Knowledge that Transforms

I demonstrate an important tension between acquiring information and incorporating it into asset prices. As a salient case, I analyze algorithmic trading (AT), which is typically associated with improved price efficiency. Using a new measure of the information content of prices and a comprehensive panel of 54, 879 stock-quarters of Securities and Exchange Commission (SEC) market data, I establish instead that the amount of information in prices decreases by 9% to 13% per standard deviation of AT activity and up to a month before scheduled disclosures. AT thus may reduce price informativeness despite its importance for translating available information into prices. Received May 21, 2016; editorial decision October 25, 2017 by Editor Itay Goldstein.

Credit default swaps can be used to lower the capital requirements of dealer banks entering into uncollateralized derivatives positions with sovereigns. We show in a model that the regulatory incentive to obtain capital relief makes CDS contracts valuable to dealer banks and empirically that, consistent with the use of CDS for regulatory purposes, there is a disconnect between changes in bond yield spreads and in CDS premiums, especially for safe sovereigns. Additional empirical tests related to the volume of contracts outstanding, effects of regulatory proxies, and the corporate bond and CDS markets support that CDS contracts are used for capital relief.

How do people cope with tail risk? In a lab experiment that removed informational and incentive confounds, subjects overwhelmingly behaved like Bayesian learners. The results of simulations further revealed that if one is to survive under tail risk, one needs to follow the Bayesian approach, as all boundedly rational alternatives fail. These findings support the Bayesian assumption commonly made in prior studies on tail risk and model uncertainty, and they also demonstrate the importance of optimal learning under tail risk. Received February 15, 2017; editorial decision December 24, 2017 by Editor Andrew Karolyi. Authors have furnished supplementary data and code, which are available on the Oxford University Press Web site next to the link to the final published paper online.

We analyze the removal of the credit-risk guarantees provided by the government-sponsored enterprises (GSEs) in a model with agents heterogeneous in income and house price risk. We find that wealth inequality increases, driven by higher mortgage spreads and housing rents. Housing holdings become more concentrated. Foreclosures fall. The removal benefits high-income households, while hurting low-and mid-income households (renters and highly leveraged mortgagors with conforming loans). GSE reform requires compensating transfers, sufficiently high elasticity of rental supply, or linking GSE reform with the elimination of the mortgage interest deduction.

We examine a change in the European Central Bank’s collateral framework, which significantly lowered the rating requirement for eligible residential mortgage-backed securities (RMBS), and its impact on bank lending and risk-taking in the Netherlands. Banks most affected by the policy increase loan supply and lower interest rates on new mortgage originations. These lower-interest-rate loans serve as collateral for newly issued RMBS with lower-rated tranches and subsequently experience worse repayment performance. The performance deterioration is pronounced among loans with state guarantees, which suggests that looser collateral requirements may lead to undesired credit risk transfer to the sovereign.

We analyze how firms’ segmentation into credit classes affects the lending standards applied by banks to small and medium enterprises over the cycle. We exploit an institutional feature of the Italian credit market that generates a discontinuity in the allocation of comparable firms into the performing and substandard classes of credit risk. In the boom period, segmentation results in a positive interest rate spread between substandard and performing firms. In the bust period, the increase in banks’ cost of wholesale funds implies that substandard firms are excluded from credit. These firms then report lower values of production and capital investments. Received January 22, 2016; editorial decision December 18, 2017 by Editor Robin Greenwood.

We study time-series and cross-firm variation in corporate cash holdings from 1920 to 2014. The recent increase in cash is not unique in magnitude. However, the recent divergence between average and aggregate cash is new and entirely driven by a shift in cash policies of newly public firms, whereas within-firm changes have been negative or flat since the 1940s. Cross-sectional relations between cash holdings and firm characteristics are stable throughout the century, though characteristics explain little of the trends in aggregate cash. Macroeconomic conditions, corporate profitability and investment, and (since 2000) repatriation taxes explain aggregate cash over the last century. Received August 23, 2017; editorial decision April 28, 2018 by Editor Andrew Karolyi.

Citation: Greenwood, Robin, Samuel G. Hanson, and Gordon Y. Liao. "Asset Price Dynamics in Partially Segmented Markets." Review of Financial Studies 31, no. 9 (September 2018): 3307–3343. (Internet Appendix Here: http://www.people.hbs.edu/shanson/smc_IA_20170910.pdf.) Link to publisher's version: https://academic.oup.com/rfs/article-abstract/31/9/3307/4985215?redirectedFrom=fulltext Keywords: System Shocks, Asset Pricing

We develop a three-factor no-arbitrage model for valuing mortgage-backed securities in which we solve for the implied prepayment function from the cross-section of market prices. This model closely fits the cross-section of mortgage-backed security prices without needing to specify an econometric prepayment model. We find that implied prepayments are generally higher than actual prepayments, providing direct evidence of significant macroeconomic-driven prepayment risk premiums in mortgage-backed security prices. We also find evidence that mortgage-backed security prices were significantly affected by Fannie Mae credit risk and the Federal Reserve’s quantitative easing programs.

Although acquisitions are a popular form of investment, the link between rms' nancial constraints and acquisition policies is not well understood. We develop a model in which nancially constrained bidders approach targets, decide how much to bid and whether to bid in cash or in stock. In equilibrium, nancial constraints do not aect the identity of the winning bidder, but they lower bidders' incentives to approach the target. Auctions are initiated by bidders with low constraints or high synergies. The use of cash is positively related to synergies and the acquirer's gains from the deal and negatively to nancial constraints. (D44, G32,