Finance →
- 20 Mar 2008
- Working Paper Summaries
Sell Side School Ties
Certain agents play key roles in revealing information into securities markets. In the equities market, security analysts are among the most important. A large part of an analyst's job (perhaps the majority) is to research, produce, and disclose reports forecasting aspects of companies' future prospects, and to translate their forecasts into stock recommendations. Therefore, isolating how, or from whom, analysts obtain the information they use to produce their recommendations is important. Do analysts gain comparative information advantages through their social networks—specifically, their educational ties with senior officers and board members of firms that they cover? This paper investigates ties between sell-side analysts and management of public firms, and the subsequent performance of their stock recommendations. Key concepts include: Equity analysts outperform on their stock recommendations when they have an educational link to that company. A simple portfolio strategy of going long the buy recommendations of analysts with school ties and going short the buy recommendations of analysts without ties earns returns of 5.40% per year in the full sample. Informal information networks are an important, yet under-emphasized channel through which private information gets revealed into prices. Closed for comment; 0 Comments.
- 12 Mar 2008
- Working Paper Summaries
Allocating Marketing Resources
Deciding how to allocate marketing resources is particularly difficult because decisions need to be made at many different levels—across countries, products, marketing mix elements, and different vehicles within elements of the mix (e.g., television versus the Internet for advertising). With the increasing availability of data and sophistication in methods, it is now possible to more judiciously allocate marketing resources. In this paper, HBS professors Gupta and Steenburgh discuss a two-stage process where a model of demand is estimated in stage-one and its estimates are used as inputs in an optimization model in stage-two. The researchers propose a matrix with three approaches for each of these two stages, and discuss the pros and cons of these methods. They highlight each method with applications and case studies to present rigorous yet practical approaches to making marketing resource allocation decisions. Key concepts include: This paper lays out a framework for managers who are responsible for allocating marketing resources for their products and services. Scores of studies in the area of allocating marketing resources now make it possible to form empirical generalizations about the impact of marketing actions on sales and profits. In practical terms, information about marketing resource allocation makes a significant impact at all levels of an organization. Closed for comment; 0 Comments.
- 26 Feb 2008
- Working Paper Summaries
Long-Run Stockholder Consumption Risk and Asset Returns
The long-run consumption risk of households that hold financial assets is particularly relevant for asset pricing. The fact that stockholders are more sensitive to aggregate consumption movements helps explain why the consumption risk of stockholders delivers lower risk aversion estimates. Understanding further why consumption growth, particularly that of stockholders, responds slowly to news in asset returns will improve finance scholars' understanding of what drives these long-run relations. HBS professor Malloy and his coauthors examine more disaggregated measures of long-run consumption risks across stockholders and non-stockholders, and provide new evidence on the long-run properties of consumption growth and its importance for asset pricing. Key concepts include: Small and value stocks earn low returns, and long-term bonds do poorly when the future consumption growth of stockholders is low. The high average returns observed for small and value stocks and long-maturity bonds may therefore reflect the premium stockholders require to bear long-run consumption risk. Closed for comment; 0 Comments.
- 22 Feb 2008
- Working Paper Summaries
Consumer Demand for Prize-Linked Savings: A Preliminary Analysis
Prize-linked savings (PLS) products are savings vehicles that may appeal to people with little savings and little interest in traditional savings products. PLS products offer savers a return in the form of the chance to earn large prizes, rather than in more traditional forms of interest or dividend income or capital appreciation. The probability of winning is typically determined by account balances, and the aggregate prize pool can be set to deliver market returns to all savers. Prize-linked assets are offered in over twenty countries around the world—including the U.K., Sweden, South Africa, and many Latin American and Middle Eastern countries—but are not available in the United States, where state laws and federal regulations make the offering of prize-linked programs problematic. This working paper provides a first look into demand for a PLS product in the United States. Key concepts include: PLS products are promising, despite formidable barriers to success in the United States. The low income population that was studied expressed substantial interest in a savings product that provides prizes as part of its return. This product appeals to non-savers, who do not save with traditional products. The product appeals to heavy lottery players, and by virtue of this fact, has the potential of turning their gambling activities into demand for savings. PLS products might face an uphill battle in the United States due significantly to well-established gambling and lottery industries that might oppose PLS, and the roadblocks due to legal uncertainty and prohibitions around this new product. Businesses or state treasurers might be reluctant to innovate around a product that must compete against heavily marketed alternatives. Closed for comment; 0 Comments.
