Heterogeneity Of Investor Beliefs Research Articles

Firm age and realized idiosyncratic return volatility in China: The role of short-sales constraints

This paper investigates how realized idiosyncratic return volatility changes with firm age in the Chinese stock market. By employing a sample of 26,676 firm-year observations of 2798 A-share listed Chinese firms from 2001 to 2019, we find that realized idiosyncratic return volatility is negatively associated with firm age. Further, we find that loosening short-sales constraints strengthens this negative association, and that heterogeneity of investor beliefs is the most likely mechanism driving the negative relation, rather than the alternative explanations of cash flow volatility and growth options. Our results are fairly consistent under two different measures of firm age, and are robust to a choice of two multiple-factor models (the Fama-French three-factor and five-factor models) as well as two data frequencies (daily and monthly) used to estimate realized idiosyncratic return volatility.

Accounting accruals, heterogeneous investor beliefs, and stock returns

We study how a firm's accounting accruals affect the heterogeneity of investor beliefs on the firm's value and further affect the firm's future stock returns. We document three findings. First, we find that the level of the heterogeneity in investor beliefs on a firm's value is higher when the firm experiences a larger increase in its accounting accruals. Second, we find that future stock returns following the earnings announcement are lower when the firm's accounting accruals increases the heterogeneity of investor beliefs to a larger degree. Finally, we also find that the effect of the accruals-induced heterogeneous investor beliefs on future stock returns is more pronounced when short-sale constraints are more binding. Overall, our empirical findings suggest that accounting accruals are a key determinant of the heterogeneity of investor beliefs. They also suggest a channel of investor beliefs whereby accruals affect future stock returns by affecting the heterogeneity of investor beliefs.

Firm Life Cycle, Heterogeneity in Investor Beliefs and Stock Price Crash Risk

This study examines the relation between firm life cycle and stock price crash risk. Consistent with the argumentation that heterogeneity in investor beliefs about firm fundamental values is highest during the introduction and growth stage, we find that crash risk peaks in these stages. Furthermore, this relation is stronger for firms without short interest, firms deriving more value from future growth opportunities and high performing growth firms. These findings provide additional support for the “heterogeneity in investor beliefs” hypothesis. We contribute to existing literature by incorporating an inherent yet dynamic firm characteristic, life cycle, into the crash risk prediction model.

Macroeconomic information and implied volatility: evidence from Australian index options

Purpose – The purpose of this paper is to understand that option pricing is the response of option implied volatility (IV) to macroeconomic announcements. Design/methodology/approach – The authors use high-frequency data on ASX SPI 200 index options to examine the response of option IV, as well as higher moments of the underlying return distribution, to macroeconomic announcements. Additionally, the authors identify the response of the moments as a function of moneyness of the options. Findings – The findings suggest that in-the-money and out-of-the money options have difference characteristics in their responses, leading to the conclusion that heterogeneity in investor beliefs and preferences affect option IV through the state price density (SPD) function. Originality/value – The research contributes to the literature that examines whether IV captures the beliefs of market participants about the likelihood of future states together with the preferences of market participants towards these states. In particular, the authors relate changes in option IV to changes in macroeconomic announcements, through the impact of these announcements on the moments of the SPD function.

Macroeconomic Information and Implied Volatility: Evidence from Australian Index Options

A key issue in understanding option pricing is the response of option implied volatility to macro-economic announcements. We use high frequency data on ASX SPI 200 Index Options to examine the response of option implied volatility, as well as higher moments of the underlying return distribution, to macroeconomic announcements. Additionally, we identify the response of the moments as a function of the moneyness of the options. Our findings suggest that in-the-money and out-of-the money options have different characteristics in their responses, leading to the conclusion that heterogeneity in investor beliefs and preferences affect option implied volatility through the state price density function.

Connecting two markets: An equilibrium framework for shorts, longs, and stock loans

We analyze a reduced-form framework for understanding the equity loan market's impact on share prices. We show that hard-to-borrow stocks will have distinct return patterns, responding more to shocks in the supply of shares available, and to changes in the heterogeneity of investor beliefs, than other stocks. We conduct two empirical tests in which we find strong support for these equilibrium predictions. In our first test, we take advantage of a tax-driven exogenous shock to share loan supply and find that when supply is reduced around dividend record dates, prices of hard-to-borrow stocks increase 1.1% while prices of easy-to-borrow stocks are unaffected. In our second test, we find that hard-to-borrow stocks have 4.8% lower three-month returns than other stocks, with negative returns concentrated in stocks with high heterogeneity in investor beliefs. Thus, we extend the Diether, Malloy, and Scherbina (2002) result that stocks with a greater dispersion of investor beliefs have lower returns.

