Knowledge that Transforms

Contrary to the predictions of traditional life-cycle models, household consumption is excessively sensitive to current income. Similarly, weak evidence of income hedging runs against standard portfolio theory. We link these two puzzles by modifying the theoretical framework of Viceira (2001) to study how consumption-income sensitivities generated by income in the utility function affect households' portfolio choices. Empirically, we find that consumption-income sensitivities affect asset allocation through the income hedging channel. In particular, we show that the interaction between consumption-income sensitivity and the correlation of income growth to stock market returns is an important explanatory variable for households' stock market holdings. Received October 20, 2016; editorial decision April 25, 2018 by Editor Wayne Ferson.

We study the workup protocol, an important size discovery mechanism in the U.S. Treasury market. We find that workup order flow shocks explain 6%–8% of the variation of returns on benchmark notes and, across maturities, 10% of the variation of the yield curve level factor. Information related to proprietary client order flow is more likely to show up in workup trades, whereas information derived from public announcements tends to come through preworkup trades. Our findings highlight how the nature of information affects the trade-off between speed and execution price when informed traders choose between the lit and workup channels. Received May 3, 2017; Editorial decision August 1, 2018 by Editor Thierry Foucault. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online. Internet Appendix tables are numbered with “IA” prefix.

Since the introduction of its quantitative and qualitative easing program in 2013, the Bank of Japan has been increasing its holdings of Japanese equity through large-scale purchases of index-linked ETFs, to lower risk premiums. We exploit the cross-sectional heterogeneity of the supply shock to identify a positive and persistent impact on stock prices, consistent with a portfolio balance channel. The evidence suggests that long-run demand curves for stocks are downward sloping with unitary price elasticity. We show that the purchases of ETFs tracking the price-weighted Nikkei 225 generate pricing distortions relative to a value-weighted benchmark. Received April 13, 2018; editorial decision July 18, 2019 by Editor Thierry Foucault.

I assess time-series return predictability using a weighted least squares estimator that is around 25% more efficient than ordinary least squares (OLS) because it incorporates timevarying volatility into its point estimates. Traditional predictors, such as the dividend yield, perform better in-and out-of-sample when using my estimator, indicating the insignificant OLS estimates may be false negatives driven by a lack of power. Some newer predictors, such as the variance risk premium and the president's political party, are insignificant when using my estimator, indicating the significant OLS estimates may be false positives driven by a few periods with high expected volatility.

We construct a traded funding liquidity measure from stock returns. Guided by a model, we extract the measure as the return spread between two beta-neutral portfolios constructed using stocks with high and low margins, to control for their sensitivity to the aggregate funding shocks. Our measure of funding liquidity is correlated with other funding liquidity proxies. It delivers a positive risk premium that cannot be explained by existing risk factors. A model augmented by our funding liquidity measure has superior pricing performance for various portfolios. Despite evident comovement, this measure contains additional information that is not subsumed by market liquidity.

We identify the causal effects of short-selling bans on stock prices using regression discontinuity (RD). We exploit three threshold-based rules that determine a stock’s short-selling eligibility on the Hong Kong Stock Exchange. Short-selling bans have a large effect on short-selling volume at all thresholds. Despite this, bans do not affect stock prices. Stock returns, volatility, and crash risk are not different for banned versus unrestricted stocks when appropriate counterfactual stocks are used to measure a ban’s effects. Our findings suggest that short-selling bans are not as costly as previously argued, but are ineffective at reducing volatility or buttressing prices. Received September 13, 2017; editorial decision April 29, 2018 by Editor Jeffrey Pontiff.

We study whether mutual funds systematically manage the downside risk of their portfolios in ways that improve their performance. We find that actively managed mutual funds on average possess positive downside-risk-timing ability. Managers adjust funds’ downside risk exposure in response to macroeconomic information; however, downside-risk-timing skills remain strong even after controlling for macro variables. Funds more skilled in timing downside risk outperform those that are not by 14.3 bp per month (or 1.73% annualized) unconditionally and by 39.9 bp per month (or 4.89% annualized) during recessions; they also attract larger flows. Received September 11, 2016; editorial decision Januaruy 08, 2018 by Editor Wayne Ferson.

The continuously compounded (CC) interest rate on a one-month Treasury bill observed at the end of month t–1 is the sum of a CC expected real return and a CC expected inflation rate, Rt–1 = Et–1(rt) + Et–1(It). Two approaches are used to split Rt–1 between its two components. In the first, models for rt produce estimates of Et–1(rt), which are used to infer Et–1(It) as Rt–1 – Et–1(rt). The second approach models It to produce estimates of Et–1(It) and infer Et–1(rt) as Rt–1 – Et–1(It). By design, the estimates of Et–1(rt) and Et–1(It) from both approaches have the properties implied by rational bill prices. Received October 10, 2018; Editorial decision December 31, 2018 By Editor Jeffrey Pontiff

The global ETF industry provides more complicated investment vehicles than low-cost index trackers. Instead, we find that the real investments of ETFs may deviate from their benchmarks to leverage informational advantages (which leads to a surprising stock-selection ability) and to help affiliated OEFs through cross-trading. These effects are more prevalent in ETFs domiciled in Europe. Moreover, ETF flows seem to respond to additional risk. These results have important normative implications for consumer protection and financial stability. Received March 18, 2017; Editorial decision October 14, 2018 by Editor Raman Uppal.

We investigate how and why relative tick sizes influence traders’ order strategies, and how this affects liquidity provision in the market. Using unique NYSE data, we find that a larger relative tick size benefits high-frequency trading (HFT) market makers: they leave orders in the book longer, trade more aggressively, and have higher profit margins. In a tick-constrained (tick-unconstrained) environment, larger relative ticks result in greater (less) depth, which is consistent with greater adverse selection coming from increased undercutting of limit orders by informed HFT market makers. Received October 12, 2017; editorial decision August 21, 2018 by Editor Thierry Foucault.