- 14 Feb 2008
- Working Paper Summaries
Laws vs. Contracts: Legal Origins, Shareholder Protections, and Ownership Concentration in Brazil, 1890-1950
The early development of large multidivisional corporations in Latin America required much more than capable managers, new technologies, and large markets. Behind such corporations was a market for capital in which entrepreneurs had to attract investors to buy either debt or equity. This paper examines the investor protections included in corporate bylaws that enabled corporations in Brazil to attract investors in large numbers, thus generating a relatively low concentration of ownership and control in large firms before 1910. The case of Brazil is particularly interesting because, in Latin America before World War I, it boasted the second-largest equity market and largest number of traded companies. As HBS professor Aldo Musacchio shows, the considerable variation of investor protections over time at the country level, and even at the company level, urges cautions against notions about the persistency of institutions, especially of legal traditions. Key concepts include: Many large Brazilian corporations at the turn of the 20th century induced small investors to buy equity by choosing bylaws that distributed power in a more democratic way among shareholders. Maximum vote provisions, and to a lesser degree graduated voting scales, were correlated with lower concentration of ownership and voting power. The shareholder protections in national laws that seem to have mattered most were those that facilitated the private monitoring of corporate activities by requiring corporations to publish important financial information. It is possible for companies to break with the institutional environment in which they operate. It is unlikely that the institutions relevant to the expansion of equity markets and development of large multidivisional corporations were determined hundreds of years ago, either at the time of colonization or when countries adopted their current legal systems. Closed for comment; 0 Comments.
- 12 Feb 2008
- Working Paper Summaries
The Small World of Investing: Board Connections and Mutual Fund Returns
How does information flow in security markets, and how do investors receive information? In the context of information flow, social networks allow a piece of information to flow along a network often in predictable paths. HBS professors Lauren Cohen and Christopher Malloy, along with University of Chicago colleague Andrea Frazzini, studied a type of dissemination through social networks tied to educational institutions, examining the information flow between mutual fund portfolio managers and senior officers of publicly traded companies. They then tested predictions on the portfolio allocations and returns earned by mutual fund managers on securities within and outside their networks. Key concepts include: Social networks are important for information flow between firms and investors. Across the spectrum of U.S. mutual fund portfolio managers, fund managers place larger concentrated bets on stocks they are connected to through their education network, and do significantly better on these holdings relative to non-connected holdings, and relative to connected firms they choose not to hold. A portfolio of connected stocks held by managers outperforms non-connected stocks by up to 8.4 percent per year. This connection is not driven by firm, fund, school, industry, or geographic location effects, nor by a subset of the school connections (e.g., Ivy League). The bulk of this premium occurs around corporate news events such as earnings announcements. This finding suggests that the excess return earned on connected stocks is driven by information flowing through the network. As the information will eventually be revealed into stock prices, advance knowledge implies return predictability. Closed for comment; 0 Comments.
- 07 Feb 2008
- Working Paper Summaries
Attracting Flows by Attracting Big Clients: Conflicts of Interest and Mutual Fund Portfolio Choice
Retirement assets make up a large and growing percentage of the mutual fund universe. In 2004, nearly 40 percent of all mutual fund assets were held by defined contribution plans and individual retirement accounts. This percentage is steadily increasing largely because these retirement accounts represent the majority of new flows into non-money market mutual funds. With such a large and growing percentage of their assets coming from retirement accounts, mutual funds are likely to be interested in securing these big clients. This paper examines a new channel through which mutual fund families can attract assets: by becoming a 401(k) plan's trustee. HBS professor Lauren Cohen and colleague Breno Schmidt provide evidence consistent with the trustee relationship affecting families' portfolio choice decisions. These portfolio decisions, however, have the potential to be in conflict with the fiduciary responsibility mutual funds have for their investors, and can impose potentially large costs. Key concepts include: Mutual fund families systematically distort their portfolios to attract 401(k) clients, presenting a conflict of interest. Mutual fund families that become trustees significantly overweight 401(k) sponsor firms' stock in their fund families. The trustee family performs a valuable service to the sponsor company by buying or holding its stocks around times of substantial selling of the sponsor firm by all other funds. Increased buying of sponsor firm shares by its trustee can have substantial price impact by propping up the sponsor firm's price. The overweighting can in some cases result in a large cost to the mutual fund investors. One possible remedy is to require the trustee to be independent of the mutual fund providers in the plan. This could greatly reduce the overweighting behavior currently seen by ostensibly ridding the relationship of its embedded, and unneeded, conflict of interest. Closed for comment; 0 Comments.
