Working Papers

All Working Papers from the Finance Department can be found online at the Social Science Research Network (SSRN).

Selected Working Papers

Portfolio Pumping, Trading Activity and Fund Performance
Sugato Bhattacharyya

This paper analyzes the investment decisions of fund managers who care about short-term performance as measured by the Net Asset Value (NAV) of the funds. Such a preference leads to excessive buying of securities as funds seek to increase the market values of securities they already own. In our model, the level of such inventory-related trading of a stock is independent of its liquidity characteristics and takes place even when the trading is not expected to generate a price impact in equilibrium. The extent to which a fund can affect its short-run NAV performance depends on the uncertainty outsiders have about its portfolio holdings. Managers are reluctant to reveal the details of their portfolios since it allows them to generate a better short-term performance, even when it hurts the payoffs received by long-term fund investors. The lack of transparency with regard to fund holdings can also impose costs on fund investors if strategic traders trade against the fund. Our model establishes that actively managed closed-end funds may trade at discounts to their measured NAVs, depending on the extent of managerial incentives to enhance short-term values. A contract that rewards managers for short-term performance is not necessarily suboptimal, however, and some conditions under which such a contract would be optimal are discussed.

Why Do Firms Use Private Equity to Opt Out of Public Markets?
Sreedhar T. Bharath and Amy K. Dittmar

We investigate how firms weigh the costs and benefits of being public in the decision to opt out of the public market and go private. We draw on previous studies of going private and on the subsequent well developed theoretical literature on why firms go public to develop our hypotheses. We employ a comprehensive sample of going private transactions from 1980-2004 in the U.S. and examine how these firms differ over their public life (from IPO to going private) relative to a sample of firms that went and remained public. Our results provide strong support for the importance of information and liquidity considerations in being a public firm. Access to capital and control considerations become increasingly important over the public life of the firm. We also find that the information and liquidity factors that drive the firms to go private are evident at the initial public offering, on average thirteen years before the going private decision.

Investment-based expected stock returns (Sept. '07)
Lu Zhang, Laura Xiaolei Liu, and Toni M. Whited

The neoclassical q-theory provides a good start to understanding the cross section of returns. Under constant return to scale stock returns equal levered investment returns, which are tied directly to firm characteristics. This equation predicts the empirical relations of average returns with book-to-market, investment, and earnings surprises. We estimate the model via GMM by minimizing the differences between average stock returns and average levered investment returns. Our model captures the average return patterns in portfolios sorted on capital investment and double-sorted on size and book-to-market, including the small-stock value premium. The model also partially captures post-earnings-announcement drift and its higher magnitude in small firms.

Corporate Hedging, Investment and Value
J. Berrospide, Amiyatosh Purnanandam and Uday Rajan

We consider the effect of hedging with foreign currency derivatives on Brazilian firms in the period 1997 through 2004, a period that includes the Brazilian currency crisis of 1999. We find that, derivative users have valuations that are 6.7-7.8% higher than non-user firms. Hedging with currency derivatives allows firms to sustain larger capital investments, and also removes the sensitivity of investment to internally generated funds. Thus, it mitigates the underinvestment friction of Froot, Scharfstein, and Stein (1993), at a time when capital in the economy as a whole is scarce. We further show that hedging increases the foreign currency debt capacity of a firm, and that foreign debt is a cheaper source of capital than domestic debt during our period of study.

Prospect Theory and Market Liquidity
Paolo Pasquariello

We study equilibrium trading strategies, market liquidity, and price efficiency in an economy in which a fraction of better-informed speculators displays preferences consistent with Kahneman and Tversky's (1979) Prospect Theory, i.e., loss aversion, risk seeking over losses, and nonlinear and asymmetric probability weighting (in the spirit of Jullien and Salanie', 2000). Loss aversion induces those speculators to trade more cautiously, while risk seeking induces them to trade more aggressively, with their private signals. We demonstrate that the latter effect dominates the former in equilibrium, leading to lower and (because of procyclical subjective loss probabilities) countercyclical adverse selection-based market liquidity and higher price efficiency. We also find that the presence of those speculators affects the extent to which the release of public news about the traded asset's terminal payoff improves market liquidity and price efficiency and makes such improvement procyclical.

Learning by Trading
Amit Seru, Tyler Shumway, Noah Stoffman

We test whether investors learn from their trading experience. Using a large sample of individual
investor records over a nine-year period, we estimate both the disposition effect and average trading performance at the individual level. We find that disposition is costly, in that a median investor who suffers from the effect earns 3.2 percent to 5.7 percent lower annual returns on average than an investor with no disposition. We also find that disposition falls and performance improves as investors become more experienced. An extra year of trading experience decreases the disposition effect of a median investor by about 7 percent, and explains about 4 percent of the increase in returns earned by these investors, even after controlling for survivorship bias and unobserved time-invariant individual heterogeneity. In addition, we find that unsophisticated investors, investors who trade more and investors who start out earning consistently poor returns learn faster.

Employee capitalism or corporate socialism? Broad-based employee stock ownership
E. Han Kim and Paige Ouimet

Adopting employee share ownership (ESO) plans leads to an increase in firm value only when the plan is small, i.e., less than 5% of outstanding shares. When the plan is larger, there is no value gain. This inverse U-shaped relation between shareholder value and ESO size is robust to firm fixed effects and controls for possible selection biases. Large ESOP adoptions are followed by substantial increases in employee compensation, whereas small ESOPs show no such increases. Compensation increases are smaller when firms have high leverage, which also counteracts the value negating impact of large ESOPs. We conclude that the adoption of an ESOP is generally followed by performance gains, most of which accrue to employees (shareholders) when employees have substantial (small) control rights.

Interest Rates, Bond Premia and Monetary Policy
Francisco Palomino

A robust empirical fact about U.S. nominal interest rates is that they exhibit time-varying risk premia. In the last 20 years, the dynamics of these premia have shifted significantly. This paper provides a monetary-policy explanation for this change. Monetary policy in the United States has achieved greater credibility and, as a result, market participants require less compensation for holding financial assets exposed to inflation risk. This explanation is substantiated using a general equilibrium model with nominal rigidities and habit formation in preferences. Two monetary policy regimes are analyzed: discretion and commitment. The model implies that the inflation risk premia are always lower under commitment and, thus, expected excess returns on bonds are lower and may become negative. The model is calibrated to the U.S. economy and is found to be consistent with the recent facts on interest rate behavior and the greater macroeconomic stability observed during the period.

Is default risk negatively related to stock returns? (2007)
Amiyatosh Purnanandam and Sudheer Chava

In contrast to theoretical arguments suggesting a positive risk-return relationship, financially distressed stocks have delivered anomalously low returns during the post-1980 period. Given the high return volatility of high default risk stock portfolios, we argue that detecting the true default risk-return relationship using realized returns as a proxy for expected returns requires a much longer time-series of data. Extending the sample period back to 1953, we show that the economic magnitude of the distress anomaly decreases significantly during the period 1953-2006. There is no anomalous negative relationship between default risk and realized returns during 1953-1980 period. Further, a patient investor who buys and holds distressed stocks for five years, as against annual re-balancing, doesn't earn low abnormal returns in either pre- or post-1980 period. Using implied cost of capital computed from analysts forecasts as a measure of expected returns, we find an economically and statistically significant positive relationship between default risk and expected returns as predicted by the theory.