Price Drift Research Articles

Valuation of investment on a firm with trade credit under uncertainty: A real options approach

This paper intends to propose a corporate valuation framework by incorporating both the stochastic product price and the stochastic interest rate in a delay payment context. By using Ito-Isometry theorem, we derived the analytical solution for corporate value, based on which sensitivity analyses and further simulations for the real option value are performed. Some critical factors were considered in the sensitivity analysis of corporate value: the drift and the volatility in the price and in the interest rate processes, the price elasticity of demand, the cost rate, the market share, as well as the length of time period for delay payments. To valuate an opportunity of investment on a firm with trade credit under uncertainty, a real options model was employed. The simulation results for the real option value indicated that increasing demand elasticity, market share, number of time periods for delay payments, interest rate drift, price volatility, and interest rate volatility all contribute to increasing real option value, whereas the increasing cost rate and price drift lead to the decreasing real option value as expected. Key words: Trade credit, stochastic price, stochastic interest rate, real option.

Pre-Earnings Announcement Drift

We present evidence of a predictable drift in stock prices before the earnings announcements of firms that announce their earnings later than other firms in their industry. We form portfolios based on the returns of later announcers that are implied by the abnormal returns of earlier announcers and the historical pair-wise covariance of the abnormal earnings announcement date returns of earlier and later announcers. A long-short trading strategy based on these implied returns generates monthly returns of more than 100 basis points. The drift is neither due to the well-known momentum effect nor a manifestation of post-earnings announcement drift; it is evident both between the earlier announcers’ earnings announcement dates and the later announcers’ earnings announcement dates and at the later announcers’ earnings announcement dates. The continued under-reaction after later announcers’ earnings announcements is shown to be an under-reaction to the later announcers’ own earnings announcements (i.e., post-earnings announcement drift) rather than a continued under-reaction to the earnings news of earlier announcers (i.e., pre-earnings announcement drift). We show that transaction costs explain the predictability of later announcers’ returns.

The Valuation and Strategy of Foreign Operations Under Stochastic Price: A Real Options Model

Many multinational firms are facing diminishing profit margins in their home countries and, as a result, may move their manufacturing facilities to foreign countries to seek the benefits of lower labor costs and tax rates. Inspired by the real option models of Moon (2010) and Wu (2010), we propose a framework to explore how the fluctuations of price, cost reduction, and tax benefit factors affect the timing and the valuation of foreign investments. The sensitivity towards corporate value (real option value) and price threshold is then analyzed in illustrations. The results indicate that price drift and price volatility have opposing effects on corporate value and price threshold. In addition, the effects of tax and cost reduction factors on price threshold depend on the range of price elasticity in the demand. This study confirms that multinational firms would always seek domestic or foreign investment opportunities with relatively lower costs, tax rates, and reduced market risks as they relate to profit maximization in a global setting. Finally, this work suggests that the decision rules for the optimal entry of foreign operations significantly depend on the price elasticity of demand.

Can Price Movement Toward Equilibrium Overshoot? Evidence from Share Repurchases and Subsidiary Selling

If a firm repurchases its own shares to signal that they are undervalued then the stock price should increase to its intrinsic level. However, it is not clear whether the price should monotonically increase to its intrinsic level or instead could reach equilibrium through a more dynamic process by which the price fluctuates around the intrinsic level and approaches that level gradually. Using unique data from the Taiwanese stock market, which allows firms to buy and sell their own shares through subsidiaries, we find strong evidence supporting the view that a price rebound does overshoot for at least some firms and the stock becomes overvalued after a repurchase announcement. Our work complements the literature regarding both seasoned equity offerings and share repurchases. Our study supports the view of Daniel, Hirshleifer, and Subrahmanyam (1998) that intermediate-term price drift is caused by investor overconfidence, which then results in market overreaction.

Continuous-time mean-variance portfolio optimization in a jump-diffusion market

In this paper, we take up an approach of (Lindberg, in Bernoulli, 15(2):464–474, 2009) who introduced a new parameterization of the Black–Scholes model that allows for an easy solution of the continuous-time Markowitz mean-variance problem. We generalize the results of (Lindberg, in Bernoulli, 15(2):464–474, 2009) to a jump-diffusion market setting and slightly correct the proof and the assertion of the main result. Further, we demonstrate the implications of the Lindberg parameterization for the stock price drift vector in different market settings, analyse the dependence of the optimal portfolio from jump and diffusion risk and finally indicate how to use the method. We particularly also show how the optimal strategy can be obtained with the restricted use of historical data.