- 30 Jan 2008
- Working Paper Summaries
Cost of External Finance and Selection into Entrepreneurship
Entrepreneurs are, on average, significantly wealthier than people who work in paid employment. Research shows that entrepreneurs comprise fewer than 9 percent of households in the United States but they hold 38 percent of household assets and 39 percent of the total net worth. This relationship between personal wealth and entrepreneurship has long been seen as evidence of market failure, meaning that talented but less wealthy individuals are precluded from entrepreneurship because they don't have sufficient wealth to finance their new ventures. Nanda studied how changes in the cost of external finance affected the characteristics and likelihood of individuals becoming entrepreneurs. He finds that market failure accounts for only a small fraction of the relationship between personal wealth and entrepreneurship in advanced economies such as the U.S. Key concepts include: Entrepreneurs are, on average, significantly wealthier than people who work in paid employment. The wealthy are also more likely to become entrepreneurs. Talent matters in entrepreneurship, more so for the less wealthy. The relationship between individual wealth and entrepreneurship in advanced economies is driven at least in part by the fact that wealthy individuals can start lower growth-potential businesses because they do not face the discipline of external finance. It may be misguided to provide a simple scheme of cheap credit for new ventures, as not all who take up the scheme will be those who really need it. Closed for comment; 0 Comments.
- 23 Jan 2008
- Op-Ed
A House Divided: Investment or Shelter?
For decades Americans viewed their homes as a safe harbor, a place to put down roots. But the last decade saw the rise of housing as an investment opportunity. What comes next? asks Harvard Business School professor Nicolas P. Retsinas, director of Harvard's Joint Center for Housing Studies. Closed for comment; 0 Comments.
- 04 Oct 2007
- What Do You Think?
Has Managerial Capitalism Peaked?
Summing Up. Professor Jim Heskett considers his reader's comments on the growing imbalance between what John Bogle terms managerial capitalism and owners' capitalism. Closed for comment; 0 Comments.
- 21 Sep 2007
- Working Paper Summaries
Intra-Industry Foreign Direct Investment
One of the enduring puzzles for researchers on FDI has been the role and importance of "horizontal" and "vertical" FDI. Horizontal FDI tends to mean locating production closer to customers and avoiding trade costs. Vertical FDI, on the other hand, represents firms' attempts to take advantage of cross-border factor cost differences. A central challenge for study has been the absence of firm-level data to distinguish properly among the types of and motivations for FDI. Alfaro and Charlton analyzed a new dataset, and in this paper present the first detailed characterization of the location, ownership, and activity of global multinational subsidiaries. Key concepts include: Most FDI occurs between rich countries. In contrast to previous research, it appears that the share of vertical FDI is larger than commonly thought, even within developed countries. Multinational firms have tended to embrace vertical FDI for highly skilled and later stages of production, and for arm's-length transactions for lower-skill inputs and processes. Closed for comment; 0 Comments.
- 12 Sep 2007
- Op-Ed
Building Sandcastles: The Subprime Adventure
The early days of the subprime industry seemed to fulfill a market need—and millions of renters became homeowners as a result. But rapidly escalating home prices masked cracks in the subprime foundation. HBS professor Nicolas P. Retsinas, who is also director of Harvard University's Joint Center for Housing Studies, lays out what went wrong and why. Closed for comment; 0 Comments.
- 11 Sep 2007
- Working Paper Summaries
Bond Risk, Bond Return Volatility, and the Term Structure of Interest Rates
This paper documents the existence of considerable variation over time in the covariance or correlation of Treasury bond returns with stock returns and with consumption growth. There are times in which bonds appear to be safe assets, while at other times they appear to be highly risky assets. The paper finds that time variation in bond risk is systematic and positively related to the level and the slope of the yield curve. These are factors that proxy for inflation and general economic uncertainty, inflation risk, and the risk premium on bonds. Key concepts include: The movement of bond returns together with stock returns (or consumption growth) can change significantly in business cycle frequencies. Bond risk changes over time, and these changes are correlated with time variation in the term structure of nominal interest rates. Closed for comment; 0 Comments.
