Knowledge that Transforms

We identify long-lived pricing errors through a model in which inattentive investors arrive stochastically to trade. The model’s parameters are structurally estimated using daily NYSE market-maker inventories, retail order flows, and prices. The estimated model fits empirical variances, autocorrelations, and cross-autocorrelations among our three data series from daily to monthly frequencies. Pricing errors for the typical NYSE stock have a standard deviation of 3.2 percentage points and a half-life of 6.2 weeks. These pricing errors account for 9.4%, 7.0%, and 4.5% of the respective daily, monthly, and quarterly idiosyncratic return variances.

We document that the relation between firm value and the use of takeover defenses is positive for young firms but becomes negative as firms age. This value reversal pattern reflects specific changes in the costs and benefits of takeover defenses as firms age and arises because defenses are sticky and rarely removed. Firms can attenuate the value reversal by removing defenses, but do so only when the defenses become very costly and adjustment costs are low. The value reversal explains previous mixed evidence about takeover defenses and implies that firm age proxies for takeover defenses’ heterogeneous impacts on firm value. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.

We provide evidence that risk aversion leads pharmaceutical firms to underinvest in radical innovation. We introduce a new measure of drug novelty based on chemical similarity and show that firms face a risk-reward trade-off: novel drug candidates are less likely to obtain FDA approval but are based on more valuable patents. Consistent with a simple model of costly external finance, we show that a positive shock to firms’ net worth leads firms to develop more novel drugs. This suggests that even large firms may behave as though they are risk averse, reducing their willingness to investment in potentially valuable radical innovation.

This paper proposes a new method for measuring the impact of inflation on the real value of public debt. The distribution of debt debasement is based on two inputs: the distribution of privately held nominal debt by maturity, for which we provide new estimates, and the distribution of risk-adjusted inflation dynamics, for which we provide a novel copula estimator using options data. We find that inflation by itself is unlikely to lower the U.S. fiscal burden significantly because debt is concentrated at short maturities and perceived inflation shocks have little short-run persistence and are small.

We show that institutional investors are more likely to invest in firms from regions to which they have stronger social ties but find no evidence that these investments earn a differential return. Firms in regions with stronger social ties to locations with many institutional investors have higher valuations and liquidity. These effects are largest for small firms with little analyst coverage, suggesting that the investors’ behavior is explained by their increased awareness of firms in socially proximate locations. Our results highlight that the social structure of regions affects firms’ access to capital and contributes to geographic differences in economic outcomes. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.

Using 9,801 director appointments during 2003–2014, we document the dramatic impact of connections. Sixty-nine percent of new directors have professional ties to incumbent boards, a group representing 13% of all potential candidates. Consistent with facilitating coordination and reducing search costs, connections help boards bring in gender diversity, new skills, and new industry background. More complex firms and firms in more competitive environments tend to appoint connected directors and experience better market reactions and higher shareholder votes. Connections to incumbent CEOs, however, result in lower announcement returns and shareholder votes. We use death (merger)-induced network loss (gain) as instruments.

We uncover new return predictability in the cross-section of delta-hedged equity options. Expected returns to writing delta-hedged calls are negatively correlated with stock price, profit margin, and firm profitability, but positively correlated with cash holding, cash flow variance, new shares issuance, total external financing, distress risk, and dispersion of analysts’ forecasts. Our option portfolio strategies have annual Sharpe ratio above two and remain profitable after transaction costs. Their profits can be explained by two option factors, while equity risk factors have no explanatory power. We find support for several economic channels at work, yet the option return predictability remains puzzling.

We establish limitations to the usage of direct revelation mechanisms (DRMs) by corporations seeking decision-relevant information in economies with securities markets. In this environment, posting a DRM increases the informed agent’s outside option: if the agent rejects the DRM, he convinces the market he is uninformed, and he can aggressively trade with low price impact, thereby generating large (off-equilibrium) trading gains. This endogenous outside option may make using a DRM to screen uninformed agents impossible. When screening is possible, solely relying on the market for information is optimal if the increase in outside option is sufficiently large. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.

Accurate credit ratings are important for both investors and regulators. We demonstrate that the market for credit risk provides an important source of discipline for credit rating agencies (CRAs). We examine a model in which a CRA’s rating is followed by a market for credit risk that provides a public signal – the price. More informative trading increases the CRA’s incentives to be accurate by making rating errors more transparent. We show that this source of discipline is (a) robust to moral hazard, multiple CRAs, and connected primary and secondary markets and (b) specific to the market for credit risk.

We argue that risk sharing motivates the bankwide structure of bonus pay. In the presence of financial frictions that make external financing costly, the optimal contract between shareholders and employees involves some degree of risk sharing whereby bonus pay partially absorbs negative earnings shocks. Using payroll data for 1.26 million employee-years in all functional divisions of Austrian, German, and Swiss banks, we uncover several empirical patterns in bonus pay that are difficult to rationalize exclusively with incentive theories of bonus pay but that support an important risk sharing motive. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.