Knowledge that Transforms

We propose and examine a novel mechanism whereby holdings of dollar assets by foreign institutions can have a large, unexpected impact on foreign Treasury yields in crisis periods. Non‐U.S. institutions hold substantial dollar assets and hedge dollar exposures by selling dollars forward. In crisis periods, the dollar appreciates against other currencies. To meet margin calls on foreign exchange (FX) hedging positions, traditionally passive institutions liquidate domestic safe assets to raise cash. We show that during the recent COVID crisis, U.K. institutions with substantial dollar holdings and FX hedging positions sold large amounts of gilts, contributing significantly to the observed gilt yield spike.

We consider an informed large shareholder who can choose between making a takeover bid herself and initiating a sale to another acquirer. Such takeover activism complements direct takeovers because the very choice mitigates the asymmetric information problem, thereby improving efficiency. As more investors enter the market for corporate control, takeover activism increasingly replaces direct takeovers as the prevailing mode of disciplinary control change, matching the evolution in practice. Our model shows how this evolution, characterized by a symbiotic relationship between investor activism and private equity, arises to overcome asymmetric information and collective action problems through intermediated transactions.

Experimental asset markets provide a controlled approach to studying financial markets. We attempt to replicate 17 key results from four prominent studies, collecting new data from 166 markets with 1,544 participants. Only three of the 14 original results reported as statistically significant were successfully replicated. We fail to replicate findings on emotions, self‐control, and gender differences in bubble formation but confirm that experience reduces bubbles and cognitive skills explain trading success. Our study demonstrates the importance of replications in enhancing the credibility of scientific results in this field.

We derive bounds on the rational variation in option‐implied beliefs about market returns. While risk preferences distort option‐implied (or risk‐neutral ) beliefs away from subjective beliefs, one can nonetheless bound risk‐neutral belief movement under a general assumption on the stochastic discount factor. The resulting test requires no knowledge of the objective distribution and allows significantly more flexibility in discount rates than standard volatility tests. Implementing our test empirically using index options, we find that there is so much movement in risk‐neutral beliefs that the bounds are routinely violated. Our results imply significant excess index‐price volatility.

We develop a model to study the efficiency of socially responsible investing (SRI) as a mechanism to control firms' externalities. When SRI is not too popular, responsible investors favor strategies that lead to a concentration of SRI in a subset of firms in the economy. This concentration can mitigate coordination issues in adopting green technologies, but it can also crowd out the green investments of excluded firms and increase the price of green products. In equilibrium, responsible investors continue to favor concentration even as SRI becomes more popular, and concentrate the most when concentration is least desirable.

Prevailing theories of financial intermediation assume an integrated financial sector with frictionless risk‐sharing. However, we identify substantial risk‐sharing frictions linked to intermediary specialization using currency derivatives markets as a laboratory. Using confidential supervisory data covering $25 trillion in daily bank exposures, we document imperfect hedging in banks' FX‐swap intermediation: banks rarely hedge their synthetic dollar lending with maturity‐matched foreign safe assets. Intermediaries specialize in markets in which they have expertise in managing the associated exposures, giving rise to cross‐market variation in deviations from covered‐interest parity. Our results highlight the importance of intermediary specialization and its impact on risk premia.

How do recent advances in Generative Artificial Intelligence (AI) affect firm value? We construct the first measure of firms' workforce exposures to Generative AI and show that an “Artificial‐Minus‐Human” portfolio earned 5% in the two weeks following the release of ChatGPT. The labor‐exposure effect is more pronounced for firms with greater data assets and is distinct from the effect of firms' product exposures to AI. We assess whether exposed workforces are substituted or complemented by Generative AI based on whether their exposed tasks are core or supplemental. Examining firms' labor demand and profitability following the release of ChatGPT supports a labor‐technology substitution channel.

Firms tend to compete more aggressively when facing financial distress. This intensified competition reduces profit margins, pushing them further into distress and adversely affecting their industry peers. To study such feedback and contagion effects, we incorporate strategic competition in a dynamic model with long‐term defaultable debt, exploring various peer interactions such as predation and price wars. The feedback effect represents a novel source of financial distress costs associated with leverage, which helps explain the negative profitability‐leverage relation across industries. Owing to the contagion effect, firms' optimal leverage is often excessively high from an industry perspective, undermining the industry's financial stability.

We show that bonds issued by financial firms have higher spreads than bonds issued by industrial firms with the same rating and maturity, a difference that we refer to as the financial premium. Over the period 1987 to 2020, in the United States, this premium is 43 basis points on average, with the premium higher for lower ratings, higher during financial crises, and increasing in bond beta. We derive a model that explains the financial premium: banks hold diversified portfolios of nonfinancial debt, and bank debt therefore reflects more systematic risk than nonfinancial debt.

I show that the recent returns to environmental, social, and governance (ESG) investing are strongly driven by price impact from flows toward ESG portfolios. Using data on trades, I estimate the market's ability to accommodate ESG flows, which is given by the elasticity of substitution between ESG and other stocks. I show that every dollar flowing toward a representative ESG portfolio increases the market value of ESG stocks by $0.8. The growing institutional flows into the ESG portfolio are the main driver of ESG returns and have caused an annual flow‐driven return of 1.9%. In the absence of flows, ESG stocks would not have outperformed the market from 2012 to 2023.