Presidential Address: How Much “Rationality” is There In Bond‐Market Risk Premiums?
Published: 6/9/2021 | DOI: 10.1111/jofi.13062
KENNETH J. SINGLETON
Beliefs of professional forecasters are benchmarked against those of a Bayesian econometrician ℬℰ who is learning about the unknown dynamics of the bond risk factors. Consistent with rational Bayesian learning, the forecast errors of individual professionals and ℬℰ are comparably predictable over the business cycle. The secular and cyclical patterns of professionals' forecasts relative to those of ℬℰ are explored in depth. Inconsistent with many models with belief dispersion, the relationship between professionals' yield disagreement and their matched disagreements about macroeconomic fundamentals is very weak.
Prospect Theory and Stock Market Anomalies
Published: 6/5/2021 | DOI: 10.1111/jofi.13061
NICHOLAS BARBERIS, LAWRENCE J. JIN, BAOLIAN WANG
We present a new model of asset prices in which investors evaluate risk according to prospect theory and examine its ability to explain 23 prominent stock market anomalies. The model incorporates all of the elements of prospect theory, accounts for investors' prior gains and losses, and makes quantitative predictions about an asset's average return based on empirical estimates of the asset's return volatility, return skewness, and past capital gain. We find that the model can help explain a majority of the 23 anomalies.
Out‐of‐Town Home Buyers and City Welfare
Published: 6/3/2021 | DOI: 10.1111/jofi.13057
JACK FAVILUKIS, STIJN VAN NIEUWERBURGH
Many cities have attracted a flurry of out‐of‐town (OOT) home buyers. Such capital inflows affect house prices, rents, construction, labor income, wealth, and ultimately welfare. We develop an equilibrium model to quantify the welfare effects of OOT home buyers for the typical U.S. metropolitan area. When OOT investors buy 10% of the housing in the city center and 5% in the suburbs, welfare among residents falls by 0.61% in consumption‐equivalent units. House prices and rents rise substantially, resulting in welfare gains for owners and losses for renters. Policies that tax OOT buyers or mandate renting out vacant property mitigate welfare losses.
Property Rights to Client Relationships and Financial Advisor Incentives
Published: 6/3/2021 | DOI: 10.1111/jofi.13058
CHRISTOPHER P. CLIFFORD, WILLIAM C. GERKEN
We study the effect of a change in property rights on employee behavior in the financial advice industry. Our identification comes from staggered firm‐level entry into the Protocol for Broker Recruiting, which waived nonsolicitation clauses for advisor transitions among member firms, effectively transferring ownership of client relationships from the firm to the advisor. After the shock, advisors appear to tend to client relationships more by investing in client‐facing industry licenses, shifting to fee‐based advising, and reducing customer complaints. Our findings support property rights based investment theories of the firm and document offsetting costs to restricting labor mobility.
Structuring Mortgages for Macroeconomic Stability
Published: 6/3/2021 | DOI: 10.1111/jofi.13056
JOHN Y. CAMPBELL, NUNO CLARA, JOÃO F. COCCO
We study mortgage design features aimed at stabilizing the macroeconomy. We model overlapping generations of borrowers and an infinitely lived risk‐averse representative lender. Mortgages are priced using an equilibrium pricing kernel derived from the lender's endogenous consumption. We consider an adjustable‐rate mortgage with an option that during recessions allows borrowers to pay only interest on their loan and extend its maturity. The option stabilizes consumption growth over the business cycle, shifts defaults to expansions, and enhances welfare. The cyclical properties of the contract are attractive to a risk‐averse lender so that the mortgage can be provided at a relatively low cost.
