Abstract We develop a stylized model that generates the following empirical predictions: the less (more) accessible the underlying market is ex ante, the more its liquidity improves (deteriorates) when basket trading becomes available. We empirically test these predictions using corporate bonds before and after the introduction of exchange-traded funds. Consistent with the model’s prediction, liquidity improvement is larger for highly arbitraged, low-volume, and high-yield bonds, and for 144A bonds to which retail investor access is prohibited by law. Our article leads to a more nuanced understanding of the impact of basket security introduction than previous research suggested.

Abstract We propose a direct test of the explanation by Modigliani and Cohn (MC) for the positive correlation between inflation and equity values—that it results from investors’ money illusion. This explanation, unlike its main rivals, suggests that because in inflationary periods dividends will, on average, be higher than expected, dividend announcements will trigger positive abnormal returns. These will be higher the higher the inflation, and the more levered the firm. The behavior of abnormal returns of US stocks on dividend-announcement days from 1955 to 2007 supports these predictions. We investigate alternative explanations of our results. None dominates MC’s.

Abstract We examine empirically the response of bond returns and their volatility to good and bad macroeconomic news during expansions and recessions. We find that macroeconomic announcements are most important when they contain bad news for bond returns in expansions and, to a lesser extent, good news in contractions. In expansions, the bond market responds most strongly to bad news in non-farm payrolls, while in recessions good news about inflation is relatively more important. We also document that macroeconomic news impacts the volatility of bond returns at all maturities by increasing jump intensities and altering the jump size distribution.

Abstract We establish an empirical link between the ex-ante uncertainty about macroeconomic fundamentals and the ex-post resolution of this uncertainty in financial markets. We measure macroeconomic uncertainty using prices of economic derivatives and relate this measure to changes in implied volatilities of stock and bond options when the economic data is released. Higher macroeconomic uncertainty is associated with greater reduction in implied volatilities following the news release. It is also associated with increased volume and decreased open interest in option markets after the release, consistent with market participants using financial options to hedge or speculate on macroeconomic news.

Abstract If a nonlinear risk premium in a conditional asset pricing model is approximated with a linear function, as is commonly done in empirical research, the fitted model is misspecified. We use a generic reduced-form model economy with moderate risk premium nonlinearity to examine the size of the resulting misspecification-induced pricing errors. Pricing errors from moderate nonlinearity can be large, and a version of a test for nonlinearity based on risk premiums rather than pricing errors has reasonable power properties after properly controlling for the size of the test. We conclude by examining the importance of moderate nonlinearity in the context of the investment-specific technology shock models of Papanikolaou (2011) and Kogan and Papanikolaou (2014).

Abstract We analyze the impact of a requirement similar to the Basel III Liquidity Coverage Ratio on the bank intermediation applying Regression Discontinuity Designs. Using a unique dataset on Dutch banks, we show that a liquidity requirement causes long-term borrowing and lending rates as well as demand for long-term interbank loans to increase. Lower levels of aggregate liquidity increase the estimated effects. Short-term borrowing and lending rates only rise during periods of lower market-wide liquidity. Further, banks do not seem able to pass on the increased funding costs in the interbank market to their private sector clients. Rather, a liquidity requirement seems to decrease banks’ interest margins.

Abstract We develop an analytical solution to the dynamic portfolio choice problem of an investor with power utility defined over wealth at a finite horizon, who faces a time-varying investment opportunity set, parameterized using a flexible vector autoregression. We apply this framework to study the horizon effects in the allocations of equity-only investors, who hold a mix of value and growth indices, and a more general investor, who also has access to Treasury bills and bonds. We find that the mean allocation of equity-only investors is heavily tilted towards value stocks at short-horizons, but the magnitude of this tilt declines dramatically with the investment horizon, implying that growth is less risky than value at long horizons. Investors with access to bills and bonds exhibit similar behavior, when value and growth tilts are computed relative to the total equity allocation of the portfolio. However, after accounting for the propensity of these investors to increase their total equity allocation as the horizon increases, the mean value tilt of the optimal allocation is shown to be positive and stable across time.

Abstract In this article, I propose a general-equilibrium model with proportional adjustment costs and industry-specific capital to study the firm migration phenomenon across market-to-book ratio. In my model, investors’ desire to diversify their portfolios and investment frictions generate a mean-reverting dynamics of Tobin’s q consistent with the probabilities of migration found in the data, and a non-linear pattern in the conditional volatility of Tobin’s q. In addition, since firms’ market-to-book ratios are function of the state of the economy and contain information about stock returns, stock prices inherit these properties, yielding asset-pricing implications in line with the empirical evidence, namely the value premium and a non-monotone relationship between the volatility of stock returns and the Tobin’s q.

Abstract We study risk-taking behavior in tournaments where the optimal strategy is to take no risk. By keeping the optimal strategy constant, while varying the competitiveness in the tournaments, we are able to investigate the relationship between competitiveness and excessive risk-taking. In the most competitive tournament, less than 10% of the subjects played the optimal strategy in the first rounds. The majority playing dominated strategies increased their risk-taking during game of play. When we removed feedback about winner’s decisions each round, and when we reduced the number of contestants in the tournaments, subjects significantly reduced their risk-taking.

Abstract Myopic loss aversion (MLA) has been proposed as an explanation for the equity premium puzzle, and experiments indicate that investors exhibit behavior consistent with MLA. But a caveat is that a large bulk of financial assets is managed by investment managers whose objectives may differ substantially from those of private investors. Most importantly they manage their clients' money, not their own. In this paper we test experimentally how individuals take risk with other people's (“clients”) money. We find that subjects behave consistently with MLA over their clients' money and take less risk with their clients' money than with their own.