- 05 Sep 2007
- Working Paper Summaries
Global Currency Hedging
This article is forthcoming in the Journal of Finance. How much should investors hedge the currency exposure implicit in their international portfolios? Using a long sample of foreign exchange rates, stock returns, and bond returns that spans the period between 1975 and 2005, this paper studies the correlation of currency excess returns with stock returns and bond returns. These correlations suggest the existence of a typology of currencies. First, the euro, the Swiss franc, and a portfolio simultaneously long U.S. dollars and short Canadian dollars are negatively correlated with world equity markets and in this sense are "safe" or "reserve" currencies. Second, the Japanese yen and the British pound appear to be only mildly correlated with global equity markets. Third, the currencies of commodity producing countries such as Australia and Canada are positively correlated with world equity markets. These results suggest that investors can minimize their equity risk by not hedging their exposure to reserve currencies, and by hedging or overhedging their exposure to all other currencies. The paper shows that such a currency hedging policy dominates other popular hedging policies such as no hedging, full hedging, or partial, uniform hedging across all currencies. All currencies are uncorrelated or only mildly correlated with bonds, suggesting that international bond investors should fully hedge their currency exposures. Key concepts include: It is striking that the U.S. dollar, Swiss franc, and euro are widely used as reserve currencies by central banks, and more generally as stores of value by corporations and individuals around the world. Interestingly, the euro, the Swiss franc, and a long-short position in the U.S. dollar and the Canadian dollar are negatively correlated with world equity markets. By contrast, other currencies such as the Australian dollar, the Canadian dollar, the Japanese yen, and the British pound are either uncorrelated or positively correlated with world stock markets. These patterns imply that international equity investors can minimize their equity risk by taking short positions in the Australian and Canadian dollars, Japanese yen, and British pound, and long positions in the U.S. dollar, euro, and Swiss franc. For U.S. investors, currency exposures of international equity portfolios should be at least fully hedged, and probably overhedged. Exceptions are the euro and Swiss franc, which should be at most partially hedged. Risk management demands for currencies by bond investors are small or zero, regardless of the home country of these investors, and regardless of whether these investors hold only domestic bonds or an international bond portfolio. Closed for comment; 0 Comments.
- 22 Aug 2007
- Research & Ideas
The Hedge Fund as Activist
Do hedge funds improve management of the companies they invest in? A new study by Harvard Business School professor Robin Greenwood and coauthor Michael Schor argues that, in fact, hedge funds create shareholder value through anticipation of change, not necessarily delivering it. Key concepts include: Hedge funds have entered the activist arena. Between 1994 and 2006, the number of public firms targeted for poor performance by hedge funds grew more than 10-fold. Hedge funds generate returns of over 5 percent on announcement of their involvement with a targeted firm. Rather than effecting significant operational change, hedge funds create value by putting firms "in play." A question for future study: Do hedge fund activist-initiated acquisitions create value for the acquirers of these firms? Closed for comment; 0 Comments.
- 20 Aug 2007
- Working Paper Summaries
Hedge Fund Investor Activism and Takeovers
Are hedge funds better than large institutional investors at identifying undervalued companies, locating potential acquirers for them, and removing opposition to a takeover? Are they best equipped to monitor management? While blockholding by large institutional investors—pension funds and mutual fund investment companies—is widespread, there is virtually no evidence that these institutional shareholders are effective monitors of management or that their presence in the capital structure increases firm value. When institutional blockholders make formal demands on management, there is no evidence of their success. This working paper outlines the advantages and limits of hedge funds to manage these tasks. Greenwood and Schor's characterization differs markedly from previous work on investor activism, which tends to attribute high announcement returns to improvements in operational performance. Key concepts include: While recent popular accounts suggest that we are in an era of the "imperial shareholder," the results in this working paper indicate that activism tends to be most successful when there is a high probability of a takeover. Where improvements may take several quarters or even years to realize, the investment horizon of hedge funds makes them unsuitable overseers of management. Firms that would benefit from modest changes in operating policy or governance, or for which a reduction in CEO pay is to be desired, are not likely to hit the radar screen of hedge funds. While hedge funds do occasionally succeed in changing the board, initiating or increasing dividends, repurchasing shares, or cutting executive pay, it is not clear that these changes increase shareholder value relative to getting the target acquired. Closed for comment; 0 Comments.
- 15 Aug 2007
- Op-Ed
3 Steps to Reduce Financial System Risk
By using complex derivative products, banks are better able to manage risk. But this "credit risk transfer" technology is transferring risk to a new set of investors inexperienced in this arena and posing exposure problems for the international financial system as a whole, argues Harvard Business School professor Mohamed El-Erian. Here's how to fix the problem. Key concepts include: Regulatory authorities must address 2 challenges to contain a new source of systemic risk in international finance: the increasing migration of complex market activities to unqualified supervisory bodies, and the growing threat of politically motivated changes to regulatory regimes. If left unchecked, systemic risk in the international financial system will increase and much of the initial beneficial impact of credit risk transfer technology may be negated. 3 steps can mitigate this new component of systemic risk: greater cooperation among supervisory bodies; encouragement of rating agencies to improve their modeling of derivative products; and inducement of new investors to evaluate the ratings issued by the agencies against improved internal risk management capabilities. Closed for comment; 0 Comments.
