Forthcoming Articles

Lazy Prices

Published: 2/22/2020  |  DOI: 10.1111/jofi.12885


Using the complete history of regular quarterly and annual filings by U.S. corporations, we show that changes to the language and construction of financial reports have strong implications for firms’ future returns and operations. A portfolio that shorts “changers” and buys “nonchangers” earns up to 188 basis points per month in alpha (over 22% per year) in the future. Moreover, changes to 10‐Ks predict future earnings, profitability, future news announcements, and even future firm‐level bankruptcies. Unlike typical underreaction patterns, we find no announcement effect, suggesting that investors are inattentive to these simple changes across the universe of public firms.

Bank Quality, Judicial Efficiency, and Loan Repayment Delays in Italy

Published: 2/20/2020  |  DOI: 10.1111/jofi.12896


Italian firms delay payment to banks weakened by past loan losses. Exploiting Credit Register data, we fully absorb borrower fundamentals with firm‐quarter effects. Identification therefore reflects firm choices to delay payment to some banks, depending upon their health. This selective delay occurs more where legal enforcement of collateral recovery is slow. Poor enforcement encourages borrowers not to pay when the value of their bank relationship comes into doubt. Selective delays occur even by firms able to pay all lenders. Credit losses in Italy have thus been worsened by the combination of weak banks and weak legal enforcement.

How Skilled Are Security Analysts?

Published: 2/20/2020  |  DOI: 10.1111/jofi.12890


The majority of security analysts are identified as skilled when the cross‐section of analyst performance is modeled as a mixture of multiple skill distributions. Analysts exhibit heterogeneous skill—some are high‐type, and some are low‐type. On average, the recommendation revisions of both types exhibit positive abnormal returns. The heterogeneity stems from differential ability to produce new information; all analysts can profitably process news. Top analysts outperform because more of their recommendations are influential (i.e., associated with statistically significant returns) and both their influential and noninfluential recommendations are more informative. A majority of research firms are also identified as skilled.

Star Ratings and the Incentives of Mutual Funds

Published: 2/20/2020  |  DOI: 10.1111/jofi.12888


We propose a theory of reputation to explain how investors rationally respond to mutual fund star ratings. A fund's performance is determined by its information advantage, which can be acquired but decays stochastically. Investors form beliefs about whether the fund is informed based on its past performance. We refer to such beliefs as fund reputation, which determines fund flows. As performance changes continuously, equilibrium fund reputation may take discrete values only and thus can be labeled with stars. Star upgrades thus imply reputation jumps, leading to discrete increases in flows and expected performance, although stars do not provide new information.

Debt Contracting on Management

Published: 2/19/2020  |  DOI: 10.1111/jofi.12893


Change of management restrictions (CMRs) in loan contracts give lenders explicit ex‐ante control rights over managerial retention and selection. This paper shows that lenders use CMRs to mitigate risks arising from CEO turnover, especially those related to the loss of human capital and replacement uncertainty, thereby providing evidence that human capital risk affects debt contracting. With a CMR in place, the likelihood of CEO turnover decreases by more than half, and future firm performance improves when retention frictions are important, suggesting that lenders can influence managerial turnover, even outside of default states, and help the borrower retain talent.

Option Profit and Loss Attribution and Pricing: A New Framework

Published: 2/19/2020  |  DOI: 10.1111/jofi.12894


This paper develops a new top‐down valuation framework that links the pricing of an option investment to its daily profit and loss attribution. The framework uses the Black‐Merton‐Scholes option pricing formula to attribute the short‐term option investment risk to variation in the underlying security price and the option's implied volatility. Taking risk‐neutral expectation and demanding no dynamic arbitrage results in a pricing relation that links an option's fair implied volatility level to the underlying's volatility level with corrections for the implied volatility's own expected direction of movement, its variance, and its covariance with the underlying security return.

Risk Management in Financial Institutions

Published: 2/17/2020  |  DOI: 10.1111/jofi.12868


We study risk management in financial institutions using data on hedging of interest rate and foreign exchange risk. We find strong evidence that institutions with higher net worth hedge more, controlling for risk exposures, across institutions and within institutions over time. For identification, we exploit net worth shocks resulting from loan losses due to declines in house prices. Institutions that sustain such shocks reduce hedging significantly relative to otherwise‐similar institutions. The reduction in hedging is differentially larger among institutions with high real estate exposure. The evidence is consistent with the theory that financial constraints impede both financing and hedging.

What Drives Anomaly Returns?

