The Cost of Equity: Evidence from Investment Banking Valuations (with Feng Guo, Tingting Liu, and Danni Tu)

Abstract: Using manually compiled cost of equity (COE) estimates disclosed in takeover regulatory filings, this paper provides novel evidence on how investment banks estimate discount rates. Bank COE estimates have a positive but relatively low correlation with rates implied from the CAPM or Fama-French models. COE estimates are related to several proxies for risk, including industry effects, beta, size, and illiquidity. COE is also related to past returns, financial distress, and volatility, though the signs on these relations contradict evidence in the academic literature. COE is unrelated to M/B, profitability, and investment. Incentives appear to impact bank COE estimates. We find evidence suggesting strategic tradeoffs between alternative valuation approaches to balance the overall valuation estimates. Banks also use significantly higher COE values in management buyout deals, which potentially underestimates target value to make the proposed bid more attractive for target shareholder approval.

Retail Option Traders and the Implied Volatility Surface (with Clifton Green, Brian Roseman, and Yanbin Wu)

Abstract: Retail investors dominate option trading in recent years. Individuals are net purchasers of options, particularly call, short-dated, and out-of-the-money options, although they tend to write long-dated puts. Retail brokerage outages are associated with reduced implied volatility overall, and the effect is stronger for options purchased by retail investors. In contrast, implied volatility increases for long-dated options during outages, consistent with reduced retail writing activity. The findings highlight the importance of retail demand pressure on the implied volatility surface and suggest that retail trading can have important effects on the implied volatility term structure, moneyness curve, and call-put spread.

Retail Trader Sophistication and Stock Market Quality: Evidence from Brokerage Outages (with Clifton Green, Brian Roseman, and Yanbin Wu)

  • Journal of Financial Economics, 2022, 146 (2), 502 - 528

  • Featured in Financial Times, MarketWatch, Bloomberg, The Verge, Trader's Magazine, Marginal Revolution

Abstract: We study brokerage platform outages to examine the impact of retail investors on financial markets. We contrast outages at Robinhood, which caters to inexperienced investors, with outages at traditional retail brokers. For stocks with high retail interest, we find that negative shocks to Robinhood investor participation are associated with reduced market order imbalances, increased market liquidity, and lower return volatility, whereas the opposite relations hold following outages at traditional retail brokerages. The findings suggest that herding by inexperienced investors can create inventory risks that harm liquidity in stocks with high retail interest, while other retail trading improves market quality.

Peer Selection and Valuation in Mergers and Acquisitions (with Feng Guo, Tingting Liu, and Micah Officer)

  • Journal of Financial Economics, 2022, 146 (1), 230 - 255

  • Featured in Bloomberg

Abstract: Using unique data, this paper examines investment banks’ choice of peers in comparable companies analysis in mergers and acquisitions. We find strong evidence that product market space is amongst the most important factors in peer selection. Banks tend to strategically select large, high growth peers with high valuation multiples, factors that are also positively related to deal premiums. Our evidence is consistent with target-firm advisors selecting peers with high valuation multiples to negotiate a higher takeover price. However, in some deal types, target advisors appear to choose peers with low multiples to ease the process of obtaining target shareholder approval.

Measuring Institutional Trading Costs and the Implications for Finance Research: The Case of Tick Size Reductions (with Paul Irvine and Tingting Liu)

  • Journal of Financial Economics, 2021, 139 (3), 832 - 851

Abstract: We demonstrate that many widely used liquidity measures do not adequately capture institutional trading costs. Using proprietary data, we construct a price impact measure that better represents the costs faced by institutional investors. We find that price impact is not correlated with many common liquidity proxies. In addition, institutional trading costs are not dramatically impacted by decimalization, casting doubt on the widely used identification strategy that employs decimalization as an exogenous shock to liquidity, particularly institutional liquidity. Indeed, we find that conclusions from prior research are significantly altered when we measure liquidity using institutional trading data.

Rethinking Measures of Mergers & Acquisitions Deal Premiums (with Tingting Liu and Micah Officer)

  • Journal of Financial and Quantitative Analysis, 2021, 56 (3), 1097 - 1126

Abstract: Most academic studies use fixed pre-announcement event days (such as -20, -42, or -63) to measure unaffected target-firm stock prices. In this paper, we demonstrate that the use of fixed pre-announcement event days generates downward bias in measured premiums, especially for more recent samples and for transactions with long deal processes (such as target-initiated deals). We take account of this bias by hand-collecting deal initiation dates and demonstrate that using these dates results in measured premiums that give contradictory conclusions to those found in the existing literature. We also offer guidance for measuring M&A premiums if hand-collecting data is impractical.

Micro(structure) before Macro? The Predictive Power of Aggregate Illiquidity for Stock Returns and Economic Activity (with Yong Chen and Bradley Paye)

Abstract: This paper constructs and analyzes various measures of trading costs in US equity markets covering the period 1926-2015. These measures contain statistically and economically significant predictive signals for stock market returns and real economic activity. We decompose illiquidity proxies into a component capturing aggregate volatility and a residual. The predictive content of these components differs in important ways. Specifically, we find strong evidence that the component of illiquidity uncorrelated with volatility forecasts stock market returns. Both the volatility and residual components of illiquidity contain information regarding future economic activity.

Payout Yields and Stock Return Predictability: How Important is the Measure of Cash Flow? (with Bradley Paye)

Abstract: We compare the stock return forecasting performance of alternative payout yields. The net payout yield produces more accurate forecasts relative to alternatives, including the traditional dividend yield. This remains true even after excluding several years during the Great Depression when issuance was unusually high. The measure of cash flow used to form the yield matters economically. Long-term investors' hedging demand for stock is considerably reduced when net payout, rather than dividends, serves as the cash flow measure. An agent relying on an incorrect payout measure is willing to pay an economically significant "management fee" to switch to the optimal policy.