Knowledge that Transforms

We use exogenous scheduling of Wall Street Journal columnists to identify a causal relation between financial reporting and stock market performance. To measure the media's unconditional effect, we add columnist fixed effects to a daily regression of excess Dow Jones Industrial Average returns. Relative to standard control variables, these fixed effects increase the R-super-2 by about 35%, indicating each columnist's average persistent "bullishness" or "bearishness." To measure the media's conditional effect, we interact columnist fixed effects with lagged returns. This increases explanatory power by yet another one-third, and identifies amplification or attenuation of prevailing sentiment as a tool used by financial journalists. 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 propose that fund performance can be predicted by its R2, obtained from a regression of its returns on a multifactor benchmark model. Lower R2 indicates greater selectivity, and it significantly predicts better performance. Stock funds sorted into lowest-quintile lagged R2 and highest-quintile lagged alpha produce significant annual alpha of 3.8%. Across funds, R2 is positively associated with fund size and negatively associated with its expenses and manager's tenure.

Order flow is toxic when it adversely selects market makers, who may be unaware they are providing liquidity at a loss. We present a new procedure to estimate flow toxicity based on volume imbalance and trade intensity (the VPIN toxicity metric). VPIN is updated in volume time, making it applicable to the high-frequency world, and it does not require the intermediate estimation of non-observable parameters or the application of numerical methods. It does require trades classified as buys or sells, and we develop a new bulk volume classification procedure that we argue is more useful in high-frequency markets than standard classification procedures. We show that the VPIN metric is a useful indicator of short-term, toxicity-induced volatility.

The returns of short-term reversal strategies in equity markets can be interpreted as a proxy for the returns from liquidity provision. Analysis of reversal strategies shows that the expected return from liquidity provision is strongly time-varying and highly predictable with the VIX index. Expected returns and conditional Sharpe Ratios increase enormously along with the VIX during times of financial market turmoil, such as the financial crisis 2007-09. Even reversal strategies formed from industry portfolios (which do not yield high returns unconditionally) produce high rates of return and high Sharpe Ratios during times of high VIX. The results point to withdrawal of liquidity supply, and an associated increase in the expected returns from liquidity provision, as a main driver behind the evaporation of liquidity during times of financial market turmoil, consistent with theories of liquidity provision by financially constrained intermediaries.

We provide evidence for the importance of information asymmetry in asset pricing by using three natural experiments. Consistent with rational expectations models with multiple assets and multiple signals, we find that prices and uninformed demand fall as asymmetry increases. These falls are larger when more investors are uninformed, turnover is larger and more variable, payoffs are more uncertain, and the lost signal is more precise. Prices fall partly because expected returns become more sensitive to liquidity risk. Our results confirm that information asymmetry is priced and imply that a primary channel that links asymmetry to prices is liquidity.

We provide evidence that creditors play an active role in the governance of corporations well outside of payment default states. By examining the Securities and Exchange Commission's filings of all U.S. nonfinancial firms from 1996 through 2008, we document that, in any given year, between 10% and 20% of firms report being in violation of a financial covenant in a credit agreement. We show that violations are followed immediately by a decline in acquisitions and capital expenditures, a sharp reduction in leverage and shareholder payouts, and an increase in CEO turnover. The changes in the investment and financing behavior of violating firms coincide with amended credit agreements that contain stronger restrictions on firm decision-making; changes in the management of violating firms suggest that creditors also exert informal influence on corporate governance. Finally, we show that firm operating and stock price performance improve post-violation. We conclude that actions taken by creditors increase the value of the average violating firm. 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.

Although it is well known that appearance-based impressions affect labor market and election outcomes, little is known about the role appearance plays in financial transactions. We address this question using photographs of potential borrowers from a peer-to-peer lending site. Consistent with the trust-intensive nature of lending, we find that borrowers who appear more trustworthy have higher probabilities of having their loans funded. Moreover, borrowers who appear more trustworthy indeed have better credit scores and default less often. Overall, our findings suggest that impressions of trustworthiness matter in financial transactions as they predict investor, as well as borrower, behavior. A man I do not trust could not get money from me on all the bonds in Christendom. –John Pierpont Morgan, 1913

[Do macroeconomic conditions affect firms' abilities to raise capital? If so, how do they affect the manner in which the capital is raised? Using a large sample of publicly traded debt issues, seasoned equity offers, bank loans, and private placements of equity and debt, we find that a borrower's credit quality significantly affects its ability to raise capital during macroeconomic downturns. For noninvestment-grade borrowers, capital raising tends to be procyclical, while for investment-grade borrowers, it is countercyclical. Poor market conditions also affect the structure of securities offered, shifting them toward shorter maturities and more security. Overall, our results suggest that macroeconomic conditions influence the securities that firms issue to raise capital, the way in which these securities are structured, and indeed firms' ability to raise capital at all.]

[We examine the performance of liquidity proxies in commodities. The Amihud measure has the largest correlation with liquidity benchmarks. Amivest and Effective Tick measures also perform well. These proxies are useful for studies of commodity liquidity over a long time period and those that lack access to high-frequency data. We use various aspects of transaction costs, such as spread, depth, immediacy, and resiliency, to give insight into the costs of different execution approaches. Transaction costs increase with volatility and exhibit mean reversion. Splitting trades over one hour can reduce trading costs by two-thirds compared to an immediate execution.]

[Probably not. First, allowing the probabilities of the states of the economy to differ from their sample frequencies, the consumption-CAPM is still rejected in both U.S. and international data. Second, the recorded world disasters are too small to rationalize the puzzle, unless one assumes that disasters occur every 6-10 years. Third, if the data were generated by the rare events distribution needed to rationalize the equity premium puzzle, the puzzle itself would be unlikely to arise. Fourth, the rare events hypothesis, by reducing the cross-sectional dispersion of consumption risk, worsens the ability of the consumption-CAPM to explain the cross-section of returns.]