Leverage Dynamics without Commitment
Published: 1/13/2021 | DOI: 10.1111/jofi.13001
PETER M. DEMARZO, ZHIGUO HE
We characterize equilibrium leverage dynamics in a trade‐off model in which the firm can continuously adjust leverage and cannot commit to a policy ex ante. While the leverage ratchet effect leads shareholders to issue debt gradually over time, asset growth and debt maturity cause leverage to mean‐revert slowly toward a target. Investors anticipate future debt issuance and raise credit spreads, fully offsetting the tax benefits of new debt. Shareholders are therefore indifferent toward the debt maturity structure, even though their choice significantly affects credit spreads, leverage levels, the speed of adjustment, future investment, and growth.
Mutual Fund Holdings of Credit Default Swaps: Liquidity, Yield, and Risk
Published: 12/22/2020 | DOI: 10.1111/jofi.12996
WEI JIANG, JITAO OU, ZHONGYAN ZHU
This study analyzes the motivations for and consequences of funds' credit default swap (CDS) investments using mutual funds' quarterly holdings from pre‐ to postfinancial crisis. Funds invest in CDS when facing unpredictable liquidity needs. Funds sell more in reference entities when the CDS is liquid relative to the underlying bonds and buy more when the CDS‐bond basis is more negative. To enhance yield, funds engage in negative basis trading and sell CDS with the highest spreads within rating categories, and with spreads higher than those of their bond portfolios. Funds with superior portfolio returns also demonstrate more skill in CDS trading.
The Misguided Beliefs of Financial Advisors
Published: 12/20/2020 | DOI: 10.1111/jofi.12995
JUHANI T. LINNAINMAA, BRIAN T. MELZER, ALESSANDRO PREVITERO
A common view of retail finance is that conflicts of interest contribute to the high cost of advice. Within a large sample of Canadian financial advisors and their clients, however, we show that advisors typically invest personally just as they advise their clients. Advisors trade frequently, chase returns, prefer expensive and actively managed funds, and underdiversify. Advisors' net returns of −3% per year are similar to their clients' net returns. Advisors do not strategically hold expensive portfolios only to convince clients to do the same; they continue to do so after they leave the industry.
The Private Production of Safe Assets
Published: 12/18/2020 | DOI: 10.1111/jofi.12997
MARCIN KACPERCZYK, CHRISTOPHE PÉRIGNON, GUILLAUME VUILLEMEY
Using high‐frequency, granular panel data on short‐term debt securities issued in Europe, we study the existence, empirical boundaries, and fragility of private assets' safety. We show that only securities with the shortest maturities, issued by banks (certificates of deposit, or CDs), benefit from a safety premium. The supply of such CDs responds positively to excess safety demand. During periods of stress, this relation vanishes for all issuers of private securities, even though their aggregate volumes do not collapse. Other dimensions of heterogeneity, including issuers' balance sheets or their domicile countries' fiscal capacity, are less relevant for private safety.
Limited Risk Sharing and International Equity Returns
Published: 12/16/2020 | DOI: 10.1111/jofi.12994
SHAOJUN ZHANG
Limited stock market participation can potentially explain the disconnect between international asset prices and macro quantities. An incomplete markets model in which risk sharing for stockholders is high generates highly correlated equity returns and relatively smooth exchange rates. Risk sharing for nonstockholders is limited because of their nonparticipation in stock markets and borrowing constraints, reducing the aggregate consumption correlation and the correlation between aggregate consumption differentials and exchange rates. Financial integration widens the disconnect by benefiting stockholders but hurting nonstockholders. Survey data indicate that international risk sharing for stockholders is better than that for nonstockholders, consistent with the predictions.
The Perception of Dependence, Investment Decisions, and Stock Prices
Published: 12/13/2020 | DOI: 10.1111/jofi.12993
MICHAEL UNGEHEUER, MARTIN WEBER
How do investors perceive dependence between stock returns; and how does their perception of dependence affect investments and stock prices? We show experimentally that investors understand differences in dependence, but not in terms of correlation. Participants invest as if applying a simple counting heuristic for the frequency of comovement. They diversify more when the frequency of comovement is lower even if correlation is higher due to dependence in the tails. Building on our experimental findings, we empirically analyze U.S. stock returns. We identify a robust return premium for stocks with high frequencies of comovement with the market return.
