Published: 10/21/2020 | DOI: 10.1111/jofi.12979
PHILIPP K. ILLEDITSCH, JAYANT V. GANGULI, SCOTT CONDIE
We show that aversion to risk and ambiguity leads to information inertia when investors process public news about assets. Optimal portfolios do not always depend on news that is worse than expected; hence, the equilibrium stock price does not reflect this bad news. This informational inefficiency is more severe when there is more risk and ambiguity but disappears when investors are risk‐neutral or the news is about idiosyncratic risk. Information inertia leads to news momentum (e.g., after earnings announcements) and is consistent with low household trading activity. An ambiguity premium helps explain the macro and earnings announcement premium.
A Unified Model of Firm Dynamics with Limited Commitment and Assortative Matching
Published: 10/19/2020 | DOI: 10.1111/jofi.12980
HENGJIE AI, DANA KIKU, RUI LI, JINCHENG TONG
We develop a unified theory of dynamic contracting and assortative matching to explain firm dynamics. In our model, neither firms nor managers can commit to arrangements that yield lower payoffs than their outside options, which are microfounded by the equilibrium conditions in a matching market. The model endogenously generates power laws in firm size and CEO compensation, and explains differences in their right tails. We also show that our model quantitatively accounts for many salient features of the time‐series dynamics and the cross‐sectional distribution of firm investment, dividend payout, and CEO compensation.
Published: 10/13/2020 | DOI: 10.1111/jofi.12976
SHAI BERNSTEIN, TIMOTHY MCQUADE, RICHARD R. TOWNSEND
We investigate how the deterioration of household balance sheets affects worker productivity, and in turn economic downturns. Specifically, we compare the output of innovative workers who experienced differential declines in housing wealth during the financial crisis but were employed at the same firm and lived in the same metropolitan area. We find that, following a negative wealth shock, innovative workers become less productive and generate lower economic value for their firms. The reduction in innovative output is not driven by workers switching to less innovative firms or positions. These effects are more pronounced among workers at greater risk of financial distress.
A Dynamic Model of Optimal Creditor Dispersion
Published: 10/13/2020 | DOI: 10.1111/jofi.12974
HONGDA ZHONG
Borrowing from multiple creditors exposes firms to rollover risk due to coordination problems among creditors, but it also improves firms' repayment incentives, thereby increasing pledgeability. Based on this trade‐off, I develop a dynamic debt rollover model to analyze the evolution of creditor dispersion. Consistent with empirical evidence, I find that firms optimally increase creditor dispersion after poor performance. In contrast, cross‐sectionally higher‐growth firms can support more dispersed creditors. Frequent debt renegotiation limits firms' ability to increase pledgeability by having more creditors. Finally, holding a cash balance while borrowing from multiple creditors improves firms' repayment incentives uniformly across all future states.
The Limits of Limited Liability: Evidence from Industrial Pollution
Published: 10/13/2020 | DOI: 10.1111/jofi.12978
PAT AKEY, IAN APPEL
We study how parent liability for subsidiaries' environmental cleanup costs affects industrial pollution and production. Our empirical setting exploits a Supreme Court decision that strengthened parent limited liability protection for some subsidiaries. Using a difference‐in‐differences framework, we find that stronger liability protection for parents leads to a 5% to 9% increase in toxic emissions by subsidiaries. Evidence suggests the increase in pollution is driven by lower investment in abatement technologies rather than increased production. Cross‐sectional tests suggest convexities associated with insolvency and executive compensation drive heterogeneous effects. Overall, our findings highlight the moral hazard problem associated with limited liability.
The Capitalization of Consumer Financing into Durable Goods Prices
Published: 10/10/2020 | DOI: 10.1111/jofi.12977
BRONSON ARGYLE, TAYLOR NADAULD, CHRISTOPHER PALMER, RYAN PRATT
Using loan‐level data on millions of used‐car transactions across hundreds of lenders, we study the consumer response to exogenous variation in credit terms. Borrowers offered shorter maturity decrease expenditures enough to offset 60% to 90% of the monthly payment increase. Most of this is driven by shifting toward lower‐quality cars, but affected borrowers offset 20% to 30% of a monthly payment shock by negotiating lower prices for equivalent cars. Our results suggest that durable goods prices adjust to reflect credit terms even at the individual level, with one year of additional loan maturity increasing a car's price by 2.8%.
