Retrospective, Perspective and Optimal Global Asset Pricing.
It has been an exciting three-year period for us. We have placed the journal on a stable upward trajectory. We could not have done this without the strong support of a talented team of distinguished advisory editors and associate editors. Some of these new advisory and associate editors have been or currently are editors of major journals like Financial Management, Financial Review, Review of Asset Pricing Studies and others. They have brought a wealth of experience and expertise to the QJFA board. The revamped editorial board reflects the new flow of papers submitted to us for publication.
We have therefore repositioned the QJFA as a general interest journal with a core focus on original finance, economics and accounting research papers. We increased the size of the overall board to 48 and have added five associate editors with strong backgrounds in accounting to reflect the increasing flow of accounting and auditing papers submitted to us. We will also consider excellent current survey articles in any area of finance, economics or accounting.
As co-editors of QJFA, we strive to publish high quality papers that advance the state of knowledge in the profession. We recognize that the production of knowledge in finance, economics, accounting and related fields has a finite life span. We therefore explicitly have aimed to fill a gap in the profession between papers that are published in the highest tiered journals and good papers that go unpublished by providing authors with a fast turnaround time for their papers. We have significantly reduced the mean time to decision on papers submitted to us. Ninety-five percent of all papers submitted receive an editorial report of some sort within the specified time frame of three months. The publication backlog has been eliminated.
We currently have enough accepted papers to fill our publication schedule through 2020. As editors we have reduced the acceptance rate to the 15-20 percent range. In this short time, we have established a reputation for fast, fair and objective reviews. Our associate editors (and the reviewers they choose) have been incredibly constructive and helpful to authors of submitted papers. We observe that some of the papers we have rejected as editors have found homes in credible journals.
The quality of the papers we have accepted has steadily improved. We publish a range of papers covering the areas of accounting, auditing, corporate finance, banking and international finance. We would like for authors of future papers to tackle problems that we think are not properly addressed in the literature. Below we list some of the papers we have accepted for publication. These papers stand out for their attempts to cast new light in their chosen areas.
In the accounting area, we highlight the three following papers. Chakraborty, Xiao and Xu's (QJFA 2019) "Further Evidence on the Association between Pension Plan Accounting and Firm Values: The Impact of SFAS 158" analyzes the pension plans of 639 separate companies over the 1993-2015 time period. They show that after the introduction of SFAS No. 158 in 2006, the association between stock prices and net pension assets (pension earnings) significantly increased (decreased). Hence, net pension assets (pension earnings) became more (less) important in firm valuation. Additionally, they show that the value relevance of net pension assets significantly increased for firms with higher institutional ownership, larger bid-ask spread, more business segments, higher E-index and larger and more independent boards. This paper shows the positive benefits of transparent rule introduction on firms that are larger and welt managed and have pricing power in the market place.
Since SFAS No. 158 migrated information on net pension asset values from footnotes to financial statements, there was a resultant increased transparency and visibility of pension plan information. It also strengthened the links between asset values and stock prices. Stock pricing errors were found to be substantially lower. This finding gives more indirect support to the functional fixation hypothesis of the next paper.
In "A Test of the Functional Fixation Hypothesis Using Derivative Financial Instruments," Alali, Siregar and Anandarajan (QJFA 2017) make a clear distinction between the limited attention hypothesis popular to finance audiences and the cognitive information processing bias that is the Functional Fixation Hypothesis (FFH). They show that FFH is a subset of limited attention. In essence, adherents who are functionally fixated ignore all information that is not prominently displayed. They reveal that when material information is placed in footnotes, the signal to the market is weaker than when such information is disclosed in the financial statements. In so doing, they provide clear evidence against the efficient market hypothesis that information is communicated seamlessly to all market participants.
Alsharairi, Smith, Glambosky and Gleason's (QDFA 2018) "Firm Investment Efficiency and Auditor Perception of Dividend Initiation" addresses the issue of how auditors treat firms that newly start dividend programs. Firms that initiate dividends have positive earnings changes both before and after the change. Alsharairi et al. (2018) find that auditors also view dividend initiations as positive signals. They attribute that positive signal to either increased managerial confidence in sustainable future cash flow or from a reduction of risk associated with agency problems due to overinvestment. Evidence is provided that initiators have lower audit fees than nonpaying firms, and firms with more investment opportunities exhibit lower audit fees. Dividend initiation appears to moderate the perceived risk of asset misappropriation.