Published: 2/13/2020  |  DOI: 10.1111/jofi.12876


We decompose the returns of five well‐known anomalies into cash flow and discount rate news. Common patterns emerge across the five factor portfolios and their mean‐variance efficient (MVE) combination. Whereas discount rate news predominates in market returns, systematic cash flow news drives the returns of anomaly portfolios and their MVE combination with the market portfolio. Anomaly cash flow and discount rate shocks are largely uncorrelated with market cash flow and discount rate shocks and with business cycle fluctuations. These rich empirical patterns restrict the joint dynamics of firm cash flows and the pricing kernel, thereby informing models of stocks' expected returns.

Insider Investment Horizon

Published: 2/13/2020  |  DOI: 10.1111/jofi.12878


We examine the relation between insiders’ investment horizon and the information content of their trades with respect to future stock returns. We conjecture that an insider's investment horizon establishes a benchmark for expected patterns of continued trading behavior and thus helps identify unexpected insider trades, which should be more informative in efficient markets. Consistent with this conjecture, the trades of short‐horizon insiders are both more unexpected and more informed, on average, than those of long‐horizon insiders. Short‐horizon insiders and their firms also tend to display characteristics that are associated with a greater focus on short‐termism.

How Does Credit Supply Expansion Affect the Real Economy? The Productive Capacity and Household Demand Channels

Published: 2/12/2020  |  DOI: 10.1111/jofi.12869


Credit supply expansion can affect an economy by increasing productive capacity or by boosting household demand. In this study, we develop a test to determine if the household demand channel is present, and we implement the test using both a natural experiment in the United States in the 1980s and an international panel of 56 countries over the last several decades. Consistent with the importance of the household demand channel, we find that credit supply expansion boosts nontradable sector employment and the price of nontradable goods, with limited effects on tradable sector employment. Such credit expansions amplify the business cycle and lead to more severe recessions.

Glued to the TV: Distracted Noise Traders and Stock Market Liquidity

Published: 2/12/2020  |  DOI: 10.1111/jofi.12863


In this paper, we study the impact of noise traders’ limited attention on financial markets. Specifically, we exploit episodes of sensational news (exogenous to the market) that distract noise traders. We find that on “distraction days,” trading activity, liquidity, and volatility decrease, and prices reverse less among stocks owned predominantly by noise traders. These outcomes contrast sharply with those due to the inattention of informed speculators and market makers, and are consistent with noise traders mitigating adverse selection risk. We discuss the evolution of these outcomes over time and the role of technological changes.

High‐Frequency Trading and Market Performance

Published: 2/8/2020  |  DOI: 10.1111/jofi.12882


We study the consequences of, and potential policy responses to, high‐frequency trading (HFT) via the tradeoff between liquidity and information production. Faster speeds facilitate HFT, with consequences for this tradeoff: Information production decreases because informed traders have less time to trade before HFTs react, but liquidity (measured by the bid‐ask spread) improves because informational asymmetries decline. HFT also pushes outcomes inside the frontier of this tradeoff. However, outcomes can be restored to the frontier by replacing the limit order book with one of two alternative mechanisms: delaying all orders except cancellations or implementing frequent batch auctions.

Can Unemployment Insurance Spur Entrepreneurial Activity? Evidence from France

Published: 2/5/2020  |  DOI: 10.1111/jofi.12880


We evaluate the effect of downside insurance on self‐employment. We exploit a large‐scale reform of French unemployment benefits that insured unemployed workers starting businesses. The reform significantly increased firm creation without decreasing the quality of new entrants. Firms started postreform were initially smaller, but their employment growth, productivity, and survival rates are similar to those prereform. New entrepreneurs' characteristics and expectations are also similar. Finally, jobs created by new entrants crowd out employment in incumbent firms almost one‐for‐one, but have a higher productivity than incumbents. These results highlight the benefits of encouraging experimentation by lowering barriers to entry.

Drilling and Debt

Published: 2/5/2020  |  DOI: 10.1111/jofi.12884


This paper documents a previously unrecognized debt‐related investment distortion. Using detailed project‐level data for 69 firms in the oil and gas industry, we find that highly levered firms pull forward investment, completing projects early at the expense of long‐run project returns and project value. This behavior is particularly pronounced prior to debt renegotiations. We test several channels that could explain this behavior and find evidence consistent with equity holders sacrificing long‐run project returns to enhance collateral values and, by extension, mitigate lending frictions at debt renegotiations.

