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Behavioral Corporate Finance. Malcolm Baker Harvard Business School October 22, 2009. 1998: The market can stay irrational longer than you can stay solvent. 1999: Successful investing is anticipating the anticipations of others.

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Behavioral corporate finance

Behavioral Corporate Finance

Malcolm Baker

Harvard Business School

October 22, 2009


1998: The market can stay irrational longer than you can stay solvent


1999: Successful investing is anticipating the anticipations of others


2008: If you owe a bank a hundred pounds, you have a problem, but if you owe a million, it has



Rational

Fundamental

Value


There is no other proposition in economics which has more solid evidence supporting it than the Efficient Markets Hypothesis


subject to solid evidence supporting it than the Efficient Markets Hypothesis


Is this the way we make decisions
Is this the way we make decisions? solid evidence supporting it than the Efficient Markets Hypothesis

  • Basis for individual investors’ intuition

  • Basis for well-capitalized investors’ strategies


Is this the way we make decisions1
Is this the way we make decisions? solid evidence supporting it than the Efficient Markets Hypothesis

  • Basis for individual investors’ intuition



Temperature on march 12 march 24 april 5
Temperature on March 12, physicist and mathematicianMarch 24… April 5?


How many people does physicist and mathematician

P&G employ?


H1N1 flu outbreak: physicist and mathematician

You have two options


Gamble physicist and mathematician: 50% chance $110;

50% chance -$100


Retirement Plan physicist and mathematician

Participation


College GPA if your HS physicist and mathematician

GPA was 2.2, 3.0, 3.8?


Four examples
Four examples physicist and mathematician

  • Categorization

  • Anchoring (expectations) and reference points (utility)

  • Inertia

  • Extrapolation


Is this the way we make decisions2
Is this the way we make decisions? physicist and mathematician

  • Basis for individual investors’ intuition

  • Basis for well-capitalized investors’ strategies



MCI irrational traders die out


Entremed irrational traders die out


Royal Dutch and Shell irrational traders die out


United Airlines irrational traders die out


Why isn t competition more effective
Why isn’t competition more effective? irrational traders die out

  • Model risk

  • Noise trader risk

  • Unwinding or endogenous risk… comes from leverage

  • Funding risk and horizon… comes from e.g. impatient limited partners


Volkswagen irrational traders die out


Is this the way we make decisions3
Is this the way we make decisions? irrational traders die out

  • Basis for individual investors’ intuition

  • Basis for well-capitalized investors’ strategies


Behavioral finance
Behavioral finance irrational traders die out

Investor errors

  • Categorization

  • Anchoring and reference points

  • Inertia

  • Extrapolation

    + Limits to arbitrage

    = Mispricing


Capital structure, maturity structure, dividend/payout policy… are irrelevant

in perfect markets


Perfect markets
Perfect Markets policy… are irrelevant

  • The difference is no one ever thought markets were absolutely perfect

    • Taxes

    • Bankruptcy costs

    • Agency costs

    • Asymmetric information

  • But market efficiency and manager rationalityare largely ignored


Behavioral corporate finance1
Behavioral Corporate Finance policy… are irrelevant

  • Different sources of capital have different costs

    • For exogenous reasons, i.e. in inefficient capital markets with irrational traders

  • Firms respond in two ways

    • Market timing, catering

  • Real consequences for investment

    • Exogenously changing constraints


Behavioral corporate finance v 1 0
Behavioral Corporate Finance, V. 1.0 policy… are irrelevant

  • Corporate financing decisions appear to be timed well

    • Ritter (1991) and many more

    • Equity issues, stock-financed mergers, repurchases

    • Flows through to investment

  • Consistent with opportunism and real consequences of inefficient markets


Managerial smarts
Managerial Smarts? policy… are irrelevant

  • Information advantage

    • Meulbroek (1992) and several more on insider trading

    • Earnings management

  • Fewer constraints

    • Particularly in expanding supply

  • Accommodating investor demand

    • Rules of thumb, investment banking


Behavioral corporate finance v 1 1
Behavioral Corporate Finance, V. 1.1 policy… are irrelevant

  • Still the question of supply versus demand

    • Risk, growth opportunities

  • Use exogenous shocks to investor demand

    • Does the supply of capital, separate from fundamentals, affect investment?


