Knowledge that Transforms

We study the effect of an asset’s volatility on the expected returns of European options on the asset. Deriving predictions from a stochastic discount factor model, we show that the effect depends on whether variations in the asset’s volatility are driven by systematic or idiosyncratic volatility. While idiosyncratic-volatility-induced variations only affect the option elasticity, systematic-volatility-induced variations also oppositely affect the expected return of the asset. Since the expected asset return (elasticity) effect dominates for options with more linear (non-linear) payoffs, systematic volatility prices sufficiently in-the-money (out-of-the-money) options with the opposite (same) sign as idiosyncratic volatility. Using single-stock calls as test assets, double-sorted portfolios and Fama–MacBeth (1973) regressions broadly support the model’s predictions.

We show that investors tend to hold the same securities as their parents. This intergenerational correlation is stronger for mothers and family members who are more likely to communicate with each other. An instrumental variables estimation and a natural experiment suggest that the correlation reflects social influence. This influence runs not only from parents to children, but also vice versa. The resulting holdings of identical securities increase intergenerational correlations in portfolio choice, exacerbate wealth inequality, and amplify the consequences of behavioral biases.

Financial markets have a central role in allocating resources in modern economies. One of the main functions of financial markets is the discovery of information. This information in turn helps guide decisions in the real side of the economy. The literature on the “feedback effect” of financial markets explores this channel. Empirical work tries to identify the informational feedback from markets to corporate decisions. Theoretical work explores implications that this feedback effect has for the equilibrium in financial markets and for economic efficiency. Current trends in information technology under the FinTech revolution change the nature of information processing in financial markets and so may change the nature of the feedback effect. In this article, I review the main themes of this developing literature and connect them to the current information revolution. I also discuss directions for future research.

This article provides a comprehensive history of default risk for newly originated home mortgages in the USA over the past quarter century. The loan-level source data include the entire guarantee book for Fannie Mae and Freddie Mac. We track many loan characteristics and produce a summary measure of risk. Among our many results, we show that mortgage risk had already risen in the 1990s, planting seeds of the financial crisis well before the actual event. Our results also cast doubt on explanations of the crisis that focus on borrowers with low credit scores. The aggregate series are available for download at https://www.fhfa.gov/papers/wp1902.aspx.

We integrate bank and bond financing into a two-sector neoclassical growth model and identify an automatic stabilization effect due to endogenous bank leverage adjustment. We show that although bank leverage amplifies shocks, the increase of leverage due to a decline in bank equity partially offsets the post crisis decline of bank lending and accelerates economic recovery by reducing the persistence of the bank lending channel. In this case, endogenous leverage adjustment is an automatic stabilizer. Regulatory state-independent capital limits and wage rigidities impair the re-allocation of capital between sectors and weaken this automatic stabilization. A quantitative analysis of the US during the Great Recession shows that the magnitude of automatic stabilization can be significant and informs about potentially high costs of strict capital regulation or wage rigidities during banking crises.

This article examines the strategic nature of banks’ charitable giving by studying bank donations to local nonprofit organizations. Relying on the application of antitrust rules in bank mergers as an exogenous shock to local deposit market competition, we find that local competition affects banks’ local donation decisions. Using county-level natural disaster shocks, we show that banks with disaster exposure reallocate donations away from nonshocked counties, where they operate branches, and toward shocked counties. The reallocation of donations represents an exogenous increase in the local share of donations in nonshocked counties for banks with no disaster exposure and leads to an increase in the local deposit market shares of such banks. Furthermore, banks can potentially earn greater profits from making donations and tend to donate to nonprofits that have the most social impact. Overall, our evidence suggests that banks participate in corporate philanthropy strategically to enhance performance.

Some market crashes occur because of significant imbalances in demand and supply. Conventional models fail to explain the large magnitudes of price declines. We propose a unified structural framework for explaining crashes, based on the insights of market microstructure invariance. A proper adjustment for differences in business time across markets leads to predictions which are different from conventional wisdom and consistent with observed price changes during the 1987 market crash and the 2008 sales by Société Générale. Somewhat larger-than-predicted price drops during 1987 and 2010 flash crashes may have been exacerbated by too rapid selling. Somewhat smaller-than-predicted price decline during the 1929 crash may be due to slower selling and perhaps better resiliency of less integrated markets.

In many countries, disproportionately many firms locate their headquarters in the capital city. Spatial proximity to a country’s leading politicians may be beneficial for a number of reasons. Since neither firms nor governments move randomly, the effects of firms’ co-locating with the government are normally hard to identify. I solve this problem by examining a unique event—the decision to relocate the German federal government from Bonn to Berlin in 1991. Following reunification, there was a free vote in the German parliament on the future location of the government. Berlin won by a narrow margin, an event that could not be anticipated even days before and that is free from confounding factors. Firms with corporate headquarters in Berlin experience abnormal equity returns of more than 3% following the relocation decision.

The 2020 CARES Act directed large cash payments to households. We analyze households’ spending responses using data from a Fintech nonprofit, exploring heterogeneity by income, recent income declines, and liquidity as well as linked survey responses about economic expectations. Households respond rapidly to payments, with spending increasing by about $0.14 per dollar during the first week and plateauing around 0.25–0.30 over 3 months. In contrast to previous stimulus programs, we see little response of durables spending. Households with lower incomes, greater income declines, and less liquidity display stronger responses whereas households that expect employment losses and benefit cuts display weaker responses.

This article shows that lending relationships insulate corporate investment from fluctuations in collateral values. The sensitivity of corporate investment to changes in real-estate collateral values is halved when the length of relationship between a bank and a firm, or its board of directors, doubles. Long relationships with board members dominate relationships with the firm in dampening the collateral channel. Moreover, lending relationships with directors in their personal capacity insulate corporate investment over and above corporate relationships. Our findings support theories where collateral and private information are substitutes in mitigating credit frictions over the cycle and show that lending relationships are more multi-faceted than previously thought.