Finance - Theses
Now showing items 1-12 of 32
Time-varying efficiency of internal capital markets
This thesis examines the time-varying efficiency of diversified firms. The first essay documents flipped Q-sensitivity of investment of conglomerates over the business cycle. I find that the internal capital markets affect investment and cash retention differently from stand-alone firms. The result is robust to the degree of diversification, matching sample and difference-in-differences analyses. The second essay examines the effect of compensation incentives on intra-firm capital allocation, of both CEOs and divisional managers. I provide novel evidence that reconciles the efficiency explanation with the theory prediction that managers require extra incentives to relinquish capital in control and finance investment.
Corporate bond market clientele
This thesis consists of two essays that explore research questions related to corporate bond market clientele. In the first essay, I examine the investment behaviour of corporate bond mutual funds, the fastest-growing clientele for corporate bonds in recent times. Specifically, I study the extent to which the funds’ investment decisions are driven by their investment mandates. In the second essay, I draw on anecdotal and empirical evidence that shows that clientele in corporate bond markets are fundamentally different from clientele in equity markets. I apply these insights to examine how corporate policy is affected by differences between corporate bond and equity investors’ pricing of risk. Theoretical and anecdotal evidence suggests that mandates are a key determinant of mutual fund investment behaviour. However, other evidence reveals that mandates are not legally binding, and funds may have incentives to deviate. In the first essay, I compare the investment expenditure of funds with different mandates within segments of the corporate bond market. The segments categorize bonds according to maturity or credit rating. I find that, in each segment, the funds that spend relatively more (less) are those whose mandates imply that they should invest more (less) in that segment. For example, if a fund states that it targets a longer portfolio maturity, the fund invests significantly more in long-term bonds, on average, relative to funds that target shorter portfolio maturities. These results apply not only to average investment expenditure, but also to how each incremental unit of flow is allocated across segments. Results hold in subsamples of secondary market bonds, as well as new issues, regardless of whether the issuer of a new bond is a firm in which the fund already invests. Overall, my findings suggest that the investment behaviour of corporate bond mutual funds is consistent with the funds’ mandates. In the second essay, I use a dynamic investment and financing model that accounts for differences between equity and corporate bond holders’ pricing of macroeconomic risk. In line with empirical and anecdotal evidence, I calibrate the bond investor’s price of risk to be unconditionally higher than the equity investor’s, as well as volatile and independent of the macroeconomy. Relative to a counterfactual scenario in which both investors price risk identically, average market (book) leverage is 2.8 (3.3) percentage points lower. These results reveal a new quantitatively significant channel to address the under-leverage puzzle. Also, in the scenario with heterogeneous risk pricing, firms issue equity more frequently as they substitute away from debt financing. Overall, relative to the scenario with homogenous risk pricing, firms exhibit a similar, albeit slightly lower, average rate of investment.
Essays on naive diversification
The mean-variance model pioneered by Nobel laureate Harry Markowitz is the foundation of modern portfolio theory, and is widely applied in asset allocation and active portfolio management. However, the naive 1/N diversification rule (the equal-weight portfolio rule) has received much academic attention because of its superior performance relative to mean-variance portfolio rules. This thesis consists of two essays with respect to the naive 1/N diversification rule. The first essay examines the sample selection bias in portfolio horse races with the 1/N rule. Numerous studies have developed mean-variance portfolio rules to outperform the naive 1/N rule. However, the outperformance is often justified with a small number of pre-selected datasets. Using a novel performance test based on a large number of datasets, I compare various ``1/N outperformers" with the naive rule. The results show that although some ``1/N outperformers" outperform the 1/N rule on an average basis, a sample selection problem generally exists in claiming significant outperformance over the naive benchmark. To further understand portfolio performance, I explore the theoretical relations between assets' return moments and the performance of optimal versus naive diversification. These relations not only imply strong performance predictability, but also can be exploited to deliver out-of-sample portfolio benefits. The second essay studies how January seasonality affects the relative performance of the mean-variance and 1/N rules. I find that the good performance of the 1/N rule does not depend on the January seasonality when value-weighted indexes are used for portfolio construction. However, when individual stocks are formed into portfolios, a large proportion of the empirical success of the 1/N rule is attributed to enormous January returns. Mean-variance portfolio rules fail to outperform the naive rule on a risk-adjusted basis; however, the relative performance reverses when January returns are excluded. The results are robust with and without transaction costs, for various mean-variance rules, and across different industries and characteristics.
