Showing papers in "Journal of Finance in 2019"
TL;DR: In this paper, the authors present causal evidence that investors marketwide value sustainability: being categorized as low sustainability resulted in net outflows of more than $12 billion while being classified as high sustainability led to net inflows of over $24 billion.
Abstract: Examining a shock to the salience of the sustainability of the U.S. mutual fund market, we present causal evidence that investors marketwide value sustainability: being categorized as low sustainability resulted in net outflows of more than $12 billion while being categorized as high sustainability led to net inflows of more than $24 billion. Experimental evidence suggests that sustainability is viewed as positively predicting future performance, but we do not find evidence that high‐sustainability funds outperform low‐sustainability funds. The evidence is consistent with positive affect influencing expectations of sustainable fund performance and nonpecuniary motives influencing investment decisions.
381 citations
TL;DR: This article found that individuals who personally experience unemployment become more pessimistic about future nationwide unemployment, and the extent of extrapolation is unrelated to how informative personal experiences are, is inconsistent with risk adjustment, and is more pronounced for less sophisticated individuals.
Abstract: Using novel survey data, we document that individuals extrapolate from recent personal experiences when forming expectations about aggregate economic outcomes. Recent locally experienced house price movements affect expectations about future U.S. house price changes and higher experienced house price volatility causes respondents to report a wider distribution over expected U.S. house price movements. When we exploit within‐individual variation in employment status, we find that individuals who personally experience unemployment become more pessimistic about future nationwide unemployment. The extent of extrapolation is unrelated to how informative personal experiences are, is inconsistent with risk adjustment, and is more pronounced for less sophisticated individuals.
125 citations
TL;DR: In this article, the authors show that since 1994, the equity premium is earned entirely in weeks 0, 2, 4, and 6 in Federal Open Market Committee (FOMC) cycle time, that is, even weeks starting from the last FOMC meeting.
Abstract: We document that since 1994, the equity premium is earned entirely in weeks 0, 2, 4, and 6 in Federal Open Market Committee (FOMC) cycle time, that is, even weeks starting from the last FOMC meeting. We causally tie this fact to the Fed by studying intermeeting target changes, Fed funds futures, and internal Board of Governors meetings. The Fed has affected the stock market via unexpectedly accommodating policy, leading to large reductions in the equity premium. Evidence suggests systematic informal communication of Fed officials with the media and financial sector as a channel through which news about monetary policy has reached the market.
114 citations
TL;DR: In this article, the authors analyze the contribution to price discovery of market and limit orders by high-frequency traders and non-HFTs and find that HFTs submit the bulk of limit orders and these limit orders provide most of price discovery.
Abstract: We analyze the contribution to price discovery of market and limit orders by high‐frequency traders (HFTs) and non‐HFTs. While market orders have a larger individual price impact, limit orders are far more numerous. This results in price discovery occurring predominantly through limit orders. HFTs submit the bulk of limit orders and these limit orders provide most of the price discovery. Submissions of limit orders and their contribution to price discovery fall with volatility due to changes in HFTs’ behavior. Consistent with adverse selection arising from faster reactions to public information, HFTs’ informational advantage is partially explained by public information.
105 citations
TL;DR: In this article, Choi et al. showed that politicians can increase the amount of government resources allocated through their social networks to the benefit of private firms connected to these networks, and that contracts allocated to connected private firms are executed systematically worse and exhibit more frequent cost increases through renegotiations.
Abstract: Exploiting a unique institutional setting in Korea, this paper documents that politicians can increase the amount of government resources allocated through their social networks to the benefit of private firms connected to these networks. After winning the election, the new president appoints members of his networks as CEOs of state‐owned firms that act as intermediaries in allocating government contracts to private firms. In turn, these state firms allocate significantly more procurement contracts to private firms with a CEO from the same network. Contracts allocated to connected private firms are executed systematically worse and exhibit more frequent cost increases through renegotiations.
104 citations
TL;DR: The authors empirically studied portfolio manager compensation structures in the U.S. mutual fund industry and found that about threequarters of portfolio managers receive explicit performance-based incentives from the investment advisors.
Abstract: This paper empirically studies portfolio manager compensation structures in the U.S. mutual fund industry. Using a unique hand-collected dataset on over 4,000 mutual funds, we find that about threequarters of portfolio managers receive explicit performance-based incentives from the investment advisors. Our cross-sectional investigation suggests that portfolio manager compensation structures are broadly consistent with an optimal contracting equilibrium. In particular, explicit performancebased incentives are more prevalent in scenarios where this incentive mechanism is more valuable or alternative incentive mechanisms, such as labor market discipline, are less effective. Specifically, our results show that explicit performance-based incentives are more common when (i) the investment advisors are larger or have more complex business models, (ii) the fund returns are less volatile, (iii) the portfolio managers are not the stakeholders of the advisors, (iv) the funds are managed by a team rather than an individual, and (v) the funds are not outsourced to an external sub-advisory firm. Overall, our study provides novel empirical evidence on optimal contracting in the delegated asset management industry.