In banking and international financial markets we showcase three papers. Abu-Alkheil, Khan and Khartabiel's (QJFA 2017) "Do Islamic Banks Optimally Balance the Trade-Off in Capital Structure Mix? A Comparison Approach" tackles the neglected topic of Islamic banking. The authors address the issue of how Islamic Banks (IBs) should be structured by looking at the evidence from a pool of 84 banks, 44 (IBs) and 40 conventional commercial banks (CBs). They uncover a non-monotonic relationship between the ROE and capital ratios (CR) for IBs and CBs. Equity issuances for all banks with low (CR) are found to be expensive, which tends to adversely affect their profitability.
Well-capitalized IBs should rely on equity at the turning point of 37.55 percent (40.17 percent for CBs), where the (CR) starts to affect profitability positively. Thus, CBs have less flexibility than IBs to issue more equity before the extra issuance starts to adversely affect the bank's profitability. CBs hold, on average, a higher percentage of their assets in loans in comparison with similarly sized IBs. CBs are shown to be more profitable than IBs in pre-, during- and post-crisis periods, respectively. IBs hold relatively more liquidity in the post-crisis period.
In their analysis presented in "Product Market Competition and Credit Ratings," Choi and Kim (QJFA 2018) investigate the ramifications of the interaction between market structure and firm credit ratings. Credit ratings can exert either a discipling effect on a firm or encourage the taking of risk to salvage bad situations. Choi and Kim (2018) try to disentangle the various effects through the channels of risk disciplining or risk increasing of the different market and credit ratings setups. After controlling for firm-specific risk characteristics and macro-economic conditions, they find that firms in competitive industries obtain higher credit ratings than do those in less competitive industries, indicating that the disciplining effects of competition outweigh risk-increasing effects.
For firms with weak corporate governance structures, they find that the positive relation between competition and credit ratings is stronger for these firms.
Abankwa's (QJFA 2020) "FX Liquidity Risk and Forward Premium Puzzle" provides a novel way of interpreting the forward premium puzzle. He investigates the role of liquidity in resolving the puzzle. After doing principal component analysis on a set of eight major factors, he extracts their common component as a measure of global liquidity. He then augments the standard Fama regression with this liquidity measure and finds that the negative beta problem almost disappears. Negative betas become positive in low liquidity regimes. This means that in low liquidity environments, high interest rate currencies depreciate and low interest rate currencies appreciate, thereby partially resolving the puzzle. He also finds that the yen has a persistent negative liquidity beta. This implies that the yen, which is used as a funding currency, provides hedging cover whenever market liquidity is low. His work also holds promise for extending the literature in basic interest rate parity theory.
In corporate finance, we showcase four papers. Kim, Kim, Kwak and Lee's (QJFA 2017) "The Effect of Ex-ante CEO Turnover Risk on Firms' Discretionary Expenditures" explores the interactions among CEOs, discretionary expenditures and subsequent firm performance. This study differs from others in the literature by the use of ex-ante measures. The authors create a prediction model where the probabilities of turnover are estimated. CEOs are concerned about their futures just like all employees. They find, not surprisingly, that managers facing ex-ante involuntary turnover risk reduce research outlays and rein in capital expenditures. Such fears perpetuate myopia within the company, and even though the CEOs who undertake such actions may ensure short-term survival, their behaviors have long-term disadvantages for the firms they lead.
Thompson (QJFA 2019), in "An Examination of the Impact of Filings on Carve-out Parent Returns," analyzes the effect of filings on the return of the parent, lust like the previous paper, Thompson is concerned with the impact of ex-ante signals of equity carve-outs instead of ex-post ones, as the existing literature does. He analyzes a data set covering the years 1988-2015 and focuses on initial filing and first price ranges on parent returns. He uses stock price performance, initial price range returns and volatility measures to predict initial returns for the carve out. He finds that 18-24 percent of the variation in market-adjusted first price range returns and 8-10 percent of the variation of carve-out parent ex-date returns can be predicted using prior public information.