Lockup Agreements during Equity Issuance
Information in the equity issuance market is highly asymmetric. Issuers have information advantages over investors and underwriters. Under asymmetric information, in the U.S., insiders from issuing companies and the underwriters voluntarily negotiate lockup agreements before the issuance of equity. Lockup agreements restrict insiders from selling their shares during the lockup period. However, underwriters have the right to release some or all of the locked-up shares, allowing insiders to sell their shares early at any time before the lockup expiration. Early sales refer to these insider sales during lockup periods. Lockups commonly exist in both initial public offerings (IPOs) and seasoned equity offerings (SEOs). This thesis investigates both the underwriters' incentives for early releases of locked-up shares during the IPO and the impact of IPO lockups on the decision to include SEO lockups. First, I study underwriters' incentives for early releases during an IPO. Ten percent of IPOs with lockup agreements have early sales by top executives. Early sales reduce the likelihood that IPO companies switch lead underwriters in their subsequent SEOs. IPO companies with early sales have better post-IPO performance than their counterparts without early sales. I argue that early sales reduce the signaling cost incurred by IPO lockups under asymmetric information. As information resolves after the IPO, good companies exercise early sales and directly benefit from the reduction in the signaling cost, while underwriters benefit from an increase in future business. Second, I examine the relation between IPO and SEO lockups. I find that underwriters are more likely to impose SEO lockups on issuers that have IPO lockups. I focus on a sample of issuers that conduct their first SEOs within four years after the IPO. I attribute the positive relation between SEO and IPO lockups partially to high correlations between company characteristics at the times of the IPO and the SEO. However, the commitment level of insiders in the issuing company does not offer an explanation for the positive relation between IPO and SEO lockups. Rather, the positive share price response to the announcement of the change from including lockups at the IPO to waiving lockups at the SEO implies that this change by underwriters conveys good news to the market, consistent with SEO lockups helping to reduce the information asymmetry in the equity issuance market.
The psychophysiology of time perception and temporal decision making
Time is a fundamental dimension of our perception of the world and therefore of critical importance to the organisation of human behaviour. Without the ability to perceive time we would not be able to navigate the world in an effective way. We would not be able to perceive the causality between events, nor would we be able to account for the future. However, despite its significance, our perception of time is not veridical, and appears to be labile to many external and internal factors. (A pertinent example is the apothegm “time flies when you’re having fun”, which reflects the temporal distortions we often experience during rewarding periods.) This thesis was aimed at characterising a novel source of volatility in time perception — the effect of reward consumption — and to assess the implications of non-veridical time perception for human decision making. The first study sought to characterise the effect of different primary rewards on interval timing. Participants performed a novel variant of a duration production paradigm, while they received different volumes of fruit juice on a trial-by-trial basis. The consumption of fruit juice lead to systematic overproductions of time (from 2-5 seconds) and this effect scaled with the volume of the consumed juice. Another four reward types were subsequently tested: money (a secondary reward), water (a tasteless, noncaloric reward), aspartame (a sweet, noncaloric reward), and maltodextrin (a tasteless, caloric reward). Maltodextrin also produced a similar effect on time productions. This pattern of results suggested that the observed effect was likely to be due to the common caloric content of both fruit juice and maltodextrin. In sum, the first study demonstrated a novel association between biologically relevant rewards and time perception. The second component of this thesis investigated the proposition that temporal decision making (i.e. decision making that involves time) operates on subjective representations of time. To explore this proposition, the second study investigated whether there was a relationship between individuals’ time perception and their temporal decision making. Participants performed both a temporal reproduction task and a temporal discounting task, while undergoing electrocardiography. The results provided no evidence that parameters from the temporal reproduction task were correlated with discount rates in the temporal discounting task. This did not support the idea that time perception and temporal decision making were related, at least as they were operationalised in this study. However, the behavioural measures from both tasks were independently related to some indices of autonomic nervous system function as measured by electrocardiography, suggesting distinct physiological correlates for both psychological processes. The third study was designed to assess whether factors that impact time perception also affect temporal decision making. Participants fasted for four hours, and then completed a task similar to a patch-leaving foraging paradigm, incentivised with monetary rewards. Participants gave up waiting for rewards significantly earlier when they experienced higher rates of reward. Participants who consumed a caloric drink in between blocks also gave up waiting significantly earlier, compared to those who consumed water (i.e. participants who consumed the caloric drink were less patient). These results suggest that the consumption of biologically relevant rewards altered time-dependent decision making. Overall, these findings support the notion that time perception can be affected by an individual’s homeostatic state, and further suggest that different homeostatic states can influence time-dependent decision making processes. Taken together, these experiments provide evidence that our experience of time may be part of a psychophysiological mechanism which may act to optimise ecological decision making.
