Knowledge that Transforms

ABSTRACT Recent theory posits a new governance channel available to blockholders: threat of exit. Threat of exit, as opposed to actual exit, is difficult to measure directly. However, a crucial property is that it is weaker when stock liquidity is lower and vice versa. We use natural experiments of financial crises and decimalization as exogenous shocks to stock liquidity. Firms with larger blockholdings experience greater declines (increases) in firm value during the crises (decimalization), particularly if the manager's wealth is sensitive to the stock price and thus to exit threats. Additional tests suggest exit threats are distinct from blockholder intervention.

ABSTRACT We show that time variation in macroeconomic uncertainty affects asset prices. Consumption volatility is a negatively priced source of risk for a wide variety of test portfolios. At the firm level, exposure to consumption volatility risk predicts future returns, generating a spread across quintile portfolios in excess of 7% annually. This premium is explained by cross‐sectional differences in the sensitivity of dividend volatility to consumption volatility. Stocks with volatile cash flows in uncertain aggregate times require higher expected returns.

ABSTRACT Differences in real interest rates across developed economies are puzzlingly large and persistent. I propose a simple explanation: bonds issued in the currencies of larger economies are expensive because they insure against shocks that affect a larger fraction of the world economy. I show that, indeed, differences in the size of economies explain a large fraction of the cross‐sectional variation in currency returns. The data also support additional implications of the model: the introduction of a currency union lowers interest rates in participating countries, and stocks in the nontraded sector of larger economies pay lower expected returns.

ABSTRACT We provide the first systematic study of liquidity in the foreign exchange market. We find significant variation in liquidity across exchange rates, substantial illiquidity costs, and strong commonality in liquidity across currencies and with equity and bond markets. Analyzing the impact of liquidity risk on carry trades, we show that funding (investment) currencies offer insurance against (exposure to) liquidity risk. A liquidity risk factor has a strong impact on carry trade returns from 2007 to 2009, suggesting that liquidity risk is priced. We present evidence that liquidity spirals may trigger these findings.

ABSTRACT We construct a risk management index (RMI) to measure the strength and independence of the risk management function at bank holding companies (BHCs). The U.S. BHCs with higher RMI before the onset of the financial crisis have lower tail risk, lower nonperforming loans, and better operating and stock return performance during the financial crisis years. Over the period 1995 to 2010, BHCs with a higher lagged RMI have lower tail risk and higher return on assets, all else equal. Overall, these results suggest that a strong and independent risk management function can curtail tail risk exposures at banks.

ABSTRACT Returns and cash flow growth for the aggregate U.S. stock market are highly and robustly predictable. Using a single factor extracted from the cross‐section of book‐to‐market ratios, we find an out‐of‐sample return forecasting R 2 of 13% at the annual frequency (0.9% monthly). We document similar out‐of‐sample predictability for returns on value, size, momentum, and industry portfolios. We present a model linking aggregate market expectations to disaggregated valuation ratios in a latent factor system. Spreads in value portfolios’ exposures to economic shocks are key to identifying predictability and are consistent with duration‐based theories of the value premium.

ABSTRACT This paper shows that active risk management policies lead to an increase in firm value. To identify the effect of hedging and to overcome endogeneity concerns, we exploit the introduction of weather derivatives as an exogenous shock to firms’ ability to hedge weather risks. This innovation disproportionately benefits weather‐sensitive firms, irrespective of their future investment opportunities. Using this natural experiment and data from energy firms, we find that derivatives lead to higher valuations, investments, and leverage. Overall, our results demonstrate that risk management has real consequences on firm outcomes.

ABSTRACT We investigate lead‐lag relationships among monthly country stock returns and identify a leading role for the United States: lagged U.S. returns significantly predict returns in numerous non‐U.S. industrialized countries, while lagged non‐U.S. returns display limited predictive ability with respect to U.S. returns. We estimate a news‐diffusion model, and the results indicate that return shocks arising in the United States are only fully reflected in equity prices outside of the United States with a lag, consistent with a gradual information diffusion explanation of the predictive power of lagged U.S. returns.

ABSTRACT We develop a model in which the speed of reaction to trading opportunities is endogenous. Traders face a trade‐off between the benefit of being first to seize a profit opportunity and the cost of attention required to be first to seize this opportunity. The model provides an explanation for maker/taker pricing, and has implications for the effects of algorithmic trading on liquidity, volume, and welfare. Liquidity suppliers’ and liquidity demanders’ trading intensities reinforce each other, highlighting a new form of liquidity externalities. Data on durations between trades and quotes could be used to identify these externalities.

ABSTRACT This paper develops an equilibrium model of a subprime mortgage market. Our goal is to offer a benchmark with which the recent subprime boom and bust can be compared. The model is tractable and delivers plausible orders of magnitude for borrowing capacities, as well as default and trading intensities. We offer simple explanations for several phenomena in the subprime market, such as the prevalence of teaser rates and the clustering of defaults. In our model, both nondiversifiable and diversifiable income risks reduce debt capacities. Thus, debt capacities need not be higher when a larger fraction of income risk is diversifiable.