101 citations
TL;DR: In this paper, the authors model a financial market where some traders of a risky asset do not fully appreciate what prices convey about others' private information, and show that making private information public raises rational and "dismissive" volume, but reduces cursed volume given moderate non-informational trading motives.
Abstract: We model a financial market where some traders of a risky asset do not fully appreciate what prices convey about others' private information. Markets comprising solely such “cursed” traders generate more trade than those comprising solely rationals. Because rationals arbitrage away distortions caused by cursed traders, mixed markets can generate even more trade. Per-trader volume in cursed markets increases with market size; volume may instead disappear when traders infer others' information from prices, even when they dismiss it as noisier than their own. Making private information public raises rational and “dismissive” volume, but reduces cursed volume given moderate noninformational trading motives.
100 citations
TL;DR: This paper applied the least absolute shrinkage and selection operator (LASSO) to make rolling one-minute-ahead return forecasts using the entire cross-section of lagged returns as candidate predictors.
Abstract: This paper applies the Least Absolute Shrinkage and Selection Operator (LASSO) to make rolling one‐minute‐ahead return forecasts using the entire cross‐section of lagged returns as candidate predictors. The LASSO increases both out‐of‐sample fit and forecast‐implied Sharpe ratios. This out‐of‐sample success comes from identifying predictors that are unexpected, short‐lived, and sparse. Although the LASSO uses a statistical rule rather than economic intuition to identify predictors, the predictors it identifies are nevertheless associated with economically meaningful events: the LASSO tends to identify as predictors stocks with news about fundamentals.
99 citations
TL;DR: This paper revisited La Porta's (1996) finding that returns on stocks with the most optimistic analyst long term earnings growth forecasts are substantially lower than those for stocks having the most pessimistic forecasts, and presented several further facts about the joint dynamics of fundamentals, expectations and returns for these portfolios.
Abstract: We revisit La Porta’s (1996) finding that returns on stocks with the most optimistic analyst long term earnings growth forecasts are substantially lower than those for stocks with the most pessimistic forecasts. We document that this finding still holds, and present several further facts about the joint dynamics of fundamentals, expectations, and returns for these portfolios. We explain these facts using a new model of belief formation based on a portable formalization of the representativeness heuristic. In this model, analysts forecast future fundamentals from the history of earnings growth, but they over-react to news by exaggerating the probability of states that have become objectively more likely. Intuitively, fast earnings growth predicts future Googles but not as many as analysts believe. We test predictions that distinguish this mechanism from both Bayesian learning and adaptive expectations, and find supportive evidence. A calibration of the
model offers a satisfactory account of the key patterns in fundamentals, expectations, and returns.
97 citations
TL;DR: The authors investigated the underlying economic mechanisms and found that common institutional investment styles (e.g., risk management, momentum trading) explain a significant portion of the relation between institutions and sentiment.
Abstract: Recent work suggests that sentiment traders shift from safer to more speculative stocks when sentiment increases. Exploiting these cross‐sectional patterns and changes in share ownership, we find that sentiment metrics capture institutional rather than individual investors’ demand shocks. We investigate the underlying economic mechanisms and find that common institutional investment styles (e.g., risk management, momentum trading) explain a significant portion of the relation between institutions and sentiment.
95 citations
TL;DR: In this article, the authors demonstrate that the funding value adjustments (FVAs) of major dealers are debt overhang costs to their shareholders, and that to maximize shareholder value, dealer quotations therefore adjust for FVAs.
Abstract: In this paper, we demonstrate that the funding value adjustments (FVAs) of major dealers are debt overhang costs to their shareholders. To maximize shareholder value, dealer quotations therefore adjust for FVAs. Our case studies include interest‐rate swap FVAs and violations of covered interest parity. Contrary to current valuation practice, FVAs are not themselves components of the market values of the positions being financed. Current dealer practice does, however, align incentives between trading desks and shareholders. We also establish a pecking order for preferred asset financing strategies and provide a new interpretation of the standard debit value adjustment.
TL;DR: The authors found that consumers often purchase dominated bonds and brokers are incentivized to sell the dominated bonds, typically earning two times greater fees for selling them, and developed and estimated a broker-intermediated search model that rationalizes this behavior.
