Finance Recent Publications
Robert H. Battalio, University of Notre Dame
with Andrew Ellul and Robert H. Jennings
Reputation Effects in Trading on the New York Stock Exchange
Journal of Finance Vol. 62 Issue 3 p. 1243-1271 June 2007
Theory suggests that reputations, developed in repeated face-to-face interactions, allow non-anonymous, floor-based trading venues to attenuate adverse selection in the trading process. We identify instances when stocks listed on the New York Stock Exchange (NYSE) relocate on the trading floor. Although the specialist follows the stock to its new location, most floor brokers do not. We use this natural experiment to determine whether reputation appears to affect trading costs. We find a discernable increase in the cost of liquidity in the days surrounding a stock's relocation. The increase is more pronounced for stocks with higher adverse selection and greater broker turnover. Using NYSE audit-trail data, we find that the floor brokers relocating with the stock obtain lower trading costs than those brokers who do not move and those that begin trading post-move. Together, these results suggest that reputation plays an important role in the liquidity provision process on the floor of the NYSE.
Jeffrey H. Bergstrand, University of Notre Dame
with Scott L. Baier
Bonus Vetus OLS: A Simple Method for Approximating International Trade-Cost Effects using the Gravity Equation
Journal of International Economics Vol. 77 Issue 1 p. 77-85 February 2009
Using a Taylor-series expansion, we solve for a simple reduced-form gravity equation revealing a transparent theoretical relationship among bilateral trade flows, incomes, and trade costs, based upon the model in Anderson and van Wincoop [Anderson, James E., and van Wincoop, Eric. “Gravity with Gravitas: A Solution to the Border Puzzle.” American Economic Review 93, no. 1 (March 2003): 170–192.]. Monte Carlo results support that virtually identical coefficient estimates are obtained easily by estimating the reduced-form gravity equation including theoretically-motivated exogenous multilateral resistance terms. We show our methodology generalizes to many settings and delineate the economic conditions under which our approach works well for computing comparative statics and under which it does not.
with Scott L. Baier
Estimating the Effects of Free Trade Agreements on International Trade Flows using Matching Econometrics
Journal of International Economics Vol. 77 Issue 1 p. 63-76 February 2009
This paper provides the first cross-section estimates of long-run treatment effects of free trade agreements on members' bilateral international trade flows using (nonparametric) matching econometrics. Our nonparametric cross-section estimates of ex post long-run treatment effects are much more stable across years and have more economically plausible values than corresponding OLS cross-section estimates from typical gravity equations. We provide plausible estimates of the long-run effects of membership in the original European Economic Community (EEC) and the Central American Common Market (CACM) between 1960 and 2000 and the estimates confirm anecdotal reports of these agreements' effectiveness.
Andriy Bodnaruk, University of Notre Dame
with Massimo Massa and Andrei Simonov
Investment Banks as Insiders and the Market for Corporate Control
Review of Financial Studies, Forthcoming
We study holdings in merger and acquisition (M&A) targets by financial conglomerates in which affiliated investment banks advise the bidders. We show that advisors take positions in the targets before M&A announcements. These stakes are positively related to the probability of observing the bid and to the target premium. We argue that this can be explained in terms of advisors who are privy to important information about the deal, investing in the target in the expectation of its price increasing. We document the high profits of this strategy. The advisory stake is positively related to the likelihood of deal completion and to the termination fees. However, these deals are not wealth creating: there is a negative relation between the advisory stake and the viability of the deal.
with Per Östberg
Does Investor Recognition Predict Returns?
Journal of Financial Economics Vol. 91 Issue 2 p. 208-226 February 2009
Merton [1987. A simple model of capital market equilibrium with incomplete information. Journal of Finance 42, 483–510] shows that stocks about which not all investors are informed should yield a return premium. This premium depends on the shadow cost of incomplete information which in turn depends on the shareholder base, relative market size, and idiosyncratic risk. Utilizing a comprehensive database of Swedish shareholdings, we demonstrate that stock returns are positively related to the shadow cost. We also find that the shareholder base is negatively related to returns when controlling for size and idiosyncratic risk. Zero-cost portfolios based on the shadow cost/shareholder base yield substantial trading profits that are never positively correlated with the market and are only modestly explained by the four-factor model.