Corporate Control around the World

Published: 1/31/2020  |  DOI: 10.1111/jofi.12889


We study corporate control tracing controlling shareholders for thousands of listed firms from 127 countries over 2004‐2012. Government and family control is pervasive in civil‐law countries. Blocks are commonplace, but less so in common‐law countries. These patterns apply to large, medium, and small firms. In contrast, the development ‐ control nexus is heterogeneous; strong for large but absent for small firms. Control correlates strongly with shareholder protection, the stringency of employment contracts and unions power. Conversely, the correlations with creditor rights, legal formalism, and entry regulation appear weak. These patterns support both legal origin and political theories of financial development.

Shorting in Speculative Markets

Published: 1/27/2020  |  DOI: 10.1111/jofi.12871


In models of trading with heterogeneous beliefs following Harrison‐Kreps, short selling is prohibited and agents face constant marginal costs‐of‐carry. The resale option guarantees that prices exceed buy‐and‐hold prices and the difference is identified as a bubble. We propose a model where risk‐neutral agents face asymmetric increasing marginal costs on long and short positions. Here, agents also value an option to delay, and a Hamilton‐Jacobi‐Bellman equation quantifies the influence of costs on prices. An unexpected decrease in shorting costs may deflate a bubble, linking financial innovations that facilitated shorting of mortgage‐backed securities to the collapse of prices.

Necessary and Sufficient Conditions for Existence and Uniqueness of Recursive Utilities

Published: 1/25/2020  |  DOI: 10.1111/jofi.12877


We obtain exact necessary and sufficient conditions for existence and uniqueness of solutions of a class of homothetic recursive utility models postulated by Epstein and Zin. The conditions center on a single test value with a natural economic interpretation. The test sheds light on the relationship between valuation of cash flows, impatience, risk adjustment, and intertemporal substitution of consumption. We propose two methods to compute the test value when an analytical solution is not available. We further provide several applications.

Taming the Factor Zoo: A Test of New Factors

Published: 1/24/2020  |  DOI: 10.1111/jofi.12883


We propose a model selection method to systematically evaluate the contribution to asset pricing of any new factor, above and beyond what a high‐dimensional set of existing factors explains. Our methodology accounts for model selection mistakes that produce a bias due to omitted variables, unlike standard approaches that assume perfect variable selection. We apply our procedure to a set of factors recently discovered in the literature. While most of these new factors are shown to be redundant relative to the existing factors, a few have statistically significant explanatory power beyond the hundreds of factors proposed in the past.

Consumption Fluctuations and Expected Returns

Published: 1/6/2020  |  DOI: 10.1111/jofi.12870


This paper introduces a novel consumption‐based variable, cyclical consumption, and examines its predictive properties for stock returns. Future expected stock returns are high (low) when aggregate consumption falls (rises) relative to its trend and marginal utility from current consumption is high (low). We show that the empirical evidence ties consumption decisions of agents to time variation in returns in a manner consistent with asset pricing models based on external habit formation. The predictive power of cyclical consumption is not confined to bad times and subsumes the predictability of many popular forecasting variables.

Relationship Trading in Over‐the‐Counter Markets

Published: 12/22/2019  |  DOI: 10.1111/jofi.12864


We examine the network of trading relationships between insurers and dealers in the over‐the‐counter (OTC) corporate bond market. Regulatory data show that one‐third of insurers use a single dealer, whereas other insurers have large dealer networks. Execution prices are nonmonotone in network size, initially declining with more dealers but increasing once networks exceed 20 dealers. A model of decentralized trade in which insurers trade off the benefits of repeat business and faster execution quantitatively fits the distribution of insurers' network size and explains the price–network size relationship. Counterfactual analysis shows that regulations to unbundle trade and nontrade services can decrease welfare.

Securitization, Ratings, and Credit Supply

Published: 12/20/2019  |  DOI: 10.1111/jofi.12866


We develop a framework to explore the effect of credit ratings on loan origination. We show that ratings endogenously shift the economy from a signaling equilibrium, in which banks inefficiently retain loans to signal quality, toward an originate‐to‐distribute equilibrium with zero retention and inefficiently low lending standards. Ratings increase overall efficiency, provided that the reduction in costly retention more than compensates for the origination of some negative net present value loans. We study how banks' ability to screen loans affects these predictions and use the model to analyze commonly proposed policies such as mandatory “skin in the game.”

