Knowledge that Transforms

This article tests Piotroski and So’s (2012) market expectation errors approach to value-growth investing in European equity markets. As in the USA, European value-growth returns are concentrated among firms with existent market expectation errors, but absent among firms without such errors which can be ex ante identified by interacting book-to-market with FSCORE, an accounting-based measure of the firm’s fundamental strength. The returns to an expectation errors-based value-growth strategy are highly persistent for up to three years after portfolio formation, pervasive among large firms, and cannot be explained by common risk factors. However, consistent with a mispricing-based interpretation, prior external financing activities significantly influence these market expectation errors. A financing-based misvaluation factor can explain the return behavior of value-growth strategies formed along market expectations errors.

We document a housing wealth effect on the stock liquidity of local firms. We first demonstrate that the heterogeneity of homeownership rates across geographical areas can explain variations in the impact that changes in house prices have on local stock liquidity. We then show, consistent with expectations that an increase in housing wealth leads to a reduction in household risk aversion, that the liquidity of lottery stocks and stocks dominated by individual investors rises. We also show that it promotes local liquidity commonality and reduces the proportion of firm-specific information revealed in stock returns.

Does market power of banks affect firm performance? To answer this question we examine 25,236 syndicated loan facilities granted between 2000 and 2010 by 296 banks to 9,029 US non-financial firms. Accounting for both observed and unobserved bank and firm heterogeneity, we find that firms that were recently poorly performing obtain loans from banks with more market power. However, in the year after loan origination market power positively affects firm performance, but only if it is not too high. Our estimates thus suggest that bank market power can facilitate access to credit by poorly performing firms, yet at the same time also boosts the performance of the firms that obtain credit.

We analyze the problem of recovering the pricing kernel and real probability distribution from observed option prices, when the state variable is an unbounded diffusion process. We derive necessary and sufficient conditions for recovery. In the general case, these conditions depend on the properties of the diffusion process, but not on the pricing kernel. We also show that the same conditions determine whether recovery works in practice, when the continuous problem is approximated on a bounded or discrete domain without further specification of boundary conditions. Altogether, our results suggest that recovery is possible for many interesting diffusion processes on unbounded domains.

How does the availability of alternative investment opportunities for banks’ depositors affect the reaction of the banking system to aggregate liquidity shocks? And what are the implications, if any, for banking regulation? To answer these questions, I study a Diamond–Dybvig environment, where banks hedge against aggregate liquidity risk in the interbank market or default, and depositors borrow and lend in a hidden-bond market. In this framework, banks offer an endogenously incomplete contract, and default in equilibrium only when facing systemic liquidity risk. In this case, the allocation at default is inefficient, and countercyclical liquidity requirements are welfare-improving.

We analyze the consequences of consumer education on prices and welfare in retail financial markets when some consumers are naive about shrouded add-on prices and banks try to exploit this. Allowing for different information and pricing strategies we show that education is unlikely to push banks to full price disclosure, which would be efficient, but instead to a new equilibrium in which banks discriminate between consumer types. Welfare analysis reveals that education, while positive for consumers who learn to make better financial decisions, imposes a negative externality on other consumers when banks respond by setting higher prices. Overall, the welfare effects of consumer education can be negative. Our results identify important pitfalls policy makers should take into account when considering the seemingly harmless intervention of consumer education.

We investigate whether value-relevant foreign information only gradually dilutes into stock prices of multinational firms worldwide. Using an international sample of firms from twenty-two developed countries, we find that a portfolio strategy based on firms’ foreign sales information yields future returns of more than 10% p.a. globally. The return spread due to foreign information is substantial across different geographical regions and cannot be explained by traditional risk factors, firm characteristics, and industry momentum. Our results are in line with limited attention of investors to foreign information being the main driver of this effect worldwide.

This article documents a significant time-series momentum effect that is consistent and robust across all examined conventional asset classes from 1969 to 2015. We find that the duration and magnitude of time-series momentum is different in developed and emerging markets, but this is no longer the case when controlling for the currency component. We further demonstrate that time-series momentum captures a significant proportion of international mutual fund performance, but this is predominantly with respect to its long aspect. Finally, the market interventions by central banks in recent years have distorted correlations across assets; this challenges the performance of such portfolios.

Supported by several recent investigations, the empirical pricing kernel (PK) puzzle might be considered as a stylized fact. Based on an economic model with reference-dependent preferences for the financial investors, we emphasize a microeconomic view that explains the puzzle via state-dependent aggregate preferences. We also investigate how the shape of the PK estimated from option and stock market index returns changes in relation to the volatility risk premium.

Previous literature on cash management has revealed that firms hoard cash to protect themselves against external financing constraints that might limit future capital budgeting policies. In a theoretical model based on this finding, we analyze how investors’ attitude toward uncertain investment returns affects the valuation of cash and the amount of cash holdings. Subsequently, we show empirically that cash holdings become less valuable with increasing ambiguity aversion in line with our model. We also demonstrate that managers react accordingly and lower cash holdings if their investors tend to be more ambiguity-averse. Several robustness tests confirm our findings.