An examination of alternative option hedging strategies in the presence of transaction costs
Substantial progress has been made in developing option hedging models that account for transaction costs. Previous analyses of option hedging strategies in the presence of transaction costs use a Monte Carlo simulation framework in conjunction with a mean variance rule to compare different strategies. These studies being based on simulated stock price data are essentially theoretical tests. It is not known, however, how various proposed hedging strategies compare in terms of hedging precision and transaction costs when tested using actual market data. In addition, the mean variance rule is subject to certain well-known restrictive assumptions. This thesis aims to fill two gaps in the literature, by: (1) using actual market data to examine hedging performance, and (2) using a stochastic dominance rule as an alternative hedging performance measure. I undertake two studies. The first compares hedging strategies using Monte Carlo simulation together with mean variance and stochastic dominance criteria. Simulation allows us to study the consistency of the hedging outcomes determined by criteria rules in a controlled environment. The second study is a comprehensive empirical investigation of the merits of competing option hedging strategies with transaction costs, using S&P 500 index options. Both studies examine the hedging performance of the delta-neutral hedge. Given the widely documented volatility risk in empirical data, I further supplement the empirical study with a delta–vega-neutral hedge. Consistent with the literature, the Monte Carlo simulation demonstrates that move-based strategies are superior to time-based strategies. In contrast, empirical testing shows time-based strategies, in particular the Black-Scholes discrete time hedging strategy, are the optimal hedging strategies. Empirically, I find that a delta-neutral hedge is sufficient for a hedger to attain the optimal tradeoff between hedging precision and transaction costs paid if the hedger is using time-based strategies. I further demonstrate that a hedger can save a substantial amount of transaction costs by simply switching from a move-based strategy to a time-based strategy. A hedger is able to save an average 46% of the transaction costs associated with a poorly performing hedging strategy by simply switching to the optimal hedging strategy. I also show that mean variance and stochastic dominance comparisons are not always mutually consistent with each other; however, the differences are usually small. The rank of each strategy under either rule is highly dependent on the characteristics of the empirical distribution of the net hedging error. I also show that a stochastic dominance test provides a precise ranking of hedging performance for each hedging strategy only when there are strong dominance relationships among the strategies, that is, when the empirical density functions of net hedging error for each of the strategies are sufficiently different. The comparisons presented in my study strengthen the confidence in the mean variance rule as a performance measure in assessing hedging outcomes in the presence of transaction costs. The findings of my thesis will assist financial institutions in making informed hedging decisions when transaction costs are taken into consideration.
Two essays on idiosyncratic stock return volatilities
This thesis consists of two essays on idiosyncratic stock return volatilities (IVOL). In the first essay (Chapter 3), I find that the negative relation between IVOL and subsequent stock returns (the IVOL puzzle) does not depend on whether the stocks perform well or poorly in the formation month. I also find that this negative relation persists for a holding period of up to 12 months. Taken together, these two findings highlight that short-term return reversals can explain only part of the IVOL puzzle. I examine the missing factors proposed in the literature and find that the common IVOL factor can largely explain the persistence of the IVOL puzzle beyond the first holding month. I also investigate a possible explanation of the IVOL puzzle related to the convex return patterns induced by the real options among high-IVOL stocks. In the second essay (Chapter 4), we show that time-varying financial leverage generates a common factor structure in firm-level IVOL, with the presence of sticky debt in a model where asset returns follow a simple linear factor structure with constant volatility. Under reasonable parameter settings in a standard dynamic capital structure model, we numerically show that on average about 25% of the time variation in firm-level IVOL can be explained by a single factor. This proportion falls to zero when using a purely equity financed sample. We also show that exposure to the common IVOL factor is negatively priced, even though IVOL is positively priced in the cross-section.
