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- Volume 6, 2014
Annual Review of Financial Economics - Volume 6, 2014
Volume 6, 2014
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History of American Corporate Governance: Law, Institutions, and Politics
Vol. 6 (2014), pp. 1–21More LessThis article presents an overview of the history of corporate governance in the United States, emphasizing the period before the advent of federal securities laws and the Securities and Exchange Commission (SEC). Recent research has overturned many widely accepted beliefs about corporate governance during this period. In particular, the evolution of American corporate governance has not followed a simple, linear trajectory, beginning with small, well-governed firms and ending with large, poorly governed ones. Over time, economic and institutional changes have given rise to successive generations of corporations with their own governance problems and their own mechanisms to address those problems. When existing governance mechanisms failed, the United States experienced corporate governance crises—episodes that shattered investors’ faith in corporate management and the legal institutions intended to protect their rights. The resolutions of these crises have sometimes been found in legal innovations and, in other cases, in institutional or market-based solutions.
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Blockholders and Corporate Governance
Vol. 6 (2014), pp. 23–50More LessThis paper reviews the theoretical and empirical literature on the channels through which blockholders (large shareholders) engage in corporate governance. In classical models, blockholders exert governance through direct intervention in a firm’s operations, otherwise known as “voice.” These theories have motivated empirical research on the determinants and consequences of activism. More recent models show that blockholders can govern through an alternative mechanism known as “exit”—selling their shares if the manager underperforms. These theories give rise to new empirical studies on the two-way relationship between blockholders and financial markets, linking corporate finance with asset pricing. Blockholders may also worsen governance by extracting private benefits of control or pursuing objectives other than firm value maximization. I highlight the empirical challenges in identifying causal effects of and on blockholders as well as the typical strategies attempted to achieve identification. I close with directions for future research.
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Corporate Takeovers and Economic Efficiency
Vol. 6 (2014), pp. 51–74More LessI review recent takeover research that advances our understanding of “who buys who” in the drive for productive efficiency. This research provides detailed information on text-based definitions of product market links between bidders and targets, the role of the supply chain and industrial networks in driving takeovers, target plant efficiency, and pre- and post-takeover investment in product innovation. Moreover, recent evidence adds to our understanding of “how firms are sold” (transaction efficiency). Almost half of takeovers involving public targets are initiated by the seller and not by the buyer. Targets are strongly averse to bidder toeholds, and the merger negotiation process strongly protects proprietary information. Takeover premiums leave traces of rational bidding strategies, including bid preemption and winner’s curse avoidance. Recent tests employing exogenous instrumentation of bidder valuations reject that bidder shares are systematically overpriced in all-stock bids and suggest that bidder synergy gains are much larger than previously thought.
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Payout Policy
Vol. 6 (2014), pp. 75–134More LessWe survey the literature on payout policy, with a particular emphasis on developments in the past two decades. The cross-sectional empirical evidence for the traditional motivations behind firms paying out (agency, signaling, and taxes) is most persuasive with regard to agency considerations. Studies centered on the May 2003 dividend tax cut confirm that differences in the taxation of dividends and capital gains have only a second-order impact on setting payout policy. None of the three traditional explanations can account for secular changes in how payouts have been made over the past 30 years, during which repurchases have replaced dividends as the prime vehicle for corporate payouts. Other payout motivations, such as changes in compensation practices and management incentives, are better able to explain the observed variation in payout patterns over time than the traditional motivations. The most recent evidence suggests that further insights can be gained from viewing payout decisions as an integral part of a firm’s larger financial ecosystem, with important implications for financing, investment, and risk management.
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Corporate Liquidity Management: A Conceptual Framework and Survey
Vol. 6 (2014), pp. 135–162More LessEnsuring that a firm has sufficient liquidity to finance valuable projects that occur in the future is at the heart of the practice of financial management. However, although discussion of these issues goes back at least to Keynes (1936), a substantial literature on the ways in which firms manage liquidity has developed only recently. We argue that many of the key issues in liquidity management can be understood through the lens of a framework in which firms face financial constraints and wish to ensure efficient investment in the future. We present such a model and use it to survey many of the empirical findings on liquidity management. In addition, we discuss agency-based theories of liquidity, the real effects of liquidity choices, and the impact of the 2008–2009 Financial Crisis on firms’ liquidity management.