Can the Market Multiply and Divide? Non‐Proportional Thinking in Financial Markets
Published: 5/28/2021 | DOI: 10.1111/jofi.13059
KELLY SHUE, RICHARD R. TOWNSEND
We hypothesize that investors partially think about stock price changes in dollar rather than percentage units, leading to more extreme return responses to news for lower‐priced stocks. Consistent with such non‐proportional thinking, we find a doubling in price is associated with a 20‐30% decline in volatility and beta (controlling for size/liquidity). To identify a causal price effect, we show that volatility jumps following stock splits and drops following reverse splits. Lower‐priced stocks also respond more strongly to firm‐specific news. Non‐proportional thinking helps explain asset pricing patterns such as the size‐volatility/beta relation, the leverage effect puzzle, and return drift and reversals.
The Limits of p ‐Hacking: Some Thought Experiments
Published: 5/17/2021 | DOI: 10.1111/jofi.13036
ANDREW Y. CHEN
Suppose that the 300+ published asset pricing factors are all spurious. How much p‐hacking is required to produce these factors? If 10,000 researchers generate eight factors every day, it takes hundreds of years. This is because dozens of published t‐statistics exceed 6.0, while the corresponding p‐value is infinitesimal, implying an astronomical amount of p‐hacking in a general model. More structure implies that p‐hacking cannot address ≈100 published t‐statistics that exceed 4.0, as they require an implausibly nonlinear preference for t‐statistics or even more p‐hacking. These results imply that mispricing, risk, and/or frictions have a key role in stock returns.
Tracking Retail Investor Activity
Published: 5/14/2021 | DOI: 10.1111/jofi.13033
EKKEHART BOEHMER, CHARLES M. JONES, XIAOYAN ZHANG, XINRAN ZHANG
We provide an easy method to identify marketable retail purchases and sales using recent, publicly available U.S. equity transactions data. Individual stocks with net buying by retail investors outperform stocks with negative imbalances by approximately 10 bps over the following week. Less than half of the predictive power of marketable retail order imbalance is attributable to order flow persistence, while the rest cannot be explained by contrarian trading (proxy for liquidity provision) or public news sentiment. There is suggestive, but only suggestive, evidence that retail marketable orders might contain firm‐level information that is not yet incorporated into prices.
Reinvestment Risk and the Equity Term Structure
Published: 5/14/2021 | DOI: 10.1111/jofi.13035
ANDREI S. GONÇALVES
The equity term structure is downward sloping at long maturities. I estimate an Intertemporal Capital Asset Pricing Model (ICAPM) to show that the trade‐off between market and reinvestment risk explains this pattern. Intuitively, while long‐term dividend claims are highly exposed to market risk, they are good hedges for reinvestment risk because dividend prices rise as expected returns decline, and longer‐term claims are more sensitive to discount rates. In the estimated ICAPM, reinvestment risk dominates at long maturities, inducing relatively low risk premia on long‐term dividend claims. The model is also consistent with the equity term structure cyclicality and the upward‐sloping bond term structure.
Do Physiological and Spiritual Factors Affect Economic Decisions?
Published: 5/14/2021 | DOI: 10.1111/jofi.13032
CEM DEMIROGLU, OGUZHAN OZBAS, RUI C. SILVA, MEHMET FATİH ULU
We examine the effects of physiology and spiritual sentiment on economic decision‐making in the context of Ramadan, an entire lunar month of daily fasting and increased spiritual reflection in the Muslim faith. Using an administrative data set of bank loans originated in Turkey during 2003 to 2013, we find that small business loans originated during Ramadan are 15% more likely to default within two years of origination. Loans originated in hot Ramadans, when adverse physiological effects of fasting are greatest, and those approved by the busiest bank branches perform worse. Despite their worse performance, Ramadan loans have lower credit spreads.
Inventory Management, Dealers' Connections, and Prices in Over‐the‐Counter Markets
Published: 5/14/2021 | DOI: 10.1111/jofi.13034
JEAN‐EDOUARD COLLIARD, THIERRY FOUCAULT, PETER HOFFMANN
We propose a new model of trading in over‐the‐counter markets. Dealers accumulate inventories by trading with end‐investors and trade among each other to reduce their inventory holding costs. Core dealers use a more efficient trading technology than peripheral dealers, who are heterogeneously connected to core dealers and trade with each other bilaterally. Connectedness affects prices and allocations if and only if the peripheral dealers' aggregate inventory position differs from zero. Price dispersion increases in the size of this position. The model generates new predictions about the effects of dealers' connectedness and dealers' aggregate inventories on prices.
