WORKING PAPER ABSTRACTS - 2009
Listed below are the abstracts for all of the working papers for this year. To see a list of paper titles (with links to available PDF files) click here.
Spending rules often guide institutions in determining the annual expenditures from their endowments. A typical rule is five percent of some measure of the value of the endowment. That many institutions utilize the same type of spending rule suggests that these institutions set their spending rules independent of their investment strategy. This paper argues that for many institutions the spending rule and the investment strategy needed to be determined simultaneously. The key to understanding this simultaneity is the institution’s willingness to reduce its endowment expenditures when the endowment drops in value. As an institution becomes more reluctant to reduce its expenditures in bad times, the need to set both its spending rule and investment strategy simultaneously increases. One practical implication is that even if an institution believes, for instance, that the returns of a particular class of assets, like equities, will be greater over the long run than the returns of other asses, that institution may still chose to hold a portfolio diversified over equities and other assets – despite the smaller long-run return.
We propose and illustrate a structural model for the forward curve produced by Eurodollar futures contracts. Our model provides a three-part functional decomposition of the forward rate: a long-term, unconditional component, a maturity-specific component, and a date-specific component. The maturity-specific component captures preferred investment habitats, and the date-specific component captures shocks to expectations of future spot rates. These functional components (modeled with exponential basis functions) of the decomposition aggregate to an arbitrage-free representation of the underlying stochastic process that drives the evolution of the Eurodollar forward curve. We demonstrate the use of this approach by fitting this model to yields over the period 12/9/19981 to 1/28/2008. The estimation is accomplished by using a Kalman filter to determine the underlying representation. The estimated yield curve provides better out-of-sample predictions than the standard random walk model in forecasts over various horizons. We further show the profitability of a trading scheme that chooses futures positions based upon the anticipated forward curve.
Conspicuous Consumption and Race
Using nationally representative data on consumption, we show that Blacks and Hispanics devote larger shares of their expenditure bundles to visible goods (clothing, jewelry, and cars) than do comparable Whites. These differences exist among virtually all sub-populations, are relatively constant over time, and are economically large. While racial differences in utility preference parameters might account for a portion of these consumption differences, we emphasize instead a model of status seeking in which conspicuous consumption is used as a costly indicator of a household’s economic position. Using merged data on race and state-level income, we demonstrate that a key prediction of the status-signaling model – that visible consumption should be declining in reference group income – is strongly borne out in the data for each racial group. Moreover, we show that accounting for differences in reference group income characteristics explains most of the racial difference in visible consumption.
Competition Among Ratings Agencies and Information Disclosure
The paper proposes an explanation for why a rating agency chooses to pool different credit risks in one rating class, and analyzes how information discloser depends of the value of information to the market. We show that an optimal disclosure policy of a monopoly rating agency is to pool companies or issuers in multiple rating classes and to have partial market coverage. It provides an opportunity for market entry. We then describe the potential market and the strategy of the entrant. We find that entry of an identical rating agency results in asymmetric rating scales. It justifies why some companies obtain multiple ratings and suggest that similar ratings from different agencies may mean different credit risks. We use Standard and Poor’s entry in to the market for insurance ratings – a market that was previously covered by the monopolist agency the A.M. Best Company – to empirically test the qualitative predictions of the model regarding the impact of competition on the information content of ratings.
Asset prices both affect and reflect real decisions. This paper provides evidence of this two-way relationship in the takeover market. We find that a firm’s discount to its potential value significantly attracts takeovers (the “trigger effect”) – but market expectations of an acquisition cause the discount to shrink (the “anticipation effect”). By controlling for the simultaneous anticipation effect, we document a markedly stronger trigger effect from prices to takeover probabilities than prior literature – an inter-quartile change in the discount leads to a 4 percentage point increase in acquisition likelihood (compared to a 6% unconditional takeover probability). This implies that financial markets may discipline managerial agency by triggering takeover threats, but the anticipation effect reduces the effectiveness of this process.
Stock market excess returns are significantly higher on days when the government is scheduled to announce inflation statistics, unemployment statistics, and interest rate decisions. The average announcement day excess return from 1958 to 2007 is 10.6 basis points versus 1.4 basis points for all the other days. In contrast, the risk-free rate is detectably lower on announcement days, consistent with a precautionary saving motive. We show that a simple equilibrium model with deterministically varying aggregate risk can generate higher risk premia and lower risk-free rates around announcements. Our results demonstrate the required trade-off between macroeconomic risk and asset returns, and provide an estimate of the premium investors demand to bear this risk.
