Recovery Risk in Stock Returns

In this paper we argue that book-to-market and size attributes represent sensitivities of firm returns to several risk factors, and in so doing they subsume the information in other attributes. Although this gives them high cross-sectional explanatory power, they are not very indicative if we are concerned with testing whether an individual risk factor is priced. In that regard, claiming that financial distress is not priced, by only considering probability of bankruptcy, seems premature. Rational investors may also care about recovery rates and the relatively higher mean returns observed for small firms with very low book-to-market ratios is consistent with this view. To analyse recovery risk, we construct mimicking portfolios by sorting stocks on less noisy attributes such as fixed-assets and intangible-assets ratios. We find that recovery risk mimicking portfolios exhibit typical risk factor characteristics, and perform well in explaining the cross-section of returns. The results suggest that recovery risk factor is a good candidate to be priced, and much of the explanatory power of the size attribute comes from the fact that it embodies useful information regarding recovery risk. Overall, our findings have important portfolio management implications.

Stock Market Performance and the Term Structure of Credit Spreads

We build a structural two-factor model of default where the stock market index is one of the stochastic factors. We allow the firm to adjust its leverage ratio in response to changes in the business climate for which the past performance of the stock market index acts as a proxy. We assume that the firm's log-leverage ratio follows a mean-reverting process and that the past performance of the stock index negatively affects the firms target leverage ratio. We show that for most credit ratings our model may explain actual yield spreads better than other well-known structural credit risk models. Also, our model shows that the past performance of the stock index returns and the firm's assets beta have a significant impact on credit spreads. Hence, our model can explain why credit spreads may be different within the same credit rating groups and why spreads are lower during economic expansions and higher during recession

Stock options and managers' incentives to cheat

This paper develops a continuous-time real options' pricing model to study managers' incentives to cheat in the presence of equity-based compensation plans. It shows that managers' incentives to cheat are strongly influenced by the efficiency of the justice. The model's main result is that managers have greater incentives to commit fraudulent actions under stock options than under common stocks based compensation plan

Liquidity Risk, Return Predictability, and Hedge Funds' Performance: An Empirical Study

This article analyzes the effect of liquidity risk on the performance of equity hedge fund portfolios. Similarly to Avramov, Kosowski, Naik, and Teo (2007), (2011), we observe that, before accounting for the effect of liquidity risk, hedge fund portfolios that incorporate predictability in managerial skills generate superior performance. This outperformance disappears or weakens substantially for most emerging markets, event-driven, and long/short hedge fund portfolios once we account for liquidity risk. Moreover, we show that the equity market-neutral and long/short hedge fund portfolios' "alphas” also entail rents for their service as liquidity providers. These results hold under various robustness test

Moral commitment: Does it reduce or enhance the response to social norms? Evidence from an experiment on earnings management

Social norms play a powerful role in guiding managerial behavior. For example, prior work has established the power of injunctive (prescriptive) norms in areas where views on what is right and wrong widely differ, such as earnings management (EM). Existing work highlights the effects of social norms on the average norm addressee. However, little is known about individual differences in reactions to injunctive norms. That is, who is more malleable, and who resists more? In this research, we conduct an experiment on EM to study such potential differences in individual responses to social norms. We find that participants with a strong commitment to honesty react less to both EM-disapproving and EM-approving injunctive norms. These findings have implications for the theoretical and empirical analysis of managerial behavior and for the use of injunctive social norms as steering tools for truthful reporting

Earnings management and managerial honesty: the investors’ perspectives

This paper studies how investors infer CEO commitment to honesty from earnings management and how these perceptions – in conjunction with investors’ own social and moral preferences – shape their investment choices. We conduct two laboratory experiments simulating investment choices. Our results show that participants perceive a CEO to be more committed to honesty when they infer that the CEO engaged less in earnings management. For investment decisions, a one standard deviation increase in a CEO's perceived commitment to honesty compared to another CEO reduces the relevance of differences in the CEOs’ claimed future returns by 40%. This effect is most prominent among investors with a proself value orientation. To prosocial investors, their own honesty values and those attributed to the CEO matter directly, while returns only play a secondary role. Overall, our results suggest that moral motives are not a niche concern for norm-constrained investors, but instead matter to different categories of investors for distinct reasons

Model misspecification analysis for bond options and Markovian hedging strategies

In this paper, we analyse the model misspecification risk of Markovian hedging strategies for discount bond options. We show how to decompose the Profit and Loss that results from model misspecification, and emphasize the importance of the position's gamma in order to control it. We further provide mathematical results on the distribution of the forward Profit and Loss function for specific univariate term structure models. Finally, we run numerical simulations for options' hedging strategies in order to examine the sensitivity of the forward Profit and Loss function with respect to the volatility of the forward rate curve, the frequency of the position rebalancing and the characteristics of the position being hedge