Knowledge that Transforms

We propose a general equilibrium model to study the link between the cross section of expected returns and book-to-market characteristics. We model two primitive assets: value assets and growth assets that are options on assets in place. The cost of option exercise, which is endogenously determined in equilibrium, is highly procyclical and acts as a hedge against risks in assets in place. Consequently, growth options are less risky than value assets, and the model features a value premium. Our model incorporates long-run risks in aggregate consumption and replicates the empirical failure of the conditional capital asset pricing model (CAPM) prediction. The model also quantitatively accounts for the pattern in mean returns on book-to-market sorted portfolios, the magnitude of the CAPM-alphas, and other stylized features of the cross-sectional data.

The last 30 years saw substantial increases in wealth inequality and stock market participation, smaller increases in consumption inequality and the fraction of indebted households, a decline in interest rates and the expected equity premium, as well as a prolonged stock market boom. In an incomplete markets, overlapping generations model I jointly explain these trends by the observed rise in wage inequality, decrease in participation costs, and loosening of borrowing constraints. After accounting for these changes, I show that the stock market played a major role in increasing wealth inequality. Crucially, these phenomena must be considered jointly; studying one independently leads to counterfactual predictions about others.

I demonstrate that acquisitions are accompanied by large, permanent increases in Chief Executive Officer (CEO) compensation, which create strong financial incentives for CEOs to pursue acquisitions earlier in their career. Accordingly, I document that a firm's acquisition propensity is decreasing in the age of its CEO: a firm with a CEO who is 20 years older is ∼30% less likely to announce an acquisition. This negative effect of CEO age on acquisitions is strongest among firms where CEOs likely anticipate or can influence high post-acquisition compensation, and is absent for other investment decisions that are not rewarded with permanent compensation gains. The age effect cannot be explained by the selection of young CEOs by acquisition-prone firms, nor by a story of declining overconfidence with age. This paper underscores the relevance of CEO personal characteristics and CEO-level variation in agency problems for corporate decisions.

Although firm-initiated clawbacks reduce accounting manipulation, they also induce managers to engage in suboptimal activities (e.g., reduce research and development (R&D) expenses) to achieve earnings targets. To assess the effectiveness of clawback provisions, we examine their impact from debtholders' point of view. We find that banks use more financial covenants and performance pricing provisions in the loan contracts and decrease interest rates after firms initiate clawbacks. Moreover, we also find that loan maturity increases and loan collateral decreases subsequent to clawback adoption. Taken together, our findings indicate that firm-initiated clawback provisions enhance financial reporting quality, thereby reducing the information uncertainty that financing providers face.

This paper presents a consumption-based general equilibrium model for valuing foreign exchange contingent claims. The model identifies a novel economic mechanism by exploiting highly but imperfectly shared consumption disaster with variable intensities which are the concerns to the representative investor under recursive utility. When applied to the data, the model simultaneously replicates (i) the moderate option-implied volatilities; (ii) substantial variations in the risk-neutral skewness of currency returns; (iii) the uncovered interest rate parity puzzle; and (iv) the first two moments of carry trade returns. Furthermore, the model rationalizes salient features of the aggregate stock, government bonds, and equity index options.

The combination of rising home prices, declining interest rates, and near-frictionless refinancing opportunities can create unintentional synchronization of homeowner leverage, leading to a “ratchet” effect on leverage because homes are indivisible and owner-occupants cannot raise equity to reduce leverage when home prices fall. Our simulation of the U.S. housing market yields potential losses of 1.7 trillion from June 2006 to December 2008 with cash-out refinancing vs. only 330 billion in the absence of cash-out refinancing. The refinancing ratchet effect is a new type of systemic risk in the financial system and does not rely on any dysfunctional behaviors.

We analyze the effect of directors' and officers' liability insurance (D&O insurance) on the spreads charged on bank loans. We find that higher levels of D&O insurance coverage are associated with higher loan spreads and that this relation depends on loan characteristics in economically sensible ways and is attenuated by monitoring mechanisms. This association between loan spreads and D&O insurance coverage is robust to controlling for endogeneity (because both could be related to firm risk). Our evidence suggests that lenders view D&O insurance coverage as increasing credit risk (potentially via moral hazard or information asymmetry). Further analyses show that higher levels of D&O insurance coverage are associated with greater risk taking and higher probabilities of financial restatement due to aggressive financial reporting. While greater use of D&O insurance increases the cost of debt, we find some evidence that D&O insurance coverage appears to improve the value of large increases in capital expenditure for firms with better internal and external governance.

We conduct an extensive empirical analysis of VIX derivative valuation models before, during, and after the 2008–2009 financial crisis. Since the restrictive mean-reversion and heteroskedasticity features of existing models yield large distortions during the crisis, we propose generalisations with a time-varying central tendency, jumps, and stochastic volatility, analyse their pricing performance, and implications for term structures of VIX futures and volatility “skews.” We find that a process for the log of the observed VIX combining central tendency and stochastic volatility reliably prices VIX derivatives. We also uncover a significant risk premium that shifts the long-run volatility level.

Using an experimental design that exploits exogenous reductions in coverage resulting from brokerage house mergers, we find that a reduction in coverage causes a deterioration in financial reporting quality. The effect of coverage on disclosure is more pronounced for firms with weak shareholder rights, consistent with a substitution effect between analyst monitoring and other corporate governance mechanisms. The effects we uncover using our experimental design are an order of magnitude larger than estimates from ordinary least squares regressions that do not account for the endogeneity of coverage. Overall, our results suggest that security analysts monitor managers and entrenched managers adopt less informative disclosure policies in the absence of such scrutiny.

This paper presents a robust new finding that delta-hedged equity option return decreases monotonically with an increase in the idiosyncratic volatility of the underlying stock. This result cannot be explained by standard risk factors. It is distinct from existing anomalies in the stock market or volatility-related option mispricing. It is consistent with market imperfections and constrained financial intermediaries. Dealers charge a higher premium for options on high idiosyncratic volatility stocks due to their higher arbitrage costs. Controlling for limits to arbitrage proxies reduces the strength of the negative relation between delta-hedged option return and idiosyncratic volatility by about 40%.