Knowledge that Transforms

Using finite mixture models, we find that financial distress is related to realized return negatively (positively) for one (the other) latent group. The negative (positive) relation concentrates in firms with large negative (positive) realized return; the likelihood for a firm to be in the latent group with a positive relation is negatively related to its price-to-value ratio estimate and mispricing score, both of which measure relative mispricing. The mispricing-correction component of realized return is negative (positive) for overvalued (undervalued) firms and decreases (increases) with corrected overvaluation (undervaluation). Overall, our findings are consistent with the view that mispricing—undervaluation and overvaluation—is larger for firms with higher financial distress. Evident in our findings, an overall negative relation between financial distress and realized return is driven by the negative relation between financial distress and the mispricing-correction component for overvalued firms and, therefore, it is not at odds with the risk-reward paradigm. • The relation between distress and realized return is positive (negative) for undervalued (overvalued) firms. • The negative overall relation between distress and realized return does not contradict the risk-reward paradigm. • Zhuo (June) Cheng acknowledges financial support from Hong Kong SAR Research Grants Council, China (#15506018).

We examine the impact of institutional democracy on firm value through the lens of dividend policies. Using instrumental variables, we find strong evidence that democracy improves dividends in an international sample of 18,410 unique firms across 63 countries over the 1991–2018 period. This effect is more pronounced for firms with high agency costs, or those in countries with weak legal protection for shareholders. Our evidence is robust to alternative measures of democracy and a battery of tests addressing the challenges associated with the instruments. Furthermore, dividends are capitalized at a higher rate in more democratic countries, especially for firms with high growth options. To the extent that investors are willing to pay a premium for firms that distribute more dividends, the democracy-induced dividends add to corporate value beyond the premium associated with shareholder rights-induced dividends. Overall, our results highlight that institutional democracy is an important, yet unexplored, determinant of corporate valuation.

We provide the most comprehensive analysis to date of the relation between ESG ratings and stock returns, using 16,000+ stocks in 48 countries and seven different ESG rating providers. We find very little evidence that ESG ratings are related to global stock returns between 2001 and 2020. This finding obtains across different regions, time periods, ESG (sub)ratings, ESG momentum, ESG downgrades and upgrades, and best-in-class strategies. We further find little empirical support for prominent hypotheses from the literature on the role of ESG uncertainty and of country-level ESG social norms, ESG disclosure standards, and ESG regulations in shaping the relation between ESG and global stock returns. Overall, our results suggest that ESG investing did not systematically affect investment performance during the past two decades.

We use microeconomic theory to describe the inner workings of Constant Function Market Makers (CFMMs). We show that standard results from consumer theory apply in this new context, endowing us with powerful tools to characterize the optimal design of CFMMs. We employ them to analyze the externalities that traders and liquidity providers exert on each other when interacting through a CFMM. Liquidity providers reduce the execution costs by flattening the bonding curve on which trades are executed. Arbitrageurs impose an adverse selection cost on liquidity providers by unfavorably rebalancing their portfolio. We show that the strengths of these two externalities are pinned down by the curvature of the bonding curve and are inversely related to each other, thereby identifying the fundamental economic tradeoff that market designers have to address.

This paper provides evidence of a new cost of fire sales: zombie lending by banks. Banks with high market share are more likely to internalize the negative spillovers of falling collateral prices during a fire sale. To prevent prices from falling further during a fire sale, these banks do not liquidate defaulted firms and instead give zombie loans to keep them alive. Using structural breaks in real estate prices to identify periods of fire sales in different MSAs, we provide evidence that banks with high market share give zombie loans to firms with relatively higher real estate assets during a fire sale. Further, congestion due to zombie firms in an industry reduces the investment and profitability of healthier firms. Overall, we highlight a new mechanism for zombie lending resulting from reduced collateral liquidation in markets prone to fire sales.

Exploiting staggered changes in state-level corporate income taxes, we document that corporate social responsibility (CSR) performance improves substantially following tax cuts, reflecting firms' reliance on internal funds for CSR investments. However, tax increases do not significantly weaken CSR performance, implying that CSR commitments are sticky on the upside. Tax cuts enhance CSR performance more for firms with greater tax exposure, tighter financial constraints, better corporate governance, stronger prosocial preferences, or higher risk. Additional analysis of the 2017 federal tax reform substantiates the CSR effect of tax cuts. Overall, our findings highlight essential CSR features and illustrate how corporate tax policy drives corporate sustainability.

The market reaction to nonroutine trades by executives and directors is conventionally viewed as increasing in the market’s assessment of insider informativeness about firm value. Using the market reaction as our instrument, we test the proposition that female directors appointed after Norway’s pioneering board gender-balancing quota law exhibit a degree of informativeness similar to that of male directors. Consistent with this proposition, we first show that the average market reaction to female director purchases jumps from a prequota value of zero to a level similar to that of male directors. Second, the market reaction is increasing in the board’s director network connectivity (but not in director busyness). Third, regardless of gender, the positive post-quota market reaction to insider purchases does not translate into holding-period adjusted abnormal performance. Fourth, insider purchase activity by both male and female directors increases significantly during the year following the 2008 financial crisis (when boards were already gender-balanced). This gender-neutral increase in insider purchases caused by the exogenous market-wide stock price drop further suggests that female directors are as informed as their male counterparts about firm value.

This paper examines the influence of stakeholder orientation on the shareholder-employee conflict characterized by the propensity of firms to engage in share purchases and leave employee pensions underfunded. Utilizing the enactment of US state-level constituency statutes, we find that firms in states that have adopted constituency statutes exhibit a weaker share repurchase-pension underfunding propensity, especially those with high default risk. The mechanism is through union intervention and labor representatives on boards. The effect is moderated for firms headquartered in high-social-capital regions, operating with higher human capital, possessing a history of employee litigation, and maintaining lower and short-horizon institutional ownership. After implementing constituency statutes, share repurchase announcements are associated with lower returns for firms with higher pension deficits. Our findings suggest that stakeholder orientation can discipline the shareholder-employee conflict.

This paper examines whether major corporate customers curb corporate carbon emissions along the supply chain. We show that suppliers with a more concentrated customer base have significantly lower carbon emissions. The results are robust to alternative measures of carbon emissions and customer concentration, alternative sample, alternative explanation, and various approaches to mitigate endogeneity concerns. The effect is more pronounced when major customers have made emission-reduction commitment, when they are exposed to greater climate regulatory shocks and risks, and when they become more concerned about regulatory scrutiny. Moreover, the curbing effect of major customers on supplier carbon emissions is stronger when customers have lower switching costs and stronger bargaining power over suppliers. We show that one way through which suppliers reduce emissions is by adopting green technologies. Our study highlights the role of major customers in facilitating the transition to a low-carbon economy through decarbonization along the supply chain.

This study examines the impact of partisan control of the United States Congress on corporations and the economy. The findings indicate that economic performance is weaker when neither party holds a majority in both chambers of Congress, resulting in a divided Congress. We propose that this outcome may be attributed to a decrease in the level and quality of regulation during divided Congress terms. To analyze the immediate effects of regulation on the economy, we leverage congressional recess periods as a source of exogenous variation. Consistent with the conjecture that the composition of Congress affects the economy through its regulatory activity, we demonstrate that a divided Congress negatively impacts economic performance when Congress is in session but has no significant effect during recesses (when regulation does not occur). In conclusion, congressional cycles and the presence of effective regulation are shown to be crucial factors influencing economic activity.