Knowledge that Transforms

We hypothesize that poor country-level governance, which makes public information less reliable, induces fund managers to increase their use of semipublic information. Utilizing data from international mutual funds and stocks over the 2000–2009 period, we find that semipublic information-related stock rebalancing can be five times higher in countries with the worst quality of governance than in countries with the best. The use of semipublic information increases price informativeness but also increases information asymmetry and reduces stock liquidity. It also intensified the price impact and liquidity crunch during the recent global financial crisis.

Relying on 2.2 million articles from forty-five national and local U.S. newspapers between 1989 and 2010, we find that firms particularly covered by the media exhibit, ceteris paribus, significantly stronger momentum. The effect depends on article tone, reverses in the long run, is more pronounced for stocks with high uncertainty, and is stronger in states with high investor individualism. Our findings suggest that media coverage can exacerbate investor biases, leading return predictability to be strongest for firms in the spotlight of public attention. These results collectively lend credibility to an overreaction-based explanation for the momentum effect.

As illustrated in the tale of “the dog that did not bark,” the absence of news and the passage of time often contain information. We test whether markets fully incorporate this information using the empirical context of mergers. During the year after merger announcement, the passage of time is informative about the probability that the merger will ultimately complete. We show that the variation in hazard rates of completion after announcement strongly predicts returns. This pattern is consistent with a behavioral model of underreaction to the passage of time and cannot be explained by changes in risk or frictions.

This paper studies the implications of opacity in financial markets for investor behavior, asset prices, and welfare. Transparent funds (e.g., mutual funds) and opaque funds (e.g., hedge funds) trade transparent assets (e.g., plain-vanilla products) and opaque assets (e.g., structured products). Investors observe neither opaque funds' portfolios nor opaque assets' payoffs. Consistent with empirical observations, an “opacity price premium” arises: opaque assets trade at a premium over transparent ones despite identical payoffs. This accompanies endogenous market segmentation: transparent (opaque) funds trade only transparent (opaque) assets. The opacity price premium incentivizes financial engineers to render transparent assets opaque deliberately.

We use credit default swaps (CDS) trading data to demonstrate that the credit risk of reference firms, reflected in rating downgrades and bankruptcies, increases significantly upon the inception of CDS trading, a finding that is robust after controlling for the endogeneity of CDS trading. Additionally, distressed firms are more likely to file for bankruptcy if they are linked to CDS trading. Furthermore, firms with more “no restructuring” contracts than other types of CDS contracts (i.e., contracts that include restructuring) are more adversely affected by CDS trading, and the number of creditors increases after CDS trading begins, exacerbating creditor coordination failure in the resolution of financial distress.

We infer conditional swap rate moments model independently from swaption cubes. Conditional volatility and skewness exhibit systematic variation across swap maturities and option expiries (conditional kurtosis less so), with conditional skewness sometimes changing sign. Conditional skewness displays some relation to the level and volatility of swap rates but is most consistently related to the conditional correlation between swap rates and swap rate variances. From realized excess returns on synthetic variance and skewness swap contracts, we infer that variance and (to a lesser extent) skewness risk premia are negative and time varying. For the most part, results hold true in both the USD and EUR markets and in both precrisis and crisis subsamples. We design and estimate a dynamic term structure model that captures much of the dynamics of conditional swap rate moments.

We propose a labor market model in which agents with heterogenous ability levels choose to work as bankers or as financial regulators. When workers extract intrinsic benefits from working in regulation (such as public-sector motivation or human capital accumulation), our model jointly predicts that bankers are, on average, more skilled than regulators and their compensation is more sensitive to performance. During financial booms, banks draw the best workers away from the regulatory sector and misbehavior increases. In a dynamic extension of our model, young regulators accumulate human capital and the best ones switch to banking in mid-career.

Investors face significant barriers in evaluating the performance of hedge funds and commodity trading advisors (CTAs). The only available performance data comes from voluntary reporting to private companies. Funds have incentives to strategically report to these companies, causing these data sets to be severely biased. And, because hedge funds use nonlinear, state-dependent, leveraged strategies, it has proven difficult to determine whether they add value relative to benchmarks. We focus on commodity trading advisors, a subset of hedge funds, and show that during the period 1994-2007 CTA excess returns to investors (i.e., net of fees) averaged 85 basis points per annum over US T-bills, which is insignificantly different from zero. We estimate that CTAs on average earned gross excess returns (i.e., before fees) of 5.4%, which implies that funds captured most of their performance through charging fees. Yet, even before fees we find that CTAs display no alpha relative to simple futures strategies that are in the public domain. We argue that CTAs appear to persist as an asset class despite their poor performance, because they face no market discipline based on credible information. Our evidence suggests that investors' experience of poor performance is not common knowledge.

We provide a rationale for window dressing wherein investors respond to conflicting signals of managerial ability inferred from a fund's performance and disclosed portfolio holdings. We contend that window dressers make a risky bet on their performance during a reporting delay period, which affects investors' interpretation of the conflicting signals and hence their capital allocations. Conditional on good (bad) performance, window dressers benefit (suffer) from higher (lower) investor flows compared with non–window dressers. Window dressers also show poor past performance, possess little skill, and incur high portfolio turnover and trade costs, characteristics which in turn result in worse future performance.

When an individual performs several tasks simultaneously, processing resources must be allocated to different brain systems to produce energy for neurons to fire. Following the evidence from neuroscience, we model the brain as an organization in which a coordinator allocates limited resources to the brain systems responsible for the different tasks. Systems are privately informed about the amount of resources necessary to perform their task and compete to obtain the resources. The coordinator arbitrates the demands while satisfying the resource constraint. We show that the optimal mechanism is to impose to each system with privately known needs a cap in resources that depends negatively on the amount of resources requested by the other system. This allocation can be implemented using a biologically plausible mechanism. Finally, we provide some implications of our theory: (i) performance can be flawless for sufficiently simple tasks, (ii) the dynamic allocation rule exhibits inertia (current allocations are increasing in past needs), and (iii) different cognitive tasks are performed by different systems only if the tasks are sufficiently important.