The culture of private negotiation: Endogenous price anchors in simple bilateral bargaining experiments

Using bilateral bargaining data from laboratory experimental markets, this paper demonstrates how common knowledge about price averages from past bargains impacts current negotiated prices. This common information creates an endogenous and declining anchor for bargaining agents. The culture of private negotiation leads parties to agreements below the anchor. Currently negotiated prices below the anchor cause reported averages in the next period to fall. The relation between the endogenous anchor and the negotiating culture leads to a downward drift in negotiated prices. Through at least 20 periods of bargaining, relative earnings are distributed toward buyers and away from sellers.

Fraud and Firm Performance: Evidence from Fraud on the Market and Securities Class Action Lawsuits

We investigate the argument that securities frauds are preceded by surprisingly good firm performance but are followed by rapid negative investor response by studying the longterm stock performance of a sample of 430 firms that disclosed securities fraud and experienced class action lawsuits filed between 1989 and 1999. Estimating Fama-French (F-F) three-factor model-based monthly abnormal returns for three events, alleged fraud commission (FC), fraud disclosure (FD), and initial class action filing (CA), we find significant upward price drift during the five-year pre-FC horizon and weak evidence of a negative drift for up to five years following CA. The observed pre- and post-event abnormal returns cannot be explained by changes in systematic risk (F-F factor loadings), suggesting that the effects of fraud are confined primarily to changes in expected cash flows rather than changes in discount rates. Further, we find positive abnormal trading volume and return volatility during the pre-FC horizon but a significant deterioration in market quality, as evidenced by a persistent negative abnormal drift in relative trading volume and a sustained increase in return volatility, for up to five years following CA.

Optimal investment with inside information and parameter uncertainty

An optimal investment problem is solved for an insider who has access to noisy information related to a future stock price, but who does not know the stock price drift. The drift is filtered from a combination of price observations and the privileged information, fusing a partial information scenario with enlargement of filtration techniques. We apply a variant of the Kalman-Bucy filter to infer a signal, given a combination of an observa- tion process and some additional information. This converts the combined partial and inside information model to a full information model, and the associated investment problem for HARA utility is explicitly solved via duality methods. We consider the cases in which the agent has information on the terminal value of the Brownian motion driving the stock, and on the terminal stock price itself. Comparisons are drawn with the classical partial informa- tion case without insider knowledge. The parameter uncertainty results in stock price inside information being more valuable than Brownian information, and perfect knowledge of the future stock price leads to infinite additional utility. This is in contrast to the conventional case in which the stock drift is assumed known, in which perfect information of any kind leads to unbounded additional utility, since stock price information is then indistinguishable from Brownian information.

Limited Attention and Stock Price Drift Following Earnings Announcements and 10-K Filings

Earnings announcements and 10-K filings are two important channels through which companies release financial information to the public. Earnings announcements, particularly for large firms, are often accompanied by intensive media coverage. In contrast, 10-K filings are usually of much lower profile, attracting little investor attention. Limited attention hypothesis suggests that investors’ failure to devote enough attention to an economic event leads to underreaction, and the degree of underreaction should decrease with the amount of investor attention. In this paper we document evidence consistent with this hypothesis. First, we show that among large firms, investors under-react more to the information contained in 10-K filings than earnings announcements. Second, underreaction to earnings announcements tends to be stronger for small firms than large firms. In contrast, investor underreaction to 10-K information is similar between the two groups of firms. Third, we find that companies report their earnings and 10-Ks earlier when there is a higher demand for such information, and document a negative relationship between the degree of underreaction and the timeliness of such information release. Finally, we show that the recent ruling by SEC to accelerate 10-K filing has little impact on the degree of investors’ underreaction to 10-K information.

