Knowledge that Transforms

ABSTRACT We study the determinants of vertical integration in a new data set of over 750,000 firms from 93 countries. We present a number of theoretical predictions on the interactions between financial development, contracting costs, and the extent of vertical integration. Consistent with these predictions, contracting costs and financial development by themselves appear to have no effect on vertical integration. However, we find greater vertical integration in countries that have both greater contracting costs and greater financial development. We also show that countries with greater contracting costs are more vertically integrated in more capital‐intensive industries.

ABSTRACT We find a significant discontinuity in the pooled distribution of monthly hedge fund returns: The number of small gains far exceeds the number of small losses. The discontinuity is present in live and defunct funds, and funds of all ages, suggesting that it is not caused by database biases. The discontinuity is absent in the 3 months culminating in an audit, suggesting it is not attributable to skillful loss avoidance. The discontinuity disappears when using bimonthly returns, indicating a reversal in fund performance following small gains. This result suggests that the discontinuity is caused at least in part by temporarily overstated returns.

We show that individual investors over-extrapolate from their personal experience when making savings decisions. Investors who experience particularly rewarding outcomes from saving in their 401(k)-a high average and/or low variance return-increase their 401(k) savings rate more than investors who have less rewarding experiences with saving. This finding is not driven by aggregate time-series shocks, income effects, rational learning about investing skill, investor fixed effects, or time-varying investor-level heterogeneity that is correlated with portfolio allocations to stock, bond, and cash asset classes. We discuss implications for the equity premium puzzle and interventions aimed at improving household financial outcomes.

ABSTRACT We provide new evidence on the success of long‐run risks in asset pricing by focusing on the risks borne by stockholders . Exploiting microlevel household consumption data, we show that long‐run stockholder consumption risk better captures cross‐sectional variation in average asset returns than aggregate or nonstockholder consumption risk, and implies more plausible risk aversion estimates. We find that risk aversion around 10 can match observed risk premia for the wealthiest stockholders across sets of test assets that include the 25 Fama and French portfolios, the market portfolio, bond portfolios, and the entire cross‐section of stocks.

ABSTRACT Stock‐market trading is increasingly dominated by sophisticated professionals, as opposed to individual investors. Will this trend ultimately lead to greater market efficiency? I consider two complicating factors. The first is crowding—the fact that, for a wide range of “unanchored” strategies, an arbitrageur cannot know how many of his peers are simultaneously entering the same trade. The second is leverage—when an arbitrageur chooses a privately optimal leverage ratio, he may create a fire‐sale externality that raises the likelihood of a severe crash. In some cases, capital regulation may be helpful in dealing with the latter problem.

ABSTRACT This paper finds support for the hypothesis that overvalued firms create value for long‐term shareholders by using their equity as currency. Any approach centered on abnormal returns is complicated by the fact that the most overvalued firms have the greatest incentive to engage in stock acquisitions. We solve this endogeneity problem by creating a sample of mergers that fail for exogenous reasons. We find that unsuccessful stock bidders significantly underperform successful ones. Failure to consummate is costlier for richly priced firms, and the unrealized acquirer‐target combination would have earned higher returns. None of these results hold for cash bids.

ABSTRACT This paper analyzes how blockholders can exert governance even if they cannot intervene in a firm's operations. Blockholders have strong incentives to monitor the firm's fundamental value because they can sell their stakes upon negative information. By trading on private information (following the “Wall Street Rule”), they cause prices to reflect fundamental value rather than current earnings. This in turn encourages managers to invest for long‐run growth rather than short‐term profits. Contrary to the view that the U.S.'s liquid markets and transient shareholders exacerbate myopia, I show that they can encourage investment by impounding its effects into prices.

ABSTRACT We study whether exposure to marketwide correlation shocks affects expected option returns, using data on S&P100 index options, options on all components, and stock returns. We find evidence of priced correlation risk based on prices of index and individual variance risk. A trading strategy exploiting priced correlation risk generates a high alpha and is attractive for CRRA investors without frictions. Correlation risk exposure explains the cross‐section of index and individual option returns well. The correlation risk premium cannot be exploited with realistic trading frictions, providing a limits‐to‐arbitrage interpretation of our finding of a high price of correlation risk.

ABSTRACT Standard credit risk models cannot explain the observed clustering of default, sometimes described as “credit contagion.” This paper provides the first empirical analysis of credit contagion via direct counterparty effects. We find that bankruptcy announcements cause negative abnormal equity returns and increases in CDS spreads for creditors. In addition, creditors with large exposures are more likely to suffer from financial distress later. This suggests that counterparty risk is a potential additional channel of credit contagion. Indeed, the fear of counterparty defaults among financial institutions explains the sudden worsening of the credit crisis after the Lehman bankruptcy in September 2008.

ABSTRACT Gruber (1996) drew attention to the puzzle that investors buy actively managed equity mutual funds, even though on average such funds underperform index funds. We uncover another puzzling fact about the market for equity mutual funds: Funds with worse before‐fee performance charge higher fees. This negative relation between fees and performance is robust and can be explained as the outcome of strategic fee‐setting by mutual funds in the presence of investors with different degrees of sensitivity to performance. We also find some evidence that better fund governance may bring fees more in line with performance.