Risk-adjusted Stock Returns Research Articles

Do Investors Value Environmental Corporate Policies? Evidence from the Australian Market

In this paper, we explore the relationship between a firm’s environmental policies and their risk-adjusted stock returns, using a sample of stock exchange-listed Australian firms over the period of 2010–2018. We observed a positive and statistically significant relationship suggesting that a firm’s environmental policies partially explain their stock performance. Moreover, we found that investors in the Australian market significantly value a companies’ efforts to reduce emissions, and that this primarily drives the investors’ observed reaction to a firm’s social corporate policies. Next, we formed portfolios and observed that portfolios formed on high environmental, social, and governance (ESG) Environmental Pillar scores consistently outperformed those formed on low-ESG Environmental Pillar scores. Overall, our results lend support to the notion that investors in the Australian market value information about a firm’s social policies.

ESG Risks and the Cross-Section of Stock Returns

This paper uses novel environmental, social, and governance (ESG) incident news data to study poor ESG practices. I find that firms’ past ESG incident rates predict more incidents, weaker profits, and lower risk-adjusted stock returns. When examining the cause of these abnormal returns, I find analyst forecast errors as well as lower returns around earnings announcements and subsequent incidents. Moreover, incident rates predict stronger abnormal returns in firms with higher short-term ownership, higher valuation uncertainty, and lower investor attention. Overall, these findings suggest that poor ESG practices negatively impact long-term value, which is not fully reflected in stock prices.

Dual Holding and Bank Risk

We show that a bank with investors holding simultaneously both its equity and bond (dual-holders) exhibits lower risk and superior performance. Using the 2007-9 financial crisis as a quasi-natural experiment, we find that the presence of dual-holders reduces risky investment and risky business portfolio choices. Dual-holders' influence is higher in more opaque banks, indicating that the mechanism of transmission is through a decrease in information asymmetry and a reduction in debtholder-shareholder conflict. This effect translates into higher unconditional and risk-adjusted stock returns. Our results have important normative implications in improving the stability of financial systems.

Managerial myopia and the mortgage meltdown

Prominent policy makers assert that managerial short-termism was at the root of the subprime crisis of 2007–2009. Prior scholarly research, however, largely rejects this assertion. Using a more comprehensive measure of Chief Executive Officer (CEO) incentives for short-termism, we uncover evidence that short-termism indeed played a role. Firms whose CEOs were contractually allowed to sell or exercise more of their stock and options holdings sooner had more subprime exposure, a higher probability of financial distress, and lower risk-adjusted stock returns during the crisis, as well as higher fines and settlements for subprime-related fraud.

Default Risk Premia and a Non-Linear Asset Pricing Model

The value of an equity investment can be framed as an embedded call option on a firm’s assets. The embedded call option creates a non-linear relationship between stock returns and underlying risk factors; however, such option value and the impact of this non-linearity are often underestimated or overlooked in most asset pricing studies. In this paper, we use the forward-looking measure of default risk in CDS spreads and an associated quadratic term as a non-linear asset pricing model to explain and predict individual stock returns. Notably, in this model, the intercept α disappears in predictions of future risk-adjusted stock returns. The model also provides an alternative to Fama and French (1993)’s three-factor model in substituting functions of our factors for size and value.

Bank Capital and Bank Stock Performance

Little is known about how bank capital affects bank stock performance. We show that capital does not affect returns unconditionally, but high-capital banks have higher risk-adjusted stock returns (alphas) than low-capital banks in bad times in and out of sample. Trading strategies earn 3.60%–4.44% annually. The results are robust to: using different bad times and capital definitions, alternative asset pricing models, and ex-ante expected returns; controlling for performance-type delistings, short-sale constraints, and trading costs; and dropping the largest or smallest banks. Our results seem to be driven by a “Surprised Investor Channel” rather than by an “Informed Investor Channel.”

