Jennifer S. Conrad

Time-Variation in Expected Returns

This article characterizes the stochastic behavior of expected retu rns on common stocks. The authors assume market efficiency and postulate an autoregressive process for conditional expected returns. They use weekly returns of ten size-based portfolios over the 1962-8 5 period and find that (1) the variation through time in expected returns is well characterized by a stationary first-order autoregression process; (2) the extracted expected returns explain a substantial proportion (up to 26 percent) of the variance in realized returns and the magnitude of this proportion has a monotonic (inverse) relation with size; (3) the degree of variation in expected returns also changes systematically over time; and (4) the forecasts subsume the information in other potential predictor variables. Copyright 1988 by the University of Chicago.

The Effects of Derivatives on Firm Risk and Value

Using a large sample of nonfinancial firms from 47 countries, we examine the effect of derivative use on firm risk and value. We control for endogeneity by matching users and nonusers on the basis of their propensity to use derivatives. We also use a new technique to estimate the effect of omitted variable bias on our inferences. We find strong evidence that the use of financial derivatives reduces both total risk and systematic risk. The effect of derivative use on firm value is positive but more sensitive to endogeneity and omitted variable concerns. However, using derivatives is associated with significantly higher value, abnormal returns, and larger profits during the economic downturn in 2001–2002, suggesting that firms are hedging downside risk.

Institutional trading and alternative trading systems

Abstract We analyze the use of alternative trading systems in a large sample of institutional orders and the trades that constitute these orders. Proprietary data allow us to distinguish between orders and trades filled by day and after-hours crossing systems, electronic communication networks (ECNs), and traditional brokers. Controlling for variation in order and security characteristics, as well as endogeneity in the choice of trading venue, we find that realized execution costs are generally lower on alternative trading systems. Order handling rules and tick size changes implemented in 1997 appear to have reduced the cost advantage of trading on ECNs.

Components of short-horizon individual security returns

Abstract In this paper, we present a simple model which relates security returns to three components: an expected return, a bid-ask error, and white noise. The relative importance of the various components is empirically assessed, and the models ability to explain the various time-series properties of individual security and portfolio returns is tested. Time-varying expected returns and bid-ask errors are found to explain substantial proportions (up to 24%) of the variance of security returns. We also reconcile the typically negative autocorrelation in security returns with the strong positive autocorrelation in portfolio returns.

Profitability of Short-Term Contrarian Strategies: Implications for Market Efficiency

In recent years, several researchers have argued that the stock market consistently overreacts to new information, which, in turn, results in price reversals. Lehmann and others showed that a contrarian can make substantial profits in the short run by simply buying losers and selling winners. We, however, demonstrate that these profits are largely generated by the bid–ask bounce in transaction prices; accounting for this “bounce” by using bid prices eliminates all profits from price reversals for NASDAQ-NMS stocks and most of the profits for NYSE/AMEX stocks. Moreover, any remaining profits (regardless of their source) disappear at trivial levels of transactions costs.

Cross-Market and Cross-Firm Effects in Implied Default Probabilities and Recovery Values

We propose a novel method of estimating default probabilities using equity option data. The resulting default probabilities are highly correlated with estimates of default probabilities extracted from CDS spreads, which assume constant recovery rates. Additionally, the option implied default probabilities are higher in bad economic times and for �?rms with poorer credit ratings and �?nancial positions. An inferred recovery rate, after controlling for liquidity effects, is also related to underlying business and �?rm conditions, varies across sectors and predicts subsequent equity returns.

Momentum and Reversal: Does What Goes Up Always Come Down?

The stocks in a momentum portfolio, which contribute to momentum profits, do not experience significant subsequent reversals. Conversely, stocks that do not contribute to momentum profits over the intermediate horizon exhibit subsequent reversals. Merging these separate securities into a single portfolio causes momentum and reversal patterns to appear linked. Stocks with momentum can be separated from those that exhibit reversal by sorting on size and book-to-market equity ratio. Controlling for proxies for behavioral biases, market illiquidity, and macroeconomic factors does not affect our results.

What Explains the Distress Risk Puzzle: Death or Glory?

Campbell, Hilscher, and Szilagyi (2008) show that firms with a high probability of default have significantly low average future returns. We show that there is a large overlap between stocks classified as high default risk, and those that are likely to produce extremely high returns over the next year (‘glory’ stocks). Predicted glory and predicted distress are highly correlated, with over 50% of firms in the top distress risk quintile also in the top quintile of predicted glory. Stocks with high predicted probabilities for glory also earn abnormally low average returns. We find evidence that low returns to high glory firms are also present in firms with zero leverage, where financial distress is unlikely, and that the low returns to high distress risk firms are large and significant in ‘speculative’ firms (with high sales growth and market-to-book ratios) that have high predicted glory; subsequent returns are small and statistically insignificant in ‘traditionally distressed’ firms. Thus, we show that, on average, firms which have a high potential for death (default) also tend to have a high potential for glory; where the two factors can be separated, the results suggest that it is glory, rather than distress, which is responsible for the low expected returns in securities.

The Term Structure of Liquidity Provision

We examine realized spreads and price impact in clock and trade time following each trade in all common stocks from 2010-2017. The term structure of realized spreads (price impact) is sharply downward (upward) sloping, implying that (a) market maker profitability is sensitive to speed, and (b) the choice of the horizon of measurement is critical when drawing inferences from spread decompositions. The majority of the price impact of trades in large (small)-capitalization stocks takes place within 15 (60) seconds. Net profits to liquidity provision, or equivalently, net costs to liquidity demanders, decline over the sample period even at the shortest horizons that we consider: at the 100-millisecond horizon, aggregate profits decline from 1.9 basis points of total dollar volume in 2010 to 1.0 basis points in 2017.

Credit Default Swaps Around the World: Investment and Financing Effects

We analyze the impact of the introduction of credit default swaps (CDS) on real decision making within the firm, taking into consideration differences in firms’ local economic and legal environments. We extend the model of Bolton and Oehmke (2011) to take into account uncertainty whether the actions taken by the reference entity will trigger credit events for the CDS obligations. We test the predictions of the model in a sample of more than 56,000 firms across 50 countries over the period 2001–2015 and find substantial evidence that the introduction of CDS affects real decisions within the firm, including those regarding leverage, investment, and the riskiness of the firm’s investments. Importantly, we find that the legal and market environments in which the reference entity operates have an influence on the impact of CDS. The effect of CDS is larger in environments where uncertainty regarding CDS obligations is reduced and where CDS mitigate weak property rights. Our results shed light on the incomplete nature of CDS contracts in international capital markets, related to significant legal uncertainty surrounding the interpretation of underlying credit events.