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WORKING PAPER ABSTRACTS - 2011

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.

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01-11 (Revised 10-08)
Are stocks really Less Volative in the Long Run?
Lubos Pastor and
Robert F. Stambaugh

According to conventional wisdom, annualized volatility of stock returns is lower when computed over long horizons than over short horizons, due to mean reversion induced by return predictability. In contrast, we find that stocks are substantiallymore volatile over long horizons from an investor’s perspective. This perspective recognizes that parameters are uncertain, even with two centuries of data, and that observable predictors imperfectly deliver the conditional expected return. Mean reversion contributes strongly to reducing long-horizon variance, but it is more than offset by various uncertainties faced by the investor, especially uncertainty about the expected return. The same uncertainties also make target-date funds undesirable to a class of investors who would otherwise find them appealing.

02-11 (Revised 01-09)

On the Size of the Active Management Industry
Lubos Pastor and Robert F. Stambaugh

We argue that the popularity of active management is not puzzling despite the industry’s poor track record. Our model features decreasing returns to scale: as the industry’s size increases, every manager’s ability to outperform passive benchmarks declines. We find that the active management industry can remain large even after significantly negative underperformance. Given the observed performance of active mutual funds, investors’ proportional allocation to active management should have shrunk only modestly since 1962. We also find investors face endogeneity that limits their learning about returns to scale and allows prolonged departures of the industry’s size from its optimal level.

03-11

The Short of It: Investor Sentiment and Anomalies
Robert Stambaugh, Jianfeng Yu and Yu Yuan

This study explores the role of investor sentiment in a broad set of anomalies in cross-sectional stock returns. We consider a setting where the presence of market- wide sentiment is combined with the argument that overpricing should be more preva lent than underpricing, due to short-sale impediments. Long-short strategies that exploit the anomalies exhibit profits consistent with this setting. First, each anomaly is stronger—its long-short strategy is more profitable—following high levels of sentiment. Second, the short leg of each strategy is more profitable following high sentiment. Finally, sentiment exhibits no relation to returns on the long legs of the strategies.

04-11

Trading Frenzies and Their Impact on Real Investment
Itay Goldstein, Emre Ozdenoren and Kathy Yuan

We study a model where a capital provider learns from the price of a firm’s security in deciding how much capital to provide for new investment. This feedback effect from the financial market to the investment decision gives rise to trading frenzies, where speculators all wish to trade like others, generating large pressure on prices. Coordination among speculators is sometimes desirable for price nformativeness and investment efficiency, but speculators’ incentives push in the opposite direction, so that they coordinate exactly when it is undesirable. We analyze the effect of various market parameters on the likelihood of trading frenzies to arise

05-11

Government Intervention and Information Aggregation
Philip Bond and Itay Goldstein

Market prices are thought to contain a lot of useful information. Hence, regulators (and other agents) are often urged to use market prices to guide decisions. An important issue to consider is the endogeneity of market prices and how they are affected by the prospect of government intervention. We show that if the government learns from the price when
taking a corrective action, it might reduce the incentives of speculators to trade on their information, and hence reduce price informativeness. We show that transparency may reduce trading incentives and price informativeness further. Diametrically opposite implications hold for the alternative case in which the government’s action amplifies the effect of underlying fundamentals. We derive implications for the optimal use of market information and for the government’s incentives to produce its own information.

06-11

Self Fulfilling Credit Market Freezes
Lucian A. Bebchuk and Itay Goldstein

This paper develops a model of a self-fulfilling credit market freeze and uses it to study alternative governmental responses to such a crisis. We study an economy in which operating firms are interdependent, with their success depending on the ability of other operating firms to obtain financing. In such an economy, an inefficient credit market freeze may arise in which banks abstain from lending to operating firms with
good projects because of their self-fulfilling expectations that other banks will not be making such loans. Our model enables us to study the effectiveness of alternative measures for getting an economy out of an inefficient credit market freeze. In particular, we study the effectiveness of interest rate cuts, infusion of capital into banks, direct lending to operating firms by the government, and the provision of government capital or
guarantees to finance or encourage privately managed lending. Our analysis provides a framework for analyzing and evaluating the standard and nonstandard instruments used by authorities during the financial crisis of 2008-2009.

07-11

Corporate Bankruptcy and Creditor Incentives
Todd Gormley, Nandini Gupta and Anand Jha

The bankruptcy process around the world can involve long delays that
erode firm value and raise the cost of capital. These inefficiencies are
likely to be greater in uncompetitive, government-dominated financial
markets where creditors lack the incentive to monitor borrowers and
recover assets. Using a unique dataset on corporate bankruptcy filings in
India, we analyze the effects of bank entry deregulation on bankruptcy
outcomes. Exploiting geographic variation in bank entry following
deregulation, we find that private bank entry in a region is associated with
an increase in frivolous filings by firms that are not financially distressed,
but seek a stay on assets to escape increased creditor scrutiny. We also
observe a decrease in delays in the bankruptcy process and fewer
liquidations, which take longer to resolve. In regions with stronger creditor rights, foreign bank entry is also associated with more bankruptcy filings. These findings suggest that the ownership and competitiveness of the banking sector can significantly affect bankruptcy outcomes.

