Knowledge that Transforms

Pressure from institutional money managers to generate profits in the short run is often blamed for corporate myopia. Theoretical research suggests that money managers' short term focus stems from their career concerns and greater fund transparency can amplify these concerns. Using a difference-in-differences design around a regulatory shock that increased transparency about fund managers' portfolio choices, we examine whether increased transparency encourages myopic corporate investment behavior. We find that corporate innovation declines following the regulatory shock. Moreover, evidence from mutual fund trading behavior corroborates that these results are driven by increased short-term focus of money managers.

We develop a three-factor no-arbitrage model for valuing mortgage-backed securities in which we solve for the implied prepayment function from the cross-section of market prices. This model closely fits the cross-section of mortgage-backed security prices without needing to specify an econometric prepayment model. We find that implied prepayments are generally higher than actual prepayments, providing direct evidence of significant macroeconomic-driven prepayment risk premiums in mortgage-backed security prices. We also find evidence that mortgage-backed security prices were significantly affected by Fannie Mae credit risk and the Federal Reserve’s quantitative easing programs. Received May 10, 2016; editorial decision September 22, 2017 by Editor Stijn Van Nieuwerburgh.

This paper uses new data from the PSID to quantify the relative importance of negative equity versus ability to pay, in driving mortgage defaults between 2009 and 2013. These data allow us to construct household budgets sets that provide better measures of ability to pay. Changes in ability to pay have large estimated effects. Job loss has an equivalent effect on the propensity to default as a 35% decline in equity. Strategic motives are also found to be quantitatively important, as we estimate more than 38% of households in default could make their mortgage payments without reducing consumption.

Standard option valuation models leave no room for option illiquidity premia. Yet we find the risk-adjusted return spread for illiquid over liquid equity options is 3.4% per day for at-the-money calls and 2.5% for at-the-money puts. These premia are computed using option illiquidity measures constructed from intraday effective spreads for a large panel of U.S. equities, and they are robust to different empirical implementations. Our findings are consistent with evidence that market makers in the equity options market hold large and risky net long positions, and positive illiquidity premia compensate them for the risks and costs of these positions.

We study whether stocks are riskier or safer in the long run from the perspective of Bayesian investors who employ the long-run risk, habit formation, or prospect theory models to form prior beliefs about return dynamics. Economic theory delivers important guidance for long-run investment opportunities. Specifically, incorporating prior information from the habit formation or prospect theory models reinforces beliefs in mean reversion and inferences that stocks are safer over longer horizons. Conversely, investors with long-run risk priors perceive weaker mean reversion and riskier equities. Model-based information is particularly important for inferences about uncertainty in the dividend growth component of returns. Received May 18, 2016; editorial decision April 25, 2017 by Editor Stijn Van Nieuwerburgh.

Credit default swaps can be used to lower the capital requirements of dealer banks entering into uncollateralized derivatives positions with sovereigns. We show in a model that the regulatory incentive to obtain capital relief makes CDS contracts valuable to dealer banks and empirically that, consistent with the use of CDS for regulatory purposes, there is a disconnect between changes in bond yield spreads and in CDS premiums, especially for safe sovereigns. Additional empirical tests related to the volume of contracts outstanding, effects of regulatory proxies, and the corporate bond and CDS markets support that CDS contracts are used for capital relief. (

We examine a change in the European Central Bank’s collateral framework, which significantly lowered the rating requirement for eligible residential mortgage-backed securities (RMBS), and its impact on bank lending and risk-taking in the Netherlands. Banks most affected by the policy increase loan supply and lower interest rates on new mortgage originations. These lower-interest-rate loans serve as collateral for newly issued RMBS with lower-rated tranches and subsequently experience worse repayment performance. The performance deterioration is pronounced among loans with state guarantees, which suggests that looser collateral requirements may lead to undesired credit risk transfer to the sovereign. Received June 14, 2016; editorial decision September 8, 2017 by Editor Philip Strahan.

We present evidence on the labor supply of CEOs and on whether family and professional CEOs differ on this dimension. We do so through a new survey instrument that allows us to codify CEOs’ diaries in a detailed and comparable fashion and to build a bottom-up measure of CEO labor supply. The comparison of 1,114 family and professional CEOs reveals that family CEOs work 9% fewer hours relative to professional CEOs. Hours worked are positively correlated with firm performance, and differences between family and non-family CEOs account for approximately 18% of the performance gap between family and non-family firms. We investigate the sources of the differences in CEO labor supply across governance types by exploiting firm and industry heterogeneity and quasi-exogenous meteorological and sport events. The evidence suggests that family CEOs value—or can pursue—leisure activities relatively more than professional CEOs. Layperson summary

Unionized workers are entitled to special treatment in bankruptcy court that can be detrimental to other corporate stakeholders, with unsecured creditors standing to lose the most. Using data on union elections, we employ a regression discontinuity design to identify the effect of worker unionization on bondholders in bankruptcy states. Closely won union elections lead to significant bond value losses, especially when firms approach bankruptcy, have underfunded pension plans, and operate in non-RTW law states. Unionization is associated with longer, more convoluted, and costlier bankruptcy court proceedings. Unions depress bondholders’ recovery values as they are assigned seats on creditors’ committees. Received September 19, 2016; editorial decision September 19, 2017 by Editor David Denis.