Knowledge that Transforms

This paper studies the impact of the confirmatory bias on financial markets. We propose a model in which some traders may ignore new evidence inconsistent with their favorite hypothesis regarding the state of the world. The confirmatory bias provides a unified rationale for several existing stylized facts, including excess volatility, excess volume, and momentum. It also delivers novel predictions for which we find empirical support using data on analysts' earnings forecasts: traders update beliefs depending on the sign of past signals and previous beliefs, and, at the stock level, differences of opinion are larger when past signals have different signs.

Short-lived arbitrage opportunities arise when prices adjust with a lag to new information. They are toxic because they expose dealers to the risk of trading at stale quotes. Hence, theory implies that more frequent toxic arbitrage opportunities and faster responses to these opportunities should impair liquidity. We provide supporting evidence using data on triangular arbitrage. As predicted, illiquidity is higher on days when the fraction of toxic arbitrage opportunities and arbitrageurs' relative speed are higher. Overall, our findings suggest that the price efficiency gain of high-frequency arbitrage comes at the cost of increased adverse selection risk.

In most U.S. states, mortgage seniority follows time priority: older mortgages are paid first. This potentially impedes refinancing of senior mortgages because replacement mortgages are junior unless the existing junior lienholders consent to resubordination. We exploit legal variation across states to provide evidence that time priority reduces refinancing, especially of smaller mortgages (suggesting a significant fixed cost of obtaining resubordination) and of mortgages close to the conforming loan limit. On the contrary, we find evidence that time priority renders second mortgages more valuable to lenders, increasing the likelihood that a borrower obtains a second mortgage. Received May 20, 2013; editorial decision June 8, 2016 by Editor Laura Starks

We consider asset pricing models in which the SDF can be factorized into an observable component and a potentially unobservable one. Using a relative entropy minimization approach, we nonparametrically estimate the SDF and its components. Empirically, we find the SDF has a business-cycle pattern and significant correlations with market crashes and the Fama-French factors. Moreover, we derive novel bounds for the SDF that are tighter and have higher information content than existing ones. We show that commonly used consumption-based SDFs correlate poorly with the estimated one, require high risk aversion to satisfy the bounds and understate market crash risk. (

A standard real business-cycle model with external habit and capital adjustment costs matches a long list of asset price and business-cycle moments: equity, firm value, and risk-free rate volatility; the equity premium; excess return predictability; consumption growth predictability; basic moments of consumption, output, and investment; among others. The model also generates endogenous consumption volatility risk. Precautionary savings motives make consumption sensitive to shocks in bad times, leading to countercyclical volatility, even with homoscedastic technology shocks. Habit acts as countercyclical leverage, which amplifies this channel. Habit also implies high risk aversion, which amplifies the stock price response.

Using proprietary data on millions of trades by retail investors, we provide the first large-scale evidence that retail short selling predicts negative stock returns. A portfolio that mimics weekly retail shorting earns an annualized risk-adjusted return of 9%. The predictive ability of retail short selling lasts for one year and is not subsumed by institutional short selling. In contrast to institutional shorting, retail shorting best predicts returns in small stocks and those that are heavily bought by other retail investors. Our findings are consistent with retail short sellers having unique insights into the retail investor community and small firms’ fundamentals. Received May 5, 2016; editorial decision September 6, 2016 by Editor Andrew Karolyi.

We use an asset pricing approach to compare the effects of the liquidity level and liquidity risk on expected U.S. corporate bond returns. Using signed transaction data, we estimate effective transaction costs for bond portfolios by a repeat-sales method. We find that the liquidity level and exposure to equity market liquidity risk affect expected bond returns. In contrast, exposure to corporate bond liquidity shocks carries an economically negligible risk premium. A simulation study shows that it is unlikely that our results are driven by measurement error in betas or multicollinearity. We present a simple theoretical model that explains these findings.

This paper examines the effects of a shock to the stock-price formation process on the design of executive incentive contracts. We find that an exogenous removal of short-selling constraints causes firms to convexify compensation payoffs by granting relatively more stock options to their managers. We also find that treated firms adopt new antitakeover provisions. These results suggest that when firms face the threat of bear raids, they incentivize managers to take actions that mitigate the adverse effects of unrestrained short selling. Overall, this paper provides causal evidence that financial markets affect incentive contract design.

Management-aligned boards exchange precise information with management and make efficient decisions. But when agency conflicts are important, management-aligned boards may not maximize shareholder value. Even if management controls all decisions and the board only provides advice, optimal boards may withhold information. This creates inefficiencies. But agency costs fall because management is induced to obey the board. When the board can directly veto management proposals, shareholders are better off. Optimal boards should then be more shareholder-aligned. Shareholder value is further enhanced if shareholders can veto management and also commit to revealing the board’s information. Optimal boards should then be perfectly shareholder-aligned.

We present evidence consistent with markets failing to properly price information in seasonal earnings patterns. Firms with historically larger earnings in one quarter of the year (“positive seasonality quarters”) have higher returns when those earnings are usually announced. Analysts have more positive forecast errors in positive seasonality quarters, consistent with the returns being driven by mistaken earnings estimates. We show that investors appear to overweight recent lower earnings following positive seasonality quarters, leading to pessimistic forecasts in the subsequent positive seasonality quarter. The returns are not explained by risk-based explanations, firm-specific information, increased volume, or idiosyncratic volatility. Received June 19, 2014; accepted April 25, 2016, by Editor David Hirshleifer.