The Financial Review

Matteo P. Arena, K. Stephen Haggard, Xuemin (Sterling) Yan

We find that returns to momentum investing are higher among high idiosyncratic volatility stocks, especially high idiosyncratic volatility losers. Higher idiosyncratic volatility stocks also experience quicker and larger reversals. The findings are consistent with momentum profits being attributable to underreaction to firm-specific information and with idiosyncratic volatility limiting arbitrage of the momentum effect. We also find a positive time-series relation between momentum returns and aggregate idiosyncratic volatility. Given the long-term rise in idiosyncratic volatility, this result helps explain the persistence of momentum profits since Jegadeesh and Titman’s (1993) study.

Keywords: price momentum, idiosyncratic volatility, limits of arbitrage

George F. Tannous, Clifton Lee-Sing

Assuming the underlying asset price remains constant, previous studies show that the time value of an option decays gradually at a rate that accelerates over time and peaks at the expiry date. Thus, a significant portion of time value is lost in the four weeks leading up to expiry. This paper shows the time value of options that are currently at- or near-the-money should be expected to decay at a rate that decreases rather than increases over time. The time values of options that are currently deep-in- or deepout- of-the-money are expected to initially rise and then resume the normal decay pattern.

Keywords: Options, Time Value Decay, Portfolio Insurance

Thomas Henker, Martin Martens

Basket securities enable investors to purchase a broad portfolio of securities in a single transaction. We examine the link between HOLDRS, a basket security comprising stocks from an industry or sector, and the underlying stocks. We find that the price of the portfolio of underlying securities leads and is more informative than the basket price. Our results are contrary to the findings of empirical studies that use futures, which are basket securities with features less like those of the underlying equities. Our findings suggest uninformed investors can minimize adverse selection costs by trading basket securities rather than the underlying stocks.

Keywords: Price discovery, basket securities, HOLDRS, information share

Shih-Chuan Tsai

This paper develops a dynamic model of the financing and operating decisions of firms in the presence of information asymmetry. When the value of growth opportunities is not fully recognized, securities are undervalued, thus influencing the financing and investment decisions. The agency-based underinvestment problem is re-examined under information asymmetry. For firms with greater growth opportunities, the investment distortion resulting from information asymmetry is especially significant. Information asymmetry also increases the expected bankruptcy cost. The cost of information asymmetry in terms of both the firm value and the information spread under the optimal capital structure could be substantial.

Keywords: growth option, investment distortion, information asymmetry, endogenous default

Manuel Ammann and Michael Verhofen

We use Bayesian model averaging to analyze industry return predictability in the presence of model uncertainty. The posterior analysis shows the importance of inflation and earnings yield in predicting industry returns. The out-of-sample performance of the Bayesian approach is, in general, superior to that of other statistical model selection criteria. However, the out-of-sample forecasting power of a naive iid forecast is similar to the Bayesian forecast. A variance decomposition into model risk, estimation risk, and forecast error shows that model risk is less important than estimation risk.

Keywords: Bayesian model averaging, tactical asset allocation

Delbert Goff, Heather Hulburt, Terrill Keasler, Joe Walsh

We investigate the information content of equity analysts’ recommendation changes subsequent to the passage of Reg FD. We find that analyst upgrades (downgrades) are associated with positive (negative) abnormal returns. Overall, stock prices tend to react significantly more strongly to recommendation changes accompanied by news events than to those that are not. Even so, returns around recommendation changes not accompanied by news are significantly different from zero. This result holds after controlling for firm-specific variables and the incidence of multiple simultaneous recommendation changes. We conclude that analyst recommendation changes, in and of themselves, are informative.

Keywords: analyst recommendation changes, analyst upgrades, analyst downgrades, Regulation Fair Disclosure, Reg FD, disclosure, fair disclosure