We show that demand pressure from retail investors makes options on low-price stocks relatively expensive-delta-hedged options on low-price stocks underperform those on high-price stocks by 0.63% per week for calls and 0.36% for puts. Natural experiments corroborate this finding: options become more expensive following stock splits, options on mini indices are more expensive than those on main indices, and mini contract options are more expensive than standard options. We attribute our findings to retail investors' preference for skewness and divergence of opinion. Limits to arbitrage and strategic quote setting by market makers contribute to, but do not fully explain, this effect. (JEL G13, G14)

We study the effects of takeover feasibility on asset prices and returns in a unified framework. We show theoretically that takeover protections increase equity risk, stock returns, and bond yields by removing a valuable put option to sell the firm, notably for firms approaching distress. We investigate these claims empirically and find that distressed firms experience a significant decrease in value and increase in returns and market betas after the passage of antitakeover laws, in line with our predictions. At issue bond yields are also higher when an antitakeover law is in effect. Consistent with the model, the effects of antitakeover laws on stock returns, respectively, bond yields, are greater when shareholders, respectively, bondholders, have greater bargaining power. This paper was accepted by Lukas Schmid, finance. Funding: E. Morellec acknowledges financial support from the Swiss Finance Institute. Supplemental Material: The online appendix and data files are available at https://doi.org/10.1287/mnsc.2022.03111 .

We consider a firm’s competitiveness based on the manner by which other firms mention it on their 10-K filings. Using all public firm filings simultaneously, we implement a PageRank-type algorithm to produce a dynamic measure of firm competitiveness, denoted C-Rank. A high-minus-low C-Rank portfolio yields 16% alpha annually, where return predictability mainly stems from cross-sector competitiveness. The findings are largely consistent with investor underreaction to firm business opportunities identified by other strong firms. Nevertheless, stock return covariation with the C-Rank portfolio spread suggests that part of the return predictability can be interpreted as compensation for systematic cross-sector disruption risk.

Abstract This paper documents that short-term options achieve significantly lower returns during months with 4 versus 5 weeks between expiration dates. The average return differential ranges from 16 to 29 basis points per week for delta-hedged portfolios, and from 101 to 187 basis points per week for straddles, over 1996–2017. Evidence based on earnings announcements and institutional holdings suggests that investor inattention to exact expiration date rather than underlying risk exposures or transaction costs can explain the mispricing. Market makers seem to adjust prices accordingly, and tend to over-trade mispriced options against less sophisticated investors.

We argue that takeover protections increase equity risk and stock returns by removing a valuable put option to sell equity when firms approach financial distress. We investigate these claims empirically by looking at the risk and return dynamics of distressed firms around the enactment of anti-takeover laws, both domestically and internationally. In line with our predictions, we find that distressed firms experience a significant increase in returns and market betas after the passage of anti-takeover laws. We find no such effects in the full sample of firms.

We partially explain the well-documented distress anomaly by studying the risk/return relation of distressed stocks across market states. We show that the anomaly does not hold in market downturns. The asset beta and financial leverage of distressed stocks rise significantly during bear markets, resulting in a dramatic increase in their equity beta. Hence, a long/short healthy-minus-distressed trading strategy leads to significant losses when the market rebounds. Managing this risk mitigates the severe losses of financial distress strategies and significantly improves their Sharpe ratios. Our results remain strongly significant controlling for the momentum effect and are robust to various estimation procedures. This paper was accepted by Tyler Shumway, finance.

ABSTRACTWe study whether default options are mispriced in equity values by employing a structural equity valuation model that explicitly takes into account the value of the option to default (or abandon the firm) and uses firm‐specific inputs. We implement our model on the entire cross section of stocks and identify both over‐ and underpriced equities. An investment strategy that buys undervalued stocks and shorts overvalued stocks generates an annual four‐factor alpha of about 11% for U.S. stocks. The model's performance is stronger for stocks with a higher value of the default option, such as distressed or highly volatile stocks.

Financially distressed stocks in the U.S. earn puzzlingly low returns giving rise to the distress risk anomaly. In this paper we provide evidence on the performance of distressed stocks in 34 different countries. We find that the distress anomaly appears to exist in developed countries but not in emerging ones. Using cross-country analyses we explore several alternative potential drivers of returns to distressed stocks. We find that the distress anomaly is stronger in countries with stronger takeover legislation, lower barriers to arbitrage, higher information transparency, and easier access to new loans. We find a weak relation between the distress anomaly and debt enforcement risk, and a measure of country-level return skewness. We find no relation between the anomaly and the legal origin of a country. These findings suggest that various aspects of shareholders’ risk play an important role in shaping distressed stocks returns.

Financially distressed stocks in the United States earn puzzlingly low returns giving rise to the distress risk anomaly. We provide evidence that the anomaly exists in developed countries, but not in emerging ones. Using cross-country analyses, we explore several potential drivers of returns to distressed stocks. The distress anomaly is stronger in countries with stronger takeover legislation, lower barriers to arbitrage, and higher information transparency. In contrast, shareholder bargaining power and expected stock return skewness in a country do not affect the anomaly. These findings suggest that various aspects of shareholders’ risk play an important role in shaping distressed stocks returns.

