Pricing Poseidon: Extreme Weather Uncertainty and Firm Return Dynamics
Version of Record online: 1/13/2025 | DOI: 10.1111/jofi.13416
MATHIAS S. KRUTTLI, BRIGITTE ROTH TRAN, SUMUDU W. WATUGALA
We empirically analyze firm‐level uncertainty generated from extreme weather events, guided by a theoretical framework. Stock options of firms with establishments in a hurricane's (forecast) landfall region exhibit large implied volatility increases, reflecting significant uncertainty (before) after impact. Volatility risk premium dynamics reveal that investors underestimate such uncertainty. This underreaction diminishes for hurricanes after Sandy, a salient event that struck the U.S. financial center. Despite constituting idiosyncratic shocks, hurricanes affect hit firms' expected stock returns. Textual analysis of calls between firm management, analysts, and investors reveals that discussions about hurricane impacts remain elevated throughout the long‐lasting high‐uncertainty period after landfall.
Version of Record online: 12/30/2024 | DOI: 10.1111/jofi.13417
INDIRA PURI
I introduce and test for preference for simplicity in choice under risk. I characterize the theory axiomatically, and derive its properties and unique predictions relative to canonical models. By designing and running theoretically motivated experiments, I document that people value simplicity in ways not fully captured by existing models that study risk premia in financial markets. Participants' risk premia increase as complexity increases, holding moments fixed; their dominance violations increase in complexity; their behavior is predicted by simplicity's characterizing axiom; and their complexity aversion is heterogeneous in cognitive ability. None of expected utility theory, cumulative prospect theory, prospect theory, rational inattention, sparsity, salience, or probability weighting that differs by number of outcomes fully capture the experimental findings. I generalize the underlying theory to additionally capture broader measures of complexity, including obfuscation, computation, and language effects.
Sustainability or Greenwashing: Evidence from the Asset Market for Industrial Pollution
Version of Record online: 12/30/2024 | DOI: 10.1111/jofi.13412
RAN DUCHIN, JANET GAO, QIPING XU
We study the asset market for pollutive plants. Firms divest pollutive plants in response to environmental pressures. Buyers are firms facing weaker environmental pressures that have supply chain relationships or joint ventures with the sellers. While pollution levels do not decline following divestitures, sellers highlight their sustainable policies in subsequent conference calls, earn higher returns as they sell more pollutive plants, and benefit from higher Environmental, Social, and Governance (ESG) ratings and lower compliance costs. Overall, the asset market allows firms to redraw their boundaries in a manner perceived as environmentally friendly without real consequences for pollution but with substantial gains from trade.
Sending Out an SMS: Automatic Enrollment Experiments for Overdraft Alerts
Version of Record online: 12/26/2024 | DOI: 10.1111/jofi.13404
MICHAEL D. GRUBB, DARRAGH KELLY, JEROEN NIEBOER, MATTHEW OSBORNE, JONATHAN SHAW
At‐scale field experiments at major U.K. banks show that automatic enrollment into “just‐in‐time” text alerts reduces unarranged overdraft and unpaid item charges 17% to 19% and arranged overdraft charges 4% to 8%, implying annual market‐wide savings of £170 million to £240 million. Incremental benefits from “early‐warning” alerts are statistically insignificant, although economically significant effects are not ruled out. Prior to the experiments, over half of overdrafts could have been avoided by using lower‐cost liquidity available in savings and credit card accounts. Alerts help consumers achieve less than half of these potential savings.
Intermediary Leverage Shocks and Funding Conditions
Version of Record online: 12/23/2024 | DOI: 10.1111/jofi.13407
JEAN‐SÉBASTIEN FONTAINE, RENÉ GARCIA, SERMIN GUNGOR
The aggregate leverage of broker‐dealers responds to demand and supply disturbances that have opposite effects on financial markets. Specifically, leverage supply shocks that relax broker‐dealers' funding constraints increase leverage, liquidity, and returns and carry a positive price of risk, while leverage demand shocks also increase leverage but reduce liquidity and returns and carry a negative price of risk. Disentangling demand‐ and supply‐like shocks resolves existing puzzles around the price of leverage risk and yields consistent evidence across many markets of a central role for intermediation frictions and dealers' aggregate leverage in asset pricing.