Xu and Pan (QJFA 2019) revisit the accrual issue from the small firm perspective in "Explaining the Accrual Anomaly: Evidence from Firm Size and Market Conditions." Much of the extant literature revolves around the issue of whether there is risk or mispricing in accruals. Other studies hypothesize that return dispersion may be the driver of the accruals anomaly. Accruals are typically thought to be associated with firms that display high idiosyncratic risk, low stock price and turnover. These are characteristics usually found in small firms and their high returns. On the other hand, large firms with extreme accruals might display abnormal returns. The authors set out to cast light on this debate and succeed in doing so.
Using independent sorting on both accruals and size, they find evidence that the majority of firms in the extreme accrual deciles are actually medium and large firms. However, large firms have significantly lower arbitrage costs than small firms. They create hedging portfolio tests and could not distinguish between the abnormal returns of large and small firms, even after controlling for transactions costs and limits to arbitrage factors. They therefore present evidence against the small firm hypothesis as drivers of accrual anomalies.
Duan and Niu (QJFA 2019), in "The Role of Founder-CEOs and Founder-families in IPOs," investigate the impact of founders on their firms' IPOs. The impact is a negative one and increasing in the retained share of the owners. They find that founders leave money on the table. Their IPOs are at least 10 percent underpriced relative to the IPOs of non-founders. The authors explain this phenomenon by hypothesizing that founders, driven by legacy concerns, attempt to push through IPOs even in adverse circumstances. However, they find that if the firm is headed by a descendant of the founder, there is less underpricing during the IPO process. Their paper adds to the rich literature on firm control by families.
In spite of the efforts of the above authors, the world of finance is still dominated by research based on models created and derived by finance professionals who work mainly in advanced and/or highly developed economies. Even in these economies there are valuation puzzles. (1) Most of these models have limited applicability for many reasons, not least of which are data limitations. We as Editors want to lay the table for the expansion of the set of models that are applied in finance. We apologize in advance for any author omissions or incomplete treatments of any of the issues treated in what follows. (2)
By and large, these advanced economies models do not work in the economies of the underdeveloped markets of the world. (3) In many cases, most of these countries do not have well-developed capital markets. Stock and bond markets, if they exist, are very basic, and the concepts of liquidity and transparency are rudimentary at best. The concept of order flow, for instance, would be quite alien in such economies. In many cases, organized forward markets are non-existent. Very few of these economies have futures and options markets. Such economies do not have deep capital, credit and currency markets and have limited risk transfer mechanisms in place. (4) They are less diverse in terms of the breadth of their financial institutions, are not fully industrialized and are highly dependent on foreign private, public and multi-lateral capital inflows. They are also heavily indebted, have limited international market power and rely excessively on commodity exports and trade services.
Hence, they face higher costs of capital, are subject to high exchange rate volatility and are dominated by bank-provided financing and risk management solutions. They are also economies in which the rule of law is not always respected. For all of these reasons, assets should be priced differently in these economies. That is, an asset generating the same cash flows in two different economies should have different prices. This very idea had been voiced as early as Edgeworth (1894). Nevertheless, theorists have tried to apply the idea of the same good being similarly priced across countries, most notably in the Law of One Price. It was championed by Cassell (1918, 1916). (5) More recently there have been widespread challenges to the Law of One Price even when it is applied to single commodities and assets, in both domestic and international settings. See, for example, Roll et at. (2007), Alessandria and Kobisk (2011) and Crucini et al. (2015).
The Law of One Price in goods has been generalized, extended and developed into the wider concept of Purchasing Power Parity (PPP). (6) However, even with all the abstractions that are made - for example, zero transactions costs, similarity of tastes, existence of representative country price indexes, no trade restrictions and so on - there are still disputes about whether PPP holds either in the short or long run. Other attempts to apply a standard rule to link different economic notions, such as import tariffs and export taxes, have come under attack as well. For example, the Lerner symmetry theorem and its generalizations, established by Lerner (1936) and Mckinnon (1966), have been challenged. We now know that the Lerner symmetry theorem breaks down, absent general taxes and subsidies, in the presence of international cross-country asset holdings, as shown several years ago by Ray (1975) and recently by Blanchard (2009) and Castinot and Werning (2018).