- 13 Jul 2007
- Working Paper Summaries
Economic Catastrophe Bonds
Pooling economic assets into large portfolios and tranching them into sequential cash-flow claims has become a big business, generating record profits for both the Wall Street originators and the agencies that rate these securities. This paper by business economics doctoral student Jakub Jurek and HBS professors Joshua Coval and Erik Stafford investigates the pricing and risks of instruments created as a result of recent structured finance activities. It demonstrates that senior collateralized debt obligation (CDO) tranches have significantly different systematic risk exposures than their credit rating-matched, single-name counterparts, and should therefore command different risk premia. Key concepts include: Investors in senior CDO tranches are grossly undercompensated for the highly systematic nature of the risks they bear. An investor willing to assume the economic risks inherent in senior CDO tranches can, with equivalent economic exposure, earn roughly 3 times more compensation by writing out-of-the-money put spreads on the market. Credit rating agencies do not provide customers with adequate information for pricing. They are willing to certify senior CDO tranches as "safe" when, from an asset pricing perspective, they are quite the opposite. Closed for comment; 0 Comments.
- 26 Jun 2007
- Working Paper Summaries
Contracting in the Self-reporting Economy
Intellectual property can be used by its owner directly, licensed to a third party for a fixed royalty, or licensed to a third party for a variable royalty. The variable royalty arrangement depends on self-reporting by the licensee, which in turn induces demand for auditing by the licensor. This research studies a setting with the following features: a production cost advantage on the part of the outside party that creates gains from licensing; a limited liability constraint that prevents the licensee from owing more royalties than the gross profits of licensing the intellectual property and prevents the licensor from capturing all of the economic surplus via a fixed royalty agreement; and accounting and auditing costs that reduce the benefits of a variable royalty agreement. Key concepts include: The owner of intellectual property will enter into a variable royalty agreement with an outside party if—and only if—the accounting and auditing costs are sufficiently low. With higher cost levels, the owner will use the property directly if the owner can do so profitably. Otherwise, the owner will prefer to license the property in exchange for a fixed royalty. The expected aggregate accounting system and audit costs are minimized when the licensor can compel the licensee to bear the audit costs in case underreporting is detected. Internal control provisions within the Sarbanes-Oxley Act make variable royalty arrangements based on self-reporting and auditing relatively more attractive than such arrangements prior to Sarbanes-Oxley. Sarbanes-Oxley effectively lowers the licensor's audit costs even though the licensor must audit all low reports, because auditing all low reports deters the licensee from underreporting in the first place. Closed for comment; 0 Comments.
Bridge Building in Venture Capital-Backed Acquisitions
The acquisition of new capabilities through the purchase of small venture capital-backed start-ups is a strategy that has been employed by many large technology firms including Cisco, Microsoft, Google, and EMC. Young venture capital-backed companies, for their part, often develop innovative technologies that can be exploited by existing technology companies. The value inherent in these start-ups is typically tied up in the intellectual property or human capital that has been developed during the early stages of the company's life. The opportunity to acquire valuable intangible assets, however, is balanced by the difficulty in assessing the value of the underlying assets. Unlike purchasing companies with substantial operating profits and a long track record of sales, the ability to fully assess the prospects of intangible assets is subject to substantial asymmetric information and uncertainty. This paper explores mechanisms for limiting the asymmetric information that potentially plagues the acquisition of young venture capital-backed companies. The results also shed light on the value that venture capitalists add to their portfolio companies as well as to companies in their venture capital network. Key concepts include: In the bridge-building alternative presented here, the personal relationship between the two firms is critical to conveying value-relevant information about both the target and the acquiring firm. The venture capital investor link between the acquirer and the target has a strong effect on how the purchase transaction is structured, how the market reacts to the announcement of the acquisition, and how the acquirer performs in the stock market in the long run. Recruitment of management and the identification of first-time customers may be improved through bridge building networks that the venture capitalist creates. Bridge building may be important in relationships with service providers and strategic partners. Closed for comment; 0 Comments.