Week 3 - Malmendier and Tate (2005)

Question 1

What is the main idea of this paper?

Answer 1

• The article looks at the relation between managerial overconfidence and corporate investment distortions.
• Overconfident CEOs systematically overestimate the return to their investment projects and the value of their
  company
• This implies that CEOs overinvest if they have sufficient internal funds. CEOs are also reluctant to issue new
  equity because they perceive the stock of their company undervalued by the market
• CEOs overinvest when they have sufficient funds, but curtail investments when they require external funds.

Question 2

What hypothesis are tested in this articel?

Answer 2

• H1: Investments of overconfident CEOs are more sensitive to CFs than the cautious one’s
• H2: The investment CF sensitivity of overconfident CEOs is more pronounced in equity-dependent firms

Question 3

How they measure overconfidence in this article?

Answer 3

Based on ”Revealed beliefs” measure of CEO overconfidence based on their
personal portfolio decisions:
Measures based on CEOs overexposure to the idiosyncratic risk of their firms
(human capital, stocks and options bear the risk of same company).

Question 4

What are the 3 overconfidence measuers?

Answer 4

1 Holder 67:
CEOs are overconfident if at least twice during the sample period they did not exercise any options when the options were more than 67% in the money beyond year 5.
58 out of 113 CEOs.
2 Longholder:
CEOs are classified as overconfident if they ever hold an option until the last year of its duration.
85 out of 661 CEOs.
3 Net buyer:
CEOs are identified as overconfident if they were net buyers of company equity during their first five years in the sample.
97 out of 158 CEOs.

Question 5

What are the conclusions?

Answer 5

• In this article, overconfidence is measured as overexposure of CEOs to the idiosyncratic risk
  of their firms.
• There is a positive relation between CEO overconfidence and investment-cash flow
  sensitivity, in other words: If CEOs have sufficient internal funds for investment and are not
  disciplined by the capital market or corporate governance mechanisms, they overinvest
  relative to the first–best
• The interaction term of overconfidence and cash-flow sensitivity is found to be highly
  significant
• The investment–cash flow sensitivity of overconfident CEOs is more pronounced in equitydependent firms (most financially constrained).
• CEOs with financial education have less investment-cash flow sensitivity.
• Implication: need for better governance and more involvement of independent directors
  (shareholders).