This paper documents that options held from one expiration date to the next achieve significantly lower returns when there are four versus five weeks between expiration dates. The average return differential ranges from 12 basis points per week for delta-hedged put portfolios to 89 basis points for straddles. Evidence based on earnings announcements and price patterns close to maturity suggests that investor inattention to exact expiration date rather than underlying risk exposures or transaction costs can explain the mispricing. The results therefore demonstrate a significant behavioral bias among option traders.

Most home stadiums/arenas of major-sport teams in the U.S. are sponsored by large publicly traded companies. Using NFL data we find that stock returns to the sponsoring firms are affected by the outcomes of games played in their stadiums. Wins in Monday night games generate next-day abnormal returns 50 basis points higher than losses. The effect is 80 basis points in the post-season and when the game outcome is unexpected. This does not revert over the next few days. Outcomes of NFL games could serve as a reasonably exogenous instrument for investor sentiment.

Durand (J Finance 12:348–363, 1957) shows that the classical St. Petersburg paradox can apply to the valuation of a firm whose dividends grow at a constant rate forever. To capture a more realistic pattern of dividends, we model the dividend growth rate as a mean reverting process, and then use the capital asset pricing model to derive the risk-adjusted present value. The model generates an equivalent St. Petersburg game. The long-run growth rate of the payoffs (dividends) is dominant in driving the value of the game (firm), and the condition under which the value is finite is less restrictive than that of the standard game.

What is the impact of long-term executive compensation, particularly large pension payouts, on the firm's current dividend policy? We argue that managers with high pension holdings are less likely to adopt a high dividend policy that can risk their future pension payouts. Using a hand-collected actuarial pension dataset we show that (i) dividend payments are significantly lower when manager compensation relies more heavily on pension payouts; (ii) higher compensation leverage and inside debt have a significant negative effect on dividend payments net of stock repurchases; and (iii) the negative effect of pension on dividend is significantly weaker when pensions are protected in a pre-funding rabbi trust. We show further that this agency behavior reduces firm performance.

We argue that default option is important for equity valuation and construct a model that explicitly prices the option to default or abandon the firm. An investment strategy that buys stocks that are classified as undervalued by our model and shorts overvalued stocks generates an annual 4-factor alpha of about 11% for U.S. stocks. The model’s performance is stronger for stocks with higher value of default option, such as distressed or highly volatile stocks. We construct a similar strategy in a sample of nine most highly capitalized developed markets and find consistent results. Our findings suggest that investors do not properly incorporate the value of default options in stock prices.

This paper examines how the similarity between the executive compensation leverage ratio and the firm leverage ratio affects the quality of the firm’s investment decisions. A larger leverage gap (i.e., a bigger difference between these two ratios) leads to more investment distortions. Managers with more debt-like compensation components tend to under-invest, whereas managers with larger equity-based compensation engage more in over-investment. Furthermore, investment distortion is likely to increase the equity (debt) value when compensation leverage is lower (higher) than firm leverage. These findings suggest that managers can deviate from an optimal investment policy to increase the value of their portfolio, and that a lower leverage gap can reduce agency costs.

Stock prices are mechanically driven by changes in either expected cash flows or discount rates (expected returns). Fundamentally firm values move with managerial decisions. We explore through which channel managers commonly affect their firms’ value. A variance decomposition analysis indicates that when managers have a greater degree of discretion – i.e., when CEO compensation and ownership are high, and in unregulated and heterogeneous industries – cash-flow news becomes significantly more important in driving stock returns, while expected - return news becomes significantly less important. This suggests that managers move firm value mainly by changing expected cash flows and not firm risk.

We model the time series behavior of dividend growth rates, as well as the profitability rate, with a variety of autoregressive moving-average processes, and use the capital asset pricing model (CAPM) to derive the appropriate discount rate. One of the most important implications of this research is that the rate of return beta changes with the time to maturity of the expected cash flow, and the degree of mean reversion displayed by the growth rate. We explore the consequences of this observation for three different strands of the literature. The first is for the value premium anomaly, the second for stock valuation and learning about long-run profitability, and the third is for the St. Petersburg paradox. One of the most surprising results is that the CAPM implies a higher rate of return beta for value stocks than growth stocks. Therefore, value stocks must have higher expected returns, and this is what is required theoretically in order to explain the well-known value premium anomaly.

Return anomalies are most pronounced among distressed stocks. We attribute this finding to the role of misvaluation and investors' inability to value distressed stocks correctly. We treat distressed stocks as options and construct a valuation model that explicitly takes into account the value of the option to default (or abandon the fi rm). We show that anomalies exist only among the subset of distressed stocks classi fied as misvalued by our model. There is little evidence that more misvalued stocks are harder to arbitrage than less misvalued stocks.