08-11

CEO Compensation and Corporate Risk-Taking: Evidence form a Natural Experiment
Todd A. Gormley, David A. Matsa and Todd Milbourn

Our paper sheds new light on the theoretically ambiguous effect of stock options on managerial incentives for risk-taking by analyzing how equity-based incentives affect firms’ responses to an unanticipated and exogenous increase in risk. The particular risk we study is an increase in liability and regulatory risk arising from workers’ exposure to newly identified carcinogens. We find that compensation contracts with high sensitivity to stock prices, low sensitivity to volatility, and options that are deep in-the-money reduce managers’ risk-taking incentives after risk increases. While options increase compensation’s sensitivity to both stock prices and volatility, on net, they encourage risk taking in our setting. We find that variation in managerial stock and option holdings causes meaningful differences in corporate decisions. Our findings underline the
importance of corporate boards structuring and maintaining compensation plans properly in order to achieve their desired corporate strategy.

09-11 (Revised 16-08)

Can Time-varying Risk of Rare Disasters Explain Aggregate Stock Market Volatility?
Jessica A. Wachter

Why is the equity premium so high, and why are stocks so volatile? Why are stock returns in excess of government bill rates predictable? This paper proposes an answer to these questions based on a time-varying probability of a consumption disaster. In the model, aggregate consumption follows a normal distribution with low volatility most of the time, but with some probability of a consumption realization far out in
the left tail. The possibility of this poor outcome results in an equity premium, while time-variation in the probability of this outcome drives high stock market volatility and excess return predictability.

10-11

Bankers and Regulators
Philip Bond and Vincent Glode

We propose a career choice model in which agents with heterogenous ability levels choose to work as bankers or as nancial regulators. When workers extract intrinsic bene ts from working in regulation (such as public-sector motivation or human capital improvement), our model jointly predicts that bankers will be, on average, more skilled than regulators and their compensation will be more sensitive to performance. During nancial booms, banks draw the best workers away from the regulatory sector and misbehavior increases. In a dynamic extension of our model, young regulators accumulate human capital and the best ones switch to banking in mid-career.

11-11

Feedback Effects and the Limits to Arbitrage
Alex Edmans, Itay Goldstein and Wei Jiang

This paper identifes a limit to arbitrage that arises from the fact that a firrm’s fundamental value is endogenous to the act of exploiting the arbitrage opportunity. Trading on private information reveals this information to managers and helps them improve their real decisions, in turn enhancing fundamental value. While this increases the profittability
of a long position, it reduces the profittability of a short position – selling on negative information reveals to the manager that firm prospects are poor, causing him to cancel investment projects. Optimal abandonment increases the firrm’s value and may cause the speculator to realize a loss on her initial sale. Thus, investors may strategically refrain from trading on negative information. This has potentially important real consequences – if negative information is not incorporated into stock prices, negative-NPV projects may not be abandoned, leading to overinvestment.

12-11
Contracting with Synergies
Alex Edmans, Itay Goldstein and John Zhu

This paper studies optimal contracting under synergies: effort by one agent reduces a colleague's marginal cost of effort. Our framework allows for agents' contributions to synergies to be asymmetric { an agent's effect on his colleague's cost differs from his colleague's effect on him { and workers to vary in the number of synergistic relationships they enjoy. In a two-agent model, effort levels are always equal even if contributions to synergies are asymmetric. An increase in synergy raises total effort and total pay, consistent with strong equity incentives in small firms, including among low-level employees. Individual pay, however, is asymmetric, with the more influential agent receiving a greater share, even though both agents exert the same effort and have the same direct effect on out- put. With three agents, effort levels differ and are higher for more synergistic
agents. An increase in the synergy between two agents can lead to the third agent being excluded from the team, even if his productivity is unchanged. This has implications for optimal team composition and firm boundaries. Agents that influence a greater number of colleagues receive higher wages, consistent with the salary differential between CEOs and divisional managers. Our results are robust to whether the production function exhibits substitutes or complements.

13-11
Expertise, Structure and Reputation of Corporate Boards
Doron Levit

This paper studies the implications of directors’s expertise for optimal board structure. The expertise of directors is particularly important when the company’s management does not cooperate with the board, and directors must rely on their own judgment when making decisions. The results of this paper demonstrate that even when the board acts in its
shareholders’best interests, its expertise can harm shareholders’value by discouraging an opportunistic management from collecting and sharing valuable information. This effect takes place when a priori management and shareholders disagree on the optimal strategy, and despite management’s free access to information. Under those circumstances, an
optimal board structure emerges: shareholders’ value is maximized when the board is inherently biased against management. Moreover, when directors are concerned about their reputations as experts, the incentives of management to cooperate with the board change. We show that management might gain more power on the expense of shareholders’
value if the uncertainty about directors’expertise is high or if a priori directors are not perceived as experts.

14-11
Notes on Bonds: Liquidity at all Costs in the Great Recession
David Musto, Gregory Nini and Krista Schwartz

We address the connection between market stress and asset pricing by
analyzing a large and systematic discrepancy arising among off-the-run U.S. Treasury securities during the crisis. We begin by showing that bonds traded for much less than notes with identical maturity and coupon. The gap exceeded five percent in December 2008. We then ask how the small differences between these securities, in particular their liquidity, could project to such a large gap in prices. We gauge the potential for bond-note arbitrage in two ways. First, with data on repurchase rates and fails, we highlight the frictions arbitrageurs encountered in funding a short position in the notes. Second, with daily transactions data on trades
by insurance companies, who are large buy-and-hold fixed income investors, we relate demand for the expensive but liquid note to the cross section of insurers’ characteristics.



Rodney L. White Center for
Financial Research
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Facsimile: (215) 573-8084
Email: rlwctr@finance.wharton.upenn.edu

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