This paper extends research investigating the persistence and market pricing of earnings components. Sloan [1996] separates earnings into cash and accrual components and finds that the cash component has greater persistence than the accrual component, investors inefficiently treat both components as having similar persistence characteristics and, therefore, the stock market underreacts to the persistence of cash earnings and overreacts to the persistence of accruals. Xie [2001] further disaggregates accrual earnings into normal and abnormal components and finds that abnormal accruals drive the accrual anomaly discovered by Sloan.
Corporate defaults exhibit two key characteristics that have profound implications for default risk management. First, default risk is correlated through time. Bankruptcies are normally the end of a process that begins with adverse economic shock and end with financial distress. Although some bankruptcies are unexpected and, therefore, are point events, like Enron and Worldcom, investors become aware of the company’s difficulties some years prior to the bankruptcy event. Second, financial wealth of companies in the same industry, or within the same economic area, is a function of managers’ skills and common factors that introduce correlations.
Companies’ default risk is linked through sector-specific and/or macroeconomic factors. Whilst a great deal of effort has been made by practitioners to measure and explain companies’ default correlations, academics have only recently began to devote attention to this issue. The existing literature on default correlations can be divided into two approaches: the structural approach that models default correlations through companies’ assets values; and the reduced-form approach that models default correlations through default intensities. While financial institutions, namely banks, are aware of these relationships, their ability to model such correlations is still not fully developed. Basle Committee on Banking and Supervision (BCBS 1999, p. 31) states “… the factors affecting the credit worthiness of obligors sometimes behave in a related manner…” which “… requires consideration of the dependencies between the factors determining credit related losses”. Whilst there are many different models and approaches to compute default probabilities, there is no consensus on the importance of different factors that drive default correlations. BCBS (1999) report points out that whilst practitioners have been managing and studying this dependence, there is a lack of theoretical and empirical work on this issue that tests the robustness of the frameworks.
Neoclassical consumer choice models presume individual rationality. Important decisions are made by weighing costs and benefits with respect to stable preferences. Psychology, in contrast, emphasizes the importance of context and cognitive limitations. Preferences are malleable, and bounded rationality makes problem-solving conflicted and error-prone. A growing body of evidence from laboratory psychology experiments supports this view of consumer choice. It suggests that choices can be manipulated by frames, cues, and other “features” of a choice set that change the presentation of the choice, but not its content or inherent value.
Economists are often skeptical of the external validity of findings from laboratory experiments. Critiques tend to emphasize that lab studies typically use non-representative and inexperienced subjects, small stakes, relatively static environments, and inherently artificial settings that do not extrapolate readily to the “real world (for a recent elaboration of these criticisms, see Levitt and List, 2005). Consequently, several recent studies have looked for violations of neoclassical consumer choice models in observational data from the field. But few field studies so far have taken the strength of the laboratory methodology a carefully controlled research design featuring random assignment and precise manipulation of specific treatments to test for systematic deviations from neoclassical consumer choice.
