Knowledge that Transforms

Do happy people predict future risk and return differently from unhappy people, or do individuals rely only on economic facts? We survey investors on their subjective sentiment-creating factors, return and risk expectations, and investment plans. We find that noneconomic factors systematically affect return and risk expectations, where the return effect is more profound. Investment plans are also affected by noneconomic factors. Sports results and general feelings significantly affect predictions. Sufferers from seasonal affective disorder have lower return expectations in the autumn than in other seasons, supporting the winter blues hypothesis.

In portfolio risk minimization, the inverse covariance matrix prescribes the hedge trades in which a stock is hedged by all the other stocks in the portfolio. In practice with finite samples, however, multicollinearity makes the hedge trades too unstable and unreliable. By shrinking trade sizes and reducing the number of stocks in each hedge trade, we propose a “sparse” estimator of the inverse covariance matrix. Comparing favorably with other methods (equal weighting, shrunk covariance matrix, industry factor model, nonnegativity constraints), a portfolio formed on the proposed estimator achieves significant out-of-sample risk reduction and improves certainty equivalent returns after transaction costs.

This article provides evidence that equity returns lead credit protection returns at daily and weekly frequencies, whereas credit protection returns do not lead equity returns. Our results indicate that informed traders are primarily active in the equity market rather than the credit default swap (CDS) market. These findings are consistent with standard theories of market selection by informed traders in which market selection is determined partially by transaction costs. We also find that credit protection returns respond more quickly during salient news events (earnings announcements) compared to days with similar equity returns and turnover. This evidence provides support for explanations related to investor inattention.

We examine the ability of three groups of informed market participants to anticipate the 2007–2008 financial crisis. Institutional investors and financial analysts exhibit some awareness of the impending crisis in their preference for nonfinancial stocks over financial stocks. In contrast, corporate insiders of financial firms appear to be completely unaware of the timing and extent of the financial crisis. Net purchases by managers of financial firms exceed those by managers of nonfinancial firms over the entire 2006–2008 period. Our results add considerable weight to the argument that the financial crisis was more a case of flawed judgment than flawed incentives.

We propose a model of volatility tail behavior in which investors display aversion to both low-volatility and high-volatility states, and hence, the derived pricing kernel exhibits an increasing and decreasing region in the volatility dimension. The model features investors who have heterogeneity in beliefs about volatility outcomes and maximize their utility by choosing volatility-contingent cash flows. Our empirical examination suggests that the model is better suited to reproduce data features in the left tail of the volatility distribution, both qualitatively and quantitatively.

We investigate whether the Troubled Assets Relief Program (TARP) gave recipients competitive advantages. Using a difference-in-difference (DID) approach, we find that: i) TARP recipients received competitive advantages and increased both their market shares and market power; ii) results may be driven primarily by the safety channel (TARP banks may be perceived as safer), which is partially offset by the cost-disadvantage channel (TARP funds may be relatively expensive); and iii) these competitive advantages are primarily or entirely due to TARP banks that repaid early. These results may help explain other findings in the literature, and yield important policy implications.

This study investigates whether the existence or strength of any misreaction in the options market is affected by investor sophistication and investor sentiment. Based on a unique data set of the complete history of all transactions in the Taiwan options market, we find that individual investors exhibit significant misreaction to information and that this misreaction becomes stronger during periods of high investor sentiment. In addition, more active or aggressive individual investors always exhibit misreaction and do not learn from their past mistakes. Our empirical results are robust to alternative measures of investor sentiment and definitions of long- and short-term horizons.

This article proposes a structural model for sovereign credit risk with endogenous sovereign debt and default policies. A maximum-likelihood estimation of the model with local stock market prices generates daily model-implied sovereign spreads. This approach explains two-thirds of the daily variation in observed sovereign spreads for emerging and European economies over the 2000–2011 period. Global factors help to further explain the time variation in sovereign credit risk. In particular, sovereign spreads in emerging markets vary with U.S. market uncertainty, whereas European spreads depend on Euro-zone bond factors.

Using a large hand-collected database of chief executive officer (CEO) bonus structures, we find that when a CEO’s bonus is directly tied to earnings per share (EPS), his company is more likely to conduct a buyback. This effect is especially pronounced when a company’s EPS is right below the threshold for a bonus award. Share repurchasing increases the probability the CEO receives a bonus and the magnitude of that bonus, but only when bonus pay is EPS based. Bonus-driven repurchasing firms do not exhibit positive long-run abnormal returns.

Stock liquidity has improved over the recent 4 decades. This improvement was accompanied by a dramatic increase in trading activity. The net effect on the liquidity premium is ambiguous. We show that the characteristic liquidity premium of U.S. stocks has significantly declined over the past 4 decades. In recent years, characteristic liquidity is significantly priced only for the smallest common stocks. This decline stems from an improvement in liquidity and from a lower sensitivity of expected returns to liquidity. By contrast, systematic liquidity has not been trending down and is still significantly priced primarily among NASDAQ stocks.