Information Consumption and Asset Pricing
Published: 10/9/2020 | DOI: 10.1111/jofi.12975
AZI BEN‐REPHAEL, BRUCE I. CARLIN, ZHI DA, RYAN D. ISRAELSEN
We study whether firm and macroeconomic announcements that convey systematic information generate a return premium for firms that experience information spillovers. We use information consumption to proxy for investor learning during these announcements and construct ex ante measures of expected information consumption (EIC) to calibrate whether learning is priced. On days when there are information spillovers, affected stocks earn a significant return premium (5% annualized) and the capital asset pricing model performs better. The positive effect of the Federal Reserve Open Market Committee announcements on the risk premia of individual stocks appears to be modulated by EIC. Our findings are most consistent with a risk‐based explanation.
The Employment Effects of Faster Payment: Evidence from the Federal Quickpay Reform
Published: 8/21/2020 | DOI: 10.1111/jofi.12955
JEAN‐NOËL BARROT, RAMANA NANDA
We study the impact of Quickpay, a reform that permanently accelerated payments to small business contractors of the U.S. government. We find a strong direct effect of the reform on employment growth at the firm level. However, we document substantial crowding out of nontreated firms' employment within local labor markets. While the overall net employment effect is positive, it is close to zero in tight labor markets. Our results highlight an important channel for alleviating financing constraints in small firms, but emphasize the general‐equilibrium effects of large‐scale interventions, which can lead to lower aggregate outcomes depending on labor market conditions.
The Forced Safety Effect: How Higher Capital Requirements Can Increase Bank Lending
Published: 8/11/2020 | DOI: 10.1111/jofi.12958
SALEEM BAHAJ, FREDERIC MALHERBE
Government guarantees generate an implicit subsidy for banks. A capital requirement reduces this subsidy, through a simple liability composition effect. However, the guarantees also make a bank undervalue loans that generates surplus in states of the world in which it defaults. Raising the capital requirement makes the bank safer, which alleviates this problem. We refer to this mechanism, which we argue is empirically relevant, as the forced safety effect.
Learning From Disagreement in the U.S. Treasury Bond Market
Published: 8/10/2020 | DOI: 10.1111/jofi.12971
MARCO GIACOLETTI, KRISTOFFER T. LAURSEN, KENNETH J. SINGLETON
We study risk premiums in the U.S. Treasury bond market from the perspective of a Bayesian econometrician BLwho learns in real time from disagreement among investors about future bond yields. Notably, disagreement has substantial predictive power for yields, and BL's risk premiums are less volatile than those in the analogous model without learning. BL's forecasts are substantially more accurate than the consensus forecasts of market professionals, particularly following U.S. recessions. The predictive power of disagreement is distinct from the (much weaker) one of inflation and output growth. Rather, it appears to reflect uncertainty about future fiscal policy.
Safety Transformation and the Structure of the Financial System
Published: 8/10/2020 | DOI: 10.1111/jofi.12967
WILLIAM DIAMOND
This paper studies how a financial system that is organized to efficiently create safe assets responds to macroeconomic shocks. Financial intermediaries face a cost of bearing risk, so they choose the least risky portfolio that backs their issuance of riskless deposits: a diversified pool of nonfinancial firms' debt. Nonfinancial firms choose their capital structure to exploit the resulting segmentation between debt and equity markets. Increased safe asset demand yields larger and riskier intermediaries and more levered firms. Quantitative easing reduces the size and riskiness of intermediaries and can decrease firm leverage, despite reducing borrowing costs at the zero lower bound.
Published: 8/10/2020 | DOI: 10.1111/jofi.12966
YI HUANG, MARCO PAGANO, UGO PANIZZA
In China, between 2006 and 2013, local public debt crowded out the investment of private firms by tightening their funding constraints while leaving state‐owned firms' investment unaffected. We establish this result using a purpose‐built data set for Chinese local public debt. Private firms invest less in cities with more public debt, with the reduction in investment larger for firms located farther from banks in other cities or more dependent on external funding. Moreover, in cities where public debt is high, private firms' investment is more sensitive to internal cash flow.
Stock Market Returns and Consumption
Published: 8/10/2020 | DOI: 10.1111/jofi.12968
MARCO DI MAGGIO, AMIR KERMANI, KAVEH MAJLESI
This paper employs Swedish data on households' stock holdings to investigate how consumption responds to changes in stock market returns. We instrument the actual capital gains and dividend payments with past portfolio weights. Unrealized capital gains lead to a marginal propensity to consume of 23% for the bottom 50% of the wealth distribution and about 3% for the top 30% of the wealth distribution. Household consumption is significantly more responsive to dividend payouts across all parts of the wealth distribution. Our findings are consistent with households treating capital gains and dividends as separate sources of income.