Analyst Coverage and Stock Returns

This study investigates the association between risk-adjusted returns and analyst coverage. We find that stocks with better risk-adjusted returns attract more analysts to provide research reports for investors. By following companies with better risk-adjusted returns, an analyst may be able to save time and effort in collecting and processing information. The empirical results indicate that earnings forecasts are more accurate for firms with better risk-adjusted stock returns. Moreover, we found that an analyst is more likely to pay more attention for stocks with better risk-adjusted returns and revise earnings forecasts more frequently for them. The results suggest that risk-adjusted returns of stocks have impacts on analysts’ performance.

Resident Networks and Firm Trade

We demonstrate that simply by using the ethnic makeup surrounding a firm’s location, we can predict, on average, which trade links are valuable for firms. Using customs and port authority data on the international shipments of all U.S. publicly-traded firms, we show that firms are significantly more likely to trade with countries that have a large resident population near their firm headquarters. We use the formation of World War II Japanese Internment Camps to isolate exogenous shocks to local ethnic populations, and identify a causal link between local networks and firm trade. Firms that exploit their local networks (strategic traders) see significant increases in future sales growth and profitability, and outperform other importers and exporters by 5%-7% per year in risk-adjusted stock returns. In sum, our results document a surprisingly large impact of immigrants’ economic role as conduits of information for firms in their new countries.

Managerial Myopia and the Mortgage Meltdown

Prominent policy makers assert that managerial short-termism was at the root of the subprime mortgage crisis of 2007-2009. Prior scholarly research, however, largely rejects this assertion. Using a more comprehensive measure of CEO incentives for short-termism, we uncover evidence that short-termism indeed played a role in the crisis. We find that shorter vesting schedules for CEO equity holdings are positively related to firm exposure to subprime mortgage assets, as well as a higher probability of financial distress and lower risk-adjusted stock returns during the crisis. Furthermore, shorter vesting schedules are positively associated with fines and settlements for subprime-related fraud.

Stock Return Predictability of Out-of-the-Money Option Trading

This paper provides evidence of the market segmentation of stock and options. We find that informed out-of-the money (OTM) option trading measure, which is publicly available, predicts the returns of underlying stock and its at-the-money (ATM) options, but not the returns of OTM options. Specifically, higher OTM put-call trading volume ratio predicts negative returns of stock and ATM calls while predicting positive returns of ATM puts. The results are robust in large stock and not driven by short-selling costs. Using the OTM put-call volume ratio, we propose an implementable investment strategy that offers 20 bp weekly risk-adjusted stock returns (i.e., about 10% annually). Our findings support the segmentation between stock and option markets and between the option contracts in the same class.

Is there Informational Value in Corporate Giving?

In this article, we propose that giving in cash and non-cash (in-kind) differ in their relation with the giving firm’s future corporate financial performance (CFP) and only cash giving is associated with future CFP. Using a novel dataset from ASSET4 that differentiates corporate giving over a sample period of 2002–2012, we examine three competing hypotheses: (1) agency cost hypothesis that cash giving reflects agency cost and destroys value for shareholders, (2) investment hypothesis that cash giving is an investment by management that aims for better future return, and (3) information hypothesis that cash giving has informational value to shareholders as cash is a critical resource at a firm and giving is a decision by managers who are insiders. We find that indeed, only cash giving is positively associated with future CFP and firm value, measured by Fama–French five-factor abnormal risk-adjusted stock returns, future return on assets, and Tobin’s Q. In addition, we find that the positive association exists only between excess, i.e., unexpected, but not expected cash giving and future CFP. Our empirical findings support the information hypothesis, but neither the agency hypothesis nor the investment hypothesis, and are robust to a number of endogeneity tests, including orthogonalized cash giving, instrumental variable regression using geography-based instruments, and propensity score matching. Furthermore, we show that the positive association between future CFP and unexpected cash giving is only pronounced at firms with good governance and relatively higher sales growth where agency problems are less likely, and at firms with no alternative mechanisms to demonstrate the strength of cash flow. Additionally, we do not find evidence that suggests in-kind giving to possess any informational value.

