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Volume 70: Issue 2 (April 2015)

How Does Household Portfolio Diversification Vary with Financial Literacy and Financial Advice?

Pages: 489-507  |  Published: 3/2015  |  DOI: 10.1111/jofi.12231  |  Cited by: 312


Household investment mistakes are an important concern for researchers and policymakers alike. Portfolio underdiversification ranks among those mistakes that are potentially most costly. However, its roots and empirical importance are poorly understood. I estimate quantitatively meaningful diversification statistics and investigate their relationship with key variables. Nearly all households that score high on financial literacy or rely on professionals or private contacts for advice achieve reasonable investment outcomes. Compared to these groups, households with below‐median financial literacy that trust their own decision‐making capabilities lose an expected 50 bps on average. All group differences stem from the top of the loss distribution.

Subsidizing Liquidity: The Impact of Make/Take Fees on Market Quality

Pages: 509-536  |  Published: 3/2015  |  DOI: 10.1111/jofi.12230  |  Cited by: 75


Facing increased competition over the last decade, many stock exchanges changed their trading fees to maker‐taker pricing, an incentive scheme that rewards liquidity suppliers and charges liquidity demanders. Using a change in trading fees on the Toronto Stock Exchange, we study whether and why the breakdown of trading fees between liquidity demanders and suppliers matters. Posted quotes adjust after the change in fee composition, but the transaction costs for liquidity demanders remain unaffected once fees are taken into account. However, as posted bid‐ask spreads decline, traders (particularly retail) use aggressive orders more frequently, and adverse selection costs decrease.

Incentivizing Calculated Risk‐Taking: Evidence from an Experiment with Commercial Bank Loan Officers

Pages: 537-575  |  Published: 3/2015  |  DOI: 10.1111/jofi.12233  |  Cited by: 95


We conduct an experiment with commercial bank loan officers to test how performance compensation affects risk assessment and lending. High‐powered incentives lead to greater screening effort and more profitable lending decisions. This effect is muted, however, by deferred compensation and limited liability, two standard features of loan officer compensation contracts. We find that career concerns and personality traits affect loan officer behavior, but show that the response to incentives does not vary with traits such as risk‐aversion, optimism, or overconfidence. Finally, we present evidence that incentives distort the assessment of credit risk, even among professionals with many years of experience.

Aggregate Jump and Volatility Risk in the Cross‐Section of Stock Returns

Pages: 577-614  |  Published: 3/2015  |  DOI: 10.1111/jofi.12220  |  Cited by: 200


We examine the pricing of both aggregate jump and volatility risk in the cross‐section of stock returns by constructing investable option trading strategies that load on one factor but are orthogonal to the other. Both aggregate jump and volatility risk help explain variation in expected returns. Consistent with theory, stocks with high sensitivities to jump and volatility risk have low expected returns. Both can be measured separately and are important economically, with a two‐standard‐deviation increase in jump (volatility) factor loadings associated with a 3.5% to 5.1% (2.7% to 2.9%) drop in expected annual stock returns.

The Recovery Theorem

Pages: 615-648  |  Published: 3/2015  |  DOI: 10.1111/jofi.12092  |  Cited by: 237


We can only estimate the distribution of stock returns, but from option prices we observe the distribution of state prices. State prices are the product of risk aversion—the pricing kernel—and the natural probability distribution. The Recovery Theorem enables us to separate these to determine the market's forecast of returns and risk aversion from state prices alone. Among other things, this allows us to recover the pricing kernel, market risk premium, and probability of a catastrophe and to construct model‐free tests of the efficient market hypothesis.

The Effect of Succession Taxes on Family Firm Investment: Evidence from a Natural Experiment

Pages: 649-688  |  Published: 3/2015  |  DOI: 10.1111/jofi.12224  |  Cited by: 80


This paper provides causal evidence on the impact of succession taxes on firm investment decisions and transfer of control. Using a 2002 policy change in Greece that substantially reduced the tax on intrafamily transfers of businesses, I show that succession taxes lead to a more than 40% decline in investment around family successions, slow sales growth, and a depletion of cash reserves. Furthermore, succession taxes strongly affect the decision to sell or retain the firm within the family. I conclude by discussing implications of my findings for firms in the United States and Europe.

