Knowledge that Transforms

Abstract This article explores the premium for bearing the variance risk of the VIX index, called the variance-of-variance risk premium. I find that during the sample period from 2006 until 2014 trading strategies exploiting the difference between the implied and realized variance of the VIX index yield average excess returns of − 24.16% per month, with an alpha of − 16.98% after adjusting for Fama–French and Carhart risk factors as well as accounting for variance risk (both highly significant). The article provides further evidence of risk premium characteristics using corridor variance swaps and compares empirical results with the predictions of reduced-form and structural benchmark models.

Abstract We study the informational channel of financial contagion in the laboratory. In our experiment, two markets with privately informed subjects open sequentially. Subjects in the second market observe the history of trades and prices in the first market. Although in both markets private information is imperfectly aggregated, subjects in the second market make correct inferences from the information coming from the first market. As theory predicts, when fundamentals are correlated, contagion occurs in the laboratory; in contrast, with independent fundamentals, there is no contagion effect. In both cases, the correlation between asset prices is very close to the theoretical one.

Abstract 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.

Abstract The literature on international equity holdings distinguishes between home bias (overweighting of home stocks) and foreign bias (relative underweighting for more “distant” countries). The two biases can be integrated into one distance-based model. We define pure home bias as the excess of home bias relative to this model, and find pure home bias only in emerging markets. Countries with high tax rates and low credit standing have higher pure home bias, and more development comes with lower distance aversion. Methodologically, the choice of portfolio bias measure matters. We find the best measure to be a covariance-based measure relative to the world average.

Abstract 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.

Abstract 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.

Abstract Can financial institutions and markets enhance the discipline imposed by competitive product markets and thus improve resource allocation in the real economy? We address this question in the context of international trade, using disaggregated product-level data from seventy-one countries exporting to the USA. We show that exported products exit the US market sooner if they stand far away from the exporting country’s comparative advantage. This pattern is stronger when the exporting country has a well-developed banking system, but it is unaffected by the depth of stock markets. These results are in accordance with theories stressing the disciplining role of debt and monitoring abilities of banks.

Abstract 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.

Abstract 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.

Abstract Usual measures of the risk-taking incentives of bank CEOs do not capture the risk-shifting incentives that the exposure of a CEO’s wealth to his firm’s stock price (delta) creates in highly levered firms. We find evidence consistent with the importance of these incentives for bank CEOs: In a sample of large US financial firms, a higher pre-crisis delta is associated with a significantly higher probability of failure during the 2007–10 financial crisis in highly levered firms, but not in less levered firms.