Knowledge that Transforms

We study price discovery in municipal bonds, an important OTC market. As in markets for consumer goods, prices “rise faster than they fall.” Round‐trip profits to dealers on retail trades increase in rising markets but do not decrease in falling markets. Further, effective half‐spreads increase or decrease more when movements in fundamentals favor dealers. Yield spreads relative to Treasuries also adjust with asymmetric speed in rising and falling markets. Finally, intraday price dispersion is asymmetric in rising and falling markets, as consumer search theory would predict.

We study the impact of social networks on agents’ ability to gather superior information about firms. Exploiting novel data on the educational background of sell‐side analysts and senior corporate officers, we find that analysts outperform by up to 6.60% per year on their stock recommendations when they have an educational link to the company. Pre‐Reg FD, this school‐tie return premium is 9.36% per year, while post‐Reg FD it is nearly zero. In contrast, in an environment that did not change selective disclosure regulation (the U.K.), the school‐tie premium is large and significant over the entire sample period.

This paper analyzes optimal executive compensation contracts when managers are loss averse. We calibrate a stylized principal‐agent model to the observed contracts of 595 CEOs and show that this model can explain observed option holdings and high base salaries remarkably well for a range of parameterizations. We also derive and calibrate the general shape of the optimal contract that is increasing and convex for medium and high outcomes and that drops discontinuously to the lowest possible payout for low outcomes. Finally, we identify the critical features of the loss‐aversion model that render optimal contracts convex.

Motivated by the literature on investment flows and optimal trading, we examine intraday predictability in the cross‐section of stock returns. We find a striking pattern of return continuation at half‐hour intervals that are exact multiples of a trading day, and this effect lasts for at least 40 trading days. Volume, order imbalance, volatility, and bid‐ask spreads exhibit similar patterns, but do not explain the return patterns. We also show that short‐term return reversal is driven by temporary liquidity imbalances lasting less than an hour and bid‐ask bounce. Timing trades can reduce execution costs by the equivalent of the effective spread.

This paper presents a model that reproduces the uncovered interest rate parity puzzle. Investors have preferences with external habits. Countercyclical risk premia and procyclical real interest rates arise endogenously. During bad times at home, when domestic consumption is close to the habit level, the representative investor is very risk averse. When the domestic investor is more risk averse than her foreign counterpart, the exchange rate is closely tied to domestic consumption growth shocks. The domestic investor therefore expects a positive currency excess return. Because interest rates are low in bad times, expected currency excess returns increase with interest rate differentials.

A goal for stock exchanges is to increase participation by firms and investors. We show how specific features of the microstructure can reduce perceived ambiguity, and induce participation by both investors and issuers. We develop a model with sophisticated traders, who we view as expected utility maximizers with rational expectations, and unsophisticated traders, who we view as rational traders facing ambiguity about the payoffs to participating in the market. We show how designing markets to reduce ambiguity can benefit investors through greater liquidity, exchanges through greater volume, and issuing firms through a lower cost of capital.

I estimate the market's valuation of the net benefits to leverage using panel data from 1994 to 2004, identified from market values and betas of a company's debt and equity. The median firm captures net benefits of up to 5.5% of firm value. Small and profitable firms have high optimal leverage ratios, as predicted by theory, but in contrast to existing empirical evidence. Companies are on average slightly underlevered relative to the optimal leverage ratio at refinancing. This result is mainly due to zero leverage firms. I also look at implications for financial policy.

This paper shows that large cash reserves lead to systematic future market share gains at the expense of industry rivals. Using shifts in import tariffs to identify exogenous intensification of competition, difference‐in‐difference estimations support the causal impact of cash on product market performance. Moreover, the analysis reveals that the “competitive” effect of cash is markedly distinct from the strategic effect of debt on product market outcomes. This effect is stronger when rivals face tighter financing constraints and when the number of interactions between competitors is large. Overall, the results suggest that cash policy encompasses a substantial strategic dimension.

We develop a dynamic multiequation model where firms make financing and investment decisions jointly subject to the constraint that sources must equal uses of cash. We argue that static models of financial decisions produce inconsistent coefficient estimates, and that models that do not acknowledge the interdependence among decision variables produce inefficient estimates and provide an incomplete and potentially misleading view of financial behavior. We use our model to examine whether firms are constrained from accessing capital markets. Unlike static single‐equation studies that find firms underinvest given cash flow shortfalls, we conclude that firms maintain investment by borrowing.

Executive compensation influences managerial risk preferences through executives' portfolio sensitivities to changes in stock prices (delta) and stock return volatility (vega). Large deltas discourage managerial risk‐taking, while large vegas encourage risk‐taking. Theory suggests that short‐maturity debt mitigates agency costs of debt by constraining managerial risk preferences. We posit and find evidence of a negative (positive) relation between CEO portfolio deltas (vegas) and short‐maturity debt. We also find that short‐maturity debt mitigates the influence of vega‐ and delta‐related incentives on bond yields. Overall, our empirical evidence shows that short‐term debt mitigates agency costs of debt arising from compensation risk.