Bank Funding Risk, Reference Rates, and Credit Supply
Version of Record online: 12/20/2024 | DOI: 10.1111/jofi.13411
HARRY COOPERMAN, DARRELL DUFFIE, STEPHAN LUCK, ZACHRY WANG, YILIN (DAVID) YANG
Corporate credit lines are drawn more heavily when funding markets are stressed. This elevates expected bank funding costs. We show that credit supply is dampened by the associated debt‐overhang cost to bank shareholders. Until 2022, this impact was reduced by linking the interest paid on lines to a credit‐sensitive reference rate like the London interbank offered rate (LIBOR). We show that transition to risk‐free reference rates may exacerbate this friction. The adverse impact on credit supply is offset if drawdowns are expected to be deposited at the same bank, which happened at some of the largest banks during the global financial crisis and COVID recession.
Version of Record online: 12/20/2024 | DOI: 10.1111/jofi.13410
ROBIN GREENWOOD, MARCO SAMMON
The abnormal return associated with a stock being added to the S&P 500 has fallen from an average of 7.4% in the 1990s to less than 1% over the past decade. This has occurred despite a significant increase in the share of stock market assets linked to the index. A similar pattern has occurred for index deletions, with large negative abnormal returns during the 1990s but an average return of only 0.1% between 2010 and 2020. We investigate the drivers of this phenomenon and discuss implications for market efficiency. We document a similar decline in the index effect among other families of indices.
The Global Credit Spread Puzzle
Version of Record online: 12/20/2024 | DOI: 10.1111/jofi.13409
JING‐ZHI HUANG, YOSHIO NOZAWA, ZHAN SHI
We examine the ability of structural models to predict credit spreads using global default data and security‐level credit spread data in eight developed economies. We find that two representative, pure default‐risk models tend to underpredict the average credit spreads on investment‐grade (IG) bonds, especially their spreads over government bonds, thereby providing evidence for a “global credit spread puzzle.” However, a model incorporating endogenous liquidity in the secondary debt market helps mitigate the puzzle. Furthermore, the model captures certain determinants of corporate bond market frictions across the eight economies and substantially improves the cross‐sectional fit of individual IG credit spreads.
Decentralized Exchange: The Uniswap Automated Market Maker
Version of Record online: 12/20/2024 | DOI: 10.1111/jofi.13405
ALFRED LEHAR, CHRISTINE PARLOUR
Uniswap is a system of smart contracts on the Ethereum blockchain and is the largest decentralized exchange with a liquidity balance worth up to 4 billion USD and daily trading volume of up to 7 billion USD. It is a new model of liquidity provision, so‐called automated market making. For this new market form, we characterize equilibrium in the liquidity pools. We collect all 95.8 million Uniswap interactions and compare this automated market maker (AMM) to a centralized limit order book. We document absence of long‐lived arbitrage opportunities, and show conditions under which the AMM dominates a limit order market.
Version of Record online: 12/18/2024 | DOI: 10.1111/jofi.13415
STEFANO GIGLIO, DACHENG XIU, DAKE ZHANG
We show that two important issues in empirical asset pricing—the presence of weak factors and the selection of test assets—are deeply connected. Since weak factors are those to which test assets have limited exposure, an appropriate selection of test assets can improve the strength of factors. Building on this insight, we introduce supervised principal component analysis (SPCA), a methodology that iterates supervised selection, principal‐component estimation, and factor projection. It enables risk premia estimation and factor model diagnosis even when weak factors are present and not all factors are observed. We establish SPCA's asymptotic properties and showcase its empirical applications.
Working More to Pay the Mortgage: Household Debt, Interest Rates, and Family Labor Supply
Version of Record online: 12/16/2024 | DOI: 10.1111/jofi.13413
Michał Zator
I show that households work and earn more (less) when their floating‐rate mortgage payments quasi‐exogenously increase (decrease). The response is sizable and asymmetric: on average, households adjust their income by 35% of the change in their mortgage payment, but the response is significantly stronger following an increase in payments. While men in dual‐earner, childless households respond the most on average, the asymmetry is most pronounced for women and young workers, who respond particularly strongly to payment increases. The asymmetry of the labor supply elasticity may help explain the wide range of elasticities found in previous research.
