How Are Derivatives Used? Evidence from the Mutual Fund Industry

Approximately 20 percent of the 675 equity mutual funds analyzed in this paper invest in derivatives. We compare the return distributions of equity mutual funds that invest in derivatives to those that do not. We also analyze the use of derivatives to affect intertemporal changes in fund risk. Equity mutual funds that invest in derivatives have similar risk and similar net return performance in those that do not. Change in fund risk is negatively related to past performance, but derivatives allow funds to dampen these changes. We interpret these results as consistent with the hypothesis that managers are slow to respond to unexpected cash flows, and inconsistent with gaming of incentive compensation systems. This paper was presented at the Financial Institutions Center's May 1996 conference on "

Overconfident Investors, Predictable Returns, and Excessive Trading

The last several decades have witnessed a shift away from a fully rational paradigm of financial markets toward one in which investor behavior is influenced by psychological biases. Two principal factors have contributed to this evolution: a body of evidence showing how psychological bias affects the behavior of economic actors; and an accumulation of evidence that is hard to reconcile with fully rational models of security market trading volumes and returns. In particular, asset markets exhibit trading volumes that are high, with individuals and asset managers trading aggressively, even when such trading results in high risk and low net returns. Moreover, asset prices display patterns of predictability that are difficult to reconcile with rational-expectations–based theories of price formation. In this paper, we discuss the role of overconfidence as an explanation for these patterns

Excess Volatility and Closed-End Funds.

If investors are rational, the variance of closed-end mutual fund returns should equal the variance of the underlying securities in their portfolios. In fact, this paper shows that the average closed-end fund's monthly return is 64 percent more volatile than its assets. Unlike variance-bounds tests, this facilitates an excess volatility test that does not rely on strong assumptions about discount rates or dividend streams. Although largely idiosyncratic, 15 percent of the average fund's excess risk is explained by market risk, small-firm risk, and risk that affects other closed-end funds. Copyright 1997 by American Economic Association.

Costly Arbitrage: Evidence from Closed-End Funds.

Arbitrage costs lead to large deviations of prices from fundamentals. Using a sample of closed-end funds, I find that the market value of a fund is more likely to deviate from the value of its assets ( 1) for funds with portfolios that are difficult to replicate, (2) for funds that pay out smaller dividends, (3) for funds with lower market values, and (4) when interest rates are high. These factors are related to the magnitude of the deviation, as opposed to the direction (i.e., whether discount or premium), and explain a quarter of cross-sectional mispricing variation. These findings are consistent with noise trader models of asset pricing. Copyright 1996, the President and Fellows of Harvard College and the Massachusetts Institute of Technology.

Hierarchies or Markets? The Survival of POWs during WWII

Using a database of virtually all American prisoners of war (POWs) during World War II, we examine for the first time how hierarchy affects success. We find that survival declines as the hierarchy of a prisoner’s group more closely matches the military population and as it becomes steeper. Those in the most hierarchical groups were 20 % less likely to survive than those in the least hierarchical groups. This holds for alternative groupings of prisoners and for both Germany and Japan, even though prisoners of Japan were far more likely to die. One explanation consistent with survivors ’ accounts is that trading among prisoners was beneficial, but the military’s hierarchy impeded markets. JEL Classification: D2