Knowledge that Transforms

Working with one of the largest brokerages in Germany, we record what happens when unbiased investment advice is offered to a random set of approximately 8,000 active retail customers out of the brokerage's several hundred thousand retail customers. We find that investors who most need the financial advice are least likely to obtain it. The investors who do obtain the advice (about 5%), however, hardly follow the advice and do not improve their portfolio efficiency by much. Overall, our results imply that the mere availability of unbiased financial advice is a necessary but not sufficient condition for benefiting retail investors.

We examine how investor preferences and beliefs affect trading in relation to past gains and losses. The probability of selling as a function of profit is V-shaped; at short holding periods, investors are more likely to sell big losers than small ones. There is little evidence of an upward jump in selling at zero profits. These findings provide no clear indication that realization preference explains trading. Furthermore, the disposition effect is not driven by a simple direct preference for selling a stock by virtue of having a gain versus a loss. Trading based on belief revisions can potentially explain these findings. The Author 2012. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: [email protected]., Oxford University Press.

We show that familiarity affects the portfolio decisions of mutual fund managers. Controlling for fund location, funds overweight stocks from their managers' home states by 12% compared with their peers. In team-managed funds, home-state overweighting is 37% larger than the fund location effect. The home-state bias is stronger if the manager is inexperienced, is resource-constrained, or spent more time in his home state. Home-state stocks do not outperform other holdings, confirming that home-state investments are not informed. The overweighting also leads to excessively risky portfolios.

The average cash holdings of Chinese-listed firms decreased significantly after the split share structure reform in China, which specified a process that allowed previously nontradable shares held by controlling shareholders to be freely tradable on the exchanges. The reduction in cash holdings is greater for firms with weaker governance and firms facing more financial constraints prior to the reform. The reform also significantly reduced the average corporate savings rate, as measured by cash-to-cash-flow sensitivity. These findings are consistent with the premise that the reform removed a significant market friction, which led to better incentive alignment between controlling shareholders and minority shareholders and relaxed financial constraints. Additional analyses show that the reform affects firms' cash management policies, investment decisions, dividend payout policies, and financing choices differently in private firms than in state-owned enterprises.

We use a structural econometric model to provide empirical evidence that safety nets in the banking industry lead to additional risk taking. To identify the moral hazard effect of bailout expectations on bank risk, we exploit the fact that regional political factors explain bank bailouts but not bank risk. The sample includes all observed capital preservation measures and distressed exits in the German banking industry during 1995–2006. A change of bailout expectations by two standard deviations increases the probability of official distress from 6.6% to 9.4%, which is economically significant.

Intuition suggests that firms with higher cash holdings should be "safer" and have lower credit spreads. Yet empirically, the correlation between cash and spreads is robustly positive. This puzzling finding can be explained by the precautionary motive for saving cash, which in our model causes riskier firms to accumulate higher cash reserves. In contrast, spreads are negatively related to the part of cash holdings that is not determined by credit risk factors. Similarly, although firms with higher cash reserves are less likely to default in the short term, endogenously determined liquidity may be related positively to the longer-term probability of default. Our empirical analysis confirms these predictions, suggesting that precautionary savings are central to understanding the effects of cash on credit risk. The Author 2012. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: [email protected]., Oxford University Press.

We derive a measure of aggregate systemic risk, designated CATFIN, that complements bank-specific systemic risk measures by forecasting macroeconomic downturns six months into the future using out-of-sample tests conducted with U.S., European, and Asian bank data. Consistent with bank “specialness,” the CATFIN of both large and small banks forecasts macroeconomic declines, whereas a similarly defined measure for both nonfinancial firms and simulated “fake banks” has no marginal predictive ability. High levels of systemic risk in the banking sector impact the macroeconomy through aggregate lending activity. A conditional asset pricing model shows that CATFIN is priced for financial and nonfinancial firms.

I propose a new measure that identifies when the market price of an over-the-counter traded asset is below its fundamental value due to selling pressure. The measure is the difference between prices paid by small traders and those paid by large traders. In a model for over-the-counter trading with search frictions and periods with selling pressures, I show that this measure identifies liquidity crises (i.e., high number of forced sellers). Using a structural estimation, the model is able to identify liquidity crises in the U.S. corporate bond market based on the relative prices paid by small and large traders. New light is shed on two crises, the downgrade of General Motors and Ford in 2005 and the subprime crisis The Author 2011. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: [email protected]., Oxford University Press.

International equity markets are characterized by nonlinear dependence and asymmetries. We propose a new dynamic asymmetric copula model to capture long-run and short-run dependence, multivariate nonnormality, and asymmetries in large cross-sections. We find that correlations have increased markedly in both developed markets (DMs) and emerging markets (EMs), but they are much lower in EMs than in DMs. Tail dependence has also increased, but its level is still relatively low in EMs. We propose new measures of dynamic diversification benefits that take into account higher-order moments and nonlinear dependence. The benefits from international diversification have reduced over time, drastically so for DMs. EMs still offer significant diversification benefits, especially during large market downturns.

We compare the dividend policies of publicly and privately held firms in order to help identify the forces shaping corporate dividends, and shed light on the behavior of privately held companies. We show that private firms smooth dividends significantly less than their public counterparts, suggesting that the scrutiny of public capital markets plays a central role in the propensity of firms to smooth dividends over time. Public firms pay relatively higher dividends that tend to be more sensitive to changes in investment opportunities than otherwise similar private firms. Ultimately, ownership structure and incentives play key roles in shaping dividend policies.