Rex Thompson

On the Diversification, Observability, and Measurement of Estimation Risk

This paper reexamines how risk return relationships are affected by investor uncertainty about the exact parameters of the joint rate of return distribution. We attempt to clarify results relating to three central issues. First, we address the issue of diversification, focusing on an APT, factor model framework. Second, we discuss the observability of estimation risk and describe research experimental designs that should encompass the existence of estimation risk and reveal it in the data. Finally, we suggest exploiting contemporaneous return observations on high and low information securities to aid in the measurement of return parameters for low information securities.

A test of dividend irrelevance using volume reactions to a change in dividend policy

Abstract We investigate the implication of clientele theories that changes in dividend policy should result in a marked increase in trading volume as shareholder clienteles change. With 192 firms announcing their first cash dividend we document both an increase in trading volume and firm value around the announcement date. We integrate these results to distinguish between the volume response to good news about the future and clientele adjustments to a change in dividend policy. Our results suggest that volume increases primarily in response to the signal about future earnings contained in the dividend. Clientele adjustments are small.

Stock price reactions as surrogates for the net cash flow effects of corporate policy decisions

Abstract This paper adopts a rational market structure to examine the link between the cash flow effects of management policy decisions and the resulting stock price reactions. The focus is on testing cross-sectional associations between cash flow effects and the underlying characteristics of affected firms. We find that it is not possible to infer the sign of association between the stock price reaction and any characteristics of the firm that are observable before management announces its decision. Our methodological suggestions involve exploiting either a priori assumptions or sample information about the probability distribution of unobservable decision variables underlying the management decision process.

Managing a Portfolio of Real Options: Sequential Exploration of Dependent Prospects

We consider the impact of sequential investment and active management on the value of a portfolio of real options. The options are assumed to be interdependent, in that exercise of any one is assumed to produce, in addition to some intrinsic value based on an underlying asset, further information regarding the values of other options based on related assets. We couch the problem in terms of oil exploration, where a discrete number of related geological prospects are available for drilling, and management’s objective is to maximize the expected value of the combined exploration campaign. Management’s task is complex because the expected value of the investment sequence depends on the order in which options are exercised. A basic conclusions is that, although dependence increases the variance of potential outcomes, it also increases the expected value of the embedded portfolio of options and magnifies the value of optimal management. Stochastic dynamic programming techniques may be used to establish the optimal sequence. Given certain restrictions on the risk structure, however, we demonstrate that the optimal dynamic program can be implemented by policies that are relatively simple to execute. In other words, we provide sufficient conditions for the optimality of intuitive decision rules, like “biggest first,” “most likely first,” or “greatest intrinsic value first,” and we develop exact analytic expressions for the implied value of the portfolio. This permits the value of active management to be assessed directly. Finally, the sufficient conditions we identify are shown to be consistent with plausible exploration risk structures.

Government Regulation and Structural Change in the Corporate Acquisitions Market: The Impact of the Williams Act

This paper presents evidence on how the Williams Act affected the corporate acquisitions market. The acquisition process is modeled and three hypotheses about the Acts effects are discussed. These hypotheses imply differing restrictions on how the Act changes the models parameters. Parameter changes are estimated but we are unable to reliably discriminate between two of the three hypotheses using the classical statistical testing approach, though the third hypothesis is reliably rejected. Bayesian analysis using a diffuse prior is employed to make formal probability comparisons among the hypotheses. The most probable hypothesis, according to the results, implies that the Williams Act reduced the expected gross present value of acquisition attempts.

The impact of reserve prices on the perceived bias of expert appraisals of fine art

We examine whether expert appraisals provided to bidders before major art auctions are unbiased indicators of value. Despite a strong grounding in theory, this aspect of optimal auction design has been frequently challenged in previous empirical research, particularly in the market for fine art. We adopt a valuation benchmark that incorporates sellers’ reserve prices as well as high bids, and recognize censoring of works that fail to make reserve. Although the auction houses never divulge reserve prices, we exploit the fact that they can be observed indirectly via their impact on buy-in rates. Using the set of French Impressionist paintings brought to auction from 1985 to 2001, we estimate the distribution of reserve prices, establish their link to a proper valuation benchmark, and isolate the selection bias due to bought-in works on the perceived market value of fine art works. After controlling for the impact of reservation prices, and considering all works brought to auction, we find no evidence of bias in the experts’ pre-sale estimates.

The Relation between Stock Prices and Accounting Information

The functional relation between expected stock prices and accounting information is analyzed through the theory of inverse probability. The approach models the mean of the posterior distribution for price, given the information that the accounting process provides. The implications of alternative assumptions about accounting measurement error and the unconditional price distribution are discussed. Our most refined model is consistent with recent empirical evidence showing convexity in the relationship between price and accounting information. Empirical tests, while exploratory, provide further evidence of a nonlinear relation between stock price and accounting measures of earnings and book value.

Chapter 29 Empirical methods of event studies in corporate finance

Publisher Summary This chapter presents the spectrum of experimental designs adopted by empiricists who employ event studies methods. In concert with the variety of detail, several investigations into empirical methods have concluded that minor variations have little impact on inferences. Researchers are left with discretion over the choice of estimation window, projection model, raw versus excess returns, forecast error versus event parameter and the form of hypothesis tests. Where these decisions are made ex ante, this discretion seems harmless although latitude can be manipulated, however unintentionally, to generate significant results in any specific application. If a researcher can choose an estimation window between 200 and 300 days, choose an event window between 1 and 5 days, select a projection model with 3 or 4 different types of explanatory variables, use raw or excess returns, pick parametric or nonparametric tests and exercise judgment over modeling how the event affects different firms, it is likely that something of interest will turn up in the data. Credibility is added to the findings of empirical investigations when the methods chosen can be defended on the basis of objective econometric or economic criteria, however minor the improvement in the estimation method on average.

Some Intriguing Relationships in Business Teaching Evaluations.

Abstract Our study of over 50,000 student rating forms from a wide spectrum of business classes tested relationships among student responses to questions that measure various faculty efforts and overall instructor effectiveness. The most influential faculty inputs were teaching courses at the right level and relating course material to the business world. We found significant differences across course and program types in teaching effectiveness by fairness in grading and preparedness for class. We conclude that instructors in different subjects provide different levels of faculty inputs, suggesting that different fields in business maintain different teaching values.

Diversification and the Value of Exploration Portfolios

Conventional wisdom holds that dependence among geological prospects increases exploration risk. However, dependence also creates the option to truncate exploration if early results are discouraging. We show that the value of this option creates incentives for explorationists to plunge into dependence; i.e., to assemble portfolios of highly correlated exploration prospects. Risk-neutral and risk-averse investors are distinguished not by the plunging phenomenon, but by the threshold level of dependence that triggers such behavior. Aversion to risk does not imply aversion to dependence. Indeed the potential to plunge may be larger for risk-averse investors than for risk-neutral investors.