Previous anomaly research may have misinterpreted corrected, for the market index, mean returns on small firms. Assuming mean-variance preferences, it is shown theoretically that corrected mean returns (i.e., market line deviations) are not indicative of the relative desirability of increasing the proportional investment in small firms. The correct improvement criterion is derived and estimated. Tests indicate that the value-weighted market index is not significantly improved with greater weight on small firms, in the average month. When seasonality is considered, the observed performance improvements due to small or large firms are significant in some months, but the required portfolio position is unclear. If a case exists for a small firm anomaly in January, it probably exists in other months and it also exists for large firms. It is doubtful whether such an anomalous stock market exists.

Private information imposes a severe trading disadvantage on uninformed traders while at the same time providing firms with valuable signals for investment adjustment. The two forces have opposite impacts on the cost of capital, and the net effect depends on which force dominates. We show that stocks of firms with low flexibility in investment adjustment (“value firms”) command an information premium, whereas stocks of firms with high flexibility in investment adjustment (“growth firms”) deliver an information discount. These results are consistent with the findings that growth firms exhibit stronger investment sensitivity to information in stock prices than value firms.

China has experienced significant capital flight over the past two decades. Despite anecdotal evidence that some of this capital has been invested in foreign residential markets, not much is known about its destination and impact. We examine the effects of capital inflows from China on residential property prices and the real economy in the USA and global metropolitan areas. We show that inflows had significant effects on residential property markets and employment in regions that i) have strong ethnic ties to China and ii) are destinations of Chinese students. We document spillovers to geographically adjacent regions without strong Chinese links.

Time variation in the discount rate affects investment and employment decisions in a manner consistent with Q-theory predictions. This evidence is uncovered when using cyclical consumption as a proxy for the discount rate. The results, which are consistent across both U.S. and international data, suggest that firms respond rationally to variations in the cost of capital and that the discount rate has a substantial impact on macroeconomic dynamics and hence business cycle fluctuations.

How does trading in one venue affect the quoting strategies of market makers in other venues? We develop a two-venue imperfect competition model in which market makers face quadratic costs when absorbing shocks. Nonconstant marginal costs imply that absorbing a shock in one venue simultaneously changes marginal costs in all other venues. Moreover, market makers strategically choose which shock(s) to absorb. These two forces may intensify competition, leading to enhanced liquidity. Using Euronext proprietary data, we track individual best bid and ask quotes of intermediaries in each venue. We uncover evidence of strategic cross-venue market-making behavior which is uniquely predicted by our model.

We examine the predictability of stock returns using implied volatility spreads (VS) from individual (nonindex) options. VS can occur under simple no-arbitrage conditions for American options when volatility is time-varying, suggesting that the VS-return predictability could be an artifact of firms’ sensitivities to aggregate volatility. Examining this empirically, we find that the predictability changes systematically with aggregate volatility and is positively related to the firms’ sensitivities to volatility risk. The alpha generated by VS hedge portfolios can be explained by aggregate volatility risk factors. Our results cannot be explained by firm-specific informed trading, transaction costs, or liquidity.

The U.S. Consumer Financial Protection Bureau has released a database of consumer complaints about banks’ financial products to the public since 2013. We find a greater reduction in mortgage applications to banks that receive more mortgage complaints in local markets after the disclosures. The effect is stronger in areas with more sophisticated consumers and higher credit competition, and for banks receiving more severe complaints. The number of monthly mortgage complaints per bank exhibits faster mean reversion after the publication of the database. These findings suggest that the public disclosure of mortgage complaints enhances product market discipline and consumer financial protection.

We study how patenting enhances customer capital and creates financial value in a product market characterized by information asymmetry between firm insiders and customers. We find that firms with more and higher quality patents develop greater customer capital, as measured by more positive customer perceptions of product novelty and quality. To establish causality, we exploit the exogenous variation in the random assignment of patent examiners to review applications and use the average examiner leniency as an instrument for patent grants. Our mediation analysis documents a positive impact of patenting on firm performance and financial market valuation through enhanced customer capital.

This paper is concerned with the validity of the conventional t tests on regression coefficients when there is serious multicollinearity between the explanatory variables. It is well known that increasing multicollinearity causes the true standard errors of regression coefficients to rise. The crucial question, however, is whether the conventional formulas will in practice reflect this rise. The purpose of this note is to show that the conventional t tests will in practice reflect this rise. But this note also points out the danger involved in mechanically dropping variables from multiple regression equations by t tests because t values of the regression coefficients may not be significantly different from zero when the true (population) values of these coefficients are in fact not zero, if the explanatory variables are highly intercorrelated.

The concept that corporate investment-growth decisions are constrained by a profit opportunities schedule is central to much of the literature on finance and the theory of the firm. These writings suggest that, for a single firm: (1) the profit opportunities schedule is a decreasing function of investment growth (the slope reflecting, inter alia, competitive conditions); (2) the schedule shifts to the right with changes in national income (except for a firm producing income-inferior goods), and (3) the schedule's position (intercept) at a moment in time reflects a host of factors that are summarized by the term “management.”

Most of the insurance oriented literature contains several levels of abstraction regarding the financial solvency of insurance companies. The first level represents those advances in the actuarial profession which are destined to eventually solve the double problem of capacity and capitalization (hereinafter referred to as the Ruin Problem). Most of these works, however, are concerned with developing the tools necessary to determine the theoretical loss distribution in insurance. The emphasis, then, is upon the mean and variance of the total loss distribution as they can be derived from the distribution of frequency and severity.

