Knowledge that Transforms

Labor market frictions help explain the credit spread puzzle. In U.S. aggregate data and newly assembled U.S. industry-level and cross-country panel datasets, the relation between unemployment and credit risk is strong and positive. In a search model of equilibrium unemployment embedded with defaultable debt and capital accumulation, search frictions create downward rigidity in expected search costs, hindering firms from repaying creditors particularly in bad times and rendering corporate debt riskier. Quantitatively, the model replicates the strongly positive relation between unemployment and credit risk as well as salient features of the credit spread, including its level, volatility, cyclicality, and skewness.

Using novel data from a crowdsourcing platform for ranking stocks, we investigate how investors form expectations about stock returns over the next week. We find that investors extrapolate from stocks’ recent past returns, with more weight on more recent returns, especially when recent returns are negative, salient, or from a dispersed cross-section. Such extrapolative beliefs are stronger among nonprofessionals and large stocks. Moreover, consensus rankings negatively predict returns over the next week, more so among stocks with low institutional ownership and a high degree of extrapolation. A trading strategy that sorts stocks on investor beliefs generates an economically significant profit.

Firms with negative net cash flows (NCFs) play an empirically important role in recent decades’ increase in the average cash-balance ratio of publicly held non-financial firms. Since 1971, negative NCFs have become much more pervasive, persistent, and greater in magnitude, and these patterns hold within the growing set of firms that have high intangible capital. In recent years, firms with negative NCFs tend to build cash balances through frequent equity offerings. The high cash balances tend to be transitory as subsequent negative NCFs lead firms to rapid cash-balance drawdowns, often followed by new stock sales and cash stockpiling of the proceeds. We conclude that funding needs and staged equity financing by negative NCF firms are central features of the secular rise in the average cash-balance ratio.

We identify a global risk factor in the cross-section of implied volatility returns in currency markets. A zero-cost strategy that buys forward volatility agreements with downward sloping implied volatility curves and sells those with upward slopes–a volatility carry strategy–generates significant excess returns. The covariation with volatility carry returns fully explains the cross-sectional variation of our slope-sorted portfolios. The lower the slope, the more the forward volatility agreement is exposed to volatility carry risk.

We study the link between beta predictability and the price of risk. An investor who desires exposure to a certain risk factor needs to predict what next period’s beta will be. We use a simple model to show that an ambiguity averse agent’s demand is lower when betas are hard to predict, leading to a reduction in risk premiums. We test the implications for downside betas and VIX betas. We find that they have economically and statistically small prices of risk once we account for the fact that an investor cannot observe ex-post realized betas when determining asset demand.

We offer a model and evidence showing that private debtholders play a key role in setting the endogenous asset value threshold below which corporations declare bankruptcy. As predicted by the model, we find that the recovery rate at emergence from bankruptcy on all of the firm’s debt taken together is increasing in the pre-bankruptcy share of private debt in all debt. We further find evidence consistent with a two-threshold model in which private debtholders force default in some cases and shareholders default strategically in others.

We theoretically analyze how index investing affects financial markets using a dynamic exchange economy with heterogeneous investors and two Lucas trees. We identify two effects of indexing: lockstep trading of stocks increases market volatility and stock return correlations but reduction in risk sharing decreases them. Overall, indexing decreases market volatility but has an ambiguous effect on the correlations. Also, index investing decreases an investor’s welfare, but indexing by other investors partially offsets the loss. When the introduction of index trading opens financial markets for new investors, the improved risk sharing makes market returns more volatile and stock returns more correlated.

We present a new approach to selecting actively managed mutual funds that uses both portfolio holdings and fund return information to eliminate funds with predicted inferior performance through a sequence of pairwise fund comparisons. Our methodology determines both the number of skilled funds and their identities, and locates funds with substantially higher risk-adjusted returns than those identified by conventional alpha-ranking methods. We find strong evidence of time-series variation in both the number of funds identified as superior using our approach, as well as in their performance across different economic states.

We examine a controversial process, known as expungement, which allows brokers to remove evidence of financial misconduct from public records. From 2007 to 2016, we identify 6660 expungement requests, suggesting that brokers attempt to expunge 12% of the allegations of misconduct reported by customers and firms. When these requests are adjudicated on the merits, arbitrators approve expungement 84% of the time. We show that expungements significantly predict future misconduct; brokers with prior expungements are 3.3 times as likely to engage in new misconduct as the average broker. Further, using an instrumental variable based on the random assignment of arbitrators, we present evidence that brokers who receive expungement are more likely to reoffend than brokers who are denied expungement. We also show that successful expungements improve long-term career prospects.

We investigate the effect of stock market liberalization on technological innovation. Using a sample of 20 economies that experience stock market liberalization, we find that these economies exhibit a higher level of innovation output after liberalization and that this effect is disproportionately stronger in more innovative industries. The relaxation of financial constraints, enhanced risk sharing between domestic and foreign investors, and improved corporate governance are three plausible channels that allow stock market liberalization to promote innovation. Finally, we show that technological innovation is a mechanism through which stock market liberalization affects productivity growth and therefore economic growth. Our paper provides new insights into the real effects of stock market liberalization on productivity growth and the economy.