Corporate Finance - CEO Overconfidence

Question 1

What is the study by Malmendier & Tate (2005) about?

Answer 1

-they argue that managerial overconfidence can account for corporate investment distortions
-they study the investment decisions of CEOs who overestimate the future returns of their companies

Overconfidence hypothesis:
CEO is overconfident if he persistently fails to reduce his personal exposure to company-specific risk (idiosyncratic).

Finding:
-overconfident managers overestimate the returns of their investment projects and view external funds as costly
-overconfident managers overinvest when they have abundant internal funds

Question 2

The overconfidence story in the paper of Malmendier & Tate (2005) builds on two effect. What are those?

Answer 2

1. “Better-than-average” effect
   -> when individuals assess their relative skill, they tend to overestimate their acumen (scharfsinn) relative to the average
   -> affects the attribution of causality: because they expect their behavior to produce success, they are more likely to attribute good outcomes to their actions
2. “Narrow confidence intervals”
   -> finding is attributed to three main factors (each triggers overconfidence)
   2.1 Illusion of control -> CEO who handpicks investment is likely to believe he can control its outcome
   2.2 High degree of commitment to good outcomes -> typical CEO is highly committed to companys success since his salary is linked to stock price
   2.3 Abstract reference points which makes it hard to compare performance across individuals

Question 3

When is a CEO overconfident in the paper of Malmendier & Tate (2005)? How is it measured?

Answer 3

=overexposure to the idiosyncratic risk of his firm

1. if he persistently exercises options later than suggested by the benchmark -> overconfident in ability to keep companys stock prices rising -> Holder 67
2. if he is optimistic enough about his firm future performance that he holds all the way to expiration -> overconfident -> Longholder
3. if he habitually increase his holdings of company stocks -> overconfident -> Net Buyer

Question 4

What are the two predictions and test in the paper of Malmendier & Tate (2005)?

Answer 4

1. The investment of overconfident CEOs is more sensitive to cash flow than the investment of CEOs who are not overconfident
   -> Test 1: Overconfidence and Investment
2. The investment-cash flow sensitivity of overconfident CEOs is more pronounced in equity dependent firms.
   -> Test 2: Overconfidence and Financial constraints