Dynamic Competition in Negotiated Price Markets
Version of Record online: 12/13/2024 | DOI: 10.1111/jofi.13408
JASON ALLEN, SHAOTENG LI
Personal Communication in an Automated World: Evidence from Loan Repayments
Version of Record online: 11/28/2024 | DOI: 10.1111/jofi.13388
CHRISTINE LAUDENBACH, STEPHAN SIEGEL
We examine the effect of personal, two‐way communication on the payment behavior of delinquent borrowers. Borrowers who speak with a randomly assigned bank agent are significantly more likely to successfully resolve the delinquency relative to borrowers who do not speak with a bank agent. Call characteristics related to the human touch of the call, such as the likeability of the agent's voice, significantly affect payment behavior. Borrowers who speak with a bank agent are also significantly less likely to become delinquent again. Our findings highlight the value of a human element in interactions between financial institutions and their customers.
Private Equity and Financial Stability: Evidence from Failed‐Bank Resolution in the Crisis
Version of Record online: 11/27/2024 | DOI: 10.1111/jofi.13399
EMILY JOHNSTON‐ROSS, SONG MA, MANJU PURI
This paper investigates the role of private equity (PE) in failed‐bank resolutions after the 2008 financial crisis, using proprietary Federal Deposit Insurance Corporation failed‐bank acquisition data. PE investors made substantial investments in underperforming and riskier failed banks, particularly in geographies where local banks were also distressed, filling the gap created by a weak, undercapitalized banking sector. Using a quasi‐random empirical design based on detailed bidding information, we show that PE‐acquired banks performed better ex post, with positive real effects for the local economy. Overall, PE investors played a positive role in stabilizing the financial system through their involvement in failed‐bank resolution.
Scope, Scale, and Concentration: The 21st‐Century Firm
Version of Record online: 11/4/2024 | DOI: 10.1111/jofi.13400
GERARD HOBERG, GORDON M. PHILLIPS
We provide evidence using firm 10‐Ks that over the past 30 years, U.S. firms have expanded their scope of operations. Increases in scope were achieved largely without increasing traditional operating segments. Scope expansion significantly increases valuation and is realized primarily through acquisitions and investment in R&D, but not through capital expenditures. Traditional concentration ratios do not capture this expansion of scope. Our findings point to a new type of firm that increases scope through related expansion, which is highly valued by the market.
Version of Record online: 10/27/2024 | DOI: 10.1111/jofi.13401
JONATHAN BROGAARD, MATTHEW C. RINGGENBERG, DOMINIK ROESCH
Although algorithmic trading now dominates financial markets, some exchanges continue to use human floor traders. On March 23, 2020 the NYSE suspended floor trading because of COVID‐19. Using a difference‐in‐differences analysis around the closure of the floor, we find that floor traders are important contributors to market quality. The suspension of floor trading leads to higher spreads and larger pricing errors for treated stocks relative to control stocks. To explore the mechanism, we exploit two partial floor reopenings that have different characteristics. Our finding suggests that in‐person human interaction facilitates the transfer of valuable information that algorithms lack.
Equilibrium Data Mining and Data Abundance
Version of Record online: 10/27/2024 | DOI: 10.1111/jofi.13397
JÉRÔME DUGAST, THIERRY FOUCAULT
We study theoretically how the proliferation of new data (“data abundance”) affects the allocation of capital between quantitative and nonquantitative asset managers (“data miners” and “experts”), their performance, and price informativeness. Data miners search for predictors of asset payoffs and select those with a sufficiently high precision. Data abundance raises the precision of the best predictors, but it can induce data miners to search less intensively for high‐precision signals. In this case, their performance becomes more dispersed and they receive less capital. Nevertheless, data abundance always raises price informativeness and can therefore reduce asset managers' average performance.
Carbon Returns across the Globe
Version of Record online: 10/21/2024 | DOI: 10.1111/jofi.13402
SHAOJUN ZHANG
The pricing of carbon transition risk is central to the debate on climate‐aware investments. Emissions are tightly linked to sales and are available to investors only with significant lags. The positive carbon return, or brown‐minus‐green return differential, documented in previous studies arises from forward‐looking firm performance information contained in emissions rather than a risk premium in ex ante expected returns. After accounting for the data release lag, carbon returns turn negative in the United States and insignificant globally. Developed markets experience lower carbon returns due to intense climate concern shocks, while countries with stringent climate policies exhibit higher carbon returns.