Published: 5/10/2021 | DOI: 10.1111/jofi.13024
JAMES R. BROWN, MATTHEW T. GUSTAFSON, IVAN T. IVANOV
Unexpectedly severe winter weather, which is arguably exogenous to firm and bank fundamentals, represents a significant cash flow shock for bank‐borrowing firms. Firms respond to these shocks by drawing on and increasing the size of their credit lines. Banks charge borrowers for this liquidity via increased interest rates and less borrower‐friendly loan provisions. Credit line adjustments occur within one calendar quarter of the shock and persist for at least nine months. Overall, we provide evidence that bank credit lines are an important tool for managing the nonfundamental component of cash flow volatility, especially for solvent, small bank borrowers.
Published: 5/8/2021 | DOI: 10.1111/jofi.13031
TONI M. WHITED, JAKE ZHAO
We estimate real losses arising from the cross‐sectional misallocation of financial liabilities. Extending a production‐based framework of misallocation measurement to the liabilities side of the balance sheet and using manufacturing firm data from the United States and China, we find significant misallocation of debt and equity in China but not the United States. Reallocating liabilities of firms in China to mimic U.S. efficiency would produce gains of 51% to 69% in real value‐added, with only 17% to 21% stemming from inefficient debt‐equity combinations. For Chinese firms that are large or in developed cities, we estimate lower distortionary financing costs.
Asset Managers: Institutional Performance and Factor Exposures
Published: 5/7/2021 | DOI: 10.1111/jofi.13026
JOSEPH GERAKOS, JUHANI T. LINNAINMAA, ADAIR MORSE
Using data on $18 trillion of assets under management, we show that actively managed institutional accounts outperformed strategy benchmarks by 75 (31) bps on a gross (net) basis during the period 2000 to 2012. Estimates from a Sharpe model imply that asset managers' outperformance came from factor exposures. If institutions had instead implemented mean‐variance efficient portfolios using index and institutional mutual funds available during the sample period, they would not have earned higher Sharpe ratios. Our results are consistent with the average asset manager having skill, managers competing for institutional capital, and institutions engaging in costly search to identify skilled managers.
How Debit Cards Enable the Poor to Save More
Published: 5/7/2021 | DOI: 10.1111/jofi.13021
PIERRE BACHAS, PAUL GERTLER, SEAN HIGGINS, ENRIQUE SEIRA
We study an at‐scale natural experiment in which debit cards were given to cash transfer recipients who already had a bank account. Using administrative account data and household surveys, we find that beneficiaries accumulated a savings stock equal to 2% of annual income after two years with the card. The increase in formal savings represents an increase in overall savings, financed by a reduction in current consumption. There are two mechanisms. First, debit cards reduce transaction costs of accessing money. Second, they reduce monitoring costs, which led beneficiaries to check their account balances frequently and build trust in the bank.
What Explains Differences in Finance Research Productivity during the Pandemic?
Published: 5/3/2021 | DOI: 10.1111/jofi.13028
BRAD M. BARBER, WEI JIANG, ADAIR MORSE, MANJU PURI, HEATHER TOOKES, INGRID M. WERNER
Based on a survey of American Finance Association members, we analyze how demographics, time allocation, production mechanisms, and institutional factors affect research production during the pandemic. Consistent with the literature, research productivity falls more for women and faculty with young children. Independently, and novel, extra time spent on teaching (much more likely for women) negatively affects research productivity. Also novel, concerns about feedback, isolation, and health have large negative research effects, which disproportionately affect junior faculty and PhD students. Finally, faculty who express greater concerns about employers’ finances report larger negative research effects and more concerns about feedback, isolation, and health.