Recurrent intervals of inattention to the stock market are optimal if consumers incur a utility cost to observe asset values. When consumers observe the value of their wealth, they decide whether to transfer funds between a transactions account from which consumption must be financed and an investment portfolio of equity and riskless bonds. Transfers of funds are subject to a transactions cost that reduces wealth and consists of two components: one is proportional to the amount of assets transferred, and the other is a fixed resource cost. Because it is costly to transfer funds, the consumer may choose not to transfer any funds on a particular observation date. In general, the optimal adjustment rule—including the size and direction of transfers, and the time of the next observation—is state-dependent. Surprisingly, unless the fixed resource cost of transferring funds is large, the consumer’s optimal behavior eventually evolves to a situation with a purely time-dependent rule with a constant interval of time between observations. This interval of time can be substantial even for tiny observation costs. When this situation is attained, the standard consumption Euler equation holds between observation dates if the consumer is sufficiently risk averse.
We identify a ‘slope’ factor in exchange rates. High interest rate currencies load more on this slope factor than low interest rate currencies. As a result, this factor can account for most of the cross-sectional variation in average excess returns between high and low interest rate currencies. A standard, no-arbitrage model of interest rates with two factors - a country- specific factor and a global factor - can replicate these findings, provided there is sufficient heterogeneity in exposure to the global risk factor. We show that our slope factor is global risk factor. By investing in high interest rate currencies and borrowing in low interest rate currencies, US investors load up on global risk, particularly during bad times.
Are there skill differences in mergers and acquisitions? To investigate this question, we focus on persistence in the performance of corporate acquirers, finding significant evidence at the firm level. Persistence may be due to skill differences across either entire corporations or specific executives. We find persistence only when successive deals occur under the same CEO, not when the CEO changes. We conclude that skill differences in acquisitions reside with the CEO, not with the firm as a whole. These differences are economically meaningful. An acquirer that was successful in its last deal and kept its CEO earns, on average, 1.02% more on its next deal than does a previously-unsuccessful firm that also kept its CEO. This percentage difference is equivalent to a $175 million difference in value creation for the shareholders of an average-sized bidder.
Contracts in a dynamic model must address a number of issues absent from static frameworks. Shocks to firm value may weaken the incentive effects of securities given to the CEO (e.g. cause options to fall out of the money), and the impact of some CEO actions may not be felt until far in the future. To address these concerns, we derive the optimal contract in a setting where the CEO can affect firm value through both productive effort or costly manipulation, and may undo the contract by privately saving. The efficient contract takes a surprisingly simple form, and can be implemented by a “Dynamic Incentive Account.” The CEO’s expected pay is escrowed into an account, a fraction of which is invested in the firm’s stock and the remainder in cash. The account features state-dependent rebalancing and time-dependent vesting. It is constantly rebalanced so that the equity fraction remains above a certain threshold; this threshold sensitivity is typically increasing over time even in the absence of career concerns. The account vests gradually both during the CEO’s employment and after he quits, to deter short-termist actions before retirement.
This paper identifies a broad class of situations in which the contract is both attainable in closed form and “detail-neutral”. The contract’s functional form is independent of the noise distribution and reservation utility; moreover, when the cost of effort is pecuniary, the contract is linear in output regardless of the agent’s utility function. Our contract holds in both continuous time and a discrete-time, multi-period setting where action follows noise in each period. The tractable contracts of Holmstrom and Milgrom (1987) can thus be achieved in settings that do not require exponential utility, Gaussian noise or continuous time. Our results also suggest that incentive schemes need not depend on complex details of the particular setting, a number of which (e.g. agent’s risk aversion) are difficult for the principal to observe. The proof techniques use the notion of relative dispersion and subdifferentials to avoid relying on the first-order approach, and may be of methodological interest.
We document significant persistence in the average announcement returns to acquisitions advised by an investment bank. Advisors in the top quintile of returns over the past two years outperform the bottom quintile by 0.92% over the next two years, compared to a full-sample average return of 0.73%. Persistence continues to hold after controlling for the component of returns attributable to acquirer characteristics. These results suggest that advisors possess skill, and contrast earlier studies which use bank reputation and market share to measure advisor quality and find no link with returns. Our findings thus advocate a new measure of advisor quality – past performance. However, acquirers instead select banks based on market share, even though it is negatively associated with future performance. The publication of league tables based on value creation, rather than market share, may improve both clients’ selection decisions and advisors’ incentives to turn away bad deals.
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