Knowledge that Transforms

This article documents a link between trading and diversification by using detailed trading records from a Swedish discount broker matched with individual tax records. Diversification is measured by the investors’ stake size, defined as the fraction of their risky financial wealth invested in individual stocks through the broker under study. High-stake investors have concentrated portfolios, trade more, and achieve lower trading performance. They share several features with those who trade excessively, namely lower income, wealth, age, and education, suggesting that they lack investment expertise. The results directly imply that trading losses in the cross-section are mainly borne by those who can least afford them.

We propose a direct test of the explanation by Modigliani and Cohn (MC) for the positive correlation between inflation and equity values—that it results from investors’ money illusion. This explanation, unlike its main rivals, suggests that because in inflationary periods dividends will, on average, be higher than expected, dividend announcements will trigger positive abnormal returns. These will be higher the higher the inflation, and the more levered the firm. The behavior of abnormal returns of US stocks on dividend-announcement days from 1955 to 2007 supports these predictions. We investigate alternative explanations of our results. None dominates MC’s.

This paper examines the relation between information differences across investors (i.e., information asymmetry) and the cost of capital and establishes that with perfect competition information asymmetry makes no difference. Instead, a firm’s cost of capital is governed solely by the average precision of investors’ information. With imperfect competition, however, information asymmetry affects the cost of capital even after controlling for investors’ average precision. In other words, the capital market’s degree of competition plays a critical role for the relation between information asymmetry and the cost of capital. This point is important to empirical research in finance and accounting.

Stock market volatility clusters in time, appears fractionally integrated, carries a risk premium, and exhibits asymmetric leverage effects. At the same time, the volatility risk premium, defined by the difference between the risk-neutral and objective expectations of the volatility, features short memory. This paper develops the first internally consistent equilibrium-based explanation for all these empirical facts. Using newly available high-frequency intraday data for the S&P 500 and the VIX volatility index, the authors show that the qualitative implications from the new theoretical continuous-time model match remarkably well with the distinct shapes and patterns in the sample autocorrelations and dynamic cross-correlations actually observed in the data.

Prices observed in the European sovereign credit default swap (CDS) market have severely increased since the beginning of the financial crisis. We document that the state of a country’s financial system and, since the beginning of the crisis, also the state of the world financial system have strong explanatory power for the behavior of CDS spreads, and the magnitude of this impact depends on the importance of a country’s financial system pre-crisis. Furthermore, Economic and Monetary Union member countries exhibit higher sensitivities to the health of the financial system. Our results suggest the presence of a private-to-public risk transfer through which market participants incorporate their expectations about financial industry bailouts.

We exploit a unique data set of executive turnovers in community banks to test the micro-mechanisms of discipline by examining the monitoring and influencing role of different stakeholders. We find executives are more likely to be dismissed in risky institutions. Examining the roles of shareholders, debtholders, and regulators as monitors, we obtain evidence for shareholder discipline. However, there is no evidence that risk affects dismissals more if debtholders have a larger stake in the bank or when regulators are aware of distress. Examining the roles of shareholders, debtholders, and regulators as monitors, we obtain evidence for shareholder discipline. However, there is no evidence that risk affects dismissals more if debtholders have a larger stake in the bank or when regulators are aware of distress. When we analyze risk, losses, and profitability following turnovers, we obtain no evidence that replacing executives improves performance.

Better measurement of the output produced and capital employed by firms substantially improves the ability to explain capital structure variation in the cross section. For every firm, we construct the set of other firms producing the same output using the set of product market competitors listed in the firm’s public Securities and Exchange Commission filings. In addition, we improve measurement of capital structure by explicitly accounting for leased capital. These two steps increase the explanatory power of the average capital structure of other firms producing similar output on a firm’s capital structure by 50% compared to using only the average unadjusted debt ratio of other firms in the same three-digit Standard Industrial Classification (SIC) code. We provide evidence that the large explanatory power of the capital structure of other firms producing similar output is related to the assets used in the production process. Our findings suggest that what a firm produces and the assets used in production are the most important determinants of capital structure in the cross section.

We are delighted to announce that the winner of the 2011 Spängler IQAM Best Paper Prize is: “Operating Leverage” by Robert Novy-Marx, The two runners-up for the award are: “Inside Debt” by Alex Edmans and Qi Liu and “Fear of the Unknown: Familiarity and Economic Decisions” by Henry Cao, Bing Han, David Hirshleifer, and Harold Zhang, The awards were presented at the 2011 annual meeting of the European Finance Association in Stockholm on August 19. We are grateful to Spängler IQAM Invest for sponsoring this award.

We develop a simple theoretical argument that generates testable predictions about how disagreement affects corporate investment and find strong empirical support for these predictions. Investment is negatively related to a proxy for disagreement, after controlling for Tobin’s q, and after dealing with the fact that Tobin’s q and our disagreement proxy contain measurement error. This proxy is unrelated to traditional indicators of asymmetric information. We also find that variation in disagreement is an important component of the portion of the variation in Tobin’s q that matters for investment, and that disagreement affects investment and Tobin’s q more if the firm has greater financial flexibility.

This is the first paper systematically calculating, testing and explaining different definitions of the survivorship bias in fund performance. We document that the survival-performance-relation is stronger for small funds and we find significant under-performance of non-survivors but no significant out-performance of new funds. Survivorship bias is still a problem as well in other fields of research, e.g., in countries where survivorship bias-free data is not available and because certain methods require truncated data. This paper provides guidance on how to deal with and reduce survivorship bias in empirical studies.