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Corporate Pension Plans
Vol. 6 (2014), pp. 163–184More LessThis article reviews the rich and vast literature on defined-benefit (DB) corporate pension plans. The analysis of how firms react to the taxation and regulation of pension plans and to the guarantees provided by the government has allowed researchers to test alternative corporate finance theories, including risk-shifting and risk management. The difficulty in measuring the value of pension liabilities has motivated the study of whether such liabilities are reflected in the cost of capital and in the value of sponsoring firms. The study of the sponsoring firms’ reaction to mandatory pension contribution has provided evidence on financing constraints and on the free-cash-flow hypothesis. Pension plan terminations and freezes have shed light on the nature of the employment contract between the firm and workers.
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Bank Capital and Financial Stability: An Economic Trade-Off or a Faustian Bargain?
Vol. 6 (2014), pp. 185–223More LessFinancial crises impose large and persistent social costs, making banking stability important. This article reviews the central issues surrounding the role bank capital plays in financial stability. Because the socially efficient capital level may exceed banks’ privately optimal capital levels, regulatory capital requirements become germane. But such requirements may entail various bank-level and social costs. Thus, despite agreement that higher capital would enhance banking stability, recognition of these costs has generated theoretical disagreement over whether capital requirements should be higher. Empirical evidence reveals that, in the cross section of banks, higher capital is associated with higher lending, higher liquidity creation, higher bank values, and higher probabilities of surviving crises. Moreover, increases in capital requirements are met with modest declines in lending. The overarching message from research is that lower capital in banking leads to higher systemic risk and a higher probability of a government-funded bailout that may elevate government debt and trigger a sovereign debt crisis. Thus, capital regulation reform, as well as tax policy, should seek to increase bank capital. This article discusses the contemporary thinking on these issues and concludes with open research questions.
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Contingent Capital Instruments for Large Financial Institutions: A Review of the Literature
Vol. 6 (2014), pp. 225–240More LessAs the recent financial crisis unfolded, a new financial instrument—contingent convertible (coco) bonds—was widely considered as a mechanism for promptly recapitalizing overlevered financial institutions. Essentially, the conversion feature of coco bonds would replace supervisory discretion about banks’ capital adequacy with rules specifying when new equity was required. Academics and regulators conjectured that including sufficient cocos in a bank’s capital structure could substantially insulate taxpayers from private investment losses. This potential fostered a literature evaluating the effect of cocos on bank and financial sector stability, risk-taking incentives, and corporate governance. I review this literature and suggest that regulatory capital definitions should be expanded to include substantial amounts of carefully designed coco bonds as a partial substitute for common equity in regulatory capital requirements.
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Counterparty Risk: A Review
Vol. 6 (2014), pp. 241–258More LessThis review provides formal definitions of the terms credit value adjustment (CVA) and debt value adjustment (DVA). Estimating these quantities requires modeling the probabilities of default and the loss given default, recognizing the dependence structure among all these inputs. In practice, marginal distributions are used and a copula function assumed. Although it has long been known that different copula functions can produce very different price estimates, keeping marginal distributions constant, there is little empirical evidence about the appropriate form of function to use for modeling default dependence. This review discusses the use of collateral for risk mitigation and its effects on CVA. Regulators have argued that standardized contracts should be cleared through central counterparties (CCPs). However, there are arguments against CCPs.
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The Industrial Organization of the US Residential Mortgage Market
Vol. 6 (2014), pp. 259–288More LessWe show that the US residential single-family mortgage-origination market is highly concentrated once account is taken of the contractual coordination that arises from the correspondent- and warehouse-funding channels. We represent these channels as a network, using the flow of loans through three strata of the loan origination market: origination, aggregation, and securitization. We develop a network representation of the origination market and demonstrate that it is a small world, in that most nodes are close in the network. We then rank-order the interlinked aggregators and securitizers using ex post mortgage foreclosure rates as a proxy for performance. Our findings suggest that these significant interlinkages in the mortgage-origination network represent a previously underappreciated source of systemic risk. Many apparently atomistic mortgage underwriters are, in fact, coordinated to act in parallel because of their funding relationships with the large, too-big-to-fail bank holding companies.
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Investor Flows to Asset Managers: Causes and Consequences
Vol. 6 (2014), pp. 289–310More LessCash flows between investors and funds are both cause and effect in a complex web of economic decisions. Among the issues at stake are the prospects and fees of the funds, the efforts and risk choices by the funds’ managers, the pricing and comovement of the assets they trade, the stability of the financial system and the real economy, and the retirement security and protection of the investors. There is an accordingly large and growing literature on flows that has concentrated on the main retail investment pool, the open-end mutual fund, and has used flows to explore many aspects of retail financial decision making. We survey this literature and, where relevant, describe how open-end flows compare to other investment vehicles. We also identify opportunities both for future research and for refinement of mutual fund design, in particular as suggested by the recent rethinking of retail investment pools in the European Union.
