Retail investor recognition and the cross section of stock returns

Academic Paper Sessions: Session 151 – The Cross-Section of Returns: Cash, Investor Recognition, and Idiosyncratic VolatilityWe test and offer support to Merton’s (1987) theory that difference in a stock’s investor recognition affects its cost of capital. In the U.S. market, using the breadth of ownership among retail investors as a proxy for investor recognition, we show that a long-short portfolio based on the annual change of shareholder base earns a compounded annual abnormal return of 6.42% after controlling for the Fama-French three factors. These results are more pronounced among young, low visibility and high idiosyncratic volatility stocks, and are robust to various controls such as momentum, breadth of institutional ownership, analyst coverage, liquidity, idiosyncratic volatility, trading volume, accruals, capital investment, probability of informed trading (PIN), and retail investor sentiment. Moreover, we present evidence that the investor recognition effect can explain approximately 20% of the net equity issuance effect documented by Pontiff and Woodgate (2008).postprintThe 2010 Annual Meeting of the Financial Management Association (FMA), New York, N.Y., 20-23 October 2010

Cross-hedging with currency options and futures

This paper develops an expected utility model of a multinational firm facing exchange rate risk exposure to a foreign currency cash flow. Currency derivative markets do not exist between the domestic and foreign currencies. There are, however, currency futures and options markets between the domestic currency and a third currency to which the firm has access. Since a triangular parity condition holds among these three currencies, the available, yet incomplete, currency futures and options markets still provide a useful avenue for the firm to indirectly hedge against its foreign exchange risk exposure. This paper offers analytical insights into the optimal cross-hedging strategies of the firm. In particular, the results show the optimality of using options in conjunction with futures in the case of currency mismatching, even though cash flows appear to be linear.published_or_final_versio

Household investments in structured financial products: pulled or pushed?

Session 175 - Crisis: Individual InvestorsStructured financial products including credit-linked notes and collateralized debt obligations were popular before the credit crisis but then delivered substantial loss to investors. Driver for investment decision in those products is key to understanding the fundamental causes of the crisis. Classical portfolio theory suggests that investors would shun away from unfamiliar financial products. This familiarity bias holds especially for unsophisticated household investors. The rapid growth of structured products market, the newest financial innovations, presents an opportune setting to test such conventional wisdoms. Using unique household investment data from Hong Kong, we show that product distributors' selling intensity is an important determinant for investors' allocation in structured products. On the other hand, more financially literate investors, who are more capable of optimizing asset allocation, include less structured products into their portfolios. Important determinants according to mean-variance analysis, such as product premium, have little explanatory power to investor's allocation decisions. Our finding suggests that investments in structured products prior to the credit crisis were more likely to be pulled by distributors. This paper demonstrates the importance of financial literacy for investment decisions.postprintThe 2010 Annual Meeting of the Financial Management Association (FMA), New York, N.Y., 20-23 October 2010

Governance through trading: does institutional trading discipline empire building and earnings management?

Accounting Session 1: Earnings ManagementThe Conference program's website is located at http://areas.kenan-flagler.unc.edu/conferences/2013cfea/Pages/Final%20Schedule.aspxThis paper empirically identifies an important external corporate governance mechanism through which the institutional trading improves firm values and disciplines managers from conducting value-destroying activities. We propose a reward-punishment intensity (RPI) measure, and show that it is positively related to firm’s subsequent Tobin’s Q. Importantly, we find that firms with higher RPI exhibit less subsequent empire building and earnings management. Furthermore, we show that the exogenous liquidity shock of Decimalization augments the governance effect of institutional trading. We also find that the discipline effect is more pronounced for firms with moderate institutional ownership concentration, higher managers’ wealth-performance sensitivity, and higher trading liquidity, which further supports the governance role of the RPI. The results are robust to using a subsample containing firms with reduced institutional ownership and to using two instrumental variables.postprin

Equilibrium asset and option pricing under jump diffusion

This paper develops an equilibrium asset and option pricing model in a production economy under jump diiffusion. The model provides analytical formulas for an equity premium and a more general pricing kernel that links the physical and risk-neutral densities. The model explains the two empirical phenomena of the negative variance risk premium and implied volatility smirk if market crashes are expected. Model estimation with the S&P 500 index from 1985 to 2005 shows that jump size is indeed negative and the risk aversion coe±cient has a reasonable value when taking the jump into account. This is a joint work with Huimin Zhao and Eric C. Chang.postprin

The relation between physical and risk-neutral cumulants

Variance swaps are natural instruments for investors taking directional bets on volatility and are often used for portfolio protection. But the crucial observation suggests that derivative professionals may desire to hedge beyond volatility risk and there exists the need to hedge higher-moment market risks, such as skewness and kurtosis risks. We propose new derivative contracts: skewness swap and kurtosis swap, which trade the forward realized third and fourth cumulants. Using S&P 500 index options data from 1996 to 2005, we document the returns of these swap contracts, i.e., skewness risk premium and kurtosis risk premium. We find that the skewness risk premium is significantly negative and kurtosis risk premium for 90 day maturity is significantly positive.postprintThe 2009 Annual Meeting of the Financial Management Association (FMA), Reno, NV., 21-24 October 2009

The Role of "Volume Dispersion" in Explaining the Price-Change Volume Relation at the Index Level

In this paper, we examine the dynamics of the price change-trading volume relation at the aggregate market/index level. We introduce the use of a novel “volume dispersion” measure designed to proxy for the variability in firm-specific information flows across securities that comprise the market. Our results suggest that the price change-volume relation can be strengthened by the introduction of this measure. We also offer evidence of a positive relation between market volatility and trading volume and a negative relation between market volatility and volume dispersion. Furthermore, we demonstrate that lagged values of market level trading volume and volume dispersion can predict the next day’s index level volatility. Our findings remain robust when the implied volatility of the S&P 100 index options is used in the analysis. This suggests that index option traders need to pay close attention to both aggregate market level trading volume and volume dispersion to better capture the dynamics of daily market volatility.postprin

Expected stock return and conditional skewness

Motivated by the parsimonious jump-diffusion model of Zhang, Zhao and Chang (2010), we show that the aggregate market returns can be predicted by the conditional skewness of returns and the variance risk premium, a difference between the physical and risk-neutral variance of market returns, even though the variance is supposed to be constant only if jump exists. The magnitude of the predictability is particularly striking at the intermediate quarterly return horizon, even combing other predictor variables, like P/D ratio, the default spread and the consumption-wealth ratio (CAY). We also find that the third central moments are significant in explaining the variance risk premium, which further implies that the potential link between the variance risk premium and the excess market return is the third central moments, not the skewness.postprintThe 9th China International Conference in Finance (CICF 2011), Wuhan, China, 4-7 July 2011

Does short selling discipline overinvestment?

We explore the disciplining effect of short selling on overinvestment. Firms with more stock lending supply have higher abnormal announcement stock returns of acquiring firms, lower subsequent abnormal capital investments, and longer spells between large investments, and higher subsequent Tobin’s Q and ROA. Alleviating the endogeneity concern, our multivariate difference-in-difference analysis shows that this disciplinary force of lending supply is more effective for firms in the Regulation SHO-PILOT Program. We identify two mechanisms through which short selling disciplines managers: managers’ wealth-performance sensitivity and likelihood of hostile takeovers. Additionally, the disciplinary force only exists for non-financial-constrained firms and nonall-cash M&A deals.postprin

Short-selling, margin-trading, and price efficiency: Evidence from the Chinese market

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