Knowledge that Transforms

Financing from family and friends is the predominant type of informal finance. This paper proposes a theory that reconciles two seemingly paradoxical traits of this form of finance, namely, it is often provided at negative prices but nevertheless eschewed by borrowers. A central prediction is that such finance, while breeding trust, deters risk taking. Demand is thus constrained: entrepreneurs may forgo risky investment rather than finance it through family and friends. Formal finance is valuable precisely because it is regulated only by contract. The highlighted trade-offs between formal and informal finance are potentially relevant for the provision of microventure capital.

More than three-quarters of U.S. households bear consumer debt, yet we have little understanding of the relationship between financial education and the debt behavior of U.S. consumers. In this paper, we study the effects of exposure to financial training on debt outcomes in early adulthood. Identification comes from variation in financial literacy, economics, and mathematics course offerings and graduation requirements mandated over the 1990s and 2000s by state-level high-school curricula. The FRBNY Consumer Credit Panel provides debt outcomes based on quarterly Equifax credit reports from 1999 to 2012. Our analysis, based on a flexible event-study approach, reveals significant effects of financial education on debt-related outcomes of youth. On the extensive margin, financial literacy education has a sizable impact on the propensity of youth having a credit report. Conditional on having a credit report, on the intensive margin, math and financial literacy education exposure reduces the incidence of adverse outcomes - such as accounts in collections and delinquent accounts - and reduces both the likelihood of youth carrying debt and their average debt balances. The net effect of both math and financial literacy education is an increase in youths' average creditworthiness, as measured by the Equifax risk score. On the other hand, economic education increases the likelihood of individuals carrying balances, leads to significant increases in debt balances - in particular, debt used to support consumption - and, at the same time, increases the likelihood of adverse credit outcomes, leading to a decline in youths' average risk scores. The effects of these financial education policies accumulate over the course of early adulthood. Our results suggest that financial education programs, increasingly promoted by policymakers, are likely to have significant impacts on the financial decision-making of youth, but the effects depend on the content of these programs.

We study government interventions in markets suffering from adverse selection. Importantly, asymmetric information prevents both the realization of gains from trade and the production of information that is valuable to other market participants. We find a fundamental tension in maximizing welfare: while some intervention is required to restore trading, too much intervention depletes trade of its informational content. We characterize the optimal policy that balances these two considerations, and explore how it depends on features of the environment. Our model can be used to study a program introduced in 2009 to restore information production in the market for legacy assets. Received February 19, 2014; accepted November 20, 2015 by Editor Itay Goldstein.

In affine asset pricing models, the innovation to the pricing kernel is a function of innovations to current and expected future values of an economic state variable, for example consumption growth, aggregate market returns, or short-term interest rates. The impulse response of this priced variable to fundamental shocks has a frequency (Fourier) decomposition, which captures the fluctuations induced in the priced variable at different frequencies. We show that the price of risk for a given shock can be represented as a weighted integral over that spectral decomposition. The weight assigned to each frequency then represents the frequency-specific price of risk, and is entirely determined by the preferences of investors. For example, standard Epstein-Zin preferences imply that the weight of the pricing kernel lies almost entirely at extremely low frequencies, most of it on cycles longer than 230 years; internal habit-formation models imply that the weight is shifted to high frequencies. We estimate the frequency-specific risk prices for the equity market, focusing on economically interesting frequencies. Most of the pricing weight falls on low frequencies -corresponding to cycles longer than 8 years -broadly consistent with Epstein-Zin preferences.

We develop and empirically test a theory of optimal security design under adverse selection accounting for strategic trading by uninformed investors who will liquidate a security in secondary markets only if their idiosyncratic carrying costs exceed the security's expected trading loss. Such investors demand primary market discounts equaling expected carrying costs borne plus trading losses incurred. Issuers minimize the total illiquidity discount by splitting cash-flow into tranched debt claims with liquidity predicted to increase with seniority, while the optimal number of tranches increases with underlying cash-flow risk. Empirical tests confirm our model predictions. Received November 7, 2013; accepted November 14, 2015 by Editor Itay Goldstein.

Association, for some very helpful comments. Any errors are our own. Share prices generally fall when a firm announces a seasoned equity offering (SEO). A stan-dard explanation of this fact is that an SEO communicates negative information to investors. We show that if repeated capital market transactions are possible, this same asymmetry of information between firms and investors implies that some firms also repurchase shares in equilibrium. A subset of these firms directly profit from the repurchase transaction, while other firms repurchase in order to improve the terms of a subsequent SEO. The possibil-ity of repurchases reduces both SEOs and investment. Overall, our analysis highlights the importance of analyzing SEOs and repurchases in a unified framework. Share prices generally fall in response to a firm’s announcement of a seasoned equity offering (SEO).1 The standard explanation for this empirical regularity is that a firm has information that investors lack, and a SEO reveals to investors that the firm’s information is negative (see, in particular, Myers and Majluf (1984)). In equilibrium firms with negative information issue equity, and accept the negative share price response because the SEO

We show that the need to “posture” can help solve the holdup problem inherent in many multistage relationships, including those between entrepreneurs and venture capitalists. Posturing arises when an informed party needs to send a strong signal to induce skeptical third parties like employees, suppliers, customers, or competitors to develop/maintain relationships with the firm or take other actions that increase firm value. In the venture capital context, this can be credibly achieved if the VC publicly invests at high prices in later rounds. This tempers holdup by shifting ex-post bargaining power toward the entrepreneur, inducing him to exert greater effort. Received February 25, 2014; accepted October 7, 2015 by Editor Itay Goldstein.

It is a major challenge for asset pricing models to generate a high equity premium and a low risk-free rate while imposing realistic consumption dynamics. To address this issue, our paper proposes a novel pricing channel: we allow for consumption drops that can spark an economic crisis. This new feature generates a large equity premium even if possible consumption drops are of moderate size. In turn, our model also matches the consumption data of 42 countries along several dimensions. In particular, our approach generates a realistic number of crises that have realistic durations and involve clustering of moderate consumption drops. Received October 17, 2014; accepted August 18, 2015 by Editor Pietro Veronesi.

We examine the dynamics of assets under management (AUM) and management fees at the portfolio manager level in the closed-end fund industry. We find that managers capitalize on good past performance and favorable investor perceptions about future performance, as reflected in fund premiums, through AUM expansions and fee increases. However, the penalties for poor performance or unfavorable investor perceptions are either insignificant, or substantially mitigated by manager tenure. Long tenure is generally associated with poor performance and high discounts. Our findings suggest substantial managerial power in capturing CEF rents. We also document significant diseconomies of scale at the manager level. Received December 2, 2013; accepted June 21, 2016 by Editor Laura Starks.

We propose a Bayesian-averaging portfolio choice strategy with excellent out-of-sample performance. Every period a new model is born that assumes means and covariances are constant over time. Each period we estimate model parameters, update model probabilities, and compute robust portfolio choices by taking into account model uncertainty, parameter uncertainty, and non-stationarity. The portfolio choices achieve higher out-of-sample Sharpe ratios and certainty equivalents than rolling window schemes, the 1/N approach, and other leading strategies do on a majority of 24 datasets. Received September 8, 2012; accepted October 18, 2015 by Editor Pietro Veronesi.