Catering Through Nominal Share Prices

Malcolm  Baker; Robin  Greenwood; Jeffrey  Wurgler

Article | Journal of Finance | December 2009

Catering Through Nominal Share Prices

by Malcolm Baker, Robin Greenwood and Jeffrey Wurgler

Abstract

We propose and test a catering theory of nominal stock prices. The theory predicts that when investors place higher valuation on low-price firms, managers will maintain share prices at lower levels, and vice-versa. Using measures of time-varying catering incentives based on valuation ratios, split announcement effects, and future returns, we find empirical support for the predictions in both time-series and firm-level data. Given the strong cross-sectional relationship between capitalization and nominal share price, an interpretation of the results is that managers may be trying to categorize their firms as small firms when investors favor small firms.

Keywords: Stocks; Stock Shares; Investment; Investment Return; Price; Theory; Valuation;

Format: Print

32 pages

Find at Harvard Read Now

Citation:

Baker, Malcolm, Robin Greenwood, and Jeffrey Wurgler. "Catering Through Nominal Share Prices." Journal of Finance 64, no. 6 (December 2009): 2559–2590. (Internet Appendix.)

We develop a model in which risk-averse, specialized bond investors must be paid to absorb shocks to the supply and demand for long-term bonds in two currencies. Since long-term bonds and foreign exchange are both exposed to unexpected movements in short-term interest rates, our model naturally links the predictability of long-term bond returns to the predictability of foreign exchange returns. Specifically, a shift in the net supply of long-term bonds in one currency influences bond term premiums in both currencies as well as the foreign exchange rate between the two currencies. Our model matches several important empirical patterns, including the co-movement between exchange rates and bond term premiums as well as the finding that central banks' quantitative easing policies impact not only local-currency long-term yields, but also foreign exchange rates. We also show that this quantity-driven approach provides a unified account explaining both why foreign exchange tends to outperform when the foreign interest rates exceed domestic rates and why long-term bonds tend to outperform when the yield curve is steep.

Reflexivity is the idea that investors' biased beliefs affect market outcomes, and that market outcomes in turn affect investors' beliefs. We develop a behavioral model of the credit cycle featuring such a two-way feedback loop. In our model, investors form beliefs about firms' creditworthiness, in part by extrapolating past default rates. Investor beliefs influence firms' actual creditworthiness because firms that can refinance maturing debt on favorable terms are less likely to default in the short run—even if fundamentals do not justify investors' generosity. Our model is able to match many features of credit booms and busts, including the imperfect synchronization of credit cycles with the real economy, the negative relationship between past credit growth and the future return on risky bonds, and "calm before the storm" periods in which firm fundamentals have deteriorated but the credit market has not yet turned.

On the afternoon of Monday October 13, 2008, Hank Paulson Jr., the Secretary of the Treasury of the United States, walked into the large conference room across the hall from his office in the Treasury Department. Joining him were Federal Reserve Chairman Ben Bernanke, President of the Federal Reserve Bank of New York Timothy Geithner, Chair of the Federal Deposit Insurance Corporate Sheila Bair, and the Chief Executive Officers of nine of the largest banks in the United States. This distinguished group had been brought together by the most serious financial crisis since the Great Depression of the 1930s. Financial panic was pushing the U.S. and European financial systems to the brink of failure. Paulson hoped his meeting with the bank CEOs would be a turning point. U.S. financial markets were closed for Columbus Day, and Paulson was planning to announce the latest government actions to stabilize the financial system before markets reopened on Tuesday.

Faculty & Research

Catering Through Nominal Share Prices

Abstract

Citation:

About the Authors

More from these Authors