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Exchange-Traded Funds: An Overview of Institutions, Trading, and Impacts
Vol. 6 (2014), pp. 311–341More LessExchange-traded funds (ETFs) have grown substantially in diversity and size in recent years, reflecting a broader shift toward passive, index investing. As a consequence, there is increased attention by investors, regulators, and academics seeking to assess and understand the implications of this rapid growth. This article provides a unified framework to examine these issues and review the research to date, demonstrating that ETFs have extended significant benefits to investors and to the functioning of markets that meaningfully outweigh any perceived or actual weaknesses.
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Stock Prices and Earnings: A History of Research
Vol. 6 (2014), pp. 343–363More LessAccounting earnings summarize periodic corporate financial performance and are key determinants of stock prices. We review research on the usefulness of accounting earnings, including research on the link between accounting earnings and firm value and research on the usefulness of accounting earnings relative to other accounting and nonaccounting information. We also review research on the features of accounting earnings that make them useful to investors, including the accrual accounting process, fair value accounting, and the conservatism convention. We finish by summarizing research that identifies situations in which investors appear to misinterpret earnings and other accounting information, leading to security mispricing.
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Information Transmission in Finance
Vol. 6 (2014), pp. 365–384More LessBecause theories in finance rely critically on what agents know, designing powerful tests of these theories requires measuring information transmission. In this review, I characterize the rapidly growing subfield directly analyzing information in financial markets. Its three hallmarks are the examination of (a) a wide array of informative events, (b) different mechanisms for transmitting information, and (c) measures of information content based on nonnumeric information. Recent research directly measures flows of information to shed light on diverse phenomena in asset pricing, such as market reactions to news and nonnews, investors’ portfolio choices, and mutual fund flows and returns, and in corporate finance, such as mergers and acquisitions, initial public offering (IPO) underpricing, and executive compensation. Continued improvements in access to data and computing power are likely to propel this line of research for years to come.
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Insider Trading Controversies: A Literature Review*
Vol. 6 (2014), pp. 385–403More LessUsing the artifice of a hypothetical trial, this article presents the cases for and against insider trading. Both sides in the trial produce as evidence the salient points made in more than 100 years of literature on insider trading. The initial days of the trial focus on the issues raised in the law literature such as fiduciary responsibility, the misappropriation theory, and the fairness and integrity of markets; however, the trial soon transfers focus to issues such as Pareto optimality, efficient contracting, market efficiency, and predictability raised in the financial economics literature. Open issues are then brought up. A jury finally hands down its verdict.
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Security Market Manipulation
Vol. 6 (2014), pp. 405–418More LessThis article uses a variety of contemporary developments to address artificial market pricing and market manipulation. It examines a variety of modern trading tactics and manipulation strategies in the context of trading and order mechanics. For example, I raise the connection between so-called best execution, cancellation rates, and manipulation. I explore the connection between manipulation and short exposures as well as potential connections between Federal Reserve policies and artificial pricing. I also examine the nature of market manipulation in different facets of the trading day and the transitions among these.
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Financialization of Commodity Markets
Ing-Haw Cheng, and Wei XiongVol. 6 (2014), pp. 419–441More LessThe large inflow of investment capital to commodity futures markets in the past decade has generated a heated debate about whether financialization distorts commodity prices. Rather than focusing on the opposing views concerning whether investment flows caused a price bubble, we critically review academic studies through the perspective of how financial investors affect risk sharing and information discovery in commodity markets. We argue that financialization has substantially changed commodity markets through these mechanisms.
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Forward Rate Curve Smoothing
Vol. 6 (2014), pp. 443–458More LessThis article reviews the forward rate curve smoothing literature. The key contribution of this review is to link the static curve fitting exercise to the dynamic and arbitrage-free models of the term structure of interest rates. As such, this review introduces more economics to an almost exclusively mathematical exercise, and it identifies new areas for research related to forward rate curve smoothing.
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Optimal Exercise for Derivative Securities
Vol. 6 (2014), pp. 459–487More LessThis article reviews the literature on American-style derivatives. The presentation stresses some of the major developments in the field. The focus is on the determination of optimal exercise policies and the structure of derivatives’ prices. Illustrative examples highlight the complexity of the optimal exercise decision.
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