Current day researchers working in the area of cross-border investments have formalized the notion of interest rate parity and conjectured what the forward rate relation should be across countries. Fama (1984) in particular has investigated the latter area, and many attempts have been made to explain the so-called forward discount puzzle that he popularized. (7) Bansal and Daqhlquist (2000) conjectured that the puzzle only exists in developed countries as they uncovered no evidence in support of the puzzle for developing countries. There are many different reasons for the existence of the forward discount puzzle, according to the prevailing literature: Peso problems, Burnside et al. (2011); incomplete information processing and habits, Verdelhan (2010); speculative efficiency, Bilson (1981); and too many other explanations to be listed here. What is remarkable is that after all of this effort there is still no simple explanation of the puzzle and no one model that can address both small and large economies. (8)
Nothing has significantly changed in this area since the documented results of Hodrick (1987) and the survey evidence of Engel (1996). The more recent survey by Engel (2016) confirms the results of his early works and extends the currency markets discussion in other directions but still does not completely explain the forward discount puzzle. Neither does the work of Boudoukh et al. (2016), who proposed a new approach to resolving the puzzle by reformulating the problem in a framework where lagged forward interest rate differentials are used as explanatory variables. (9)
As mentioned earlier, the forward discount puzzle is a major pricing puzzle mainly for its persistence, duration and widespread existence. (10) It is not only that there are instances of arbitrage in the forward markets (covered interest rate arbitrage) but that the models predict price changes in variance with what is actually realized. (11) Of course, it is quite clear that well-functioning markets require at least some instances of arbitrage possibilities, the so-called paradox of arbitrage. This would provide incentives to some group of traders to invest in the needed resources to acquire data and create the markets. However, all such opportunities should not be persistent and should rapidly clear. (12)
We see the same types of pricing issues in stocks where the CAPM has failed to provide consistent explanations of the risks of stocks. (13) The model has proven to be too blunt an instrument, relying on the core notions of the market portfolio and beta, to explain returns on individual assets as well in the cross-section. Many stocks do not perform the way it predicts, and researchers keep tinkering to find new explanations. (14) This has led to a veritable explosion of models that attempt to explain the cross-section of results. (15) Fama and French (1993) add two more variables, or factors, to the model that meaningfully improve its predictability. Their research shows that stocks that are cheap relative to their fundamentals tend to produce higher returns than more expensive ones, and that smaller companies by market value tend to outperform larger ones. This confirms the earlier findings of Banz (1981). (16)
Researchers have tried to mine the data to find new factors. Hou et al. (2018), in their recent study of dozens of papers on various anomalies, analyzed 450 purported factors to see whether they were statistically significant. During their replication tests, 294 of these factors failed a test of statistical significance. Hou et al. (2018) could not say with 95 percent confidence that the surviving factors were not the result of random chance. In fact, only 81 factors survived a more stringent test of significance at the 99.5 percent level. (17) However, the search for new theories continues apace, and Fama and French (2015, 2017) have proposed and tested a new five factor model. It is still too early to make any judgements on this new model. However, in my opinion, it cannot resolve all the problems that exist in asset pricing. (18)
In many instances there are market bubbles, irrationality in asset prices, exuberance, animal spirits, etc. These are not captured in the CAPM. The vast majority of asset pricing models are set in risk-neutral or risk-averse frame works. Those settings are obviously not representative of situations where there are volatile sentiments at work. It also excludes the entire behavioral approach to finance and the role of risk lovers. We think the fundamental bedrock on which all asset pricing models lie should be re-examined.
Portfolio theory states that the expected return on asset S is its mean return [[mu].sub.s]. This assumes that we know the underlying return generating structure of the asset, that there are no measurement errors and implicitly that the market is risk-neutral. (19) What if we follow an extended version of Hicks' (1934) suggestion and make the expected return equal to [[mu].sub.s,t] + [F.sub.t] ([sigma].sub.s,t], [[PI].sub.s,t] and [K.sub.s,t]) where [F.sub.t] is some general function of the stock's own volatility [[sigma].sub.s,t], the market's risk preference [[PI].sub.s.t] and where [K.sub.st] is a measure of all that we do not know for sure. (20) It is quite possible that we perhaps should include a preference for skewness in our generalized function. (21) Such an extension would permit a theory of asset pricing that potentially embraces risk lovers. (22)
More generalized specifications would of course generate a whole new type of CAPM theories where perhaps we can once and for all conclusively say whether idiosyncratic risk should or should not be part of a well-diversified portfolio. No one knows what that ultimate specification would be, but we have offered some ideas of how to change a few of the prescripts.
