Knowledge that Transforms

We study a model where some investors (“hedgers”) are bad at information processing, while others (“speculators”) have superior information-processing ability and trade purely to exploit it. The disclosure of financial information induces a trade externality: if speculators refrain from trading, hedgers do the same, depressing the asset price. Market transparency reinforces this mechanism, by making speculators’ trades more visible to hedgers. Hence, issuers will oppose both the disclosure of fundamentals and trading transparency. Issuers may either under- or over-provide information compared to the socially efficient level if speculators have more bargaining power than hedgers, while they never under-provide it otherwise. When hedgers have low financial literacy, forbidding their access to the market may be socially efficient.

This paper documents the history of aggregate positions in US index options and investigates the driving factors behind use of this class of derivatives. We construct several measures of the magnitude of the market and characterize their level, trend, and covariates. Measured in terms of volatility exposure, the market is economically small, but it embeds a significant latent exposure to large price changes. Out-of-the-money puts are the dominant component of open positions. Variation in options use is well described by a stochastic trend driven by equity market activity and a significant negative response to increases in risk. Using a rich collection of uncertainty proxies, we distinguish distinct responses to exogenous macroeconomic risk, risk aversion, differences of opinion, and disaster risk. The results are consistent with the view that the primary function of index options is the transfer of unspanned crash risk.

Many households concurrently hold low-yield liquid assets while incurring costly credit card debt. In our sample, more than 80% of households with credit card debt also have low-yield liquid assets. Using data from the Health and Retirement Study (N = 30,517), we examine the role of noncognitive skills as well as the economic, financial, and demographic factors that affect the likelihood of co-holding. We find that the “Big Five” personality traits have a statistically significant and economically important effect: households with a more agreeable, introvert, and less conscientious head of household are more likely to co-hold. We also examine the role of intra-household dynamics.

In this paper, we forecast industry returns out-of-sample using the cross-section of book-to-market (BM) ratios and investigate whether investors can exploit this predictability in portfolio allocation. Cash-flow and return forecasting regressions show that cross-industry BM ratios contain significant predictive information beyond aggregate and industry-specific BM ratios. Forecast combination methods based on industry BM ratios generate significant out-of-sample predictability for many industries. Real-time portfolio-rotation strategies that buy industries with high predicted returns and short industries with low predicted returns based on combination forecasts earn significant alpha with respect to standard asset pricing models net of transaction costs.

At the beginning of the past financial crisis sponsoring banks rescued their structured investment vehicles (SIVs) despite of lack of contractual obligation to do so. I show that this outcome may arise as the equilibrium of a signaling game between banks and their debt investors when a negative shock affects the correlated asset returns of a fraction of banks and their sponsored vehicles. The rescue is interpreted as a good signal and reduces the refinancing costs of the sponsoring bank. If banks’ leverage is high or the negative shock is sizable enough, the equilibrium is a pooling one in which all banks rescue. When the aggregate financial sector is close to insolvency, banks’ expected net worth would increase if rescues were banned. The model can be extended to discuss the circumstances in which all banks collapse after rescuing their vehicles.

We investigate whether acquiring more primary education has long-term effects on risk-taking behavior in financial markets. Using exogenous variation in education from a compulsory schooling change combined with wealth data for the Swedish population, we estimate the effect of education on stock market participation and on the share of financial wealth invested in stocks, conditional on participation. For men, an extra year of education increases market participation by two percentage points and the share of financial wealth allocated to stocks by 10%. We find suggestive evidence that greater financial wealth is a potential channel through which education increases participation, consistent with the existence of fixed costs. Lower risk aversion is a potential channel through which education increases the stock share. The reform has less effect on female schooling attainment and there is no evidence that this additional education affects women’s asset allocation. There is no evidence of spillovers to children.

We find the confluence of CEO-same industry experience makes independent directors particularly helpful in enhancing value-added growth and we identify a channel: guidance toward higher value-added R&D investments and higher quality innovations. Further corroborating these inferences, we find greater improvement in value-added growth when (1) independent directors with industry–CEO experience (IDICEs) have experience in more similar industries; (2) they create more shareholder value as CEO; and (3) they are current CEOs. In addition, IDICEs contribute to value-added growth most when firm environments and characteristics are conducive for active board-management interaction; namely, when product markets are more competitive and dynamic, when outsiders can more easily acquire firm-specific information, and when firms are younger and smaller. Consistent with our inferences on how IDICEs contribute to value-added growth, firms growing faster, less successfully innovating, and/or under strong governance tend to be matched with IDICEs.

We extend previous studies on the effect of behavioral biases on investor hold/sell decisions, and examine whether behavioral biases affect the order submission strategies. We use a unique database provided by the Shanghai Stock Exchange, which contains order submissions and executions as well as trading records of all investors. We find investors are less aggressive in submitting sell orders for stocks that experienced losses, and more aggressive in submitting sell orders for stocks that experienced gains. The sell order aggressiveness is negatively related to the size of losses, but has a quadratic relationship with the size of gains. Results are consistent with the combination of the disposition and the house money effects.

Using euro conversion as the trigger, we examine what drives volume and spread changes when stock exchanges compete. Results show average trading costs on European exchanges decrease almost 9%, and turnover increases over 30%. Trading costs decline or remain unchanged on all exchanges, but volume deteriorates in some markets and improves in others. Frankfurt, Paris, London, and Milan are winners, while Madrid and Brussels lose volume. We examine the role of the spread-volume relation, firm characteristics, exchange trading rules, and country-level factors in determining these outcomes. Results suggest that euro conversion prompted competition by increasing transparency in market prices.

The standard measures of distress risk ignore the fact that firm defaults are correlated and that some defaults are more likely to occur in bad times. We use risk premium computed from corporate credit spreads to measure a firm’s exposure to systematic variation in default risk. Unlike previously used measures, the credit risk premium explicitly accounts for the non-diversifiable component of distress risk. In contrast to prior findings in the literature, we find that stocks with higher systematic default risk exposures have higher expected equity returns which are largely explained by the Fama–French risk factors. We confirm the robustness of these results by using an alternative systematic default risk factor for firms that do not have bonds outstanding.