Recently, Lusztig and Schwab [5] drew attention to a problem which occurs when applying linear programming methods to portfolio selection where capital is rationed over several investment periods. The problem is to determine the relevant discount rate with which to calculate the net present values of the objective function when this same rate is dependent upon the optimal solution to the linear program. Lusztig and Schwab suggested a neat procedure by which it was claimed that one could overcome this difficulty and which also does not rely upon the measurement of subjective utility as did the Baumol and Quandt approach [2]. It was decided to test the Lusztig and Schwab model (afterwards called the L-S procedure for brevity) on a hypothetical problem, and doing so resulted in two conclusions:

(a) The L–S procedure, as described, is incomplete but with small modification may be useful; however,

(b) concentration upon the discount rate problem in isolation from other capital budgeting problems may well be a pointless exercise.

A financial decision model of the firm, in which most prior deterministic decision models' assumptions were relaxed, was developed and solved for its policy and state variables' time-optimal trajectories. In particular, the three alternative modes of corporate financing, with their respective explicit and implicit costs, were treated as distinct, time-variant decision variables. In addition, their dynamic interdependent relationship with the firm's investment-possibilities schedule was clearly delineated. Besides eliminating the usual constant returns assumption, our model further introduced a dividends discount factor which was an explicit function of the firm's debt-equity ratio.

Furthermore, despite the generality of the model solutions, valuable economic implications were determined; namely, (1) conditions for the existence of a steady-state equilibrium were established with the critical role of nonproportional external equity flotation costs being observed; (2) the firm's dynamic equilibrium path was locally unstable in the initial, high-growth phase of its life cycle and was locally stable in its declining-growth stage–a result consistent with the growth literature in security valu ation theory; and (3) the usual assumptions of the balanced-growth path models are sufficient for the optimality of their decision policies.

The appropriate set of parameters determining the volatility of the value of a portfolio of fixed cash flows of arbitrary maturities is the covariance matrix of unexpected interest rate changes over the term. Equilibrium models of the term structure limit the rank of the covariance matrix and implicitly impose restrictions on covariance estimation. The “full information” approach to risk measurement imposes only time stationarity assumptions on covariance matrix estimators and can result in sample matrices of full rank. Hilliard and Jordan (1989) develop a structured full rank covariance matrix that depends on only two parameters. This paper tests the Hilliard-Jordan model using likelihood ratios and criteria of forecast accuracy.

This paper by Hughes, Logue, and Sweeney offers an excellent summary of recent theoretical work on the advantages of multinational firms in providing opportunities for international diversification. In addition, some interesting empirical tests of an international version of the capital asset pricing model (IAPM) are reported. Neither of these topics is original as several writers have explored the theoretical advantages of the multinational firm providing international diversification, including this discussant [1]. The IAPM has been tested by Solnik [2] and others who find that systematic risk is lower in international financial markets than in domestic ones.

Although the effects of pure diversification and synergistic mergers on market valuation have been widely discussed and there have been a number of studies estimating. merger performance using the two-parameter model of Sharpe-Lintner, the investigation of the corporate determinants of beta is of recent vintage. A variation on this theme, namely whether merger activity is impounded into beta and its speed of being impounded, is the focus of the Joehnk-Nielsen (J-N) study.

The large volume of government bonds issued since 1975 has been a strong driving force for structural change in the Japanese bond markets during the last decade. The increasing amount of outstanding government bonds has made the trading volume in the secondary market increase rapidly, accompanied with the development of interdealer trading.

A piecewise linear weighting function for Black-Scholes implied volatilities is used in conjunction with the Black-Scholes call pricing model to approximate stochastic volatility European call prices. A sensitivity analysis is conducted to compare simulated stochastic volatility call prices to the Black-Scholes prices calculated with the weighted implied volatilities. The analysis indicates that a simple model can provide close approximations to the simulated prices with far less computational effort.

The mean-variance capital asset pricing model (CAPM) of Sharpe and Lintner was extended by Brennan [3] to incorporate divergent borrowing and lending rates. He found that in equilibrium the security market line (SML) has the same structure as the SML under the single-rate CAPM of Sharpe and Lintner. That is, the expected return of a security or a portfolio remains linear in its systematic risk, with the intercept replaced by an equivalent risk-free return, which is an average of the divergent borrowing and lending rates weighted by the investors' taste parameters. The equivalent risk-free return is larger than the riskless lending rate and, hence, does not represent an inconsistency with the empirical findings by Friend and Blume [4] and by Black, Jensen and Scholes [1[ that the intercept of empirical SML estimated for the single-rate CAPM is larger than the riskless rate. Moreover, Brennan attempted to show that his construct can be extended to the extreme case where there are no riskless opportunities. The case of no riskless opportunities was of course investigated by Black [2], who generalized the CAPM and SML by inventing the concept of zero-beta port-folio to account for the same empirical problem encountered in the traditional SML tests of CAPM. Since the Sharpe-Lintner single-riskless-rate CAPM implies a perfect loan market, we may view the attempts by Black and Brennan as generalizing the CAPM by incorporating financial restrictions and loan market imperfections. Their primary motive, however, is empirical, i.e., to reconcile the results from the traditional SML tests with their generalized CAPM.

We show that cross-border leveraged buyout investments involving U.S. rather than non-U.S. private equity (PE) investors are more likely to have a successful exit (initial public offering or acquisition). Exogenous increases in effective proximity following the signing of “open sky agreements” between the United States and target firms’ home countries increases both the propensity of U.S. PE firms to invest in these firms and the value addition by these investors. We show that such increases in value addition by U.S. PE investors following proximity increases are at least partially due to better monitoring, facilitated by the more efficient allocation of experienced U.S. PE managers to cross-border deals.