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Alali, F., D. Siregar, and A. Anandarajan. "A Test of the Functional Fixation Hypothesis Using Derivative Financial Instruments." Quarterly Journal of Finance and Accounting, vol. 56, no. 1-2, 2018, pp. 1-28.
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Lloyd P. Blenman, Co-Editor
University of North Carolina - Charlotte
John R. Wingender, Co-Editor
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(1) There are many clear instances of mispricing at work in all types of assets and corporations themselves. In some cases, the sum of the whole is less than particular pieces of a corporation. This would seem to imply that some parts of a firm may have a negative value. For instances of corporation mis-valuation, see Lamont and Thaler (2003a). Some of the mispricing of assets could be driven by sentiment. See Brown and Cliff (2005) for further insights.
(2) This paper is not intended to be a review article. A complete review of any the topics covered in what follows would necessitate a paper-long treatment. We also could not do justice to any of the topics in this overview of what we perceive to be problems in the finance literature. The subset of topics addressed reflects the editors' own interests and views of the state of finance theory, especially as it applies to emerging market countries and their capital markets, in particular. We recognize that we could not give credit in this article to all the important contributors to the ongoing debates in any of the areas covered here.
(3) In many instances, the models do not even work in advanced economies. Further in this article, we will highlight specific models that have failed. Then we will try to advance a key suggestion that can potentially solve one of the most famous model failures. Model failures in finance are typically called puzzles. We believe that conclusively solving one asset pricing puzzle will have overwhelming implications for many other puzzles in finance.
(4) This means that they are relatively defenseless against external shocks and have economies that are highly volatile, much more so than the economies of developed economies. See Koren and Tenreyo (2007) and Bloom (2014) for more extensive treatments of the problems faced by economies with low levels of development.
(5) The Law of One Price has been studied at the individual goods level by many authors, including Protopadakis and Stoll (1983) and Roll (1979), to name some of the most influential studies. These authors report widespread deviations from the law across different commodities. Protopapdakis and Stoll (1983) showed that for individual commodities, the size of the price deviations diminished as the length of the contract increases. Even within the U.S., there is substantial evidence that the Law of One Price does not work for goods. Price deviations across markets are an increasing function of distance. See Crucini et al. (2015) for a good introduction to the issues. For a good review of the purchasing power literature, see Rogoff (1997) and Taylor and Taylor (2004).
(6) Of course, earlier authors like Isard (1977) recognized the inherent limitations of this argument. But the reservations noted by Isard (1977) have not slowed down the attempts to expand the Law of One Price applications nor its extensions to PPP, in both absolute and relative variants. See Taylor (2001) for some of the econometric problems in testing the PPP theories.
(7) Earlier researchers who raised the alarm about the simple interest rate parity theory on which the forward discount puzzle is based include Stein (1961 and 1965) and Hansen and Hodrick (1980). It is very important that this puzzle be resolved as the currency markets are the world's largest market by far. On average, the daily, official trading volume was US$ 5.1 trillion, according to the Bank for International Settlements' most recent report in 2016. All countries have currency markets, whereas fewer have organized capital markets.
(8) The explanatory power of these currency models is woefully low. Many published papers in the currency markets literature have adjusted [R.sup.2] well below 50 percent. If we are to follow the guidance of Roll (1988), who bemoaned the low adjusted [R.sup.2] of 35 percent in trying to model stock price changes with monthly data and 20 percent for daily data, we should set our sights much higher than the 50 percent threshold. In addition, the current currency models have not been able to explain the apparent failure to forecast exchange rate changes in the right direction.
(9) This paper does show some promise but still cannot consistently forecast the currency changes in the right direction for all currencies tested. Hence, the negative beta issue has not been solved. In addition, the study only covers major countries with well-developed markets.
(10) See Froot and Thaler (1990) for a report on the comprehensive description and nature of the puzzle. In essence, the explanatory variable for future exchange rate changes has the wrong sign in most regressions, thus the negative beta problem. According to theory, changes in interest rate differentials should be positively related to future exchange rate changes. The empirical evidence finds the complete opposite!