Subprime Mortgage Defaults and Credit Default Swaps

Pages: 689-731  |  Published: 3/2015  |  DOI: 10.1111/jofi.12221  |  Cited by: 34


We offer the first empirical evidence on the adverse effect of credit default swap (CDS) coverage on subprime mortgage defaults. Using a large database of privately securitized mortgages, we find that higher defaults concentrate in mortgage pools with concurrent CDS coverage, and within these pools the loans originated after or shortly before the start of CDS coverage have an even higher delinquency rate. The results are robust across zip code and origination quarter cohorts. Overall, we show that CDS coverage helped drive higher mortgage defaults during the financial crisis.

Size Anomalies in U.S. Bank Stock Returns

Pages: 733-768  |  Published: 3/2015  |  DOI: 10.1111/jofi.12235  |  Cited by: 204


The largest commercial bank stocks, ranked by total size of the balance sheet, have significantly lower risk‐adjusted returns than small‐ and medium‐sized bank stocks, even though large banks are significantly more levered. We uncover a size factor in the component of bank returns that is orthogonal to the standard risk factors, including small minus big, which has the right covariance with bank returns to explain the average risk‐adjusted returns. This factor measures size‐dependent exposure to bank‐specific tail risk. These findings are consistent with government guarantees that protect shareholders of large banks, but not small banks, in disaster states.

Estimating Oil Risk Factors Using Information from Equity and Derivatives Markets

Pages: 769-804  |  Published: 3/2015  |  DOI: 10.1111/jofi.12222  |  Cited by: 86


We introduce a novel approach to estimating latent oil risk factors and establish their significance in pricing nonoil securities. Our model, which features four factors with simple economic interpretations, is estimated using both derivative prices and oil‐related equity returns. The fit is excellent in and out of sample. The extracted oil factors carry significant risk premia, and are significantly related to macroeconomic variables as well as portfolio returns sorted on characteristics and industry. The average nonoil portfolio exhibits a sensitivity to the oil factors amounting to a sixth (in magnitude) of that of the oil industry itself.

Defined Contribution Pension Plans: Sticky or Discerning Money?

Pages: 805-838  |  Published: 3/2015  |  DOI: 10.1111/jofi.12232  |  Cited by: 131


Participants in defined contribution (DC) retirement plans rarely adjust their portfolio allocations, suggesting that their investment choices and consequent money flows are sticky and not discerning. However, participants’ inertia could be offset by DC plan sponsors, who adjust the plan's investment options. We examine these countervailing influences on flows into U.S. mutual funds. We find that flows into funds from DC assets are more volatile and exhibit more performance sensitivity than non‐DC flows, primarily due to adjustments to the investment options by the plan sponsors. Thus, DC retirement money is less sticky and more discerning than non‐DC money.

Yesterday's Heroes: Compensation and Risk at Financial Firms

Pages: 839-879  |  Published: 3/2015  |  DOI: 10.1111/jofi.12225  |  Cited by: 189


Many believe that compensation, misaligned from shareholders’ value due to managerial entrenchment, caused financial firms to take risks before the financial crisis of 2008. We argue that, even in a classical principal‐agent setting without entrenchment and with exogenous firm risk, riskier firms may offer higher total pay as compensation for the extra risk in equity stakes borne by risk‐averse managers. Using long lags of stock price risk to capture exogenous firm risk, we confirm our conjecture and show that riskier firms are also more productive and more likely to be held by institutional investors, who are most able to influence compensation.

On the Design of Contingent Capital with a Market Trigger

Pages: 881-920  |  Published: 3/2015  |  DOI: 10.1111/jofi.12134  |  Cited by: 128


Contingent capital (CC), which aims to internalize the costs of too‐big‐to‐fail in the capital structure of large banks, has been under intense debate by policy makers and academics. We show that CC with a market trigger, in which direct stakeholders are unable to choose optimal conversion policies, does not lead to a unique competitive equilibrium unless value transfer at conversion is not expected ex ante. The “no value transfer” restriction precludes penalizing bank managers for taking excessive risk. Multiplicity or absence of equilibrium introduces the potential for price uncertainty, market manipulation, inefficient capital allocation, and frequent conversion errors.


Pages: 921-922  |  Published: 3/2015  |  DOI: 10.1111/jofi.12256  |  Cited by: 0


Pages: 923-923  |  Published: 3/2015  |  DOI: 10.1111/jofi.12267  |  Cited by: 0


Pages: 924-924  |  Published: 3/2015  |  DOI: 10.1111/jofi.12268  |  Cited by: 0