Knowledge that Transforms

Information-theoretic methods recover investors’ subjective beliefs by minimizing the statistical discrepancy between beliefs and the data-generating process, subject to assets’ Euler constraints. We show that the estimated beliefs converge in probability to their pseudo-true value. Comparing estimators in the Cressie–Read family, we show that the exponential tilting and empirical likelihood estimators produce qualitatively similar estimates of the risk aversion levels and beliefs. The quadratic divergence estimator leads to negative subjective probabilities, implausibly large risk aversion levels, and underestimation of left tail risk. Our results suggest that large institutional investors, like pension funds, have countercyclical beliefs about the market return, while extrapolative investors have procyclical beliefs. Our results offer an alternative explanation of the momentum effect in stock returns, help reconcile procyclical beliefs reported in individual investor surveys versus countercyclical beliefs implied by rational expectations representative agent models, and establish the information-theoretic approach as a powerful methodology for the recovery of beliefs.

The rise in passively managed corporate debt funds has resulted in an increasingly inelastic demand for corporate debt. In this study, we quantify how passive debt ownership affects firms’ financial policy. Using fund-specific flows to capture firm-level changes in passive debt ownership that are exogenous to firm fundamentals, we find that firms respond to higher levels of passive debt ownership by increasing leverage. The borrower-friendly terms provided by passive debtholders could also theoretically lead to several potential changes in investment or payout policy. We show that passive debt holding does not affect investment policy. Instead, higher passive ownership predicts increased dividend payouts—even for firms far from index thresholds—exacerbating shareholder-debtholder conflicts. Passive debtholders enable these effects by reducing aggregate ex-ante and ex-post monitoring. The presence of a bank monitor moderates the relationship between passive debt ownership and increased payout, reinforcing the importance of this monitoring channel.

This study analyzes the wide dispersion in bid-ask spreads across clients in over-the-counter (OTC) markets. Our data detailed data comprise a dealing bank's complete trading record in a major OTC contract and include client IDs, seven client types, and precise markups. Average spreads are lowest for hedge funds (<1 basis point, bp) and highest for individuals and for small and medium enterprises (>50 bps). Regression results suggest that the primary source of variation is clients’ execution efficiency, meaning their ability to minimize execution costs. Efficient trading, which can require investments in knowledge and technology, has three dimensions: reliance on low-cost platforms; familiarity with market technologies, conventions, and negotiating strategies; and breadth of dealing relationships. Relations between proxies for client execution efficiency and client incentives to invest, such as trade frequency, are consistent with rational inattention.

Rapid growth of stablecoins has raised concerns about issuer default and spillover risks. To assess these risks, we model a stablecoin issuer facing persistent demand shocks. Absent regulation, the issuer holds little capital and favours interest-bearing but illiquid bonds over cash. This exposes coin-holders to default risk and poses spillovers via bond fire-sales. How can regulation mitigate these risks? Capital and liquidity thresholds can help, especially when introduced as usable buffers. The thresholds can be breached, providing flexibility. However, breaches trigger additional redemptions that discipline the issuer. The thresholds operate through asymmetric channels: the liquidity threshold raises only cash, whereas the capital threshold increases both capital and cash. Both thresholds mitigate default and spillover risks, making them substitutes when either risk is targeted separately but complements when both risks are targeted jointly. We provide a two-way mapping that helps derive capital-liquidity threshold combinations implied by chosen risk targets (and vice-versa).

We study the interaction of expansionary rate-based monetary policy and quantitative easing, despite their concurrent implementation, by exploiting heterogeneous banks and the introduction of negative monetary-policy rates in a fragmented euro area. Quantitative easing increases credit supply less when banks’ funding costs do not decrease simultaneously. Using administrative data from Germany, we uncover that among banks selling their securities, central-bank reserves remain disproportionately with high-deposit banks that are constrained due to sticky customer deposits at the zero lower bound. Affected German banks lend relatively less to firms while increasing their interbank exposure in the euro area.

Startups face a trade-off between short-term profitability and long-term growth. Their cash flows are said to follow a so-called J-curve. The shape of the curve depends on investors’ financing capacity: their ability to sustain prolonged periods of negative cash flow. US venture capitalists are often believed to have greater financing capacity. We examine a large Swedish dataset with detailed cash flow information. Swedish startups backed by US venture capitalists experience deeper J-curves, with larger short-term losses and higher long-term sales, relative to those backed by non-US venture capitalists. These results are consistent with US venture capitalists having greater financing capacity: they can provide more funding directly and have better access to later-stage investors.

In credit markets where borrower types are observable, is it welfare-maximizing for a rate-setting institution to offer different rates to different borrower types, or to pool them at a common rate? Moral hazard favours separation; deadweight default costs favour pooling, since compressing rates reduces aggregate defaults through hazard rate heterogeneity. We derive the condition determining which force dominates: the ratio of default cost intensity to moral hazard intensity. We show that there is a single threshold value of this ratio such that separation strictly dominates below it, complete pooling strictly dominates above it, and the two are welfare-equivalent exactly at it, for every possible value of the ratio. The result does not depend on information being scarce: even though borrower types are observable throughout, pooling can still dominate separation when default costs are sufficiently large, provided the maintained compression and effort conditions we state precisely continue to hold; we conjecture, but do not formally establish, that the same logic extends to imperfect information if the threshold, recomputed for that weaker information structure, continues to be exceeded. The welfare criterion is utilitarian surplus; the efficiency claim is surplus maximisation, not Pareto improvement.

Using transaction data from a U.S. account aggregator, I study how household balance-sheet conditions drive within-person variation in marginal propensities to consume, repay debt, and invest across three rounds of pandemic stimulus. Using a machine learning imputation estimator, I measure the sensitivity of responses to time-varying financial circumstances. Spending responses fall as liquid assets increase, while debt repayments crowd out consumption only for those with binding borrowing limits. Transfers also encourage retail investment in stocks and cryptocurrencies at both intensive and extensive margins. The findings show how liquidity constraints and debt overhang influence the allocation of transfers across spending, deleveraging, and financial assets.

We propose a new framework to explain the factor structure in the full cross section of Treasury bond returns. Our method unifies non-parametric curve estimation with cross-sectional factor modeling. We identify smoothness as a fundamental principle of the term structure of returns. Our approach implies investable factors, which correspond to the optimal spanning basis functions in decreasing order of smoothness. Our factors explain the slope and curvature shapes frequently encountered in PCA. In a comprehensive empirical study, we show that the first four factors explain the time-series variation and risk premia of the term structure of excess returns. Cash flows are covariances as the exposure of bonds to factors is fully explained by cash flow information. We identify a state-dependent complexity premium. The fourth factor, which captures complex shapes of the term structure premium, substantially reduces pricing errors and pays off during recessions.

We study how fatal and nonfatal health shocks affect households’ ability to meet their financial obligations. We find that fatal shocks substantially increase the likelihood of default and that housing wealth plays a key role as a self-insurance mechanism. Surviving spouses who experience the largest income losses are more likely to sell their homes, and those without housing wealth face a sharply higher risk of debt collection. In the most financially vulnerable families, these shocks even generate intergenerational spillovers. In contrast, nonfatal health shocks lead to only modest increases in default risk. Taken together, our findings suggest that strengthening survivors’ benefits for households with limited resources could improve welfare across generations.