Knowledge that Transforms

ABSTRACT The conditional covariance between aggregate stock returns and aggregate consumption growth varies substantially over time. When stock market wealth is high relative to consumption, both the conditional covariance and correlation are high. This pattern is consistent with the “composition effect,” where agents' consumption growth is more closely tied to stock returns when stock wealth is a larger share of total wealth. This variation can be used to test asset‐pricing models in which the price of consumption risk varies. After accounting for variations in this price, the relation between expected excess stock returns and the conditional covariance is negative.

ABSTRACT We show that aggregate consumption risks embodied in cash flows can account for the puzzling differences in risk premia across book‐to‐market, momentum, and size‐sorted portfolios. The dynamics of aggregate consumption and cash flow growth rates, modeled as a vector autoregression, are used to measure the consumption beta of discounted cash flows. Differences in these cash flow betas account for more than 60% of the cross‐sectional variation in risk premia. The market price for risk in cash flows is highly significant. We argue that cash flow risk is important for interpreting differences in risk compensation across assets.

ABSTRACT Using data on the investments a large number of individual investors made through a discount broker from 1991 to 1996, we find that households exhibit a strong preference for local investments. We test whether this locality bias stems from information or from simple familiarity. The average household generates an additional annualized return of 3.2% from its local holdings relative to its nonlocal holdings, suggesting that local investors can exploit local knowledge. Excess returns to investing locally are even larger among stocks not in the S&P 500 index (firms for which information asymmetries between local and nonlocal investors may be largest).

ABSTRACT This paper investigates the performance and capital inflows of private equity partnerships. Average fund returns (net of fees) approximately equal the S&P 500 although substantial heterogeneity across funds exists. Returns persist strongly across subsequent funds of a partnership. Better performing partnerships are more likely to raise follow‐on funds and larger funds. This relationship is concave, so top performing partnerships grow proportionally less than average performers. At the industry level, market entry and fund performance are procyclical; however, established funds are less sensitive to cycles than new entrants. Several of these results differ markedly from those for mutual funds.

ABSTRACT Diamond and Dybvig (1983) show that while demand–deposit contracts let banks provide liquidity, they expose them to panic‐based bank runs. However, their model does not provide tools to derive the probability of the bank‐run equilibrium, and thus cannot determine whether banks increase welfare overall. We study a modified model in which the fundamentals determine which equilibrium occurs. This lets us compute the ex ante probability of panic‐based bank runs and relate it to the contract. We find conditions under which banks increase welfare overall and construct a demand–deposit contract that trades off the benefits from liquidity against the costs of runs.

ABSTRACT The value anomaly arises naturally in the neoclassical framework with rational expectations. Costly reversibility and countercyclical price of risk cause assets in place to be harder to reduce, and hence are riskier than growth options especially in bad times when the price of risk is high. By linking risk and expected returns to economic primitives, such as tastes and technology, my model generates many empirical regularities in the cross‐section of returns; it also yields an array of new refutable hypotheses providing fresh directions for future empirical research.

ABSTRACT This paper examines whether there are efficiencies that benefit issuers and underwriters when a financial intermediary concurrently lends to an issuer while also underwriting its public securities offering. We find issuers, particularly noninvestment‐grade issuers for whom informational economies of scope are likely to be large, benefit through lower underwriter fees and discounted loan yield spreads. Underwriters, both commercial banks as well as investment banks, engage in concurrent lending and provide price discounts, albeit in different ways. We find concurrent lending helps underwriters build relationships, increasing the probability of receiving current and future business.

ABSTRACT We develop a principal‐agent model in an entrepreneurial setting and test the model's predictions using unique data on entrepreneurial effort and wealth in privately held firms. Accounting for unobserved firm heterogeneity using instrumental‐variables techniques, we find that entrepreneurial ownership shares increase with outside wealth and decrease with firm risk; effort increases with ownership; and effort increases firm performance. The magnitude of the effects in the cross‐section of firms suggests that agency costs may help explain why entrepreneurs concentrate large fractions of their wealth in firm equity.

ABSTRACT We estimate the impact of bank merger announcements on borrowers' stock prices for publicly traded Norwegian firms. Borrowers of target banks lose about 0.8% in equity value, while borrowers of acquiring banks earn positive abnormal returns, suggesting that borrower welfare is influenced by a strategic focus favoring acquiring borrowers. Bank mergers lead to higher relationship exit rates among borrowers of target banks. Larger merger‐induced increases in relationship termination rates are associated with less negative abnormal returns, suggesting that firms with low switching costs switch banks, while similar firms with high switching costs are locked into their current relationship.

ABSTRACT Goyal and Santa‐Clara (2003) find a significantly positive relation between the equal‐weighted average stock volatility and the value‐weighted portfolio returns on the NYSE/AMEX/Nasdaq stocks for the period of 1963:08 to 1999:12. We show that this result is driven by small stocks traded on the Nasdaq, and is in part due to a liquidity premium. In addition, their result does not hold for the extended sample of 1963:08 to 2001:12 and for the NYSE/AMEX and NYSE stocks. More importantly, we find no evidence of a significant link between the value‐weighted portfolio returns and the median and value‐weighted average stock volatility.