Strategic liquidity management and opportunistic trading: an empirical investigation
This research examines strategic liquidity management and opportunistic trading by studying portfolio decisions of United States insurers. I find that insurers located in hurricane-prone areas sell bonds to hold cash before disasters. Interestingly, inland insurers also sell bonds to hold cash before disasters, leading to prices falling excessively after disasters when affected insurers are forced to sell. Using approximately 40% of pre-disaster cash holdings, inland insurers exploit discounted prices after disasters and realize $5.72 million in abnormal profits. This finding is consistent with models in which opportunistic traders take advantage of the price pressure from liquidity-constrained, disaster-affected traders. These results highlight the strategic motive for managing liquidity and the effect of opportunistic trading on the corporate bond market.
Crowdfunding in capital formation: an empirical investigation
This thesis includes two essays studying a new type of entrepreneurial financing institution. Recently a new type of institution has emerged, crowd funders. These entities: 1) channel capital to create intellectual property; 2) gather information on project and entrepreneur quality; and 3) gauge demand information directly from individuals to improve the efficiency of capital allocation. Traditional financial institutions are notoriously secretive about applicant loans or business proposals, creating research challenges in tracking post-funding performance, especially for start-ups. In the second essay, I analyze all Kickstarter applicants, both funded and rejected, along with the real outcomes of a feature movie project. I show some of the first definitive evidence on the effectiveness of crowdfunding for new ventures. I find that successful crowdfunding increases the likelihood of receiving later-stage funding by 50%. Moreover, crowdfunded movies generate higher revenue and better quality measures when compared to rejected crowdfunding projects that nevertheless obtain funding elsewhere. Early involvement of experienced backers and movie backers appear key to overall funding. In the second essay, we use data from crowd funder Kickstarter, which allows new insights on capital formation and the role of entrepreneurial reputation formation in the venture funding process. This funding method includes all cases where entrepreneurs try yet fail to raise funds, a feature heretofore unavailable to researchers. Although it is not a causal statement, we further quantify that entrepreneurs who have acquired positive reputation through previously successful funding history are 16% more likely to get funded and 50% more likely to get funded if entrepreneurs received all positive comments from previously funded projects on Kickstarter. However entrepreneurs who have acquired a negative reputation through previously failed funding projects are 13% less likely to get funded. This thesis investigates the role of the crowdfunding in financing early stage entrepreneurial ventures and provides empirical evidence of the size of the effect of an individual's reputational capital in a financial transaction.
Where do informed traders trade? Evidence from corporate earnings
This thesis examines informed trading activity in opaque markets around corporate earnings releases. I find that prior to surprise earnings news, informed traders use opaque markets to conceal their informational advantage. However, informed trading is only prominent in one particular market that allows access to any market participant. Other opaque markets that restrict participation do not exhibit any evidence of informed trading. Since opaque markets are primarily intended for uninformed trading, my results have important implications for market design.
Technology shocks, capital reallocation frictions and the cross-section of stock returns
I study the cross-sectional return implications of technology shocks through the channel of capital reallocation. I present a model in which capital reallocation frictions limit the ability of non-innovating firms to redeploy assets when facing technology shocks and force them to hold unproductive capital. As a result, the values of non-innovating firms depreciate more when reallocation frictions are higher. The frictions also amplify firms' risk exposure to technology shocks and hence the risk premium by altering consumption dynamics. Empirically, I find that the stock prices of non-innovating firms respond more negatively to technology shocks in industries with lower asset liquidity, while innovating firms' responses to technology shocks do not vary with the degree of asset liquidity in their industry. The results shed light on the role of capital reallocation in the creative destruction process and its asset pricing implications.
The role of mutual funds in the real economy
This thesis studies the roles of equity mutual funds in the real economy. I review the literature and identify two channels through which mutual funds can exert influences on the real economy: first as informed financiers in the new equity issues market and second as informed traders in the secondary market. I then focus on the first channel and present a simple of model of mutual fund intermediation to show that when mutual funds have superior screening abilities relative to retail investors, the participation of mutual funds in new equity issues conveys information about the underlying productivity of the equity issuers and hence real economic output in the macroeconomy. Empirically I find that mutual fund participation in new equity issues predicts the sensitivity of output to new issues, at both the aggregate level and the industry level. In addition, smaller net fund flows are associated with a stronger sensitivity of output to fund participation, due to funds' reduced information costs when they have less capital. At the firm level, I find that mutual fund participation positively predicts the productivity growth of the seasoned equity issuers, providing supporting evidence for the screening explanation. The results in this thesis offer a novel perspective by showing a relation between mutual fund screening and the real economy.