Abstract: I study how brokers distort household investment decisions. Using a novel convertible bond data set, I find that consumers often purchase dominated bonds—cheap and expensive otherwise‐identical bonds coexist in the market. Brokers are incentivized to sell the dominated bonds, typically earning two times greater fees for selling them. I develop and estimate a broker‐intermediated search model that rationalizes this behavior. The estimates indicate that costly search is a key friction in financial markets, but the effects of search costs are compounded when brokers are incentivized to direct the search of consumers toward high‐fee inferior products.
TL;DR: In this article, the authors derive a formula for the expected return on a stock in terms of the risk-neutral variance of the market and the stock's excess risk neutral variance relative to that of the average stock.
Abstract: We derive a formula for the expected return on a stock in terms of the risk-neutral variance of the market and the stock's excess risk-neutral variance relative to that of the average stock. These quantities can be computed from index and stock option prices; the formula has no free parameters. The theory performs well empirically both in and out of sample. Our results suggest that there is considerably more variation in expected returns, over time and across stocks, than has previously been acknowledged.
TL;DR: In this article, the authors characterize the optimal mix of short and long-term compensation along the manager's tenure, the optimal vesting period of incentive pay, and the dynamics of short-termism over the CEO's tenure.
Abstract: This paper studies optimal contracts when managers manipulate their performance measure at the expense of firm value. Optimal contracts defer compensation. The manager's incentives vest over time at an increasing rate, and compensation becomes very sensitive to short‐term performance. This generates an endogenous horizon problem whereby managers intensify performance manipulation in their final years in office. Contracts are designed to encourage effort while minimizing the adverse effects of manipulation. We characterize the optimal mix of short‐ and long‐term compensation along the manager's tenure, the optimal vesting period of incentive pay, and the dynamics of short‐termism over the CEO's tenure.
TL;DR: This paper proposed a general equilibrium model in which central countries' consumption growth is more exposed to global consumption growth shocks, which causes the currencies of central countries to appreciate in bad times, resulting in lower interest rates and currency risk premia.
Abstract: I uncover an economic source of exposure to global risk that drives international asset prices. Countries that are more central in the global trade network have lower interest rates and currency risk premia. To explain these findings, I present a general equilibrium model in which central countries' consumption growth is more exposed to global consumption growth shocks. This causes the currencies of central countries to appreciate in bad times, resulting in lower interest rates and currency risk premia. Empirically, central countries' consumption growth covaries more with world consumption growth, further validating the proposed mechanism.
TL;DR: In this article, the authors document a highly significant, strongly nonlinear dependence of stock and bond returns on past equity market volatility as measured by the VIX and propose a new estimator for the shape of the nonlinear forecasting relationship that exploits variation in the cross-section of returns.
Abstract: We document a highly significant, strongly nonlinear dependence of stock and bond returns on past equity market volatility as measured by the VIX. We propose a new estimator for the shape of the nonlinear forecasting relationship that exploits variation in the cross‐section of returns. The nonlinearities are mirror images for stocks and bonds, revealing flight‐to‐safety: expected returns increase for stocks when volatility increases from moderate to high levels while they decline for Treasuries. These findings provide support for dynamic asset pricing theories in which the price of risk is a nonlinear function of market volatility.
TL;DR: In this article, the authors analyze whether high-frequency traders (HFTs) lean against large institutional orders that execute through a series of child orders, and they find that HFTs initially lean against these orders but eventually change direction and take positions in the same direction for the most informed institutional orders.
Abstract: Liquidity suppliers lean against the wind. We analyze whether high-frequency traders (HFTs) lean against large institutional orders that execute through a series of child orders. The alternative is HFTs trading with the wind, that is, in the same direction. We find that HFTs initially lean against these orders but eventually change direction and take positions in the same direction for the most informed institutional orders. Our empirical findings are consistent with investors trading strategically on their information. When deciding trade intensity, they seem to trade off higher speculative profits against higher risk of being detected and preyed on by HFTs.
TL;DR: In this article, the authors proposed a theory of the profitability anomaly, where past profits forecast future returns (the profitability anomaly), and measured expectation stickiness at the firm level and found strong support for three additional model predictions: analysts are on average too pessimistic regarding the future profits of high-profit firms, stocks that are followed by stickier analysts, and stocks with more persistent profits.
Abstract: We propose a theory of the “profitability” anomaly. In our model, investors forecast future profits using a signal and sticky belief dynamics. In this model, past profits forecast future returns (the profitability anomaly). Using analyst forecast data, we measure expectation stickiness at the firm level and find strong support for three additional model predictions: (1) analysts are on average too pessimistic regarding the future profits of high‐profit firms, (2) the profitability anomaly is stronger for stocks that are followed by stickier analysts, and (3) the profitability anomaly is stronger for stocks with more persistent profits.