with Eugene Kandel, Massimo Massa and Andrei Simonov
Shareholder Diversification and the Decision to Go Public
Review of Financial Studies Vol. 21 Issue 6 November 2008
We study IPOs by focusing on the degree of portfolio diversification of the shareholders taking the company public. We argue that a less diversified shareholder has more to gain from taking the company public and would be more willing to accept a lower price for the sale of its shares, i.e. tolerate higher underpricing. We test these hypotheses by considering all the IPOs that took place in Sweden in the period 1995-2001. We have obtained detailed information on the portfolio composition of all the investors in the companies being taken public, both before and after the IPO, as well as the portfolio composition of investors in similar (in terms of size, book-to-market and industry) companies not taken public. The information is detailed at the stock level, for both private and public companies. We construct several proxies for portfolio diversification of the shareholders and relate them to both the probability of the IPO and the underpricing. We show that companies held by less diversified shareholders are more likely to go public and suffer a higher underpricing. We show that, as predicted, the degree of diversification explains a significant (economically and statistically) part of the probability of going public, and may account for between one third and one half of the reported underpricing. This suggests that the degree of diversification of controlling shareholders should play a prominent role in the discussion of the process of going public.
Shane A. Corwin, University of Notre Dame
with Jay Coughenour
Limited Attention and the Allocation of Effort in Securities TradingJournal of Finance Vol. 63 Issue 6 p. 3031 - 3067 December 2008
While limited attention has been analyzed in a variety of economic and psychological settings, its impact on financial markets is not well understood. In this paper, we examine individual NYSE specialist portfolios and test whether liquidity provision is affected as specialists allocate their attention across stocks. Our results indicate that specialists allocate effort toward their most active stocks during periods of increased activity, resulting in less frequent price improvement and increased transaction costs for their remaining assigned stocks. Thus, the allocation of effort due to limited attention has a significant impact on liquidity provision in securities markets.
Thomas F. Cosimano, University of Notre Dame
with Y. Chen and Alex Himonas
Continuous Time One-Dimensional Asset Pricing Models with Analytic Price-Dividend Functions
Economic Theory, Forthcoming.
A continuous time one-dimensional asset-pricing model can be described by a second-order linear ordinary differential equation which represents equilibrium or a no-arbitrage condition within the economy. If the stochastic discount factor and dividend process are analytic, then the resulting differential equation has analytic coefficients. Under these circumstances, the one-dimensional Cauchy–Kovalevsky Theorem can be used to prove that the solution to such an asset-pricing model is analytic. Also, this theorem allows for the development of a recursive rule, which speeds up the computation of an approximate solution. In addition, this theorem yields a uniform bound on the error in the numerical solution. Thus, the Cauchy–Kovalevsky Theorem yields a quick and accurate solution of many known asset-pricing models.
Zhi Da, University of Notre Dame
Consumption Risk and Cross Section of Stock Returns
Journal of Finance Vol. 64 Issue 2 p. 923-956 April 2009
I link an asset’s risk premium to two characteristics of its underlying cash flow: covariance and duration. Using empirically novel estimates of both cash flow characteristics based exclusively on accounting earnings and aggregate consumption data, I examine their dynamic interaction in a two-factor cash flow model and find that they are able to explain up to 82% of the cross-sectional variation in the average returns on size, book-to-market, and long-term reversal-sorted portfolios for the period 1964 to 2002. This finding highlights the importance of fundamental cash flow characteristics in determining the risk exposure of an asset.
with Mitchell C. Warachka
Cashflow risk, systematic earnings revisions, and the cross-section of stock returns
Journal of Financial Economics, Forthcoming
The returns of stocks are partially driven by changes in their expected cashflow. Using revisions in analyst earnings forecasts, we construct an analyst earnings beta that measures the covariance between the cashflow innovations of an asset and those of the market. A higher analyst earnings beta implies greater sensitivity to marketwide revisions in expected cashflow, and therefore higher systematic risk. Our analyst earnings beta captures exposure to macroeconomic fluctuations and has a positive risk premium that provides a partial explanation for the value premium, size premium, and long-term return reversals. From 1984 to 2005, 55.1% of the return variation across book-to-market, size, and long-term return reversal portfolios is captured by their analyst earnings betas.
