Knowledge that Transforms

Levered noise occurs when no-arbitrage replication hedges fundamentals but amplifies price errors. Motivated by our theory, we use widely-available end-of-day OptionMetrics data to improve accuracy of synthetic dividend strip prices and provide longer samples than prior studies. Term structure point estimates are approximately flat in simple returns (88 bp/month vs. 87 bp/month for short-term dividends vs. index), and upward-sloping in measurement-error-robust logarithmic returns (43 bp/month vs. 77 bp/month). These results from prominent index options show the importance of diagnosing noise in no-arbitrage prices. Prior conclusions of an average downward slope in the equity term structure are not robust.

We examine the pecuniary externalities that arise when active fund manager compensation contracts have common components. This commonality in the compensation structure and loadings on each component across funds reduces asset price informativeness, amplifies the distortions from active managers’ benchmark-hedging demand, and lowers the price of risk in financial markets. This is because contract commonality distorts investors’ capital allocation to active management, and active managers’ information acquisition and trading decisions. From a normative perspective, contract commonality increases the rigidity of the active industry size and performance-based fee. As a result, they do not vary enough with financial market conditions compared with a Planner’s economy. Quantitatively, an increase in asset payoff uncertainty increases the size and performance-based fee twice as much in the Planner economy compared with the decentralized economy. From a positive perspective, contract commonality contributes to the inconsistency of several widely adopted measures of active manager skill.

We study how firms build relations with local governments in emerging markets without established rules of political lobbying. We document that following a turnover of the Party Secretary or mayor of a city in China, firms (especially privately owned enterprises, POEs hereafter) headquartered in that city significantly increase their “perk spending,” for example, expenses for travel and entertainment among others. Both the instrumental-variable-based results and heterogeneity analysis are consistent with the interpretation that the perk spending is used to build relations with local governments. In addition, we find that local political turnover in a city tends to be followed by changes of the Chairmen or the CEOs of state-owned enterprises that are controlled by the local government. We also discuss and rule out several alternative explanations for the above findings.

We exploit the release of a mobile application for a financial aggregation platform to analyze how technology adoption changes consumer financial decision making. The app reduced the cost of accessing personal financial information, and we find that this led to a drop in non-sufficient fund fees. Because of the manner in which these fees are incurred, this represents an unambiguous welfare improvement for users of the platform. The leading explanation for this result appears to be mistake avoidance due to easier access to information.

We propose and test a new channel that links liquidity risk and interest rates in short-term funding markets. Unlike existing theories that focus on premiums demanded by lenders, the liquidity risk channel postulates that borrowers that are more exposed to urgent liquidity needs are willing to pay a markup for immediate funding. We test and quantify the channel using unique trade-by-trade data and uncover systematic differences across individual banks’ funding cost driven by differences in banks’ liquidity risk. These differences are persistent over a decade, suggesting that the liquidity risk channel is relevant in general and not only arises during crisis times.

This article studies optimal capital structure when firms learn from financial markets. We present a tractable model of stock market feedback with imperfect information aggregation. Debt issuance affects speculators’ incentives to trade both directly, by changing the payoff structure of equity holders, and indirectly, through an asset substitution effect. We show that issuing debt can increase market informativeness and firm value, and may eliminate a coordination failure equilibrium with no provision of market information. We derive the optimal capital structure in this setting and present novel empirical predictions regarding the relationship between market frictions, market informativeness, and capital structure. Once the effect of debt on market informativeness is considered, risky debt does not necessarily lead to risk shifting.

We examine the links between human capital and endowment investing. Harnessing detailed information on university endowments, we find that higher asset allocations to alternative assets accompany higher levels of human capital in the endowment’s investment process. Moreover, high levels of human capital are linked to larger returns, even on a risk-adjusted basis. The improved investment outcomes arise because endowments (i) capture higher returns that can accompany alternative assets, (ii) select or have access to high performing managers, and (iii) minimize fees by accessing funds directly rather than through funds of funds. Our measures of human capital include expertise in alternatives on governing bodies, the presence of a chief investment officer, and the size of the investment staff. Finally, we conduct a novel survey of endowments and confirm that human capital is central in facilitating alternative investments.

We show that US firms increase their sustainability performance when their directors acquire expertise through their exposure to sustainability reforms in foreign countries where they serve as directors. Our results suggest that a board that gains sustainability expertise increases a firm’s overall sustainability performance by 7.1%. The increase in sustainability comes both from improvements in environmental and social practices. Directors also consider the tradeoffs between sustainability improvements and firm characteristics, with boards having a stronger impact on sustainability in firms from clean industries and firms that face fewer operational and financial constraints.

We study the economic value of market timing in foreign exchange (FX) markets, that is, using information about the conditional Sharpe ratio to adjust the notional value of a conditionally mean–variance efficient currency portfolio. Our strategy trades more (less) aggressively when the conditional risk-return trade-off is more (less) favorable. This leads to a significant improvement in the out-of-sample unconditional Sharpe ratio, skewness, and maximum drawdown per 1% expected excess return. The strategy’s market timing predicts returns, volatility, and skewness in FX markets. Popular currency pricing factors do not explain the strategy’s high average excess returns. Our findings suggest that it is costly to impose leverage or risk (i.e., conditional volatility) limits or other inferior market timing policies when constructing currency trading strategies.

How is technically skilled human capital reflected in firm performance? We leverage a uniquely detailed employer–employee matched dataset to measure US firms’ technical human capital in information technology (IT), Software Engineering, Mobile Networks, Data Analysis, and Web Development. All five technical skillsets are associated with higher firm valuations. However, they negatively forecast both financial and operational performance in the future. For example, a one-standard-deviation increase in employees with IT skills corresponds to 2.2% higher Tobin’s q but predictable future returns of –10 basis points per month. Our results are stronger in tighter labor markets, in firms with more cash, and during time periods when each technical skillset is especially popular. These patterns suggest that the market expects too much from popular technologies, leading to over-valuation. Overall, our results highlight how corporate over-investment can extend to intangible capital such as skilled employees.