Knowledge that Transforms

We estimate the risk and expected return of private equity using market prices of publicly traded funds of funds holding unlisted private equity funds and of publicly traded private equity funds participating directly in private equity transactions. We find that the market expects unlisted private equity funds to earn abnormal returns between –0.5% and 2% per year. In addition, private equity has a market beta close to one and a positive beta on the SMB factor. These listed funds exhibit greater systematic risk than an index based on the self-reported net asset value of unlisted private equity funds.

We score 10-K text to obtain annual measures of financial constraints, with separate measures for firms reporting equity and debt financing issues. Equity market constraints are associated with firms funding growth opportunities, have more severe consequences for the firm following large unexpected negative shocks, and are likely driven by informational asymmetries. A significant population of firms reporting equity market constraints also declare that they possess material undisclosed proprietary information. Constraints in the debt markets are distinct and are linked to covenant violations. Our measures outperform others used in the literature in predicting investment cuts following negative shocks.

We hypothesize that cognitive limitation may be manifested in a disproportionately large volume of limit orders submitted at round-number prices if investors use these numbers as cognitive shortcuts. Using detailed limit order data in the Taiwan Futures Exchange, we find that investors with lower cognitive abilities, defined as higher limit order submission ratios at round numbers, suffer greater losses in their round-numbered and non-round-numbered limit orders, market orders, and round-trip trades. The positive correlation between cognitive ability and investment performance is monotonic and robust across futures and options markets. In addition, past trading experience helps mitigate cognitive limitation.

We develop a theory of income and payout smoothing by firms when insiders know more about income than outside shareholders, but property rights ensure that outsiders can enforce a fair payout. Insiders set payout to meet outsiders' expectations and underproduce to manage future expectations downward. The observed income and payout process are smooth and adjust partially and over time in response to economic shocks. The smaller the inside ownership, the more severe underproduction is, resulting in an "outside equity Laffer curve."

In a Kyle (1985) model, the sign of the correlation between a firm's debt and equity returns is the same as the sign of the cross-market Kyle's lambda. The sign is positive (negative) if private information concerns the mean (risk) of the firm's assets. We show empirically that information conveyed by order flows is primarily about asset means. The cross-market lambdas are quite large; consequently, the portions of bond and stock returns explained by order flows are highly correlated, even though the order flows themselves are virtually uncorrelated.

Neoclassical finance assumes that investors are Bayesian. In many realistic situations, Bayesian learning is challenging. Here, we consider investment opportunities that change randomly, while payoffs are observable only when invested. In a stylized version of the task, we wondered whether performance would be affected if one were to follow reinforcement learning principles instead. The answer is a definite yes. When asked to perform our task, participants overwhelmingly learned in a Bayesian way. They stopped being Bayesians, though, when not nudged into paying attention to contingency shifts. This raises an issue for financial markets: who has the incentive to nudge investors?

I use industry-level returns in foreign markets to examine the hypothesis that value-relevant foreign information slowly diffuses into the stock prices of U.S. multinational firms. A trading strategy that exploits foreign information generates abnormal returns of 0.8% monthly. I find that the market responds more slowly in periods with lower media coverage of foreign news and to information from more linguistically and culturally distant countries. These results suggest that both investors' inattention and lack of understanding of foreign information slow the incorporation of new information into prices. I further separate these two mechanisms by examining market responses to earnings surprises.

We analyze the determinants of a firm's ownership structure when decisions over risk are taken by majority vote of risk-averse shareholders. We show that when a fraction of small, diversified shareholders abstains from voting, mid-sized blockholders may emerge to mitigate the conflict of interests between one large shareholder, who prefers less risky investments, and these small, non-voting shareholders. The paper offers a novel explanation for the puzzling observation that many firms have multiple blockholders. The paper develops numerous empirical implications, for example on the link between ownership structure and risk choices and on the relative size of blocks.

We propose a new investor sentiment index that is aligned with the purpose of predicting the aggregate stock market. By eliminating a common noise component in sentiment proxies, the new index has much greater predictive power than existing sentiment indices have both in and out of sample, and the predictability becomes both statistically and economically significant. In addition, it outperforms well-recognized macroeconomic variables and can also predict cross-sectional stock returns sorted by industry, size, value, and momentum. The driving force of the predictive power appears to stem from investors' biased beliefs about future cash flows.

This paper studies how investors' differences of opinion affect liquidity and asset prices. In our economy, excessively optimistic investors are subject to an endogenous funding constraint that prevents default due to ex-ante-limited commitment. When the funding constraint binds, optimists use their savings to increase their consumption share, deterring default. This allows them to place speculative trades, increasing market liquidity. Their losses on these trades make them prone to default, leading to a renewed binding of the funding constraint. This feedback between funding illiquidity, disagreement, and market liquidity is consistent with several empirical features of liquidity and financial asset prices.