TL;DR: The authors empirically study whether systematic over-the-counter (OTC) market frictions drive the large unexplained common factor in yield spread changes and find that marketwide inventory, search, and bargaining frictions explain 23.4% of the variation in the common component.
Abstract: We empirically study whether systematic over‐the‐counter (OTC) market frictions drive the large unexplained common factor in yield spread changes. Using transaction data on U.S. corporate bonds, we find that marketwide inventory, search, and bargaining frictions explain 23.4% of the variation in the common component. Systematic OTC frictions thus substantially improve the explanatory power of yield spread changes and account for one‐third of their total explained variation. Search and bargaining frictions combined explain more in the common dynamics of yield spread changes than inventory frictions. Our findings support the implications of leading theories of intermediation frictions in OTC markets.
TL;DR: This paper found that a 1 percentage point increase in interest rate at the time of adjustable-rate mortgage reset results in a 2.5 percentage increase in the probability of foreclosure in the following year and that each foreclosure filing leads to an additional 0.3 to 0.6 completed foreclosures within a 0.10-mile radius.
Abstract: In this paper, I identify shocks to interest rates resulting from two administrative details in adjustable‐rate mortgage contract terms: the choice of financial index and the choice of lookback period. I find that a 1 percentage point increase in interest rate at the time of adjustable‐rate mortgage (ARM) reset results in a 2.5 percentage increase in the probability of foreclosure in the following year, and that each foreclosure filing leads to an additional 0.3 to 0.6 completed foreclosures within a 0.10‐mile radius. In explaining this result, I emphasize price effects, bank‐supply responses, and borrower responses arising from peer effects.
TL;DR: In this article, the authors show that deposit insurance removed market discipline constraining uninsured banks and increased insolvency risk and competition aggressively for deposits, and when prices fell after the war, insurance systems collapsed and suffered high losses.
Abstract: Deposit insurance reduces liquidity risk but can increase insolvency risk by encouraging reckless behavior. Several U.S. states installed deposit insurance laws before the creation of the Federal Deposit Insurance Corporation, and those laws applied only to some depository institutions within those states. These experiments present a unique testing ground for investigating the effect of deposit insurance. We show that deposit insurance removed market discipline constraining uninsured banks. Taking advantage of World War I's rise in world agricultural prices, insured banks increased their insolvency risk and competed aggressively for deposits. When prices fell after the war, the insurance systems collapsed and suffered high losses.
TL;DR: In this paper, a risk-averse entrepreneur with access to a profitable venture needs to raise funds from investors and cannot indefinitely commit her human capital to the venture, which limits the firm's debt capacity, distorts investment and compensation, and constrains the entrepreneur's risk sharing.
Abstract: A risk‐averse entrepreneur with access to a profitable venture needs to raise funds from investors. She cannot indefinitely commit her human capital to the venture, which limits the firm's debt capacity, distorts investment and compensation, and constrains the entrepreneur's risk sharing. This puts dynamic liquidity and state‐contingent risk allocation at the center of corporate financial management. The firm balances mean‐variance investment efficiency and the preservation of financial slack. We show that in general the entrepreneur's net worth is overexposed to idiosyncratic risk and underexposed to systematic risk. These distortions are greater the closer the firm is to exhausting its debt capacity.
TL;DR: In this paper, the authors investigate how capital shocks at protection sellers impact pricing in the CDS market and find that sellers' capital shocks, measured as CDS portfolio margin payments, account for 12% of the time series variation in weekly spread changes.
Abstract: Using proprietary credit default swap (CDS) data, I investigate how capital shocks at protection sellers impact pricing in the CDS market. Seller capital shocks—measured as CDS portfolio margin payments—account for 12% of the time‐series variation in weekly spread changes, a significant amount given that standard credit factors account for 18% during my sample. In addition, seller shocks possess information for spreads that is independent of institution‐wide measures of constraints. These findings imply a high degree of market segmentation, and suggest that frictions within specialized financial institutions prevent capital from flowing into the market at shorter horizons.
TL;DR: In this article, a model with priced stochastic asset risk that is able to fit medium to long-term spreads is proposed, augmented by jumps to help explain short-term spread.
Abstract: Most extant structural credit risk models underestimate credit spreads—a shortcoming known as the credit spread puzzle. We consider a model with priced stochastic asset risk that is able to fit medium‐ to long‐term spreads. The model, augmented by jumps to help explain short‐term spreads, is estimated on firm‐level data and identifies significant asset variance risk premia. An important feature of the model is the significant time variation in risk premia induced by the uncertainty about asset risk. Various extensions are considered, among them optimal leverage and endogenous default.
