Tom Nohel

Share repurchases and firm performance:: new evidence on the agency costs of free cash flow

Abstract In this paper we examine tender offer share repurchases to differentiate between the information signaling and free cash flow hypotheses. Previous work in this area has focused on announcement period returns. While we also examine announcement returns, our primary emphasis is on operating performance changes surrounding repurchases. We argue that the information contained in changes in operating performance, and its determinants, enables us to differentiate between the two hypotheses. Our primary finding is that operating performance following repurchases improves only in low-growth firms, and that these gains are generated by more efficient utilization of assets, and asset sales, rather than improved growth opportunities. Thus, repurchases do not appear to be pure financial transactions meant to change the firms capital structure but are part of a restructuring package meant to shrink the assets of the firm. This evidence leads us to conclude that the positive investor reaction to repurchases is best explained by the free cash flow hypothesis.

The stock-market reaction to dividend cuts and omissions by commercial banks

Abstract We postulate that the announcement effect of dividend reductions should be more severe for banks than for nondashfinancial firms because bank customers may avoid financially weak institutions and discontinue the relationship when negative information is released. To test our hypothesis we investigate a total of 81 dividend reductions by 56 commercial banks listed on the NYSE, AMEX and NASDAQ for the period 1974–1991. We find significant abnormal returns of −8.02% for the two-day event window and − 11.46% for a two-week period. These negative valuation effects are stronger than those reported in studies for dividend reductions of nondashfinancial firms and for other negative bank announcements. We also explore the relationship between abnormal returns and specific bank characteristics cross-sectionally and find a stronger reaction for larger banks.

Compensation for managers with career concerns: the role of stock options in optimal contracts

We study the problem of compensating a manager whose career concerns affect his investment strategy. We consider contracts that include cash, shares, and call options, focusing on the role of options in aligning incentives. We find that managers are optimally paid in cash, supplemented by a small amount of call options; shares are excluded. The options are struck at-the-money, consistent with the near uniform practice of compensation committees. The convexity of option payoffs helps to overcome managerial conservatism, though a non-trivial under-investment problem persists. Our model yields several testable implications regarding cross-sectional variation in the size of option grants and pay-for-performance sensitivity.

Value maximization and the information content of corporate investment with respect to earnings

Abstract In this paper we study the dynamic nature of the relationship between earnings and investment. If managers act as wealth maximizers, we would expect that new investments should lead to increased earnings. However, past research has found that investment is not causally prior to earnings. Using recent developments in time-series econometrics, we show that the dynamic nature of the relationship between earnings and investment exhibits bi-directional causality. Our results are consistent with managers investing in positive NPV projects, but managers appear to face financing constraints because investment decisions are driven by the availability of internally generated earnings.

Time-Varying Systematic and Idiosyncratic Risk Exposures of US Bank Holding Companies

We analyze the time-varying risk exposures of US bank holding companies for the period from 1986 to 2012 by decomposing total bank risk into systematic banking-industry risk, systematic market-wide risk, and unsystematic or idiosyncratic bank risk. Banking-industry risk factors are directly related to banks’ intermediation functions, while market-wide risk factors are affecting banks and industrial firms alike. Idiosyncratic bank risk relates to characteristics that are specific to an individual bank. Our empirical results suggest that credit risk is most important in crisis periods, while real estate risk emanates in the context of adverse real estate market conditions. The banks’ interest rate risk sensitivity reverses over the sample period. We provide evidence that banks’ market risk exposure can be explained by asset-wide risk factors such as liquidity, volatility, and foreign exchange risk. Analyzing individual bank risk suggests that differences in risk exposures are directly related to bank characteristics including the equity ratio, loan loss provisions, and real estate loans. In addition, individual bank risk has a strong state-level business cycle component that is not captured by the systematic banking-industry and market-wide risk factors. Our results are robust to alternative risk factor specifications. Overall, our study contributes to understanding the structure and time-variation of banks’ systematic and idiosyncratic risks.

Activism and the Shift to Annual Director Election

We examine a comprehensive sample of firms that dismantle their staggered board in favor of annual director elections. We focus on the period following the passage of the Sarbanes-Oxley act of late 2002 and we find 465 instances between 2003 and 2010. Investor reaction to these decisions is muted but nonetheless significantly positive at the 5% level. We find that the type shareholder activism is of considerable importance in determining the form of this self-imposed governance reform: when the change is pushed by aggressive hedge fund activists the board is more likely to embrace annual elections immediately and the markets react very favorably to the change, but if the change is pushed by non-binding shareholder proposals, the response is to drag out the change as much as possible and the markets are commensurately unimpressed. Moreover, our sample firms are substantially more likely to be taken over in the ensuing two years when the shift to annual director elections is pushed by activist hedge funds.

Forecasting Volatility in the Presence of Limits to Arbitrage

In this article, we develop a novel model to forecast the volatility of S&P 500 futures returns by considering measures of limits to arbitrage. When arbitrageurs face constraints on their trading strategies, option prices can become disconnected from fundamentals, resulting in a distortion that reflects the limits to arbitrage. The corresponding market based implied volatility will therefore also contain these distortions. Our contributions are both conceptual and empirical. Conceptually, the limits to arbitrage framework can shed light on relative asset prices as exemplified by this particular study. Empirically, our volatility forecasting model explains 71% of the variation in realized volatility, a substantial improvement over a naive forecast based only on lagged realized volatility, which produces an R-super-2 of 53%.