Department of Finance

ABSTRACT Testing the hypothesis that international equity market correlation increases in volatile times is a difficult exercise and misleading results have often been reported in the past because of a spurious relationship between correlation and volatility. Using “extreme value theory” to model the multivariate distribution tails, we derive the distribution of extreme correlation for a wide class of return distributions. Empirically, we reject the null hypothesis of multivariate normality for the negative tail, but not for the positive tail. We also find that correlation is not related to market volatility per se but to the market trend. Correlation increases in bear markets, but not in bull markets.

ABSTRACT When capital market investors and firm insiders possess the same information about a company's prospects, its liabilities will be priced in a way that makes the firm indifferent to the composition of its financial liabilities (at least under certain, well‐known circumstances). However, if firm insiders are systematically better informed than outside investors, they will choose to issue those types of securities that the market appears to overvalue most. Knowing this, rational investors will try to infer the insiders' information from the firm's financial structure. This paper evaluates the extent to which a firm's choice of risky debt maturity can signal insiders' information about firm quality. If financial market transactions are costless, a firm's financial structure cannot provide a valid signal. With positive transaction costs, however, high‐quality firms can sometimes effectively signal their true quality to the market. The existence of a signalling equilibrium is shown to depend on the (exogenous) distribution of firms' quality and the magnitude of underwriting costs for corporate debt.

There have long been conflicting expectations of the nature of companies’ responsibilities to society. However, for those businesses that do undertake what might be termed “corporate social responsibility”, what is actually socially responsible behaviour as opposed to management of corporate image management or other activity aimed predominantly at business benefits? This article reviews definitions of corporate social responsibility from both practice and the literature and looks at theories to explain why such behaviour takes place. The literature has strong divides between normative or ethical actions and instrumental activities. The article concludes by posing the question of when instrumental activities become business activities rather than largely social responsibility.

Unlike Dutch auction repurchases and tender offers, open‐market repurchase programs do not precommit firms to acquire a specified number of shares. In a sample of 450 programs from 1981 to 1990, firms on average acquire 74 to 82 percent of the shares announced as repurchase targets within three years of the repurchase announcement. We find that share repurchases are negatively related to prior stock price performance, suggesting that firms increase their purchasing depending on its degree of perceived undervaluation. In addition, repurchases are positively related to levels of cash flow, which is consistent with liquidity arguments.

A volatility model must be able to forecast volatility; this is the central requirement in almost all financial applications. In this paper we outline some stylized facts about volatility that should be incorporated in a model: pronounced persistence and mean-reversion, asymmetry such that the sign of an innovation also affects volatility and the possibility of exogenous or pre-determined variables influencing volatility. We use data on the Dow Jones Industrial Index to illustrate these stylized facts, and the ability of GARCH-type models to capture these features. We conclude with some challenges for future research in this area.

ABSTRACT Firms in bilateral relationships are likely to produce or procure unique products—especially when they are in durable goods industries. Consistent with the arguments of Titman and Titman and Wessels, such firms are likely to maintain lower leverage. We compile a database of firms' principal customers (those that account for at least 10% of sales or are otherwise considered important for business) from the Business Information File of Compustat and find results consistent with the predictions of this theory.

Existing studies of mutual fund market timing analyze monthly returns and find little evidence of timing ability. We show that daily tests are more powerful and that mutual funds exhibit significant timing ability more often in daily tests than in monthly tests. We construct a set of synthetic fund returns in order to control for spurious results. The daily timing coefficients of the majority of funds are significantly different from their synthetic counterparts. These results suggest that mutual funds may possess more timing ability than previously documented.

ABSTRACT This paper seeks to explain the combination of explicit and implicit pricing for deposit insurance employed by the FDIC. Essentially, the FDIC sells two products—insurance and regulation. To span the product space, it must and does set two prices. We argue that the need to establish regulatory disincentives to bank risk‐taking is the heart of the controversy over the adequacy of bank capital and that the ability to close risky banks before exhausting their charter value (i.e., the value of their right to continue in business) stands at the center of these disincentives and in front of the FDIC's insurance reserves.

The investment role of precious metals in financial markets is investigated by analysis of daily data for gold, platinum, and silver from 1976 to 2004. All three precious metals have low correlations with stock index returns, which suggests that these metals may provide diversification within broad investment portfolios. Moreover, the data reveal that all three precious metals have some hedging capability, particularly during periods of "abnormal" stock market volatility. Financial portfolios that contain precious metals perform significantly better than standard equity portfolios.

ABSTRACT We investigate whether the media plays a role in corporate governance by disseminating news. Using a comprehensive data set of corporate and insider news coverage for the 2001–2012 period, we show that the media reduces insiders’ future trading profits by disseminating news on prior insiders’ trades available from regulatory filings. We find support for three economic mechanisms underlying the disciplining effect of news dissemination: the reduction of information asymmetry, concerns regarding litigation risk, and the impact on insiders’ personal wealth and reputation. Our findings provide new insights into the real effect of news dissemination.

ABSTRACT We develop a simple framework for analyzing a finite‐horizon investor's asset allocation problem under inflation when only nominal assets are available. The investor's optimal investment strategy and indirect utility are given in simple closed form. Hedge demands depend on the investor's horizon and risk aversion and on the maturities of the bonds included in the portfolio. When short positions are precluded, the optimal strategy consists of investments in cash, equity, and a single nominal bond with optimally chosen maturity. Both the optimal stock‐bond mix and the optimal bond maturity depend on the investor's horizon and risk aversion.