TL;DR: In this paper, the authors investigated the consequences of liquidation and reorganization on the allocation and subsequent utilization of assets in bankruptcy, using the random assignment of judges to bankruptcy cases as a natural experiment that forced some firms into liquidation.
Abstract: This paper investigates the consequences of liquidation and reorganization on the allocation and subsequent utilization of assets in bankruptcy. Using the random assignment of judges to bankruptcy cases as a natural experiment that forces some firms into liquidation, we find that the long‐run utilization of assets of liquidated firms is lower relative to assets of reorganized firms. These effects are concentrated in thin markets with few potential users and in areas with low access to finance. These findings suggest that when search frictions are large, liquidation can lead to inefficient allocation of assets in bankruptcy.
TL;DR: This paper showed that underfunded pension plans optimally use swaps for duration hedging, and this demand can drive swap spreads to become negative, which helps explain 30-year swap spreads.
Abstract: The 30‐year U.S. swap spreads have been negative since September 2008. We offer a novel explanation for this persistent anomaly. Through an illustrative model, we show that underfunded pension plans optimally use swaps for duration hedging. Combined with dealer banks' balance sheet constraints, this demand can drive swap spreads to become negative. Empirically, we construct a measure of the aggregate funding status of defined benefit pension plans and show that this measure helps explain 30‐year swap spreads. We find a similar link between pension funds' underfunding and swap spreads for two other regions.
TL;DR: In this article, the false discovery rate (FDR) was used to separate skill (alpha) from luck (luck) in fund performance, and they found that this methodology is conservative and underestimates the proportion of nonzero-alpha funds.
Abstract: Barras, Scaillet, and Wermers propose the false discovery rate (FDR) to separate skill (alpha) from luck in fund performance. Using simulations with parameters informed by the data, we find that this methodology is conservative and underestimates the proportion of nonzero‐alpha funds. For example, 65% of funds with economically large alphas of ±2% are misclassified as zero alpha. This bias arises from the low signal‐to‐noise ratio in fund returns and the resulting low statistical power. Our results question FDR's applicability in performance evaluation and other domains with low power, and can materially change the conclusion that most funds have zero alpha.
TL;DR: In this article, the authors show that the content of dynamic trade-off theory must depend on the commitment technology and that ex ante optimal commitments are likely to be suboptimal ex post.
Abstract: Optimal dynamic capital structure choice is fundamentally a problem of commitment. In a standard trade‐off setting with shareholder‐debtholder agency conflicts, full commitment counterfactually predicts the firm would rely almost exclusively on debt financing. Conversely, absent commitment a Modigliani‐Miller‐like value irrelevance and policy indeterminacy result holds. Thus, the content of dynamic trade‐off theory must depend on the commitment technology. In this context, collateral is valuable as a low‐cost commitment device. Because ex ante optimal commitments are likely to be suboptimal ex post, observed capital structure dynamics will exhibit hysteresis and depart significantly from standard predictions.
TL;DR: For example, the authors found that demand for dividends is systematically higher in periods of low interest rates and poor market performance, leading to lower returns for dividend-paying stocks, and that investors rarely reinvest dividends, and trade as if dividends are a separate, stable income stream.
Abstract: Many individual investors, mutual funds, and institutions trade as if dividends and capital gains are disconnected attributes, not fully appreciating that dividends result in price decreases. Behavioral trading patterns (e.g., the disposition effect) are driven by price changes instead of total returns. Investors rarely reinvest dividends, and trade as if dividends are a separate, stable income stream. Analysts fail to account for the effect of dividends on price, leading to optimistic price forecasts for dividend‐paying stocks. Demand for dividends is systematically higher in periods of low interest rates and poor market performance, leading to lower returns for dividend‐paying stocks.
TL;DR: The authors recover the model-free conditional minimum variance projection of the pricing kernel on various tradeable realized moments of market returns under mild assumptions and give insight into the cyclicality of equity premia, variance risk premia and the highest attainable Sharpe ratios under the minimum variance probability.
Abstract: Under mild assumptions, we recover the model‐free conditional minimum variance projection of the pricing kernel on various tradeable realized moments of market returns. Recovered conditional moments predict future realizations and give insight into the cyclicality of equity premia, variance risk premia, and the highest attainable Sharpe ratios under the minimum variance probability. The pricing kernel projections are often U‐shaped and give rise to optimal conditional portfolio strategies with plausible market timing properties, moderate countercyclical exposures to higher realized moments, and favorable out‐of‐sample Sharpe ratios.