Knowledge that Transforms

Prior theory suggests that time variation in the degree to which leverage constraints bind affects the pricing kernel. We propose a measure for this leverage constraint tightness by inverting the argument that constrained investors tilt their portfolios to riskier assets. We show that the average market beta of actively managed mutual funds—intermediaries facing leverage restrictions—captures their desire for leverage and thus the tightness of constraints. Consistent with theory, it strongly predicts returns of the betting-against-beta portfolio, and is a priced risk factor in the cross-section of mutual funds and stocks. Funds with low exposure to the factor outperform high-exposure funds by 5% annually, and for stocks this difference reaches 7%. Our results show that the tightness of leverage constraints has important implications for asset prices.

Are endogenous liquidity providers (ELPs) reliable in times of market stress? We examine the activity of a common ELP type—high frequency traders (HFTs)—around extreme price movements (EPMs). We find that on average HFTs provide liquidity during EPMs by absorbing imbalances created by non-high frequency traders (nHFTs). Yet HFT liquidity provision is limited to EPMs in single stocks. When several stocks experience simultaneous EPMs, HFT liquidity demand dominates their supply. There is little evidence of HFTs causing EPMs.

This article studies the effect of cash windfalls on the acquisition policy of companies. As identification, I use a German tax reform that permitted firms to sell their equity stakes tax free. Companies that could realize a cash windfall by selling equity stakes see an increase in the probability of acquiring another company by 14%. I find that these additional acquisitions destroy firm value. Following the tax reform, affected firms experience a decrease of 1.2 percentage points in acquisition announcement returns. These effects are stronger for larger cash windfalls. My findings are consistent with the free cash flow theory.

The Hou et al. (2015) q-factor model outperforms other factor models in capturing the price-to-high (PTH, the ratio of current price to 52-week high price) anomaly; that is, high-PTH stocks earn high future returns. PTH's relations with future profitability and future investment growth are both significantly positive, and they mirror PTH's relation with future returns in the cross section and by time horizons. Incorporating the information about future investment growth contained in price level variables (e.g., PTH) helps the q factors to capture better those anomalies rooted in future investment growth. Together, these results suggest that the PTH anomaly is consistent with the investment capital asset pricing model.

We explore the term structures of claims to a variety of cash flows, namely, US government bonds (claims to dollars), foreign government bonds (claims to foreign currency), inflation-adjusted bonds (claims to the price index), and equity (claims to future equity indexes or dividends). The average term structures reflect the dynamics of the dollar pricing kernel, cash flow growth, and the interaction between the two. We use an affine model to illustrate how these two components can deliver term structures with a wide range of levels and shapes. Finally, we calibrate a representative agent economy to show that the evidence is consistent with the equilibrium models.

We find that shareholder-friendly corporate governance is associated with higher stand-alone and systemic risk in the banking sector. Specifically, shareholder-friendly corporate governance results in higher risk for larger banks and for banks that are located in countries with generous financial safety nets as banks try to shift risk toward taxpayers. We confirm our findings by comparing banks to nonfinancial firms and examining changes in bank risk around an exogenous regulatory change in governance. Our results underline the importance of the financial safety net and too-big-to-fail guarantees in thinking about corporate governance reforms at banks.

Prominent policy makers assert that managerial short-termism was at the root of the subprime crisis of 2007–2009. Prior scholarly research, however, largely rejects this assertion. Using a more comprehensive measure of Chief Executive Officer (CEO) incentives for short-termism, we uncover evidence that short-termism indeed played a role. Firms whose CEOs were contractually allowed to sell or exercise more of their stock and options holdings sooner had more subprime exposure, a higher probability of financial distress, and lower risk-adjusted stock returns during the crisis, as well as higher fines and settlements for subprime-related fraud.

We show a positive relation between network centrality and risk-adjusted performance in a delegated investment management setting. More connected managers take more portfolio risk and receive higher investor flows, consistent with these managers improving their ability to exploit investment opportunities through their network connections. Greater network connections are shown to be particularly important in reducing the diseconomies of scale for large managers who are well connected. We also use the exogenous merger of two investment consultants, which creates a sudden change in the network connections of the managers they oversee, to provide evidence that a greater number of connections translates into better portfolio performance.

This paper studies the value of more precise signals on agent performance in an optimal contracting model with endogenous effort. With limited liability, the agent’s wage is increasing in output only if output exceeds a threshold, else it is zero regardless of output. If the threshold is sufficiently high, the agent only beats it, and is rewarded for increasing output through greater effort, if there is a high noise realization. Thus, a fall in output volatility reduces effort incentives—information and effort are substitutes—offsetting the standard effect that improved information lowers the cost of compensation. We derive conditions relating the incentive effect to the underlying parameters of the agency problem.

Prize-linked savings (PLS) accounts, which allocate interest using lottery payments rather than fixed interest, encourage savings by appealing to households’ gambling preferences. I introduce new data on casino cash withdrawals to measure gambling, and examine how individual gambling expenditures respond to the introduction of PLS in Nebraska using a difference-in-differences design. After PLS is introduced, individuals who live in counties that offer PLS reduce gambling by at least 3% more than unaffected individuals. The substitution effect is stronger in low-frills gambling environments, which most resemble PLS, indicating that these accounts fulfill the desire to gamble.