Knowledge that Transforms

The article develops a dynamic model that nests the rational expectations (RE) and differences of opinion (DO) approaches to study how investors use prices to update their valuations. When investors condition on prices (RE), investor disagreement is related positively to expected returns, return volatility, and market beta, but negatively to return autocorrelation. When investors do not use prices (DO), these relations are reversed. Tests of these predictions on the cross-section of stocks using analyst forecast dispersion and volume as proxies for disagreement provide empirical evidence that is consistent with investors using prices on average. The Author 2011. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: [email protected]., Oxford University Press.

We examine whether the sign and magnitude of intra-daily returns have impact on expected volatility the next day or over longer future horizons. We first let the ’data speak’, namely with minimal interference we capture the mapping between intra-daily returns and future volatility. We revisit the concept of news impact curves introduced by Engle and Ng (1993). Overall, we find that moderately good (intra-daily) news reduces volatility (the next day), while both very good news (unusual high intra-daily positive returns) and bad news (negative returns) increase volatility, with the latter having a more severe impact. The asymmetries disappear over longer horizons. We also introduce a new class of parametric models which feature asymmetries and with close ties to ARCH-type models, albeit applicable to a mixture of high and low frequency data. Models featuring asymmetries dominate, especially during the 2007-2008 financial crisis. ∗We like to thank Oliver Linton for comments and sharing with us software. In addition, we like to thank the Referees and the Editor for many helpful suggestions and comments on a previous version of

This article studies differences in the information content of 870,000 news announcements in 56 markets around the world. In most developed markets, a firm's stock price moves much more on days with public news about the firm. In contrast, in many emerging markets volatility is similar on news and non-news days. We examine several hypotheses for our findings. Cross-country differences in stock price reactions are best explained by insider trading, followed by differences in the quality of the news dissemination mechanism. Our findings are useful for quantifying the extent of insider trading and how the financial media affects international markets.

This article studies whether the volume and composition of capital flows affect the degree of credit crunch during the 2007–2009 crisis. Using data on 3,823 firms in 24 emerging countries, we find that, on average, the decline in stock prices was more severe for firms that are intrinsically more dependent on external finance for working capital. Interestingly, while the volume of capital flows per se has no significant effect, the composition matters a lot. In particular, greater dependence on non-FDI capital inflows before the crisis worsens the credit crunch during the crisis, while exposure to FDI alleviates the liquidity constraint.

The empty creditor problem arises when a debtholder has obtained insurance against default but otherwise retains control rights in and outside bankruptcy. We analyze this problem from an ex ante and ex post perspective in a formal model of debt with limited commitment, by comparing contracting outcomes with and without insurance through credit default swaps (CDS). We show that CDS, and the empty creditors they give rise to, have important ex ante commitment benefits: By strengthening creditors' bargaining power, they raise the debtor's pledgeable income and help reduce the incidence of strategic default. However, we also show that lenders will over-insure in equilibrium, giving rise to an inefficiently high incidence of costly bankruptcy. We discuss a number of remedies that have been proposed to overcome the inefficiency resulting from excess insurance.

This article examines the impact of leveraged buyout firms' bank relationships on the terms of their syndicated loans. We examine a sample of 1,590 loans financing private equity sponsored leveraged buyouts between 1993 and 2005, and find that private equity firms' bank relationships are an important factor in cross-sectional variation in the loan interest rate and covenant structure. Our results indicate that bank relationships formed through repeated interactions reduce inefficiencies from information asymmetry and allow leveraged buyouts sponsored by private equity firms to occur on favorable loan terms. A one-standard-deviation increase in bank relationship strength is associated with an 8-basis-point (3%) decrease in the spread and a 0.21-basis-point (4%) increase in the maximum debt to EBITDA covenant. We also find evidence that banks price loans to cross-sell other fee business. A one-standard-deviation increase in both bank relationship strength and cross-selling potential translates into as much as a 4-percentage-point increase in equity return to the leveraged buyout firm.

We provide a simple argument that suggests that better-informed hedge funds choose to have less exposure to factor risk. Consistent with this argument, we find that hedge funds that exhibit lower R-squareds with respect to systematic factors have higher Sharpe ratios, higher information ratios, and higher alphas. They also exhibit higher manipulation-proof performance measures and charge higher fees.

Pensions and deferred compensation represent substantial components of CEO incentives. We study stockholder and bondholder reactions to companies' initial reports of CEOs' inside debt positions following a 2007 SEC disclosure reform. We find that bond prices rise, equity prices fall, and the volatility of both securities drops for firms whose CEOs have sizeable defined benefit pensions or deferred compensation. Similar changes occur for credit default swap spreads and exchange-traded options. The results indicate a reduction in firm risk, a transfer of value from equity toward debt, and an overall destruction of enterprise value when CEOs' inside debt holdings are large.

What is the effect of financial crises and their resolution on banks' choice of liquidity? When banks have relative expertise in employing risky assets, the market for these assets clears only at fire-sale prices following a large number of bank failures. The gains from acquiring assets at fire-sale prices make it attractive for banks to hold liquid assets. The resulting choice of bank liquidity is countercyclical, inefficiently low during economic booms but excessively high during crises. We present evidence consistent with these predictions. While interventions to resolve banking crises may be desirable ex post, they affect bank liquidity in subtle ways: Liquidity support to failed banks or unconditional support to surviving banks reduces incentives to hold liquidity, whereas support to surviving banks conditional on their liquid asset holdings has the opposite effect. The Author 2011. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: [email protected]., Oxford University Press.

We explore whether government ownership affects the cost of debt using a sample of fully and partially privatized companies. On average across firms, a one-percentage-point decrease in government ownership is associated with an increase in the credit spread, used as a proxy for the cost of debt, by three-quarters of a basis point. However, fully privatized companies exhibit lower credit spreads than partially privatized firms, indicating the cost of a lengthy privatization process. Empirical evidence suggests that these findings result from decreasing government guarantees, firm performance improvements, ownership uncertainty, and bondholder-shareholder conflicts. The Author 2011. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: [email protected]., Oxford University Press.