Knowledge that Transforms

We develop a theory of income and payout smoothing by firms when insiders know more about income than outside shareholders, but property rights ensure that outsiders can enforce a fair payout. Insiders set payout to meet outsiders' expectations and underproduce to manage future expectations downward. The observed income and payout process are smooth and adjust partially and over time in response to economic shocks. The smaller the inside ownership, the more severe underproduction is, resulting in an “outside equity Laffer curve.”

Extensive empirical research has shown that in many markets institutional investors have a significant impact on prices and mitigate its adverse effects through their trading strategies. This paper develops a dynamic model of such thin markets, in which the market structure is one of bilateral oligopoly. The paper demonstrates that market thinness qualitatively changes equilibrium properties of prices and dynamic trading strategies, compared to the existing theories of asset pricing. The predictions match a number of empirical facts that are hard to reconcile with the competitive or Cournot-based models. The paper further establishes that the nonstrategic general-equilibrium approach and the strategic approach to trade via Nash in demands are dual representations of a model with endogenous price impact. The proposed approach yields an analytical framework that can be used to study dynamic markets with bilateral market power.

We outline a dividend signaling model that features investors who are averse to dividend cuts. Managers with strong unobservable cash earnings pay high dividends but retain enough to be likely not to fall short next period. The model is consistent with a Lintner partial-adjustment model, modal dividend changes of zero, stronger market reactions to dividend cuts than increases, comparatively infrequent and irregular repurchases, and a mechanism that does not depend on public destruction of value, which managers reject in surveys. New tests involve stronger reactions to changes from longer-maintained dividend levels and reference point currencies of American Depository Receipt dividends. Received July 16, 2012; accepted September 15, 2015 by Editor David Hirshleifer.

Using investor-level data, I document that the disposition effect is absent following a stock split; inattentive investors may fail to split-adjust their reference point, confusing the winner versus loser status of their holdings. Consistent with the disposition effect impeding the incorporation of news, ex-date returns are significantly higher for split stocks with higher gains. However, the magnitude is small relative to momentum, and momentum remains robustly present among this sample of stocks void of the disposition effect. The results suggest that the disposition effect may slow the incorporation of news, but not to the extent that it alone explains momentum.

We derive a foreign ownership return as the weighted average return of foreign stocks that are connected to a stock through common ownership. The foreign ownership return is of similar economic significance as traditional country and industry factors in explaining international stock returns. It is not related to omitted fundamentals or wealth effects but shifts substantially around ADR and index listings when the investor habitat changes. A decomposition shows that the foreign ownership return is driven by active reallocations of global institutions as opposed to fund flows from end investors. Our findings have important implications for international portfolio diversification.

We propose a new method for constructing the hedge component in Merton's ICAPM that uses a daily summary measure of economic activity to track time-varying investment opportunities. We then use nonparametric projections to compute a robust estimate of the conditional covariance between stock market returns and our daily economic activity index. We find that the new conditional covariance risk measure plays an important role in explaining time variation in the equity risk premium. Specification tests as well as out-of-sample forecasts of aggregate stock returns suggest that the new covariance risk measure performs well compared to alternative covariance measures previously proposed in the literature.

The rise of computerized trading strategies in equity markets has spurred competition between trading venues. This paper shows that cross-venue strategies create highly interlinked markets: trades on one venue are followed by sizeable cancellations of limit orders on competing venues. These cancellations are explained in a simple model of competition between two limit order markets with fast and slow traders. Only the fast traders can access the liquidity of both venues simultaneously. Empirically, we confirm the predictions that the fraction of fast traders (1) reduces the equilibrium liquidity supply and (2) reduces the magnitude of the cancellations following a trade.

We provide a model of nonredundant credit default swaps (CDSs), building on the observation that CDSs have lower trading costs than bonds. CDS introduction involves a trade-off: it crowds out existing demand for the bond, but improves the bond allocation by allowing long-term investors to become levered basis traders and absorb more of the bond supply. We characterize conditions under which CDS introduction raises bond prices. The model predicts a negative CDS-bond basis, as well as turnover and price impact patterns that are consistent with empirical evidence. We also show that a ban on naked CDSs can raise borrowing costs.

Published in Review of Financial Studies https://doi.org/10.1093/rfs/hhu078

We find that differences in individuals' prenatal environments explain heterogeneity in financial decisions later in life. An exogenous increase in exposure to prenatal testosterone is associated with the masculinization of financial behavior, specifically with elevated risk taking and trading in adulthood. We also examine birth weight. Those with higher birth weight are more likely to participate in the stock market, whereas those with lower birth weight tend to prefer portfolios with higher volatility and skewness, consistent with compensatory behavior. Our results contribute to the understanding of how the prenatal environment shapes an individual's behavior in financial markets later in life. Received May 2, 2014; accepted September 30, 2015 by Editor David Hirshleifer.