Sovereign Debt Portfolios, Bond Risks, and the Credibility of Monetary Policy
Published: 8/9/2020 | DOI: 10.1111/jofi.12965
WENXIN DU, CAROLIN E. PFLUEGER, JESSE SCHREGER
We document that governments whose local currency debt provides them with greater hedging benefits actually borrow more in foreign currency. We introduce two features into a government's debt portfolio choice problem to explain this finding: risk‐averse lenders and lack of monetary policy commitment. A government without commitment chooses excessively countercyclical inflation ex post, which leads risk‐averse lenders to require a risk premium ex ante. This makes local currency debt too expensive from the government's perspective and thereby discourages the government from borrowing in its own currency.
Every Cloud Has a Silver Lining: Fast Trading, Microwave Connectivity, and Trading Costs
Published: 8/8/2020 | DOI: 10.1111/jofi.12969
ANDRIY SHKILKO, KONSTANTIN SOKOLOV
Modern markets are characterized by speed differentials, with some traders being fractions of a second faster than others. Theoretical models suggest that such differentials may have both positive and negative effects on liquidity and gains from trade. We examine these effects by studying a series of exogenous weather episodes that temporarily remove the speed advantages of the fastest traders by disrupting their microwave networks. The disruptions are associated with lower adverse selection and lower trading costs. In additional analysis, we show that the long‐term removal of speed differentials results in similar effects and also increases gains from trade.
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.
Mortgage Design in an Equilibrium Model of the Housing Market
Published: 8/4/2020 | DOI: 10.1111/jofi.12963
ADAM M. GUREN, ARVIND KRISHNAMURTHY, TIMOTHY J. MCQUADE
How can mortgages be redesigned to reduce macrovolatility and default? We address this question using a quantitative equilibrium life‐cycle model. Designs with countercyclical payments outperform fixed payments. Among those, designs that front‐load payment reductions in recessions outperform those that spread relief over the full term. Front‐loading alleviates liquidity constraints when they bind most, reducing default and stimulating housing demand. To illustrate, a fixed‐rate mortgage (FRM) with an option to convert to adjustable‐rate mortgage, which front‐loads payment reductions relative to an FRM with an option to refinance underwater, reduces price and consumption declines six times as much and default three times as much.
Credit Rating Inflation and Firms' Investments
Published: 7/29/2020 | DOI: 10.1111/jofi.12961
ITAY GOLDSTEIN, CHONG HUANG
We analyze credit rating effects on firm investments in a rational bond financing game that features a feedback loop. The credit rating agency (CRA) inflates the rating, providing a biased but informative signal to creditors. Creditors' response to the rating affects the firm's investment decision and thus its credit quality, which is reflected in the rating. The CRA might reduce ex ante economic efficiency, which results solely from its strategic effect: the CRA assigns more firms high ratings and allows them to gamble for resurrection. We derive empirical predictions on the determinants of rating standards and inflation and discuss policy implications.
Measuring Mutual Fund Flow Pressure as Shock to Stock Returns
Published: 7/28/2020 | DOI: 10.1111/jofi.12962
MALCOLM WARDLAW
A large and rapidly growing literature examines the impact of misvaluation on firm policies by using mutual fund outflow‐induced price pressure to isolate nonfundamental price variation. I demonstrate that the standard approach to computing outflow‐induced price pressure produces a measure that is inadvertently a direct function of a stock's actual realized return during the outflow quarter, raising doubts about its orthogonality to fundamentals. After removing these direct measurements of return, outflows generate a fairly negligible quarterly decline in returns, with no subsequent reversal, and many established results in this literature no longer hold. I provide suggestions for future analysis.
Monetary Policy and Global Banking
Published: 7/27/2020 | DOI: 10.1111/jofi.12959
FALK BRÄUNING, VICTORIA IVASHINA
When central banks adjust interest rates, the opportunity cost of lending in local currency changes, but—absent frictions—there is no spillover effect to lending in other currencies. However, when equity capital is limited, global banks must benchmark domestic and foreign lending opportunities. We show that, in equilibrium, the marginal return on foreign lending is affected by the interest rate differential, with lower domestic rates leading to an increase in local lending, at the expense of a reduction in foreign lending. We test our prediction in the context of changes in interest rates in six major currency areas.
Inalienable Customer Capital, Corporate Liquidity, and Stock Returns
Published: 7/24/2020 | DOI: 10.1111/jofi.12960
WINSTON WEI DOU, YAN JI, DAVID REIBSTEIN, WEI WU
We develop a model in which customer capital depends on key talents' contribution and pure brand recognition. Customer capital guarantees stable demand but is fragile to financial constraints risk if retained mainly by talents, who tend to quit financially constrained firms, damaging customer capital. Using a proprietary, granular brand‐perception survey, we construct a firm‐level measure of the inalienability of customer capital (ICC) that captures the degree to which customer capital depends on talents. Firms with higher ICC have higher average returns, higher talent turnover, and more precautionary financial policies. The ICC‐sorted long‐short portfolio's spread comoves with financial constraints factor.