ABSTRACT This paper develops a model in which managers can signal their firms' true values by using either a dividend or a stock repurchase or both. The authors explain a number of stylized facts about these cash‐disbursement mechanisms, particularly those concerning the relative magnitudes of stock price responses to dividends and repurchases. Most importantly, they explain why a stock repurchase elicits a significantly higher price response, on average, than a dividend announcement.

ABSTRACT We examine the value of bank durability to borrowing firms. The analysis is based on theoretical models of the asset services view of intermediation which imply that private information and associated relationship‐specific activities are intrinsic to bank lending. We analyze share price effects on firms with lending relationships with Continental Illinois Bank during its de facto failure and subsequent FDIC rescue. We find the bank's impending insolvency had negative effects and the FDIC rescue positive effects on client firm share prices. We conclude that borrowers incur significant costs in response to unanticipated reductions in bank durability and thus are bank stakeholders.

Refined economic value added (REVA) provides an analytical framework for evaluating operating performance measures in the context of shareholder value creation. Economic value added (EVA) performs quite well in terms of its correlation with shareholder value creation, but REVA is a theoretically superior measure for assessing whether a firm's operating performance is adequate from the standpoint of compensating the firm's financiers for the risk to their capital. In this article, comprehensive statistical analysis of both REVA and EVA is used to estimate their correlation with and their ability to predict shareholder value creation. REVA statistically outperforms EVA in this regard. Moreover, the realized returns for the 1988–92 period for the top 25 REVA firms were higher than the realized returns for the top 25 EVA firms.

This article proposes a consistent and efficient estimator of the high-frequency covariance (quadratic covariation) of two arbitrary assets, observed asynchronously with market microstructure noise. This estimator is built on the marriage of the quasi–maximum likelihood estimator of the quadratic variation and the proposed generalized synchronization scheme and thus is not influenced by the Epps effect. Moreover, the estimation procedure is free of tuning parameters or bandwidths and is readily implementable. Monte Carlo simulations show the advantage of this estimator by comparing it with a variety of estimators with specific synchronization methods. The empirical studies of six foreign exchange future contracts illustrate the time-varying correlations of the currencies during the 2008 global financial crisis, demonstrating the similarities and differences in their roles as key currencies in the global market.

While substantial research finds that financial development boosts overall economic growth, we study whether financial development disproportionately raises the incomes of the poor and alleviates poverty.Using a broad cross-country sample, we distinguish among competing theoretical predictions about the impact of financial development on changes in income distribution and poverty alleviation.We find that financial development reduces income inequality by disproportionately boosting the incomes of the poor.Countries with better-developed financial intermediaries experience faster declines in measures of both poverty and income inequality.These results are robust to controlling for other country characteristics and potential reverse causality.

A number of studies have provided evidence of increased correlations in global financial market returns during bear markets. Other studies, however, have shown that some of this evidence may be biased. We derive an alternative to previous estimators for implied correlation that is based on measures of portfolio downside risk and that does not suffer from bias. The unbiased quantile correlation estimates are directly applicable to portfolio optimization and to risk management techniques in general. This simple and practical method captures the increasing correlation in extreme market conditions while providing a pragmatic approach to understanding correlation structure in multivariate return distributions. Based on data for international equity markets, we found evidence of significant increased correlation in international equity returns in bear markets. This finding proves the importance of providing a tail-adjusted mean–variance covariance matrix.

ABSTRACT We propose a theory of information gathering agencies in a world of informational asymmetries and moral hazard. In a setting in which true firm values are certified by screening agents whose payoffs depend on noisy ex post monitors of information quality, the formation of information gathering agencies (groups of screening agents) is justified on two grounds. First, it enables screening agents to diversify their risky payoffs. Second, it allows information sharing. The first effect itself is insufficient despite the risk aversion of screening agents and the stochastic independence of the monitors used to compensate them.

In this paper we analyze the factors that affect the tenure choice of young adults, highlighting the impact of mortgage lender imposed borrowing constraints.The data set is a panel of youth age 20-33 for the years 1985-90.Our methods differ from most prior studies in many ways including consideration of possible sample selection bias, a richer model of the stochastic error structure, better measurement of which households are bound by borrowing constraints, and a fuller consideration of the endogeneity of wealth and income.Once all changes are implemented, we find ownership tendencies to be quite sensitive to economic variables.Specifically, potential earnings, the relative cost of owning a home, and especially borrowing constraints affect the tendency to own a home.In our sample of youth, 37% of households are constrained even after choosing their loan-to-value ratio to minimize the impact of the separate wealth and income requirements.The constraints reduce the probability of ownership of these households by 10 to 20 percentage points (a third to a halo depending on the particular characteristics of the household.

The empirical evidence documenting the association between a firm's level of corporate social performance (CSP) and corporate financial performance (CFP) remains divided. This paper reinvestigates the CSP/CFP association using a more rigorous methodology whilst taking advantage of a superior measure of CSP. In contrast to the findings of much of the prior research, the market-based tests suggest a negative association between CSP and CFP, while the accounting tests indicate no association exists. We suggest that the negative market CSP/CFP relation should not be interpreted as CSP having no value. Rather, our results may suggest that leading CSP firms trade at a price premium (i.e. returns discount) relative to lagging CSP firms, thereby indicating that financial markets value CSP and are prepared to realise lower returns. For firms, this signals an ability to obtain a lower cost of equity capital when they proactively manage their CSP profiles.