Knowledge that Transforms

We document strong comovement in the returns of hedge funds sharing the same prime broker. This comovement is driven neither by funds in the same family nor in the same style, and it is distinct from market-wide and local comovement. The common information hypothesis attributes this phenomenon to the prime broker providing valuable information to its hedge fund clients. The prime broker-level contagion hypothesis attributes the comovement to the prime broker spreading funding liquidity shocks across its hedge fund clients. We find strong evidence supporting the common information hypothesis, but limited evidence in favor of the prime broker-level contagion hypothesis. Received September 6, 2014; accepted January 7, 2016 by Editor Philip Strahan.

We explore a new mechanism by which investors take correlated shortcuts and present evidence that managers—using sales management—take advantage of these shortcuts. Specifically, we exploit a regulatory provision wherein a firm's primary industry is determined by the highest sales segment. Exploiting this regulation, we provide evidence that investors classify operationally nearly identical firms as starkly different depending on their placement around this sales cutoff. Moreover, managers appear to exploit this by manipulating sales to be just over the cutoff in favorable industries. Further evidence suggests that managers engage in activities to realize large, tangible benefits from this opportunistic action. Received July 28, 2014; accepted February 8, 2016 by Editor Andrew Karolyi.

When a proxy contest is looming, the rate at which CEOs exercise options to sell (hold) the resulting shares slows down by 80% (accelerates by 60%), consistent with their desire to maintain or strengthen voting rights when facing challenges. Such deviations are closely aligned with features unique to proxy contests, such as the record dates and nomination status, and are more pronounced when the private benefits are higher or when the voting rights are more crucial. The distortions suggest that incumbents value their stocks higher than the market price when voting rights are valuable for defending control. Received June 3, 2014; accepted August 11, 2015 by Editor David Denis.

We model the interplay between trade in the interbank market and creditor runs on financial institutions. We show that the feedback between them can amplify a small shock into “interbank market freezing” with “liquidity evaporating.” Credit crunches of the interbank market drive up the interbank rate. For an individual institution, a higher interbank rate — meaning a higher funding cost — results in more severe coordination problems among creditors in debt rollover decisions. Creditors thus behave more conservatively and run more often. Facing an increased chance of creditor runs, institutions demand more and supply less liquidity, tightening the interbank market. Received September 29, 2014; accepted March 7, 2016 by Editor Itay Goldstein.

High expected inflation is known to predict low future real growth. We show that, relative to nondurable goods sectors of the economy, such predictability is significantly more pronounced in durable sectors. Consistent with this macroeconomic evidence, the equity returns of durable goods-producing firms have a larger negative exposure to expected inflation risks. We estimate a two-good recursive utility model that features persistent growth fluctuations and inflation nonneutrality for durable and nondurable consumption. Our model can quantitatively account for the levels and volatilities of bond and equity prices, and correlations of equity returns with bond returns and with expected inflation. Received January 25, 2012; accepted July 13, 2015 by Editor Geert Bekaert.

We study rating shopping on the MBS market. Outside of AAA, losses are higher on single-rated tranches than on multi-rated ones, and yields predict future losses for single-rated tranches, but not for multi-rated ones. Conversely, ratings have less explanatory power for single-rated tranches. These results suggest that single-rated tranches have been “shopped,” whereby pessimistic ratings never reach the market. For AAA-rated MBS, by contrast, 93% receive two or three such ratings, and those ratings agree 97% of the time. This ratings convergence suggests that agencies “cater” to investors, who cannot purchase a tranche unless it has multiple AAA ratings. Received January 22, 2014; accepted October 21, 2015 by Editor Andrew Karolyi.

We characterize linkages between average returns calculated at different horizons. Theoretically, when stocks incorporate information slowly, average short-horizon returns are downward biased. Buy-and-hold strategies can amplify the effect. In contrast, existing theories analyze price noises that are independent of fundamentals, and buy-and-hold portfolio returns are unaffected. We document horizon effects as large as 10% annualized in daily and monthly style portfolios and international indices. Slow reaction to market information, identified by gradually declining lagged betas, is an important cause. These findings have natural consequences for performance evaluation. Received July 2, 2012; accepted June 28, 2015 by Editor Andrew Karolyi.

The Home Affordable Modification Program’s (HAMP’s) Principal Reduction Alternative (PRA) is a government-sponsored program to reduce the principal balances and monthly mortgage payments of troubled borrowers. We examine the effect of principal forgiveness on borrowers’ subsequent mortgage default. The program’s rules imply a kink in the relationship between principal forgiveness and a borrower’s initial equity level. Our identification strategy exploits the quasi-experimental variation in principal forgiveness generated by this kink using a regression kink design (RKD), which compares the relationship between initial equity and default on either side of the kink. We estimate that HAMP PRA reduced the quarterly default hazard from <f>3.8\%</f> to <f>3.1\%</f>. Received February 4, 2015; accepted August 2, 2015 by Editor Philip Strahan.

We present a model in which firms compete for scarce managerial talent (“alpha”) and managers are risk averse. When managers cannot move across firms after being hired, employers learn about their talent, efficiently allocate them to projects, and provide insurance to low-quality managers. When, instead, managers can move across firms, firm-level coinsurance is no longer feasible, but managers may self-insure by switching employer to delay the revelation of their true quality. However, this results in inefficient project assignment, with low-quality managers handling projects that are too risky for them. Received September 10, 2015; accepted April 23, 2016 by Editor Itay Goldstein.

Why do value stocks have higher average returns than growth stocks, despite having lower risk? Why do these stocks exhibit positive abnormal performance, while growth stocks exhibit negative abnormal performance? This paper offers a rare-event-based explanation that can also account for the high equity premium and volatility of the aggregate market. The model explains other puzzling aspects of the data, such as joint patterns in time-series predictablity of aggregate market and value and growth returns, long periods in which growth outperforms value, and the association between positive skewness and low realized returns. (JEL G12)