Sentiment Trading and Hedge Fund Returns
Published: 4/29/2021 | DOI: 10.1111/jofi.13025
YONG CHEN, BING HAN, JING PAN
In the presence of sentiment fluctuations, arbitrageurs may engage in different strategies leading to dispersed sentiment exposures. We find that hedge funds in the top decile ranked by sentiment beta outperform those in the bottom decile by 0.59% per month on a risk‐adjusted basis, with the spread being larger among skilled funds. We also find that about 10% of hedge funds have sentiment timing skill that positively correlates with fund sentiment beta and contributes to fund performance. Our findings show that skilled hedge funds can earn high returns by predicting and exploiting sentiment changes rather than betting against mispricing.
Don't Take Their Word for It: The Misclassification of Bond Mutual Funds
Published: 4/29/2021 | DOI: 10.1111/jofi.13023
HUAIZHI CHEN, LAUREN COHEN, UMIT G. GURUN
We provide evidence that bond fund managers misclassify their holdings, and that these misclassifications have a real and significant impact on investor capital flows. The problem is widespread, resulting in up to 31.4% of funds being misclassified with safer profiles, compared to their true, publicly reported holdings. “Misclassified funds”—those that hold risky bonds but claim to hold safer bonds—appear to on‐average outperform lower risk funds in their peer groups. Within category groups, misclassified funds receive more Morningstar stars and higher investor flows. However, when we correctly classify them based on actual risk, these funds are mediocre performers.
Published: 4/26/2021 | DOI: 10.1111/jofi.13022
YUNZHI HU, FELIPE VARAS
An entrepreneur borrows from a relationship bank or the market. The bank has a higher cost of capital but produces private information over time. While the entrepreneur accumulates reputation as the lending relationship continues, asymmetric information is also developed between the bank/entrepreneur and the market. In this setting, zombie lending is inevitable: Once the entrepreneur becomes sufficiently reputable, the bank will roll over loans even after learning bad news, for the prospect of future market financing. Zombie lending is mitigated when the entrepreneur faces financial constraints. Finally, the bank stops producing information too early if information production is costly.
Time Variation of the Equity Term Structure
Published: 4/22/2021 | DOI: 10.1111/jofi.13020
NIELS JOACHIM GORMSEN
I study the term structure of one‐period expected returns on dividend claims with different maturity. I find that the slope of the term structure is countercyclical. The countercyclical variation is consistent with theories of long‐run risk and habit, but these theories cannot explain the average downward slope. At the same time, the cyclical variation is inconsistent with recent models constructed to match the average downward slope. More generally, the average and cyclicality of the slope are hard to reconcile with models with a single risk factor. I introduce a model with two priced factors to solve the puzzle.
Rent Extraction with Securities Plus Cash
Published: 4/6/2021 | DOI: 10.1111/jofi.13018
TINGJUN LIU, DAN BERNHARDT
In our target‐initiated theory of takeovers, a target approaches potential acquirers that privately know their standalone values and merger synergies, where higher synergy acquirers tend to have larger standalone values. Despite their information disadvantage, targets can extract all surplus when synergies and standalone values are concavely related by offering payment choices that are combinations of cash and equity. Targets exploit the reluctance of high‐valuation acquirers to cede equity claims, inducing them to bid more cash. When synergies and standalone values are not concavely related, sellers can gain by combining cash with securities that are more information sensitive than equities.
Published: 4//2021 | DOI: 10.1111/jofi.13019
STEVEN N. KAPLAN, MORTEN SORENSEN
Using 2,603 executive assessments, we study how CEO candidates differ from candidates for other top management positions, particularly CFOs. More than half of the variation in the 30 assessed characteristics is explained by four factors that we interpret as general ability, execution (vs. interpersonal), charisma (vs. analytical), and strategic (vs. managerial). CEO candidates have more extreme factor scores that differ significantly from those of CFO candidates. Conditional on being considered, candidates with greater general ability and interpersonal skills are more likely to be hired. These and our previous results on CEO success suggest that boards overweight interpersonal skills in hiring CEOs.