Knowledge that Transforms

Two intermediary-based factors—a corporate bond dealer inventory measure and a broad intermediary distress measure—explain more than 40% of the puzzling common variation in credit spread changes beyond canonical structural factors. A simple intermediary-based model with partial market segmentation accounts for intermediary factors’ explanatory power and delivers three further implications with empirical support. First, whereas bond sorts on risk-related variables produce monotonic loading patterns on intermediary factors, non-risk-related sorts produce no pattern. Second, dealer inventory comoves with corporate-credit assets only, whereas intermediary distress comoves with both corporate-credit and non-corporate-credit assets. Third, dealers’ inventory responds to (instrumented) bond sales by institutional investors.

This paper proposes a novel quantitative framework with endogenous strategic competition in heterogeneous concentrated industries. Oligopolies compete strategically for profit margins in repeated games, trading off the benefits of future cooperation against those of reaping higher short-run profits by undercutting their rivals. Cross-industry dispersions in market leadership persistence and cash flow loadings on expected growth, as primitive characteristics, simultaneously determine the relationships among profitability, book-to-market ratios, and systematic risk exposures, thereby quantitatively rationalizing the gross profitability and value premium across industries and, importantly, their interactions. Controlling for the book-to-market ratio (gross profitability) makes the gross profitability (value) premium more pronounced.

I build a search model of bond and credit default swap (CDS) markets with endogenous investor participation and show that shorting bonds through CDS increases the liquidity and price of bonds. By allowing investors to trade the credit risk of bonds without trading the bonds, CDS introduction expands the set of feasible trades and attracts investors into the credit market. Because search is nondirected within the credit market, new investors also trade bonds and consequently increase their price and liquidity. My results suggest that naked CDS bans increased sovereigns’ borrowing costs and thereby exacerbated the 2010–2012 European debt crisis.

Hedge fund positions are an important component of crowded trades. These vehicles are particularly active, take highly concentrated positions, and utilize leverage and short sales. Using a database of hedge fund holdings, we measure the degree of security-level crowdedness. The difference between the average returns on portfolios sorted by high versus low crowdedness portfolios is sizable, and the variation in the realized portfolio returns is distinct from other traditional risk factors. Further, hedge fund exposures to crowdedness are often significant, and they help to explain downside “tail risk,” as funds with higher exposures experience relatively larger drawdowns during periods of industry distress.

We study data on commercial banks and securities firms across multiple countries since 1870. Balance sheet expansion of leveraged intermediaries negatively predicts returns of stocks, bonds, currencies, and housing. The predictability is stronger at shorter horizons, is robust to macroeconomic controls, and holds outside distress periods, in contrast to models featuring nonlinearities during distress. Intermediaries in global financial centers predict international equity returns. A new data set on individual stock holdings of Japanese intermediaries since 1955 shows intermediaries affect returns of stocks directly held. Our results suggest a strong universal link between intermediaries and asset returns distinct from macroeconomic channels.

We document a striking pattern in U.S. and international stock returns: double sorting on the previous month’s return and share turnover reveals significant short-term reversal among low-turnover stocks, whereas high-turnover stocks exhibit short-term momentum. Short-term momentum is as profitable and as persistent as conventional price momentum. It survives transaction costs and is strongest among the largest, most liquid, and most extensively covered stocks. Our results are difficult to reconcile with models imposing strict rationality but are suggestive of an explanation based on some traders underappreciating the information conveyed by prices.

Theory suggests that dark pools may facilitate or discourage information acquisition. We find that more dark pool trading leads to greater information acquisition. We measure information acquisition using stock price dynamics around earnings announcements. To overcome endogeneity concerns, we exploit a large exogenous decrease to dark pool trading that results from the implementation of the Security and Exchange Commission’s (SEC’s) Tick Size Pilot Program. The results cannot be explained by lit venue liquidity, algorithmic trading, or informational efficiency. A battery of additional tests, such as documenting a shift in SEC EDGAR searches, supports the information acquisition interpretation.

In 2007, as American housing markets started to decline, the government-sponsored enterprises dramatically increased their acquisitions of low FICO and high loan-to-value mortgages. By 2008, the agencies had reversed course by decreasing their high-risk acquisitions. I develop a theory in which large lenders temporarily increase high-risk activity at the end of a boom. In the model, lenders with many outstanding mortgages have incentives to extend risky credit to prop up house prices. The increase in house prices lessens the losses they make on their outstanding portfolio of mortgages. As the bust continues, lenders slowly wind down their mortgage exposure.

We examine the variable annuity market to study conflicts of interest and the effect of fiduciary duty in brokerage markets. Insurers typically pay brokers higher commissions for selling more expensive annuities. Our results indicate that sales are four times as sensitive to brokers’ interests as to investors’. To limit conflicts of interest, the Department of Labor proposed a rule in 2016 holding brokers to a fiduciary standard. We find that after the proposal, sales of high-expense products fell by 52% as sales became more sensitive to expenses. Based on our structural estimates, investor welfare improved overall.

We investigate the effects of opioid abuse on municipal finance. We employ instrumental variables, border discontinuity difference-in-differences regressions, and coarsened exact matching to identify consistent causal effects, while controlling for variation in economic conditions and demographics. Opioid abuse lowers credit ratings, increases new offer yields, and reduces bond issuance. Reversal of these effects following effective antiopioid legislation further supports causality. Differential effects due to investor heterogeneity suggest that opioid abuse affects municipal finance through a capital supply channel. Overall, we conclude that local opioid abuse impedes municipalities’ access to capital and thus hurts their ability to provide public services and infrastructure.