Knowledge that Transforms

We consider a model in which a security issuer can manipulate information observed by a credit rating agency (CRA). We show that stricter screening by the CRA can sometimes lead to increased manipulation by the issuer. Accounting for the issuer’s behavior pulls optimal CRA screening toward the extremes of laxness or stringency. Surprisingly, an improvement in prior asset quality can result in more rating errors. In a two-period version of the model, stricter screening can result in more short-run rating errors. Our results suggest complex interplay between issuer and CRA behavior, complicating the evaluation of CRA policy effectiveness.

We document that implied volatility (IV) curves of short-term equity options frequently become concave prior to earnings announcements day (EAD), typically reflecting a bimodal risk-neutral distribution for the underlying stock price. Firms with concave IV curves exhibit significantly higher absolute stock returns on EAD and higher realized volatility after the announcement, rendering concavity an ex-ante signal for event risk. Returns on delta-neutral straddles, delta-neutral strangles, and delta- and vega-neutral calendar straddles are negative and significantly lower in the presence of concave IV curves, showing that investors pay a substantial premium to hedge against the gamma risk arising from this event.

We provide causal evidence on the effects of mandated board independence. We compare firms that replace existing non-independent directors to firms that retain these directors by reclassifying them as independent. Reclassification eligibility, being largely predetermined, offers quasi-exogenous variation in compliance strategies. We show that firms required to replace insiders perform worse post-mandate, driven by increased operational costs and reduced labor efficiency. Boards of non-reclassifying firms retain fewer former employees and replace them with directors more likely to join monitoring-focused committees, emphasizing the shift from advising to monitoring. Overall, these findings suggest that firm-specific director expertise contributes materially to performance and is consistent with pre-mandate board compositions optimized to balance benefits of enhanced monitoring against costs of reduced advisory capacity. We rule out alternative explanations, including adjustment costs due to director turnover and co-option. Our study underscores the importance of allowing firms’ flexibility in governance structures and cautions against uniform mandates.

This article examines how biased income expectations affect annual contributions to retirement accounts, highlighting variations across income levels. Empirical findings show that low-income workers are generally pessimistic about future earnings, whereas high-income workers tend to be overly optimistic. I develop a lifecycle model that merges these expectation biases with US 401(k) plan features. The model reveals that biased expectations can account for observed delays in retirement contributions, which increase gradually with tenure. Contributions rise at different rates, with low-income workers starting later than high-income workers. Policy simulations indicate that automatic enrollment boosts initial contributions but results in a relative decline compared to active enrollment. Nonetheless, cumulative savings increase by 4.8 percent on average, with gains surpassing 10 percent for the lowest income quartile. These results highlight the significance of addressing income expectations in retirement policies and show that automatic enrollment can enhance welfare, particularly for lower-income individuals.

We propose a model with mean-variance foreign investors who exhibit a convex disutility associated to brown bond holdings. The model predicts that bond green premia should be smaller in economies with more closed financial accounts and highly volatile exchange rates. This happens because foreign intermediaries invest relatively less in such economies, and this lowers the marginal disutility of investing in polluting activities. We find strong empirical evidence in favor of this hypothesis using a global bond market dataset. Exchange rate volatility and financial account openness are thus able to explain the higher financing costs of green projects in emerging markets relative to advanced economies, especially when green bonds are denominated in local currency: a disadvantage that we can call the “green sin” of emerging economies.

This article studies the optimal design of bank capital regulations when capital markets are subject to adverse selection. I show how the implementation of capital requirements can eliminate the information frictions that make raising capital costly by screening banks to reveal their private information to the market. The optimal regulations induce information revelation via recapitalization programs when the banking sector is weak and pool the banks’ private information via uniform capital requirements otherwise. Optimal capital requirements are linked to the securities issued to meet them, demonstrating potential welfare gains from incorporating more and less informationally sensitive securities into the design of capital regulations. Finally, the analysis generates insights into the joint design of equity capital requirements and additional tier 1 capital securities.

This article presents a general conceptual and statistical framework for measuring the severity of financial crises on a continuous scale and in real time. It results in a composite index that operationalizes the concept of systemic financial stress. The framework nests many existing financial stress and systemic risk indicators as special cases. The Composite Indicator of Systemic Stress (CISS) is introduced as an index design that provides crisis signals which are timely, robust, and free of look-ahead bias. The CISS aggregates a representative set of market-specific stress indicators using their time-varying cross-correlations as systemic risk weights. Confirming its nature as a crisis severity measure, empirical analysis shows that the CISS has strong short-term predictive and nowcasting power for economic activity, and that these effects are stronger in bad states of the economy.

Large firms typically increase their cash holdings as they grow to buffer against greater cash flow volatility. However, data on 11.2 million small firms show the opposite: cash levels decline as firms expand. We explain this phenomenon through a liquidity management model. Small firms with limited cash flows rely on cash reserves for investment due to costly external financing. As they grow, they do not fully replenish their cash reserves because investment incentives decrease, and increased cash flows support more of their anticipated investments. This mechanism generates a negative correlation between cash holdings and firm size among small firms.

In Kyle (1985), the ratio of fundamental variance to price impact measures the value of information to a monopolist strategic informed investor. We show that this same statistic provides an approximation for the value of information in a more general setting with multiple differentially informed investors, and estimate it using high-frequency stocks data. We find that the value of information rises during crises. The value of information is higher for large, growth, and momentum stocks. Its most dramatic spikes occur at the start of the Covid-19 pandemic and the financial crisis of 2008, when the Fed announces liquidity facilities.

I document that the network structure of the online economy significantly contributes to rising industry concentration. Firms that are central in the online economy benefit more from increased economies of scale, decreased search costs, and network effects resulting from digitalization. Industries with firms that are more central become more concentrated and central firms have larger increases in market share. These results are driven by firms’ ability to generate revenue, as evidenced by central firms earning higher risk-adjusted returns and having more positive earnings surprises. Centrality is also associated with increasing productivity, but profitability only increases for central firms in business-to-consumer industries.