Asset price bubbles from heterogeneous beliefs about mean reversion rates

Harrison and Kreps showed in 1978 how the heterogeneity of investor beliefs can drive speculation, leading the price of an asset to exceed its intrinsic value. By focusing on an extremely simple market model—a finite-state Markov chain—the analysis of Harrison and Kreps achieved great clarity but limited realism. Here we achieve similar clarity with greater realism, by considering an asset whose dividend rate is a mean-reverting stochastic process. Our investors agree on the volatility, but have different beliefs about the mean reversion rate. We determine the minimum equilibrium price explicitly; in addition, we characterize it as the unique classical solution of a certain linear differential equation. Our example shows, in a simple and transparent manner, how heterogeneous beliefs about the mean reversion rate can lead to everlasting speculation and a permanent “price bubble.”

The Diversification Effect on the Heterogeneity of Investor Beliefs

In the paper, we study the effect of multiple industry operations on the heterogeneity of investor beliefs. In particular, we compare the levels of heterogeneous beliefs between diversified firms and focused firms. We study the change in the level of heterogeneous beliefs subsequent to diversifying and non-diversifying mergers. We also relate the diversification effect on investors' heterogeneous beliefs to the diversification effect on firm value and ex-post stock returns. We document four findings. First, we find that diversification reduces the level of heterogeneous beliefs on a firm's future prospects. Second, the excess level of heterogeneous beliefs on diversified firms relative to focused firms follows a pattern of mean-reverting. Third, the value of diversified firms increases relative to focused firms with an increase in the diversified firms' excess level of heterogeneous beliefs. Finally, we find that a smaller excess heterogeneity of beliefs on diversified firms is followed by an increase in the diversified firm's ex-post excess values and an increase in their ex-post stock returns. Overall, our results contribute to the understanding about how corporate organization structure affects the heterogeneity of investor beliefs and firm values.

Product Market Advertising, IPO Valuation, and Long-Run Stock Returns

We study the impact of product market advertising on IPO valuation and long-run post-IPO stock returns. We find that a firm going public with a greater extent of advertising in its IPO year is valued higher both in the IPO as well as in the immediate market, and experiences lower long-run post-IPO stock returns. Such an IPO firm is also characterized by a greater upward price revision from the mid-point of its filing range during its book-building period. We conjecture that the above results are due to the effect of advertising on the heterogeneity in IPO market investor beliefs about the prospects of the firm going public: advertising may make retail investor investors more optimistic about the firm (leaving institutional investors unaffected), thus increasing the heterogeneity in beliefs among investors as a whole. This, in turn, increases both IPO valuation and immediate aftermarket valuation, and lowers long-run stock returns. We test this beliefs hypothesis using the dispersion in analysts' earnings forecasts and the stock turnover in the IPO aftermarket as proxies for the degree of heterogeneity in investor beliefs. We document three important findings consistent with the heterogeneous beliefs hypothesis. First, product market advertising increases both analyst forecast dispersion about the firm going public and stock turnover in the IPO aftermarket. Second, a greater extent of product market advertising is associated with a smaller fraction of equity holdings in the IPO firm's stock by institutional investors. Third, the higher IPO valuation and long run post-IPO stock returns induced by product market advertising are related to the higher analyst forecast dispersion, the higher stock turnover, and the lower institutional investor holdings experienced by the IPO firm.