Is There Informational Value in Corporate Giving?

In this article, we propose that giving in cash and non-cash (in-kind) differ in their relation with the giving firm’s future corporate financial performance (CFP) and only cash giving is associated with future CFP. Using a novel dataset from ASSET4 that differentiate corporate giving over a sample period of 2002-2012, we examine three competing hypotheses: (1) agency cost hypothesis that cash giving reflects agency cost and destroys value for shareholders, (2) investment hypothesis that cash giving is an investment by management that aims for better future return, and (3) information hypothesis that cash giving has informational value to shareholders as cash is a critical resource at a firm and giving is a decision by managers who are insiders. We find that indeed, only cash giving is positively associated with future CFP and firm value, measured by Fama-French five-factor abnormal risk adjusted stock returns, future return on assets (ROA) and Tobin’s Q. In addition, we find that the positive association exists only between excess, i.e., unexpected, but not expected cash giving and future CFP. Our empirical findings support the information hypothesis, but neither the agency hypothesis nor the investment hypothesis, and are robust to a number of endogeneity tests, including orthogonalized cash giving, instrumental variable regression using geography-based instruments, and propensity score matching. Furthermore, we show that the positive association between future CFP and unexpected cash giving is only pronounced at firms with good governance and relatively higher sales growth where agency problems are less likely, and at firms with no alternative mechanisms to demonstrate the strength of cash flow. Additionally, we do not find evidence that suggests in-kind giving to possess any informational value.

Relative Peer Quality and Firm Performance

This study examines the performance impact of the relative quality of a CEO’s compensation peers (peers selected to determine a CEO’s overall compensation) and bonus peers (peers selected to determine a CEO’s relative-performance-based bonus). We use the fraction of peers with greater managerial ability scores (Demerjian, Lev, and McVay, 2012) than the reporting firm to measure this CEO’s relative peer quality (RPQ). We find that firms with higher RPQ tend to earn superior risk-adjusted stock returns and experience higher profitability growth compared with firms that have lower RPQ. These results cannot be fully explained by a CEO’s power, compensation level, intrinsic talent, nor by a board’s possible motivation to use peers to signal a firm’s prospect. Learning among peers and the increased incentive to work harder induced by the peer-based tournament, however, might contribute to RPQ’s positive performance effect. Preliminary evidence also shows that high RPQ is not associated with increased earnings management or increased risk-taking behaviors.

Relative Peer Quality and Firm Performance

​This study examines the performance impact of the relative quality of a CEO’s compensation peers (peers selected to determine a CEO’s overall compensation) and bonus peers (peers selected to determine a CEO’s relative-performance-based bonus). We use the fraction of peers with greater managerial ability scores (Demerjian, Lev, and McVay, 2012) than the reporting firm to measure this CEO’s relative peer quality (RPQ). We find that firms with higher RPQ tend to earn superior risk-adjusted stock returns and experience higher profitability growth compared with firms that have lower RPQ. These results cannot be fully explained by a CEO’s power, compensation level, intrinsic talent, nor by the board’s possible motivation to use peers to signal a firm’s prospect. Learning among peers and the increased incentive to work harder induced by the peer-based tournament, however, might contribute to RPQ’s positive performance effect. Preliminary evidence also shows that high RPQ is not associated with increased earnings management or increased risk-taking behaviors.

The relationship between the option-implied volatility smile, stock returns and heterogeneous beliefs

We study the relationship between stock returns and the implied volatility smile slope of call and put options. Stocks with a steeper put slope earn lower future returns, while stocks with a steeper call slope earn higher future returns. Using dispersion of opinion as a proxy for belief differences, we find that the slope–stock return relation is strongest for stocks with high belief differences. The idiosyncratic component of the put slope fully explains the negative risk-adjusted stock returns. For the call slope, the idiosyncratic component dominates the systematic one, and explains the positive risk-adjusted returns.

