Research

 

Publications

CEO Compensation, Diversification and Incentives, Journal of Financial Economics, October 2002

Abstract:     
This paper examines the relation between chief executive officers’ (CEOs’) incentive levels and their firms’ risk characteristics. I show theoretically that, when CEOs cannot trade the market portfolio, optimal incentive level decreases with firm's nonsystematic risk but is ambiguously affected by firm's systematic risk; when CEOs can trade the market portfolio, optimal incentive level decreases with nonsystematic risk but is unaffected by systematic risk. Empirically I find support for these predictions. Furthermore, I find that incentives for CEOs likely facing binding short-selling constraints decrease with systematic as well as nonsystematic risk, as predicted by theory. Thus, compensation practice is consistent with predictions of theory.

 

R2 Around the World: New Theory and New Tests, with Stewart C. Myers, Journal of Financial Economics, February 2006

Abstract:     
Morck, Yeung and Yu show that R2 is higher in countries with less developed financial systems and poorer corporate governance. We show how control rights and information affect the division of risk bearing between managers and investors. Lack of transparency increases R2 by shifting firm-specific risk to managers. Opaque stocks with high R2’s are also more likely to crash, that is, to deliver large negative returns. Using stock returns from 40 stock markets from 1990 to 2001, we find strong positive relations between R2 and several measures of opaqueness. These measures also explain the frequency of crashes.

Winner, FAME research Prize, 2005

 

Capital Gain Tax Overhang and Price Pressure, Journal of Finance, April 2006

Abstract:     
I study whether the capital gains tax is an impediment to selling by some investors and if so, to what degree associated delayed selling affects stock prices. I find that selling decisions by institutions serving tax-sensitive clients are sensitive to cumulative capital gains, a pattern not observed for institutions with predominantly tax-exempt clients. Moreover, tax-related underselling impacts stock prices during large earnings surprises for stocks held primarily by tax-sensitive investors. The corresponding price reactions are less negative (more positive) with higher cumulative capital gains. This price pressure pattern is more severe when arbitrage is more costly.

Second Place Winner, Richard Crowell Memorial Prize, 2005

 

Do a Firm's Equity Returns Reflect the Risk of Its Pension Plan? with Robert C. Merton and Zvi Bodie, forthcoming, Journal of Financial Economics

Abstract:     
This paper examines the empirical question of whether systematic equity risk of US firms as measured by beta from the capital asset pricing model reflects the risk of their pension plans. There are a number of reasons to suspect that it might not. Chief among them is the opaque set of accounting rules used to report pension assets, liabilities, and expenses. Pension plan assets and liabilities are off-balance sheet and are often viewed as segregated from the rest of the firm, with its own trustees. Pension accounting rules are complicated. Furthermore, the role of the Pension Benefit Guaranty Corporation clouds the real relation between pension plan risk and firm equity risk. The empirical findings in this paper are consistent with the hypothesis that equity risk does reflect the risk of the firm’s pension plan despite arcane accounting rules for pensions. This finding is consistent with informational efficiency of the capital markets. It also has implications for corporate finance practice in the determination of the cost of capital for capital budgeting. Standard procedure uses de-leveraged equity return betas to infer the cost of capital for operating assets. But the de-leveraged betas are not adjusted for the risk of the pension assets and liabilities. Failure to make this adjustment typically biases upward estimates of the discount rate for capital budgeting. The magnitude of the bias is shown here to be large for a number of well-known US companies. This bias can result in positive net present value projects being rejected.

 

Working Papers

 

Effect of Personal Taxes on Managers' Decision to Sell Unrestricted Equity, with S.P. Kothari

Abstract:     
We examine how personal taxes affect CEOs' decision to sell their vested equity and compare it against diversification, managerial overconfidence and other determinants of CEOs' sale of equity. While CEOs frequently sell large amounts of their unrestricted firm equity, we find that the tax burden associated with the sale deters CEOs from selling their equity. The effect of taxes remains significant even after controlling for other determinants of CEOs' sale of equity. We also find that taxable institutional investors and CEOs both respond to taxes in their selling of equity, although the CEOs appear to be less tax-sensitive. Other determinants affect CEOs' selling decisions largely as predicted in the existing literature.

 

Inheriting Losers, with Anna Scherbina

Abstract:     
New managers who take over mutual fund portfolios, typically proceed to sell off inherited momentum losers. Relative to continuing fund managers holding the same stocks, new managers tend to reduce their holdings of losers at a higher rate than of winners or stocks in other momentum deciles. This result holds even for the subset of well-performing funds with positive fund flows, for which it is unlikely that the new manager was brought in to change the fund’s strategy. We conjecture that continuing fund managers tend to hold on to losers because of their inability to ignore the sunk costs associated with the stocks’ poor performance.

 

Do Underwater Executive Stock Options Still Align Incentives? The Effect of Stock Price Movements on Managerial Incentive-Alignment, with Lisa Meulbroek

Abstract:     
The concern that out-of-the-money stock options are not an effective way to motivate managers has led boards of directors to consider measures such as lowering the exercise price of underwater options, or issuing new option grants, to restore the incentive managers have to increase shareholder value. This paper explores whether such measures are needed: do out-of-the-money options lose their power to align incentives? We address this question by estimating how the incentive-alignment power of options changed over the course of the year 2000, a year that for many firms marked the derailment of the long-running bull stock market. Examining the sensitivity in the value of the manager's stock option to changes in the firm's stock price (one metric for incentive-alignment power), we find that in general the ability of options to align incentives remained remarkably intact. This resilience in incentive-alignment power stems from the long maturity of executive stock options, the relatively high stock price volatility of firms that experienced stock price declines, and to a lesser extent, the increase in volatility levels that accompanied weakening stock prices. We test the robustness of these results to the metric of incentive-alignment power, replacing market values with the value that managers place on their stock and option holdings, adjusting for managers' inability to fully diversify their portfolios. We also test how sensitive our results are to volatility assumptions. We conclude that even a steep decline in stock price can leave incentive levels intact, so restoring incentive-alignment is seldom a good justification for resetting the stock price or issuing new option grants. Before rejecting such measures, however, boards must examine whether the ability of stock and option holdings to retain key managerial talent deteriorated as the stock price declined, for our findings suggest that in selected firms or industries, the value of those holdings declined substantially.