Limited attention and stock price drift following earnings announcements and 10‐K filings

PurposeThis study aims to examine whether limited attention leads to the market underreaction to earnings announcement and 10‐K filings.Design/methodology/approachThis is an empirical study involving statistical analysis of a large sample of data, obtained from Compustat, CRSP and Xignite Inc. Both portfolio analysis and multivariate regressions are used in hypotheses testing.FindingsThe following key findings are presented in the paper. First, we show that among large firms, investors under‐react more to the information contained in 10‐K filings than earnings announcements. Second, underreaction to earnings announcements tends to be stronger for small firms than large firms. Third, we find that companies report their earnings and 10‐Ks earlier when there is a higher demand for such information, and document a negative relationship between the degree of underreaction and the timeliness of such information release. Finally, we show that the recent ruling by SEC to accelerate 10‐K filing has little impact on the degree of investors' underreaction to 10‐K information.Research limitations/implicationsThe findings of this study suggest that investors' failure to devote enough attention to an economic event leads to underreaction, and the degree of underreaction is negatively correlated with the amount of investor attention.Practical implicationsInvestors need to periodically reassess the informational contents of economic events, and allocate their attention accordingly, in order to avoid underreaction.Originality/valueThis study analyzes and the roles of limited attention in determining the degree of investor underreaction to earnings announcement and 10‐K filings. The comparison of the two related but distinct financial reporting events yields interesting insights.

Equilibrium Driven by Discounted Dividend Volatility

We derive representations for the stock price drift and volatility in the equilibrium of agents with arbitrary, heterogeneous utility functions and with the aggregate dividend following an arbitrary Markov diffu- sion. We introduce a new, intrinsic characteristic of the aggregate div- idend process that we call the ”rate of discounting volatility” and show that, in equilibrium, the size of market price of risk is determined by the market price of discounted dividend volatility (DDV), discounted at that rate, and multiplied by the aggregate risk aversion. The stock price volatility is equal to the market price of DDV plus a volatility risk premium. In particular, stock price volatility is larger than the dividend volatility if the aggregate risk aversion is decreasing, dividend volatility is countercylical and the rate of discounting volatility is procyclical. We also obtain a representation for the optimal portfolios. Under the above cyclicality conditions, we show that the non-myopic (hedging) component of an agent’s portfolio is positive (negative) if the product of agent’s prudence and risk tolerance is below (above) two, and the sign is reversed for the reversed cyclicality conditions.

Price Drift as an Outcome of Differences in Higher-Order Beliefs

Motivated by the insight of Keynes (1936) on the importance of higher-order beliefs in financial markets, we examine the role of such beliefs in generating drift in asset prices. We show that in a dynamic setting, a higher-order difference of opinions is necessary for heterogeneous beliefs to generate price drift. Such drift does not arise in standard difference of opinion models, since investors' beliefs are assumed to be common knowledge. Our results stand in contrast to those of Allen, Morris, and Shin (2006) and others, as we argue that in rational expectation equilibria, heterogeneous beliefs do not lead to price drift.

Asset Prices, Funds' Size and Portfolio Weights in Equilibrium with Heterogeneous and Long-Lived Funds

We perform a detailed asymptotic analysis of the equilibrium behavior of the asset prices, wealth size and portfolio weights in complete markets equilibria, with long-lived funds. In equilibrium, the fund with the (closest to) log preference will dominate the other funds in size, in the long-run, with probability one. On the other hand, two funds on the opposite sides of the log preference will never dominate each other in expected size. In the very long run, the price behavior of the risky asset will be determined solely by the fund closest to the log preference. However, the price drift and volatility still are affected by higher risk aversions, and the optimal portfolio weights contain a hedging component, positive (negative) for the risk aversions higher (lower) than log.The hedging component is monotone increasing in risk aversion for the times further away from the terminal horizon, but it may become monotone decreasing closer to the terminal horizon. For earlier, but still asymptotically infinite times, the price behavior is impacted also by the funds with risk aversions greater than one. Selling short is never optimal. There are distinct increasing time periods such that the price has the same asymptotic behavior in each period. The long-run per-period return gets lower with time.

The Unappreciated Value of Marketing: The Moderating Role of Changes in Marketing and R&D Spending on Valuation of Earnings Reports

Because current earnings predict future financial performance, the stock market reacts strongly to earnings announcements. How rapidly and in what manner information about marketing actions and strategies is accounted for in the stock valuation is less clear. We examine the financial market's ability to fully and timely value marketing-related information released along with quarterly earnings announcements. We find evidence consistent with the market initially under-appreciating marketing and R&D effort. Specifically, we find differences in the immediate market response to earnings announcements for firms expanding versus reducing their marketing and R&D effort. However, we also observe a significantly greater positive stock price drift (i.e., systematic stock price adjustment) in the months following an earnings announcement for firms increasing marketing and/or R&D expenditures. We examine the dynamics and the mechanism underlying this differential drift. Firms increasing their marketing and/or R&D spending report significantly greater future operating performance than firms decreasing their marketing and R&D spending and the stock price adjustment (drift) accelerates around the time of the subsequent earnings announcement. Our findings suggest that the stock market takes time to fully incorporate implications of strategic marketing decisions. They also suggest the stock market tends to update firm valuation when the outcomes of marketing strategies are realized in future financial performance and new performance signals are sent to the market.

