Knowledge that Transforms

This article studies how fund managers’ relative-performance concerns affect their investment strategies in bubble periods. The managers compete for flows that are sensitive to their performance ranking. Severe ranking tournaments with highly convex flow-performance relationship lead managers to ride bubbles to outperform each other, making bubbles long-lived. However, moderate tournaments may lead them to attack bubbles quickly. The results are consistent with the observed cross-sectional variation in funds’ investment strategies in bubble periods. Bubble-riding behavior is pronounced if the funds’ tournament is too close to call, as interim followers try to catch up while interim leaders try to stay ahead.

Theory predicts rating agencies’ incentive conflicts to be stronger in boom periods, leading to biased ratings and a reduced level of rating quality. We investigate this prediction empirically based on three different approaches. First, we show that initial ratings disagree with bond spread levels during boom periods in the way that rating agencies hold a systematically more optimistic view. Second, we reveal that boom bond ratings tend to be more heavily downgraded from an ex post perspective; and, third, we demonstrate that boom ratings are inflated compared with “conflicts-free” benchmark ratings. In several robustness tests we show that the observed “boom bias” does not result from changes in credit-worthiness, adjustments in rating standards, competitive pressure, or market supply, but rather from rating agencies’ incentive conflicts.

This article shows that improving financial efficiency may reduce real efficiency. While the former depends on the total amount of information available, the latter depends on the relative amounts of hard and soft information. Disclosing more hard information (e.g., earnings) increases total information, raising financial efficiency and reducing the cost of capital. However, it induces the manager to prioritize hard information over soft by cutting intangible investment to boost earnings, lowering real efficiency. The optimal level of financial efficiency is non-monotonic in investment opportunities. Even if low financial efficiency is desirable to induce investment, the manager may be unable to commit to it. Optimal government policy may involve upper, not lower, bounds on financial efficiency.

We assess the impact of institutional investors’ demand for gilts on UK real rates by structurally estimating the model of Vayanos and Vila (2009). We therefore include those investors believed to display inelastic demand for gilts and preferences for longer-term maturities. The estimated model fits the term structure of real rates well, and strongly supports our choice of institutional investors. These investors’ demand contributed to the decline in medium- to longer-term real rates by compressing bond risk premia. However, the price impact varied across investors and over time, and was only partly attenuated by increased supply.

The sign of the correlation between equity returns and exchange rate returns can be positive or negative in theory. Using data for a broad set of forty-two countries, we find that exchange rate movements are in fact unrelated to differentials in country-level equity returns. Consequently, a trading strategy that invests in countries with the highest expected equity returns and shorts those with the lowest generates substantial returns and Sharpe ratios. These returns partially reflect compensation for global equity volatility risk, but significant excess returns remain after controlling for exposure to standard risk factors.

This article investigates the impact of changes in risk perception on bond markets triggered by the 2007–08 financial crisis. Using a methodology novel to empirical finance, we quantify the increase in credit spreads caused by changes in risk pricing and changes in risk factors. The lasting increase in credit spreads is almost exclusively due to time-varying prices of risk. We interpret this as a change in risk perception which provides a possible solution to the credit spread puzzle. Default premia spiked during the crisis and did not return to their pre-crisis levels. Liquidity premia increased during and after the crisis.

In a proposed model of a multinational bank, interest margins determine local lending by foreign affiliates and the internal funding by parent banks. We exploit detailed parent-affiliate-level data of all German banks to empirically test our theoretical predictions in pre-crisis times. Local lending by affiliates depends negatively on price margins, the difference between lending and deposit rates in foreign markets. The effect of funding cost margins, the gap between local deposit rates faced by affiliates abroad and the funding costs of their parents, on internal capital market funding is positive but statistically weak. Interest margins are central to explain the interaction between internal capital markets and foreign affiliates lending.

This article studies the condominium loan market, which experienced a 15-fold increase in origination and constituted 15% of the overall residential loan originations from 2001 to 2007. Condominium loan defaults grow at a faster rate than single-family (including subprime) loan defaults. Further analysis suggests that the greater default level and growth rate in later loan cohorts are consistent with the investor channel explanation: investor borrowers default more, especially when house prices start to decline. We also show that condo defaults have triggered more defaults of the same cohort subprime mortgages at the same location.

Using data from Chinese stock markets, we examine the effect of speculative trading on stock returns. We develop a volume-related variable, abnormal turnover ratio (ATR), by isolating speculative trading from liquidity and other components in trading volume. After a group of tests verifying that ATR indeed represents speculative trading, we show that ATR negatively predicts future stock returns. The average monthly return spread between the top and bottom ATR deciles is −1.87%, suggesting a highly significant negative ATR premium. The return predictability of ATR survives after controlling for common risk factors and event-driven information shocks. These findings indicate that speculative trading affects asset prices.

We propose a simple model of non-exclusive financial advice in which two households rely on a self-interested (common) expert to make their investment choices. There is only one source of risk, and the expert is privately informed about the risky asset’s volatility. When monetary transfers are unenforceable, we show that investors may delegate their investment decisions to the expert. When doing so, however, they impose restrictions on her choices which crucially depend on whether the expert perceives investors’ asset allocations as complements or as substitutes. Finally, we analyze the implications of non-exclusivity in financial advice on investment behavior and welfare, and highlight a set of novel testable implications.