Published: 12/11/2020 | DOI: 10.1111/jofi.12992
DANIEL L. GREENWALD, TIM LANDVOIGT, STIJN VAN NIEUWERBURGH
Shared appreciation mortgages (SAMs) feature mortgage payments that adjust with house prices. They are designed to stave off borrower default by providing payment relief when house prices fall. Some argue that SAMs may help prevent the next foreclosure crisis. However, home owners' gains from payment relief are mortgage lenders' losses. A general equilibrium model in which financial intermediaries channel savings from saver to borrower households shows that indexation of mortgage payments to aggregate house prices increases financial fragility, reduces risk‐sharing, and leads to expensive financial sector bailouts. In contrast, indexation to local house prices reduces financial fragility and improves risk‐sharing.
Published: 12/6/2020 | DOI: 10.1111/jofi.12988
TOM GRIMSTVEDT MELING
In this paper, I explore a reform at the Oslo Stock Exchange to assess the causal effect of posttrade trader anonymity on stock liquidity and trading volume. Using a regression discontinuity approach, I find that anonymity leads to a reduction in bid‐ask spreads of 40% and an increase in trading volume of more than 50%. The increase in trading volume is accounted for largely by increased trading activity by institutional investors, while retail investors do not adjust their trading behavior in response to anonymity. The results suggest that posttrade anonymity positively affects standard measures of market quality.
Liquidity Supply in the Corporate Bond Market
Published: 12/5/2020 | DOI: 10.1111/jofi.12991
JONATHAN GOLDBERG, YOSHIO NOZAWA
This paper examines dealer inventory capacity, or liquidity supply, as a driver of liquidity and expected returns in the corporate bond market. We identify shocks to aggregate liquidity supply using data on corporate bond yields and dealer positions. Liquidity supply shocks lead to persistent changes in market liquidity, are correlated with proxies for dealer financial constraints, and have significant explanatory power for cross‐sectional and time‐series variation in expected returns, beyond standard risk factors. Our findings point to liquidity supply by financially constrained intermediaries as a main driver of market liquidity and asset prices.
Public Thrift, Private Perks: Signaling Board Independence with Executive Pay
Published: 11/27/2020 | DOI: 10.1111/jofi.12989
PABLO RUIZ‐VERDÚ, RAVI SINGH
We analyze how boards' reputational concerns influence executive compensation and the use of hidden pay. Independent boards reduce disclosed pay to signal their independence, but are more likely than manager‐friendly boards to use hidden pay or to distort incentive contracts. Stronger reputational pressures lead to lower disclosed pay, weaker managerial incentives, and higher hidden pay, whereas greater transparency of executive compensation has the opposite effects. Although reputational concerns can induce boards to choose compensation contracts more favorable to shareholders, we show that there is a threshold beyond which stronger reputational concerns harm shareholders. Similarly, excessive pay transparency can harm shareholders.
The Impact of Repossession Risk on Mortgage Default
Published: 11/25/2020 | DOI: 10.1111/jofi.12990
TERRY O'MALLEY
I study the effect of removing repossession risk on a mortgagor's decision to default. Reducing default costs may result in strategic default, particularly during crises when homeowners can be substantially underwater. I analyze difference‐in‐differences variation in repossession risk generated by an unexpected legal ruling in Ireland that prohibited collateral enforcement on delinquent residential mortgages originated before a particular date. I estimate that borrowers defaulted by 0.3 percentage points more each quarter after the ruling, a relative increase of approximately one‐half. High loan‐to‐value ratios and low liquidity are associated with a larger treatment effect, suggesting both equity and consumption‐based motivations.
Equilibrium Asset Pricing with Leverage and Default
Published: 11/23/2020 | DOI: 10.1111/jofi.12987
JOÃO F. GOMES, LUKAS SCHMID
We develop a general equilibrium model linking the pricing of stocks and corporate bonds to endogenous movements in corporate leverage and aggregate volatility. The model features heterogeneous firms making optimal investment and financing decisions and connects fluctuations in macroeconomic quantities and asset prices to movements in the cross section of firms. Empirically plausible movements in leverage produce realistic asset return dynamics. Countercyclical leverage drives predictable variation in risk premia, and debt‐financed growth generates a high value premium. Endogenous default produces countercyclical aggregate volatility and credit spread movements that are propagated to the real economy through their effects on investment and output.
Model‐Free International Stochastic Discount Factors
Published: 8/8/2020 | DOI: 10.1111/jofi.12970
MIRELA SANDULESCU, FABIO TROJANI, ANDREA VEDOLIN
We provide a theoretical framework to uncover in a model‐free way the relationships among international stochastic discount factors (SDFs), stochastic wedges, and financial market structures. Exchange rates are in general different from the ratio of international SDFs in incomplete markets, as captured by a stochastic wedge. We show theoretically that this wedge can be zero in incomplete and integrated markets. Market segmentation breaks the strong link between exchange rates and international SDFs, which helps address salient features of international asset returns while keeping the volatility and cross‐country correlation of SDFs at moderate levels.