Knowledge that Transforms

We model a financial market where some traders of a risky asset do not fully appreciate what prices convey about others' private information. Markets comprising solely such “cursed” traders generate more trade than those comprising solely rationals. Because rationals arbitrage away distortions caused by cursed traders, mixed markets can generate even more trade. Per‐trader volume in cursed markets increases with market size; volume may instead disappear when traders infer others' information from prices, even when they dismiss it as noisier than their own. Making private information public raises rational and “dismissive” volume, but reduces cursed volume given moderate noninformational trading motives.

I demonstrate that nonfinancial corporations act as cross‐market arbitrageurs in their own securities. Firms use one type of security to replace another in response to shifts in relative valuations, inducing negatively correlated financing flows in different markets. Net equity repurchases and net debt issuance both increase when expected excess returns on debt are particularly low, or when expected excess returns on equity are relatively high. Credit valuations affect equity financing as much as equity valuations do, and vice versa. Cross‐market corporate arbitrage is most prevalent among large, unconstrained firms, and helps account for aggregate financing patterns.

We introduce a return predictor related to the slope and curvature of the futures term structure: basis‐momentum. Basis‐momentum strongly outperforms benchmark characteristics in predicting commodity spot and term premiums in both the time series and the cross section. Exposure to basis‐momentum is priced among commodity‐sorted portfolios and individual commodities. We argue that basis‐momentum captures imbalances in the supply and demand of futures contracts that materialize when the market‐clearing ability of speculators and intermediaries is impaired, and that it represents compensation for priced risk. Our findings are inconsistent with alternative explanations based on storage, inventory, and hedging pressure.

Examining a shock to the salience of the sustainability of the U.S. mutual fund market, we present causal evidence that investors marketwide value sustainability: being categorized as low sustainability resulted in net outflows of more than $12 billion while being categorized as high sustainability led to net inflows of more than $24 billion. Experimental evidence suggests that sustainability is viewed as positively predicting future performance, but we do not find evidence that high‐sustainability funds outperform low‐sustainability funds. The evidence is consistent with positive affect influencing expectations of sustainable fund performance and nonpecuniary motives influencing investment decisions.

I study how brokers distort household investment decisions. Using a novel convertible bond data set, I find that consumers often purchase dominated bonds—cheap and expensive otherwise‐identical bonds coexist in the market. Brokers are incentivized to sell the dominated bonds, typically earning two times greater fees for selling them. I develop and estimate a broker‐intermediated search model that rationalizes this behavior. The estimates indicate that costly search is a key friction in financial markets, but the effects of search costs are compounded when brokers are incentivized to direct the search of consumers toward high‐fee inferior products.

Modigliani and Miller show that the total market value of a firm is unaffected by a repackaging of asset return streams to equity and debt if pricing is arbitrage‐free. We investigate this invariance theorem in experimental asset markets, finding value‐invariance for assets of identical risks when returns are perfectly correlated. However, exploiting price discrepancies has risk when returns have the same expected value but are uncorrelated, in which case the law of one price is violated. Discrepancies shrink in consecutive markets, but persist even with experienced traders. In markets where overall trader acuity is high, assets trade closer to parity.

A unique data set from a large Ponzi scheme allows me to study word‐of‐mouth diffusion of investment information. Investors could join the scheme only by invitation from an existing member, which allows me to observe how the idea spreads from one person to the next based on inviter‐invitee relationships. I find that the observed social network has a scale‐free connectivity structure, which significantly facilitates the diffusion of the investment idea and contributes to the growth and survival of the socially spreading Ponzi scheme. I further find that investors invest more if their inviter has comparatively higher age, education, and income.

We study the effect of subjective mortality beliefs on life‐cycle behavior. With new survey evidence, we document that survival is underestimated (overestimated) by the young (old). We calibrate a canonical life‐cycle model to elicited beliefs. Relative to calibrations using actuarial probabilities, the young undersave by 26%, and retirees draw down their assets 27% slower, while the model's fit to consumption data improves by 88%. Cross‐sectional regressions support the model's predictions: Distorted mortality beliefs correlate with savings behavior while controlling for risk preferences, cognitive, and socioeconomic factors. Overweighting the likelihood of rare events contributes to mortality belief distortions.

Using novel survey data, we document that individuals extrapolate from recent personal experiences when forming expectations about aggregate economic outcomes. Recent locally experienced house price movements affect expectations about future U.S. house price changes and higher experienced house price volatility causes respondents to report a wider distribution over expected U.S. house price movements. When we exploit within‐individual variation in employment status, we find that individuals who personally experience unemployment become more pessimistic about future nationwide unemployment. The extent of extrapolation is unrelated to how informative personal experiences are, is inconsistent with risk adjustment, and is more pronounced for less sophisticated individuals.

We propose a theoretical measure of income hedging demand and show that it affects asset prices. We focus on the value factor and first demonstrate that our demand estimates are correlated with the actual demands of retail and mutual fund investors. We then show that the aggregate high‐minus‐low (HML) demand predicts HML returns. Exploiting the state‐level variation in income risk, we demonstrate that state‐level hedging demands predict state‐level HML returns. A long‐short portfolio that exploits this hedging‐induced predictability earns an annualized risk‐adjusted return of 6%.