Knowledge that Transforms

ABSTRACT Severe flight to quality episodes involve uncertainty about the environment, not only risk about asset payoffs. The uncertainty is triggered by unusual events and untested financial innovations that lead agents to question their worldview. We present a model of crises and central bank policy that incorporates Knightian uncertainty. The model explains crisis regularities such as market‐wide capital immobility, agents' disengagement from risk, and liquidity hoarding. We identify a social cost of these behaviors, and a benefit of a lender of last resort facility. The benefit is particularly high because public and private insurance are complements during uncertainty‐driven crises.

ABSTRACT We develop a model that shows that an overconfident manager, who sometimes makes value‐destroying investments, has a higher likelihood than a rational manager of being deliberately promoted to CEO under value‐maximizing corporate governance. Moreover, a risk‐averse CEO's overconfidence enhances firm value up to a point, but the effect is nonmonotonic and differs from that of lower risk aversion. Overconfident CEOs also underinvest in information production. The board fires both excessively diffident and excessively overconfident CEOs. Finally, Sarbanes‐Oxley is predicted to improve the precision of information provided to investors, but to reduce project investment.

ABSTRACT I develop a dynamic structural model in which a firm makes rational decisions to buy or sell assets in the presence of productivity shocks. By identifying equilibrium asset prices, the model also examines the aggregate asset sales activity over the business cycle. It shows that changes in productivity, rather than productivity levels, affect decisions: Firms with rising productivity buy assets and firms with falling productivity downsize (“rising buys falling”). As such, industries in which firms have less persistent and more volatile productivity experience greater asset reallocation. Using plant‐level data from Longitudinal Research Database (LRD), I find strong support for the model's predictions.

ABSTRACT Using a sample of small firms that defaulted on their bank debt in France, Germany, and the United Kingdom, we find that large differences in creditors' rights across countries lead banks to adjust their lending and reorganization practices to mitigate costly aspects of bankruptcy law. In particular, French banks respond to a creditor‐unfriendly code by requiring more collateral than lenders elsewhere, and by relying on collateral forms that minimize the statutory dilution of their claims in bankruptcy. Despite such adjustments, bank recovery rates in default remain sharply different across the three countries, reflecting very different levels of creditor protection.

ABSTRACT We propose a model in which assets with identical cash flows can trade at different prices. Infinitely lived agents can establish long positions in a search spot market, or short positions by first borrowing an asset in a search repo market. We show that short‐sellers can endogenously concentrate in one asset because of search externalities and the constraint that they must deliver the asset they borrowed. That asset enjoys greater liquidity, a higher lending fee (“specialness”), and trades at a premium consistent with no‐arbitrage. We derive closed‐form solutions for small frictions, and provide a calibration generating realistic on‐the‐run premia.

ABSTRACT We find a strong positive link between past IPO returns and future subscriptions at the investor level in Finland. Our setting allows us to trace this effect to the returns personally experienced by investors; the effect is not explained by patterns related to the IPO cycle, or wealth effects. This behavior is consistent with reinforcement learning, where personally experienced outcomes are overweighted compared to rational Bayesian learning. The results provide a microfoundation for the argument that investor sentiment drives IPO demand. The paper also contributes to understanding how popular investment styles develop, and has implications for the marketing of financial products.

ABSTRACT Gruber (1996) and Zheng (1999) report that investors channel money toward mutual funds that subsequently perform well. Sapp and Tiwari (2004) find that this “smart money” effect no longer holds after controlling for stock return momentum. While prior work uses quarterly U.S. data, we employ a British data set of monthly fund inflows and outflows differentiated between individual and institutional investors. We document a robust smart money effect in the United Kingdom. The effect is caused by buying (but not selling) decisions of both individuals and institutions. Using monthly data available post‐1991 we show that money is comparably smart in the United States.

ABSTRACT We present a model of equity trading with informed and uninformed investors where informed investors trade on firm‐specific and marketwide private information. The model is used to identify the component of order flow due to marketwide private information. Estimated trades driven by marketwide private information display little or no correlation with the first principal component in order flow. Indeed, we find that co‐movement in order flow captures variation mostly in liquidity trades. Marketwide private information obtained from equity market data forecasts industry stock returns, and also currency returns.

ABSTRACT We examine the selection and termination of investment management firms by 3,400 plan sponsors between 1994 and 2003. Plan sponsors hire investment managers after large positive excess returns but this return‐chasing behavior does not deliver positive excess returns thereafter. Investment managers are terminated for a variety of reasons, including but not limited to underperformance. Excess returns after terminations are typically indistinguishable from zero but in some cases positive. In a sample of round‐trip firing and hiring decisions, we find that if plan sponsors had stayed with fired investment managers, their excess returns would be no different from those delivered by newly hired managers. We uncover significant variation in pre‐ and post‐hiring and firing returns that is related to plan sponsor characteristics.

ABSTRACT The book‐to‐market ratio (B/M) is a noisy measure of expected stock returns because it also varies with expected cashflows. Our hypothesis is that the evolution of B/M, in terms of past changes in book equity and price, contains independent information about expected cashflows that can be used to improve estimates of expected returns. The tests support this hypothesis, with results that are largely but not entirely similar for Microcap stocks (below the 20 th NYSE market capitalization percentile) and All but Micro stocks (ABM).