Some examples
Some Examples policy… are irrelevant

  • Instruments for the supply of capital

    • Flows into high-yield funds  investment by below investment grade firms

    • Chernenko and Sunderam (2009)

    • Many more examples like this emerging

  • Crisis parallel: securitization, screening  real estate, PE


Behavioral corporate finance v 2 0
Behavioral Corporate Finance, V. 2.0 policy… are irrelevant

  • Mounting evidence for supply effects

    • Independent of fundamentals

  • Still, it would be nice to tie this more closely to investor behavior

    • As opposed to e.g. institutional rigidities


Back to behavioral finance
Back to Behavioral Finance policy… are irrelevant

Investor errors

  • Categorization

  • Anchoring and reference points

  • Inertia

  • Extrapolation

    + Limits to arbitrage

    = Mispricing


Categorization and dividend policy
Categorization and Dividend Policy policy… are irrelevant

  • Test the hypothesis that investors categorize firms according to whether they pay a dividend

    • Remember March versus April

    • Four measures of a ‘dividend premium’

  • Examine the corporate response


Dividend Premium and policy… are irrelevant

Initiations

Dividend Premium

Propensity to Initiate

Dividend Initiations


Reference points and m a pricing
Reference Points and M&A Pricing policy… are irrelevant

  • Investors are reluctant to sell at a loss

    • Remember H1N1 experiment and loss aversion

    • Shefrin and Statman (1984) and Odean (1998) study individual investors

  • This means it’s hard to do a deal when a firm is selling well off its recent highs


A Discontinuity in Offer policy… are irrelevant

Prices

Offer Price = 52-week High Price

Density

(Offer Price – 52-week High Price) Pt-30


A Discontinuity in Offer policy… are irrelevant

Prices

Density

(Offer Price – 52-week High Price) Pt-30


Past High Prices and policy… are irrelevant

Average Offer Premia

Offer Price  Pt-30

52-week High Price  Pt-30


Inertia and equity financing
Inertia and Equity Financing policy… are irrelevant

  • Default setting matters in raising equity

    • Remember 401-K enrollments

    • Follow-on offers require active participation

    • Stock mergers require active opt out

  • Inertia makes price impact in stock financed mergers lower

    • Implications for equity-financed growth


Sleepy Investors policy… are irrelevant


Limits to arbitrage and fdi
Limits to Arbitrage and FDI policy… are irrelevant

  • Mispriced equity across borders

    • Remember Royal Dutch and Shell

    • A problem is mobility of capital across borders, by mandate or regulation

  • FDI is a form of cross-border corporate arbitrage

    • Source country mispricing drives FDI, especially in the presence of restrictions on private capital flows


Recap
Recap policy… are irrelevant

  • The supply of capital, separate from fundamentals, and capital market mispricing have real consequences for corporate finance and investment

    • These effects can often be traced back to investor errors and limits to arbitrage


The crisis some parallels
The crisis: Some parallels policy… are irrelevant

  • Valuation of AAA securities

    • Categorization

  • Real estate prices

    • Extrapolation

  • Deal volumes, raising capital

    • Reference points

  • Models and marks

    • Problematic belief in market efficiency, liquidity


Interactions
Interactions policy… are irrelevant

  • These behavioral biases interact with incentive problems, fragility of banking

  • Much of this was present in the Internet bubble, but a difference was the players involved

    • Large, leveraged financial institutions, consumers were doubly exposed


All parties believed they were getting a good deal... Many of the structured finance securities with AAA-ratings offered yields that were attractive relative to other, rating-matched alternatives

Coval, Jurek, and Stafford (2008)


There is no housing bubble in this country… of the structured finance securities with AAA-ratings offered yields that were attractive relative to other, rating-matched alternatives

Home prices on average have risen at a 6% annual pace since 1999, and 13% over the past year

Neil Barsky, managing partner of Alson Capital Partners, LLC, 2005


First Pacific Advisors: of the structured finance securities with AAA-ratings offered yields that were attractive relative to other, rating-matched alternatives“What are the key drivers of your rating model?”Fitch: “FICO scores and home price appreciation of low single digit or mid single digit, as home price appreciation has been for the past 50 years.”

FPC: “What if home price appreciation was flat for an extended period of time?”Fitch: “Our model would start to break down.”

FPC: “What if home prices were to decline 1% to 2% for an extended period of time?”

Fitch: “The models would break down completely.”

FPC: “With 2% depreciation, how far up the rating’s scale would it harm?”

Fitch: “It might go as high as the AA or AAA tranches.”


When the music stops, in terms of liquidity, things will get complicated. As long as the music is playing, you’ve got to get up and dance. We’re still dancing.

Chuck Prince, CEO of Citigroup in 2007


[John complicated. As long as the music is playing, you’ve got to get up and dance. We’re still dancing.Thain] didn’t have the same pride of ownership in Merrill that [Richard] Fuld had in Lehman. That is why he was willing to sell $31 billion worth of mortgage-backed derivatives for 22 cents on the dollar in late July.

New York Times, 9/16/2008


Concluding thought bcf 3 0
Concluding Thought: BCF 3.0 complicated. As long as the music is playing, you’ve got to get up and dance. We’re still dancing.

  • We need an integration of behavioral finance and the traditional academic approaches to corporate finance, banking, regulation, and the agency problems of managers and intermediaries


Concluding thought bcf 3 01
Concluding Thought: BCF 3.0 complicated. As long as the music is playing, you’ve got to get up and dance. We’re still dancing.

  • We need an integration of behavioral finance and the traditional academic approaches to corporate finance, banking, regulation, and the agency problems of managers and intermediaries


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