We investigate incentive effects of a typical hedge fund contract for a manager with power utility. With a one-year horizon, the manager displays risk taking that varies dramatically with fund value. We extend the model to multiple yearly evaluation periods and find that the manager's risk taking is rapidly moderated if the fund performs reasonably well. The most realistic approach to modeling fund closure uses an endogenous shutdown barrier where the manager optimally chooses to shut down. The manager increases risk taking as fund value approaches that barrier, and this boundary behavior persists strongly with multiyear horizons.

This paper examines whether self-described market timing hedge funds have the ability to time the U.S. equity market. We propose a new measure for timing return and volatility jointly that relates fund returns to the squared Sharpe ratio of the market portfolio. Using a sample of 221 market timing funds during 1994–2005, we find evidence of timing ability at both the aggregate and fund levels. Timing ability appears relatively strong in bear and volatile market conditions. Our findings are robust to other explanations, including public information-based strategies, options trading, and illiquid holdings. Bootstrap analysis shows that the evidence is unlikely to be attributed to luck.

We analyze a new class of linear factor models in which the factors are latent and the covariance matrix of excess returns follows a multivariate stochastic volatility process. We evaluate cross-sectional restrictions suggested by the arbitrage pricing theory (APT), compare competing stochastic volatility specifications for the covariance matrix, and test for the number of factors. We also examine whether return predictability can be attributed to time-varying factor risk premia. Analysis of these models is feasible due to recent advances in Bayesian Markov chain Monte Carlo (MCMC) methods. We find that three latent factors with multivariate stochastic volatility best explain excess returns for a sample of 10 size decile portfolios. The data strongly favor models constrained by APT pricing restrictions over otherwise identical unconstrained models.

Analysts' earnings forecasts are influenced by their desire to win investment banking clients. We hypothesize that the equity bull market of the 1990s, along with the boom in investment banking business, exacerbated analysts' conflicts of interest and their incentives to strategically adjust forecasts to avoid earnings disappointments. We document shifts in the distribution of earnings surprises and related changes in the market's response to surprises and forecast revisions. The evidence for shifts is stronger for growth stocks, where conflicts of interest are more pronounced. However, shifts are less notable for analysts without ties to investment banking and in international markets.

International asset pricing models suggest that barriers to portfolio flows and availability of market substitutes affect the degree and time variation of world market integration. We use GARCH-in-mean methodology to assess the evolution in market integration for eight emerging markets over the period 1977–2000. Our results suggest that while local risk is still a relevant factor in explaining time variation of emerging market returns, none of the countries appear to be completely segmented. We find that there are substantial crossmarket differences in the degree of integration. The evolution toward more integrated financial markets is apparent although at times we do observe reversals. In addition, we provide clear evidence on the impropriety of directly using correlations of market-wide index returns as a measure of market integration. Finally, financial market development and financial liberalization policies play important roles in integrating emerging markets.

This paper examines the valuation impacts of outside independent directors in Korea, where a regulation requiring outside directors was instituted after the Asian financial crisis. In contrast to studies of U.S. firms, the effects of independent directors on firm performance are strongly positive. Foreigners also have positive impacts. The effects of indigenous institutions such as chaebol or family control are insignificant or negative. This implies that the effect of outsiders depends on board composition as well as the nature of the market in which the firm operates.

The forward bias anomaly implies that currency excess returns are predictable by the forward premium. Yet, recent studies suggest that statistical inference problems may spuriously account for this predictability. This article demonstrates that while currency excess returns are not predictable out of sample using a standard mean square forecast error criterion, the forward premium nonetheless has directional predictability. This directional forecasting accuracy translates into statistically significant profits from trading on the forward bias anomaly.

This study investigates whether the difference in individual shareholder tax rates between dividend income and capital gain (the dividend tax penalty) affects a firm's choice between distributing funds to shareholders through dividends or share repurchases. The results of this study suggest that, in periods in which the dividend tax penalty increases, firms are more likely to distribute funds to shareholders through share repurchases as opposed to dividends. The results also indicate that the relation between the dividend tax penalty and corporate payout choice is affected by the types of shareholders who own stock in the firm. As tax-disfavored institutional ownership increases and the dividend tax penalty increases, firms are more likely to repurchase shares as opposed to distributing dividends. In contrast, as tax-favored institutional ownership increases and the dividend tax penalty increases, firms are less likely to repurchase shares as opposed to distributing dividends. As senior managerial share ownership increases and the dividend tax penalty increases, firms are more likely to make distributions to shareholders in the form of share repurchases.

When market returns follow a long memory volatility process, standard approaches to estimating dynamic minimum variance hedge ratios (MVHRs) are misspecified. Simulation results and an application to the S&P 500 index document the magnitude of the misspecification that results from failure to account for basis convergence and long memory in volatility. These results have important implications for the estimation of MVHRs in the S&P 500 example and other markets as well.

Prior research concludes that option introductions improve the average liquidity of the underlying stocks. We develop an improved, generalizable test to assess whether market quality changes occur on or near an event date. Applying this method to option listing events, we conclude that options do not systematically improve the market quality of the underlying security; rather, the market quality of the underlying security improves before the listing decision. Hazard model tests indicate that improving liquidity is a selection criterion in the option listing decision. Moreover, these tests suggest that the size of a stock's bid-ask spread is the single most important option listing determinant.