Beyond Random Assignment: Credible Inference and Extrapolation in Dynamic Economies

Published: 12/19/2019  |  DOI: 10.1111/jofi.12862


We derive analytical relationships between shock responses and theory‐implied causal effects (comparative statics) in dynamic settings with linear profits and linear‐quadratic stock accumulation costs. For permanent profitability shocks, responses can have incorrect signs, undershoot, or overshoot depending on the size and sign of realized changes. For profitability shocks that are i.i.d., uniformly distributed, binary, or unanticipated and temporary, there is attenuation bias, which exceeds 50% under plausible parameterizations. We derive a novel sufficient condition for profitability shock responses to equal causal effects: martingale profitability. We establish a battery of sufficient conditions for correct sign estimation, including stochastic monotonicity. Simple extrapolation/error correction formulas are presented.

What Is a Patent Worth? Evidence from the U.S. Patent “Lottery”

Published: 12/18/2019  |  DOI: 10.1111/jofi.12867


We provide evidence on the value of patents to startups by leveraging the quasi‐random assignment of applications to examiners with different propensities to grant patents. Using unique data on all first‐time applications filed at the U.S. Patent Office since 2001, we find that startups that win the patent “lottery” by drawing lenient examiners have, on average, 55% higher employment growth and 80% higher sales growth five years later. Patent winners also pursue more, and higher quality, follow‐on innovation. Winning a first patent boosts a startup’s subsequent growth and innovation by facilitating access to funding from venture capitalists, banks, and public investors.

Informed Trading and Intertemporal Substitution

Published: 11/13/2019  |  DOI: 10.1111/jofi.12857


I examine the possibility of information‐based trading in a multiperiod consumption setting. I develop a necessary and sufficient condition for trade to occur. Intertemporal substitution introduces a desire to correlate current consumption with future aggregate shocks. When agents have heterogeneous time‐inseparable preferences, information differentially affects relative preferences for current and future consumption, making information‐based trading mutually acceptable. The no‐trade result continues to hold if there is no aggregate shock, or if agents have either homogeneous or time‐separable preferences.

Tax‐Efficient Asset Management: Evidence from Equity Mutual Funds

Published: 11/12/2019  |  DOI: 10.1111/jofi.12843


We investigate the relation between tax burdens and mutual fund performance from both a theoretical and an empirical perspective. The theoretical model introduces heterogeneous tax clienteles in an environment with decreasing returns to scale and shows that the equilibrium performance of mutual funds depends on the size of the tax clienteles. Our empirical results show that the performance of U.S. equity mutual funds is related to their tax burdens. We find that tax‐efficient funds exhibit not only superior after‐tax performance, but also superior before‐tax performance due to lower trading costs, favorable style exposures, and better selectivity.

Measuring Innovation and Product Differentiation: Evidence from Mutual Funds

Published: 11/12/2019  |  DOI: 10.1111/jofi.12853


We study innovation and product differentiation using a uniqueness measure based on textual analysis of prospectuses. We find that small and start‐up families have higher start rates than larger families, and their products are more unique. Unique strategies attract more inflows in the first three years, and investors respond more to text‐based uniqueness than other measures such as holdings or returns uniqueness. For established funds, word uniqueness has weak negative power for explaining returns, so investors in competitive equilibrium do not sacrifice much performance to get specialized products. Uniqueness attenuates the flow‐performance relation, reducing the risk of investor outflows.

The Market for Conflicted Advice

Published: 11/8/2019  |  DOI: 10.1111/jofi.12848


We present a model of the market for advice in which advisers have conflicts of interest and compete for heterogeneous customers through information provision. The competitive equilibrium features information dispersion and partial disclosure. Although conflicted fees lead to distorted information, they are irrelevant for customers' welfare: banning conflicted fees improves only the information quality, not customers' welfare. Instead, financial literacy education for the least informed customers can improve all customers' welfare because of a spillover effect. Furthermore, customers who trade through advisers realize lower average returns, which rationalizes empirical findings.

Does Borrowing from Banks Cost More than Borrowing from the Market?

Published: 10/30/2019  |  DOI: 10.1111/jofi.12849


This paper investigates the pricing of bank loans relative to capital market debt. The analysis uses a novel sample of loans matched with bond spreads from the same firm on the same date. After accounting for seniority, lenders earn a large premium relative to the bond‐implied credit spread. In a sample of secured term loans to noninvestment‐grade firms, the average premium is 140 to 170 bps or about half of the all‐in‐drawn spread. This is the first direct evidence of firms' willingness to pay for bank credit and raises questions about the nature of competition in the loan market.