Knowledge that Transforms

Using a unique data set on French firms, we show that credit constrained firms that face liquidity shocks are more likely to default on their payments to suppliers. Credit constrained firms pass on a sizeable fraction of such shocks to their suppliers. This is consistent with the idea that firms provide liquidity insurance to each other and that this mechanism is able to alleviate credit constraints. We show that the chain of defaults stops when it reaches unconstrained firms. Liquidity appears to be allocated from firms with access to outside finance to credit constrained firms along supply chains.

Remuneration systems in the banking industry, in particular bonus payments, have frequently been blamed for contributing to the buildup of risks leading to the recent financial crisis. In our model, banks compete for managerial talent that is private information. Competition for talent sets incentives to offer bonuses inducing risk-taking that is excessive not only from society’s perspective but also from the viewpoint of the banks themselves. In fact, bonus payments and excessive risk-taking are increasing with competition. Thus, our model offers a rationale why bonuses are paid even when reducing the expected profits of banks.

We analyze the performance of irrational investors, who mistake expected returns of assets in a multi-asset economy. Mistakes by probabilistically unsophisticated investors that a priori seem small lead to severe underperformance compared with rational investors, under general conditions. Our results contrast with previous studies of single-asset economies, which find modest underperformance by irrational investors. In a calibration, an irrational investor who mistakes expected returns by 20% loses almost 95% of his consumption and wealth in about 25 years. The welfare cost of this underperformance is significant, about 40% of the total wealth in the economy.

This paper provides evidence that “illusory correlations”—a well-documented source of cognitive bias—lead some agents to be imperfectly rational noise traders. We focus on the head-and-shoulders chart pattern, considered by technical analysts to provide one of the most reliable trading signals. Our findings indicate that the pattern is associated with a substantial rise in trading volume even though it does not profitably predict directional movements. We further substantiate the connection between head-and-shoulders trading and imperfectly rational noise trading by showing that the pattern is associated with lower bid-ask spreads.

This article examines how accounting transparency and corporate governance interact. Firms with better governance are associated with higher abnormal returns, but even more so if they also have higher transparency. The effect is largely monotonic—it is small and insignificant for opaque firms and large and significant for transparent firms—and survives numerous robustness tests. We find supportive evidence for firm value and operating performance. Hence, governance and transparency are complements. This complementarity effect is consistent with the view that more transparent firms are more likely takeover targets, because acquirers can bid more effectively and identify synergies more precisely.

This paper examines how shareholder investment horizons influence payout policy choices. The authors infer institutional shareholders' investment horizons using the churn rate of their overall stock portfolios prior to the payout decision. The authors find that the frequency and amount of repurchases increases with ownership by short-term investors to the detriment of dividends. They also find that the market reacts less positively to repurchase announcements made by firms held by short-term institutions. These findings are consistent with a model in which undervalued firms signal their value through repurchases, but firms held by short-term investors make repurchases more often because those investors care mostly about the short-term price reaction. Hence, the market rationally discounts the signal provided by such repurchases. Our findings suggest that shorter shareholder investment horizons might be one contributing factor to the increasing popularity of buybacks.

Commodity futures risk premiums vary across commodities and over time depending on the level of physical inventories. The convenience yield is a decreasing, nonlinear function of inventories. Price measures, such as the futures basis, prior futures returns, prior spot returns, and spot price volatilities reflect the state of inventories and are informative about commodity futures risk premiums. We verify these theoretical predictions using a comprehensive data set on 31 commodity futures and physical inventories between 1971 and 2010. We find no evidence that the positions of participants in futures markets predict risk premiums on commodity futures.

Why do investors keep different opinions even though they learn from their own failures and successes? Why do investors keep different opinions even though they observe each other and learn from their relative failures and successes? We analyze beliefs dynamics when beliefs result from a very general learning process that favors beliefs leading to higher absolute or relative utility levels. We show that such a process converges to the Nash equilibrium in a game of strategic belief choices. The asymptotic beliefs are subjective and heterogeneous across the agents. Optimism (respectively overconfidence) as well as pessimism (respectively doubt) emerge from the learning process. Furthermore, we obtain a positive correlation between pessimism (respectively doubt) and risk tolerance. Under reasonable assumptions, beliefs exhibit a pessimistic bias and, as a consequence, the risk premium is higher than in a standard setting.

Using age as a proxy for learning within a firm, we show that the investments of firms with younger projects react more to profit realizations. With time, firms learn about their long-term quality, and their investment decisions become less influenced by the random shocks they receive. We also show that the learning process depends on the volatility of the economic environment. In more volatile industries, firms observe more noise and less signal from profit realizations. Their investments are therefore less influenced by profits. These new empirical results are consistent with a Tobin’s q framework augmented with Bayesian learning.

Several recent studies document that sorting stocks first on certain stock-level characteristics and then on past returns results in elevated momentum profits. We show that such strategies enhance momentum profits simply by trading in stocks with more extreme past returns. Adjusted for this effect, elevated momentum profits resulting from characteristics (size, R2, turnover, age, analyst coverage, analyst forecast dispersion, market-to-book, price, illiquidity, credit rating) disappear almost entirely. Interaction patterns have been used to support behavioral and limits-to-arbitrage explanations of momentum; our findings imply that explanations of momentum should instead focus on the link between momentum profits and extreme past returns.