Capital Structure and Security Issuance Under Heterogeneous Beliefs

Using a sample of debt and seasoned equity issues from 1980-2004 and different proxies of investor optimism and the dispersion in investor beliefs, we empirically analyze, for the first time in the literature, the effect of heterogeneous beliefs among outside investors on the capital structure and security issuance choices made by a firm. The paper consists of three parts: In the first part of the paper, we study how heterogeneous beliefs affect a firm's choice between equity and debt for raising external financing; in the second part of the paper, we study the effect of heterogeneous beliefs on the price impact of a security issue on the firm's equity; and in the third part of the paper, we study the effect of heterogeneous beliefs on the long-term stock performance of equity and debt issuers. Our empirical results can be summarized as follows. First, the probability of a firm issuing equity rather than debt is increasing in both the average level of optimism of outside investors and the dispersion in outsider beliefs. Second, the price impact on the firm's equity is negative for an equity issue and zero for a debt issue; further, the price impact of an equity issue is decreasing (more negative) as the dispersion in outsider beliefs is greater. Finally, while the long-term stock returns to both equity and debt issuers is negative, the stock returns to equity issuers is significantly more negative than that of debt issuers. Further, the more optimistic outsiders are on average about a firm's prospects at the time of an equity issue and the more dispersed their beliefs, the more negative the long-term stock returns to the firm. Overall, our results indicate the importance of heterogeneity in investor beliefs as a determinant of the financing decision of a firm.

Heterogeneous Beliefs, Short Sale Constraints, and the Economic Role of the Underwriter in IPOs

Several theoretical papers have argued that the valuation of equity will reflect the beliefs of the most optimistic investors and be at a premium over intrinsic value when rational investors subject to short sale constraints have heterogeneous priors. We test the above theories by analyzing the effect of IPO underwriter reputation on the heterogeneity in investor beliefs and the tightness of short sale constraints and consequently on equity valuation in IPOs. We propose a “market power” hypothesis, postulating that higher reputation underwriters are able to attract a greater number of higher quality market participants (such as institutional investors, analysts, and co-managing underwriters) to the IPOs backed by them, thereby yielding higher IPO valuations by increasing the heterogeneity in investor beliefs and the tightness of short sale constraints. We empirically distinguish between the above hypothesis and the “certification hypothesis,” which implies that higher reputation underwriters are associated with IPOs priced closer to intrinsic value. We find that equity in higher reputation underwriter backed IPOs are priced higher and further away from intrinsic value compared to lower reputation underwriter backed IPOs. We show that the above relationship between underwriter reputation and IPO valuation is driven by the greater heterogeneity in investor beliefs, tighter short sale constraints, and greater participation by institutional investors, analysts, and higher reputation co-managing underwriters that characterize higher reputation underwriter backed IPOs. Overall, our results support the market power hypothesis and reject the certification hypothesis.

The Role of Venture Capital Backing in Initial Public Offerings: Certification, Screening, or Market Power?

We empirically distinguish between three possible roles of venture backing in IPOs: certification, where venture-backed IPOs are priced closer to intrinsic firm value than non-venture backed IPOs due to venture capitalists' concern for their reputation; screening and monitoring, where VCs are able to either select better quality firms to back (screening), or help create such higher quality firms by adding value to them (monitoring) in the pre-IPO stage; and market power, where venture capitalists attract a greater number and higher quality of market participants such as underwriters, institutional investors, and analysts to an IPO, thus obtaining a higher valuation for the IPOs of firms backed by them. We argue that IPO underpricing is not the most appropriate measure to evaluate the role of venture backing in IPOs. Instead, we compare four sets of more direct measures between VC backed and non-VC backed (and between high-reputation VC backed and low-reputation VC backed) IPOs. The evidence strongly rejects the certification hypothesis, while finding considerable support for the market power hypothesis and some support for the screening and monitoring hypothesis. We find that venture capitalists attract higher quality market participants to the IPOs of firms backed by them, thus increasing the heterogeneity in investor beliefs about these firms, resulting in higher valuations for the equity of these firms (both in the IPO and in the secondary market immediately following the IPO).

A Catering Theory of Analyst Bias

We posit a theory that runs counter to how conventional wisdom thinks about analyst bias, that it is result of distorted incentives by the system - especially upstream factors like analysts' employers. We suggest that analysts are also heavily influenced by what investors believe, purported victims of analyst bias. We adapt Mullainathan-Shleifer's theory of media bias to build a theory of how analysts cater to what investors believe. The theory also predicts that competition among analysts does not reduce their bias. We provide empirical support for this theory, using an enormous dataset built from over 6.5 million analyst estimates and 42.8 million observations on investor holdings, which we argue is a proxy for what they believe. We use a simultaneous-equations model for estimation, with instruments to rule out alternative interpretations of direction of causality. For additional robustness, we investigate time series of analyst bias and heterogeneity in investor beliefs from 1987 through 2003. Dickey-Fuller tests show that both have unit roots, but we establish that cointegration hold. Further, we employ a vector-autoregressive model to show Granger - causality between two.