The Neuroscience Behind the Stock Market's Reaction to Corporate Earnings News

ABSTRACTUsing functional magnetic resonance imaging, we capture neural activity in the ventral striatum—a key area in the human brain's reward processing circuit—of 35 adult investors learning the earnings per share disclosed by 60 publicly traded companies. Before imaging, investors forecasted each company's earnings and took either a long or a short position in its stock. Consistent with prospect theory, we find strong neurobiological evidence of an asymmetric reaction to positive and negative earnings surprises. Moreover, investors' personality traits and investment positions, as well as firms' earnings predictability, modulate the brain's reaction to earnings news. We also find a strong association between the magnitude of the brain's reaction and risk-adjusted stock returns and abnormal share trading around earnings announcements for our sample firms; these findings evince the brain's reaction to earnings news as an alternative, biological measure of the information content of earnings.Data Availability: Data are available from the authors.

Boardroom Networks and the Cross-Section of Stock Returns

Board directorships link organizations and directors forming a complex, continuously evolving corporate boardroom network. Using a novel and unique comprehensive monthly boardroom network dataset for the Netherlands, home to one of the largest and most liquid European stock markets, this paper finds that a firm’s connectedness in this network is a strong predictor of subsequent risk-adjusted monthly stock returns. Consistent with a weakened corporate governance hypothesis, the paper documents a negative impact on future returns for firms with relatively well-connected directors. And consistent with an access to resources hypothesis, the paper finds a positive impact for firms that are relatively well-connected through inter-board ties. Importantly, while past director ties are informative for future returns, past inter-board ties are not. Fama-MacBeth regressions suggest the results are not confounded by other board characteristics. Connectedness is also systematically mispriced in analysts’ forecasts. Taken together, the findings strongly suggest that boardroom networks simultaneously exert distinct positive and negative effects through complex corporate governance, informational and other channels.

Boardroom centrality and firm performance

Firms with central boards of directors earn superior risk-adjusted stock returns. A long (short) position in the most (least) central firms earns average annual returns of 4.68%. Firms with central boards also experience higher future return-on-assets growth and more positive analyst forecast errors. Return prediction, return-on-assets growth, and analyst errors are concentrated among high growth opportunity firms or firms confronting adverse circumstances, consistent with boardroom connections mattering most for firms standing to benefit most from information and resources exchanged through boardroom networks. Overall, our results suggest that director networks provide economic benefits that are not immediately reflected in stock prices.

The Neuroscience Behind the Stock Market's Reaction to Corporate Earnings News

Using functional magnetic resonance imaging, we capture neural activity in the ventral striatum — a key area in the human brain’s reward processing circuit — of 35 adult investors learning the earnings per share disclosed by 60 publicly traded companies. Before imaging, investors forecasted each company’s earnings and took either a long or a short position in its stock. We find that striatal activation in investors’ brains explains just as much or more of the variation in risk-adjusted stock returns and abnormal share trading around earnings announcements than the dollar or percentage magnitude of the earnings surprise itself. We also find that, in aggregating investors’ individual reactions, the market seems to weigh more heavily the reactions of investors with greater brain activation, even after controlling for their financial expertise, forecasting ability, investment positions, and overall sensitivity to rewards and punishment.

On the value relevance of customer satisfaction. Multiple drivers and multiple markets

Existing research implicitly assumes that all factors known to influence customer satisfaction are likewise important for investor behavior. However, if investors do not equally value activities targeting different satisfaction drivers, managers focusing on short-term stock returns might over- or under-emphasize certain satisfaction drivers to the detriment of the long-term success of the firm. Therefore, we extend prior research on the value relevance of customer satisfaction by assessing the relationship between the dynamics of key satisfaction drivers and contemporaneous risk-adjusted stock returns. Moreover, we compare three major markets using a dataset covering nearly the entire set of car brands sold between 2004 and 2008. Our results show that investors react to information related to perceived product quality, whereas, surprisingly, the cost of ownership and dealer service quality are unimportant despite the importance attributed to them in consumer research. Furthermore, we observe that information concerning the U.S. market dominates that of the UK and German markets.