Knowledge that Transforms

Abstract Efficiency in the capital markets requires that capital flows are sufficient to arbitrage anomalies away. We examine the relation between flows to a quantitative (quant) strategy that is based on capital market anomalies and the subsequent performance of this strategy. When these flows are high, quant funds are able to implement arbitrage strategies more effectively, which in turn leads to lower profitability of market anomalies in the future, and vice versa. Thus, the degree of cross-sectional equity market efficiency varies across time with the availability of arbitrage capital.

In this article, we examine the extent to which firm fundamentals can explain the cross-sectional variation in credit default swap (CDS) spreads. We construct a fundamental CDS valuation by combining the Merton distance-to-default measure with a long list of firm fundamentals via a Bayesian shrinkage method. Regressing CDS quotes against the fundamental valuation cross-sectionally generates an average R 2 of 77%. The explanatory power is stable over time and robust in out-of-sample tests. Deviations between market quotes and the valuation predict future market movements. The results highlight the important role played by firm fundamentals in differentiating the credit spreads of different firms.

We study the investment–cash flow sensitivities of U.S. firms from 1971–2009. Our tests extend the literature in several key ways and provide strong evidence that cash flow explains investment beyond its correlation with q . A dollar of current- and prior-year cash flow is associated with $0.32 of additional investment for firms that are the least likely to be constrained and $0.63 of additional investment for firms that are the most likely to be constrained, even after correcting for measurement error in q . Our results suggest that financing constraints and free-cash-flow problems are important for investment decisions.

This article shows that correlated errors in news about fundamentals are an important, rational determinant of excess comovement. Individual analysts’ forecast errors tend to be correlated across stocks. Using a proxy for correlated forecast errors based on analyst coverage, I find that stocks with similar sets of analysts exhibit more excess comovement, controlling for industry and other variables. Exogenous changes in commonality in analyst coverage around i) brokerage firm mergers and ii) additions to an index lead to changes in excess comovement. This information channel explains 10% to 25% of the increase in comovement around additions to the S&P 500 index.

Recently, exchanges have been directly selling market data. We analyze how this practice affects price discovery, the cost of capital, return volatility, market liquidity, information production, and trader welfare. We show that selling price data increases the cost of capital and volatility, worsens market efficiency and liquidity, and discourages the production of fundamental information relative to a world in which all traders observe prices. Generally, allowing exchanges to sell price information benefits exchanges and harms liquidity traders. Overall, our results suggest that regulations on selling market data can play an important role in improving market quality and trader welfare.

Abstract Efficient contracting predicts that ex ante severance pay contracts are offered to chief executive officers (CEOs) as protection against downside risk and to encourage investment in risky projects with a positive net present value (NPV). Consistent with this prediction, we find that ex ante contracted severance pay is positively associated with proxies for a CEO’s risk of dismissal and costs the CEO would incur from dismissal. Additionally, we show that the contracted severance payment amount is positively associated with CEO risk taking and the extent to which a CEO invests in projects that have a positive NPV. Overall, our findings imply that ex ante severance pay contracts are consistent with efficient contracting.

Abstract This paper studies the optimal consumption and portfolio problem of an investor with recursive preferences who is subject to time-varying margin requirements. The level of the requirements at each moment is determined by contemporaneous volatility of returns, which is stochastic and may have jumps. I show that the nonstandard hedging demand produced by margin requirements increases with their persistence and volatility. However, for realistic values of parameters, the hedging demand is small even in the presence of jumps, and contemporaneous jumps in prices have a much stronger effect on optimal portfolio than jumps in constraints.

Abstract A popular view is that private equity (PE) firms tend to expropriate other stakeholders of their portfolio companies. Bonds offered during 1992–2011 by companies after their initial public offerings (IPOs) do not reflect this view. We find that yield spreads on bonds offered by PE-backed companies are, on average, 70 basis points lower, holding other things constant. We also find that PE-backed companies have more conservative investment and dividend policies after bond offerings compared with non-PE-backed companies. These results suggest that PE firms’ reputational concerns dominate their wealth expropriation incentives and help their portfolio companies reduce the costs of debt.

Abstract We compare reactions in the prices and trading patterns of common stocks and closed-end funds (CEFs), securities with substantially different investor clienteles, to the Sept. 11, 2001 terrorist attacks. When the market reopened 6 days later, retail investors sold and there were sharp price declines, even in assets with net institutional buying. In the subsequent 2 weeks, price reversals were substantially security specific and thus not simply due to improved systematic sentiment. Consistent with microstructure theory, comparisons between CEFs and common stocks show the speed of these reversals depended significantly on the relative quality and availability of information about fundamental values.

Abstract Using a data set of Korean business groups in the period 1999–2006, just after the Asian Financial Crisis, this study shows how business groups’ financial leverage can lead group-affiliated firms to lose market share to industry rivals. This analysis reveals that the negative effect of group leverage is greater when an affiliated firm is financially weak. Additionally, high group leverage is more detrimental to firms operating in fast-growing industries, discouraging affiliated firms from investing while encouraging their rivals. The results suggest that groups’ financial positions encompass a substantial strategic dimension of group-affiliated firms.