution quality. The effective and quoted spreads for our study sample of NYSE, AMEX, and NASDAQ stocks declined significantly after implementation of the Rule. The decline cannot be attributed to a secular trend in spreads, concurrent changes in stock attributes, or the effect of decimal pricing. Although the quoted depth of NYSE stocks also declined, overall market quality is higher after implementation of the Rule. Based on these results, we conclude that the SEC's goal to improve execution quality through more transparent markets has been achieved.

I test the Duffie, Gârleanu, and Pedersen hypothesis that security prices incorporate expected future securities lending income. To determine whether institutional investors anticipate gains from future lending of securities, I examine their trading behavior around loan-fee increases. The evidence suggests that institutions buy shares in response to an increase in lending fees, and that this could explain the premium associated with high-lending-fee stocks. Expected future lending income affects stock prices, although the effect seems to be attenuated by the negative information that arises from short selling.

This paper proposes modified versions of the Sharpe ratio and Jensen's alpha, which are appropriate in a simple continuous-time model. Both are derived from optimal portfolio selection. The modified Sharpe ratio equals the ordinary Sharpe ratio plus half of the volatility of the fund. The modified alpha also differs from the ordinary alpha by a second-moment adjustment. The modified and the ordinary Sharpe ratios may rank funds differently. In particular, if two funds have the same ordinary Sharpe ratio, then the one with the higher volatility will rank higher according to the modified Sharpe ratio. This is justified by the underlying dynamic portfolio theory. Unlike their discrete-time versions, the continuous-time performance measures take into account that it is optimal for investors to change the fractions of their wealth held in the fund vs. the riskless asset over time.

This paper provides a closed form solution for the value of a multiple claim insurance contract that is subject to a deductible amount and/or an upper limit on claims. The solution is a time integral of European option prices. The model provides three important insights. First, systematic risk in insurance policies is altered in the presence of deductibles and maximum indemnity levels. Second, idiosyncratic risk affects policy valuation and the required rates of return on underwriting portfolios. Finally, contrary to traditional actuarial intuition, changes in the risk-free interest rate may either increase or reduce policy values.

This study investigates whether the existence or strength of any misreaction in the options market is affected by investor sophistication and investor sentiment. Based on a unique data set of the complete history of all transactions in the Taiwan options market, we find that individual investors exhibit significant misreaction to information and that this misreaction becomes stronger during periods of high investor sentiment. In addition, more active or aggressive individual investors always exhibit misreaction and do not learn from their past mistakes. Our empirical results are robust to alternative measures of investor sentiment and definitions of long- and short-term horizons.

This paper provides the first theoretical explanation and the first empirical analysis of contingent value rights (CVRs), which have been used as a means of payment in acquisitions, exchange offers, debt restructurings, Chapter 11 reorganizations, and lawsuit settlements. A CVR is a put option committing to pay additional cash or securities to CVR holders, contingent on the issuer's share price falling below a prespecified reference level. In this paper, we develop a model to show that CVRs can help a higher-intrinsic-value firm to reveal its firm type when the firm faces an asymmetric information problem. Our model predicts that i) when CVRs are offered along with cash or stock, the announcement period abnormal stock return is greater than that in stock offers, ii) firms facing more severe asymmetric information problems are more likely to offer CVRs to signal their firm type, and iii) firms that are relatively more cash-constrained are more likely to offer CVRs rather than cash. We test all three predictions using a sample of mergers and acquisitions. Our empirical results are consistent with the predictions of the model.