Knowledge that Transforms

Many event studies only measure a fraction of an event's full value effect because they do not adjust for market anticipation of the event. We present a method based on stock and options prices to measure the full effect that accounts for market anticipation. We apply the method to the passage of Obamacare. Our method estimates the full value effect of Obamacare on the healthcare sector as 55 billion, compared to 16 billion when market anticipation is ignored. The method is applicable to most major events because it only requires that some affected firms have traded stock options.

We study the out-of-sample performance of portfolio trading strategies used when an investor faces capital gain taxation and proportional transaction costs. Overlaying simple tax trading heuristics on trading strategies improves out-of-sample performance. For medium to large transaction costs, no trading strategy can outperform a 1/N trading strategy augmented with a tax heuristic, not even the most tax and transaction cost-efficient buy-and-hold strategy. Overall, the best strategy is 1/N augmented with a heuristic that allows for a fixed deviation in absolute portfolio weights. Our results thus show that the best trading strategies balance diversification considerations and tax considerations.

Mortgage companies (MCs) do not fall under the strict regulatory regime of depository institutions. We empirically show that this gap resulted in regulatory arbitrage and allowed bank holding companies (BHCs) to circumvent consumer compliance regulations, mitigate capital requirements, and reduce exposure to loan-related losses. Compared to bank subsidiaries, MC subsidiaries of BHCs originated riskier mortgages to borrowers with lower credit scores, lower incomes, higher loan-to-income ratios, and higher default rates. Our results imply that precrisis regulations had the capacity to mitigate the deterioration of lending standards if consistently applied and enforced for all types of intermediaries.

Recent empirical findings document downward-sloping term structures of equity return volatility and risk premia. An equilibrium model with rare disasters followed by recoveries helps reconcile theory with empirical observations. Indeed, recoveries outweigh the upward-sloping effect of time-varying disaster intensity and expected growth, generating downward-sloping term structures of dividend growth risk, equity return volatility, and equity risk premia. In addition, the term structure of interest rates is upward-sloping when accounting for recoveries and downward-sloping otherwise. The model quantitatively reconciles high risk premia and a low risk-free rate with the shape of the term structures, which are at odds in other models.

Using daily fluctuations in local sunshine as an instrument for sentiment, we study its effect on day-to-day decisions of lower-level financial officers. Positive sentiment is associated with higher credit approvals, and negative sentiment has the opposite effect of a larger magnitude. These effects are stronger when financial decisions require more discretion, when reviews are less automated, and when capital constraints are less binding. The variation in approval rates affects ex post financial performance and produces significant real effects. Our analysis of the economic channels suggests that sentiment influences managers' risk tolerance and subjective judgment.