Asset Prices, Funds' Size and Portfolio Weights in Equilibrium with Heterogeneous and Long-Lived Funds

We perform a detailed asymptotic analysis of the equilibrium behavior of the asset prices, wealth size and portfolio weights in complete markets equilibria, with long-lived funds. In equilibrium, the fund with the (closest to) log preference will dominate the other funds in size, in the long-run, with probability one. On the other hand, two funds on the opposite sides of the log preference will never dominate each other in expected size.In the very long run, the price behavior of the risky asset will be determined solely by the fund closest to the log preference. However, the price drift and volatility still are affected by higher risk aversions, and the optimal portfolio weights contain a hedging component, positive (negative) for the risk aversions higher (lower) than log. The hedging component is monotone increasing in risk aversion for the times further away from the terminal horizon, but it may become monotone decreasing closer to the terminal horizon.For earlier, but still asymptotically infinite times, the price behavior is impacted also by the funds with risk aversions greater than one. Selling short is never optimal. There are distinct increasing time periods such that the price has the same symptotic behavior in each period. The long-run per-period return gets lower with time.

Underreaction to Dividend Reductions and Omissions?

ABSTRACTUsing a sample of 2,337 cash dividend reduction or omission announcements over the 1927 to 1999 period, this study reports significant negative post‐announcement long‐term abnormal returns, which last 1 year only. However, this long‐term abnormal performance is driven by the post‐earnings‐announcement drift. After controlling for the earnings performance and the skewness of buy‐and‐hold abnormal returns, there is no compelling evidence of a post‐dividend‐reduction or post‐dividend‐omission price drift.

Costly Information Processing: Evidence from Earnings Announcements

I examine the role of information processing costs on post earnings announcement drift. I distinguish between hard information —quantitative information that is more easily processed — and soft information which has higher processing costs. I find that qualitative earnings information has additional predictability for asset prices beyond the predictability in quantitative information. I also find that qualitative information has greater predictability for returns at longer horizons, suggesting that frictions in information processing generate price drift. Using a tool from natural language processing called typed dependency parsing, I demonstrate that qualitative information relating to positive fundamentals and future performance is the most difficult information to process.

Do reverse stock splits indicate future poor stock performance?

There has been much written on the individual topics of bankruptcy prediction, corporate performance, and forward/reverse stock splits. However, there is little research into the relationship between reverse stock splits and subsequent corporate performance and the potential for bankruptcy. Previous research suggested there is a negative drift in stock prices following reverse splits. The purpose of this study is to provide and empirically support rationales for reverse splits by classifying reverse splitting firms into two groups. The presumed rationales for engaging in reverse splits would differ between the two groups, so do the subsequent stock performance. Our results show that both neural networks and Z-scores can successfully distinguish the two groups of firms while neural networks outperforms Z-scores in finding the firms with best performing stocks.

Financial Reporting Complexity and Investor Underreaction to 10-K Information

We study the immediate and delayed market response to SEC EDGAR 10-K filings. Unusual trading volumes and stock price movements are documented during the days around the 10-K filing dates. The abnormal price movements are positively associated with future accounting profitability, indicating that 10-K filings contain useful information about future firm performance. In addition, investors' reaction to 10-K information seems sluggish, as evidenced by the stock price drift during the twelve month period after 10-K filing. We find that investors' under-reaction tends to be stronger for firms with more complex 10-K filings.

The Disposition Effect and Underreaction to News

ABSTRACTThis paper tests whether the “disposition effect,” that is the tendency of investors to ride losses and realize gains, induces “underreaction” to news, leading to return predictability. I use data on mutual fund holdings to construct a new measure of reference purchasing prices for individual stocks, and I show that post‐announcement price drift is most severe whenever capital gains and the news event have the same sign. The magnitude of the drift depends on the capital gains (losses) experienced by the stock holders on the event date. An event‐driven strategy based on this effect yields monthly alphas of over 200 basis points.