Zhi Da and Pengjie Gao, University of Notre Dame
Clientele Change, Liquidity Shock, and the Return on Financially Distressed Stocks
Journal of Financial and Quantitative Analysis, Forthcoming
We show that the abnormal returns on high-default risk stocks documented by Vassalou and Xing (2004) are driven by short-term return reversals rather than systematic default risk. These abnormal returns occur only during the month after portfolio formation and are concentrated in a small subset of stocks that had recently experienced large negative returns. Empirical evidence supports the view that the short-term return reversal arises from a liquidity shock triggered by a clientele change.
Paul H. Schultz, University of Notre Dame
Rational Cross-Sectional Differences in Market Efficiency: Evidence from Mutual Funds
Journal of Financial and Quantitative Analysis, Forthcoming.
Markets should be inefficient enough to allow returns to security analysis to adequately compensate the marginal analyst for his efforts. Cross-sectional differences in the costs of analysis therefore imply cross-sectional differences in market efficiency and in before-cost returns to smart investors. I examine abnormal returns of mutual fund investments in two stock types that were costly to analyze: small growth stocks over 1980-2006 and internet stocks over 1999-2000. Small growth stocks held by funds earned average monthly abnormal returns of 0.76%. Internet stocks held by technology funds outperformed other internet stocks by 3% per month.
Downward Sloping Demand Curves, the Supply of Shares, and the Collapse of Internet Stock Prices
Journal of Finance Vol. 63 Issue 1 p. 351-378 April 2008
During five weeks over March and April 2000, internet stocks declined 58%. Almost $700 billion in capitalization was lost. This sudden collapse has been attributed to an increase in the supply of shares from lock-up expirations and equity offerings. In this paper, I show that internet stocks collapsed in this period regardless of whether their lock-ups expired or not. Furthermore, daily internet stock portfolio returns were almost unaffected by the number or dollar amount of lock-up expirations that day, or by the amount of stock offered in IPOs or SEOs.
Sophie A. Shive, University of Notre Dame
An Epidemic Model of Investor Behavior
Journal of Financial & Quantitative Analysis, Forthcoming
I test whether social influence affects individual investors' trading and stock returns. In each of the 20 most active stocks in Finland over nine years, the number of owners in a municipality multiplied by the number of investors who do not own a stock, a measure of the rate of transmission of diseases and rumors through social contact, predicts individual investor trading. I control for known determinants of trade including daily news and show that competing explanations for the relation are unlikely. Socially motivated trades predict stock returns and the effects are not reversed, suggesting that individuals share useful information. Individuals' susceptibility to social influence has declined during the period, but the opportunities for social influence have increased.
Hayong Yun, University of Notre Dame
The Choice of Corporate Liquidity and Corporate Governance
Review of Financial Studies Vol. 22 Issue 4 p. 1447-1475 April 2009
In this paper, I study how corporate governance influences firms' choices between cash and lines of credit. Stakeholders may disagree about firms' liquidity choices because they differ in the allocation of ex-post control rights for the firms' liquidity reserves. Using state-level changes in takeover protection as exogenous shocks to corporate governance, I find that firms increase cash relative to lines of credit when the threat of takeover weakens. Consistent with the theory, this tendency is weaker for firms with good internal governance. Overall my findings suggest the choice of corporate liquidity is a channel through which corporate governance works.
with Kenneth M. Ayotte
Matching Bankruptcy Laws to Legal Environments
Journal of Law, Economics and Organization Vol. 25 No. 1 p. 2-30 May 2009
We study a model of optimal bankruptcy law in an environment where legal quality can vary along two dimensions: the expertise of judges and the quality of contract enforcement. We analyze a model in which a judicially influenced bankruptcy process can enhance the efficiency of incomplete contracts by conditioning the allocation of control rights in bankruptcy on firm quality.We consider the optimal balance of debtor and creditor interests as a function of the legal environment and show that the optimal degree of ‘‘creditor-friendliness’’ in the bankruptcy code increases as judicial ability to recognize firm quality falls and as the quality of contract enforcement deteriorates. Our model shows that a bankruptcy law that attempts to preserve going-concern value, such as US Chapter 11, requires judicial expertise to be effective. Where such expertise is unavailable, a law that focuses more on creditor recovery is preferred.