(11) For further treatments on covered interest rate arbitrage theory and empirical evidence, see Aliber (1973), Frenkel and Levich (1975,1977), Levy (1977), Dooley and Isard (1980) and Blenman (1991), to list just a few of the more important papers.
(12) See Grossman and Stiglitz (1980) for a pioneering and clear exposition of the intertwined issues of why arbitrage must exist in viable markets and what the notion of efficiency actually could mean. Theirs is a model with a degree of disequilibrium in which prices are not fully revealing.
(13) The Sharpe (1964), Linter (1965), Markowitz (1952) and Merton (1973) models have been the primary work horses in finance. We as finance professionals owe a great deal of gratitude to their efforts. However, their theories' promises have not been realized in the empirical data.
(14) There are many things that can not be explained in asset pricing, and we call them puzzles. If the CAPM is a true model, it should price all assets in all countries, albeit with slightly varying levels of precision. However, it clearly does not. The basic CAPM was then extended to Conditional CAPM, Consumption-based CAPM, using different type of preferences, but all of these approaches have failed. See Hou et al. (2018) for the most recent negative evidence on the search for factors to explain these puzzles. For an earlier alarm call see Harvey et al. (2015).
(15) See Harvey et al. (2015) on the possible limitations on such factor research and questions about the reliance on statistical levels of significance to determine the existence of causal relationships. Problems also exist around the composition of the portfolio holdings of well diversified investors. According to CAPM theory, all investors should be long the market portfolio and vary the composition of their holdings of the risk-free asset. Empirical evidence suggests that this is not the case. See Green and Holifield (1992) and Levy and Roll (2010) for an introduction to some of those problems.
(16) What we need is theory to support all the possible results we find in the data. There is no theory that supports a small firm effect as far as I am aware, or all the other puzzles that are reported. The evidence at hand suggests that we should re-examine the foundations of the CAPM. Promise for a new direction and resolution of many problems may lie in the paper of Markowitz (1952) and an unexplored insight of Hicks and Allen (1934). See also Hicks (1946).
(17) Hou et al. (2018) noted that many of the factors they analyzed were highly correlated, and so one could not uniquely attribute influence to any one group or set of factors. There were so many factors, 450 in total, that they tried to organize them into categories. The factors were highly correlated both within and across groups.
(18) In spite of the heroic efforts made by Fama and French (2015, 2017), which added two factors to Fama and French (1993), the small firm puzzle is still not resolved. We quote from Fama and French (2017), "As in Fama and French (2015, 2016), the model's prime problem is failure to capture fully the low average returns of small stocks whose returns behave like those of low profitability firms that invest aggressively" (441).
(19) There is of course an extensive literature dealing with parameter uncertainty and its effects on asset pricing that originated with the works of Klein and Bawa (1976) and Bawa, Brown and Klein (1979). Their efforts have been continued by many other authors, notably Coles et al. (1995) and Kan and Zhou (2007), who investigated the effects of parameter uncertainty on portfolio choice. However, even if we know the true parameters of the distributions of the process, we cannot rule out change during the period under analysis. Hence, one would optimally want the parameters of the distributions to randomly change over time.
(20) Such a generalized return specification would of course permit prices to have a wider range of variation depending on preferences, risk behaviors and market volatility conditions.
(21) Work on portfolio theory suggests that higher order preferences might be quite useful even though standard asset pricing theory confines itself to the first two moments of the distribution and mainly assumes normality or log normality of returns. It is not clear that we need more than three moments to accurately characterize investor behavior. For a complete treatment, see Samuelson (1970), Kraus and Litzenberger (1976) and Singleton and Wingender (1986). There are potential problems in measuring the degree of risk aversion in markets. For exploratory treatments, see Quah (1997 and 2003).
(22) Risk-loving behavior is absent from finance theory except for some studies on race track betting by Quandt (1986) and others. Golec and Tamarkin (1998) claimed that bettors wanted skewness rather than risk, but it is not clear how one disentangles the two concepts. Borch (1978) showed that CAPM could be extended to inctude risk lovers, but his article is very succinct and he never explained how his examples were derived. His paper has languished for its lack of exposure. See also Asch, Malkiel and Quandt (1982 and 1984).
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|Author:||Blenman, Lloyd P.; Wingender, John R.|
|Publication:||Quarterly Journal of Finance and Accounting|
|Date:||Jan 1, 2019|
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