Knowledge that Transforms

Benchmark models that exogenously specify equity dynamics cannot explain the large spread in prices between put options written on individual banks and options written on the bank index during the financial crisis. However, theory requires that asset dynamics be specified exogenously and that endogenously determined equity dynamics exhibit a “leverage effect” that increases put prices by fattening the left tail of the distribution. The leverage effect is larger for puts on individual stocks than for puts on the index, thus increasing the basket-index spread. Time-series and cross-sectional variation in the leverage effect explains option prices well.

We use a unique data set of hedge fund long equity and equity option positions to investigate a significant lockup-related premium earned during the tech bubble (1999–2001) and financial crisis (2007–2009). Net fund flows are significantly greater among lockup funds during crisis and noncrisis periods. Managers of hedge funds with locked-up capital trade opportunistically against flow-motivated trades of non-lockup managers, consistent with a hypothesis of rent extraction in providing crisis era liquidity. The success of this opportunistic trading is concentrated during periods of high borrowing costs, in less liquid stock markets, and is enhanced by hedging in the equity option market.

We provide evidence that managers and controlling shareholders time management buyouts (MBOs) and freezeout transactions to take advantage of industry-wide undervaluation. Portfolios of industry peers of MBO and freezeout targets show significant alphas of around 1% per month over the 12-month period following the transaction. These returns are not explained by a battery of risk factors or empirical methodologies, but exhibit significant heterogeneity across deals. Additional tests show that, on average, abnormal returns to industry peers are a reliable proxy for those to the target firm. Further, MBOs and freezeouts are announced during troughs of industry profitability.

We show significant US monetary policy (MP) spillovers to international bond markets. Our methodology identifies US MP shocks as the change in short-term Treasury yields around Federal Open Market Committee meetings and traces their effects on international bond yields using panel regressions. We emphasize three main results. First, US MP spillovers to long-term yields have increased substantially after the 2007–2009 global financial crisis. Second, spillovers are large compared with the effects of other events, and at least as large as the effects of domestic MP after 2008. Third, spillovers work through different channels, concentrated in risk-neutral rates (expectations of future MP rates) for developed countries, but predominantly on term premia in emerging markets. In interpreting these findings, we provide evidence consistent with an exchange rate channel, according to which foreign central banks face a trade-off between narrowing MP rate differentials or experiencing currency movements against the US dollar. Developed countries adjust in a manner consistent with freely floating regimes, responding partially with risk-neutral rates and partially through currency adjustments. Instead, emerging countries display patterns consistent with foreign exchange interventions, which cushion the response of exchange rates but reinforce capital flows and their effects in bond yields through movements in term premia. Our results suggest that the endogenous effects of currency interventions on long-term yields should be added into the standard cost-benefit analysis of such policies.

Stocks that initiate dividends tend to comove more with other dividend-paying stocks and comove less with non-dividend payers. This is also true for: (a) dividend initiations that are motivated by the exogenous 2003 dividend tax cut; and (b) the cash dividend share class of Citizens Utilities (relative to its stock dividend class). We find that flows to dividend prone (averse) mutual funds increase the comovement among dividend-paying (non-dividend paying) stocks. Overall, the evidence supports the proposition that the trading of pro-dividend (dividend-averse) clienteles induces an extra factor in dividend payers (non-payers), beyond those associated with changes in common factors.

We develop a new empirical approach to term structure analysis that allows testing for time-varying risk premiums and arbitrage opportunities in models with both unobservable factors and factors identified as the innovations to observed macroeconomic variables. Factors can play double roles as both covariance-generating common shocks driving yields and determinants of market prices of risk in cross-sectional pricing. The evidence favors time-varying risk prices significantly related to the second Stock–Watson principal component of macroeconomic variables and to changes in the industrial production index. Our preferred specification includes these two observable and two unobservable factors, with the no-arbitrage condition imposed.

This paper investigates how jump risks are priced in currency markets. We find that currencies whose changes are more sensitive to negative market jumps provide significantly higher expected returns. The positive risk premium constitutes compensation for the extreme losses during periods of market turmoil. Using the empirical findings, we propose a jump modified carry trade strategy, which has approximately two-percentage-point (per annum) higher returns than the regular carry trade strategy. These findings result from the fact that negative jump betas are significantly related to the riskiness of currencies and business conditions.

We test the effects of uncertainty on market liquidity using Hurricane Sandy as a natural experiment. Given the unprecedented strength, scale, and nature of the storm, the potential damages of a landfall near the Greater New York area were unpredictable and therefore uncertain. Using a difference-in-differences setting, we compare the market reactions of Real Estate Investment Trusts (REITs) with and without properties in the widely published evacuation zone of New York City prior to landfall. We find relatively less trading and wider bid-ask spreads in affected REITs. The results confirm theory on the detrimental effects of uncertainty on market functioning.

This paper examines the effect of prior investment experience in specific industries on subsequent investment decisions. Using households’ trading records from a large discount broker between 1991 and 1996, I find that prior success in a given industry increases the likelihood of subsequent purchases in the same industry. The effect is stronger for more recent experiences and for less sophisticated or diversified investors, and it is not wealth enhancing. The results suggest investors categorize industries at a highly resolved level, finer than the Fama–French ten-industry classification. Similar effects are also apparent for size- and value-based categories but at smaller magnitudes.

We estimate the degree of uncertainty faced by potential bidders in takeover auctions and quantify how it affects prices in auctions and negotiations. The high degree of uncertainty revealed by our structural estimation encourages entry in auctions but reduces a target’s bargaining power in negotiations. In the aggregate, auctions and negotiations produce similar prices, even though auctions are preferred in takeover markets with high uncertainty, while the reverse is true for negotiations. Firm characteristics predict pre-entry uncertainty and thus are informative about the relative performance of auctions and negotiations for individual targets.