Knowledge that Transforms

ABSTRACT Given the competition for top journal space, there is an incentive to produce “significant” results. With the combination of unreported tests, lack of adjustment for multiple tests, and direct and indirect p‐ hacking, many of the results being published will fail to hold up in the future. In addition, there are basic issues with the interpretation of statistical significance. Increasing thresholds may be necessary, but still may not be sufficient: if the effect being studied is rare, even t > 3 will produce a large number of false positives. Here I explore the meaning and limitations of a p‐ value. I offer a simple alternative (the minimum Bayes factor). I present guidelines for a robust, transparent research culture in financial economics. Finally, I offer some thoughts on the importance of risk‐taking (from the perspective of authors and editors) to advance our field. SUMMARY Empirical research in financial economics relies too much on p ‐values, which are poorly understood in the first place. Journals want to publish papers with positive results and this incentivizes researchers to engage in data mining and “ p ‐hacking.” The outcome will likely be an embarrassing number of false positives—effects that will not be repeated in the future. The minimum Bayes factor (which is a function of the p ‐value) combined with prior odds provides a simple solution that can be reported alongside the usual p ‐value. The Bayesianized p ‐value answers the question: What is the probability that the null is true? The same technique can be used to answer: What threshold of t ‐statistic do I need so that there is only a 5% chance that the null is true? The threshold depends on the economic plausibility of the hypothesis.

ABSTRACT From 2007 to 2009 U.S. house prices plunged and mortgage defaults surged. While ostensibly consistent with widespread “ruthless default,” analysis of detailed mortgage and house price data indicates that borrowers do not walk away until they are deeply underwater—far deeper than traditional models predict. The evidence suggests that lender recourse is not the major driver of this result. We argue that emotional and behavioral factors play an important role in decisions to continue paying. Borrower reluctance to walk away implies that the moral hazard cost of default as a form of social insurance may be lower than suspected.

ABSTRACT We show that sovereign debt impairments can have a significant effect on financial markets and real economies through a credit ratings channel. Specifically, we find that firms reduce their investment and reliance on credit markets due to a rising cost of debt capital following a sovereign rating downgrade. We identify these effects by exploiting exogenous variation in corporate ratings due to rating agencies' sovereign ceiling policies, which require that firms' ratings remain at or below the sovereign rating of their country of domicile.

ABSTRACT We trace the impact of formative experiences on portfolio choice. Plausibly exogenous variation in workers’ exposure to a depression allows us to identify the effects and a new estimation approach makes addressing wealth and income effects possible. We find that adversely affected workers are less likely to invest in risky assets. This result is robust to a number of control variables and it holds for individuals whose income, employment, and wealth were unaffected. The effects travel through social networks: individuals whose neighbors and family members experienced adverse circumstances also avoid risky investments.

ABSTRACT To understand why investors hold socially responsible mutual funds, we link administrative data to survey responses and behavior in incentivized experiments. We find that both social preferences and social signaling explain socially responsible investment (SRI) decisions. Financial motives play less of a role. Socially responsible investors in our sample expect to earn lower returns on SRI funds than on conventional funds and pay higher management fees. This suggests that investors are willing to forgo financial performance in order to invest in accordance with their social preferences.

ABSTRACT I decompose the variation of credit spreads for corporate bonds into changing expected returns and changing expectation of credit losses. Using a log‐linearized pricing identity and a vector autoregression applied to microlevel data from 1973 to 2011, I find that expected returns contribute to the cross‐sectional variance of credit spreads nearly as much as expected credit loss does. However, most of the time‐series variation in credit spreads for the market portfolio corresponds to risk premiums.

ABSTRACT Agency mortgage‐backed securities (MBS) trade simultaneously in a market for specified pools (SPs) and in the to‐be‐announced (TBA) forward market. TBA trading creates liquidity by allowing thousands of different MBS to be traded in a handful of TBA contracts. SPs that are eligible to be traded as TBAs have significantly lower trading costs than other SPs. We present evidence that TBA eligibility, in addition to characteristics of TBA‐eligible SPs, lowers trading costs. We show that dealers hedge SP inventory with TBA trades, and they are more likely to prearrange trades in SPs that are difficult to hedge.

ABSTRACT Persistent interest rate differentials account for much of the currency carry trade profitability. “Commodity currencies” offer high interest rates on average, while countries that export finished goods tend to have low interest rates. We develop a general equilibrium model of international trade and currency pricing where countries have an advantage in producing either basic inputs or final goods. In the model, domestic production insulates commodity‐producing countries from global productivity shocks, forcing final‐good producers to absorb them. Commodity‐currency exchange rates and risk premia increase with productivity differentials and trade frictions. These predictions are strongly supported in the data.

ABSTRACT We build an equilibrium model to explain why stock return predictability concentrates in bad times. The key feature is that investors use different forecasting models, and hence assess uncertainty differently. As economic conditions deteriorate, uncertainty rises and investors' opinions polarize. Disagreement thus spikes in bad times, causing returns to react to past news. This phenomenon creates a positive relation between disagreement and future returns. It also generates time‐series momentum, which strengthens in bad times, increases with disagreement, and crashes after sharp market rebounds. We provide empirical support for these new predictions.

ABSTRACT Financial intermediation naturally arises when knowing how loan payoffs are correlated is valuable for managing investments but lenders cannot easily observe that relationship. I show this result using a costly enforcement model in which lenders need ex post incentives to enforce payments from defaulted loans and borrowers' payoffs are correlated. When projects have correlated outcomes, learning the state of one project (via enforcement) provides information about the states of other projects. A large correlated portfolio provides ex post incentives for enforcement. Thus, intermediation dominates direct lending, and intermediaries are financed with risk‐free deposits, earn positive profits, and hold systemic default risk.