The Journal of Finance

Endogenous Borrowing Constraints With Incomplete Markets

Published: 04/18/2012   |   DOI: 10.1111/j.1540-6261.1997.tb02758.x

HAROLD H. ZHANG

This article develops ways to endogenize the borrowing constraints used in a class of computable incomplete markets models. We allow the constraints to depend on an investor's characteristics such as time preference, risk aversion, and income streams. The proposed constraint can be interpreted as a borrowing limit within which an investor has no incentive to default. Using a numerical algorithm, we find that for an array of structural parameters, the endogenous borrowing constraints can be much less stringent than the ad hoc borrowing constraints adopted by the existing studies.

Operating Hedge and Gross Profitability Premium

Published: 09/13/2023   |   DOI: 10.1111/jofi.13275

LEONID KOGAN, JUN LI, HAROLD H. ZHANG

We show theoretically that variable production costs reduce systematic risk of firms' cash flows if capital and variable inputs are complementary in firms' production and input prices are procyclical. In our dynamic model, this operating hedge effect is weaker for more profitable firms, giving rise to a gross profitability premium. Moreover, gross profitability and value factors are distinct and negatively correlated, and their premia are not captured by the capital asset pricing model (CAPM). We estimate the model by simulated method of moments, and find that its main implications for stock returns and cash flow dynamics are quantitatively consistent with the data.

Neglected Risks in the Communication of Residential Mortgage‐Backed Securities Offerings

Published: 09/13/2023   |   DOI: 10.1111/jofi.13278

HAROLD H. ZHANG, FENG ZHAO, XIAOFEI ZHAO

Examining the contractual disclosures during the sale of private‐label residential mortgage‐backed securities before the 2008 financial crisis, we find that textual contents in the risk‐factor section predict subsequent losses and yet were not reflected in pricing. Insurance companies, especially life insurers and insurers with low regulatory capital ratios, are more exposed to textual risks. Consistent with issuers hedging litigation risks with disclosure, we find that textual contents are associated with second‐lien underreporting and preissuance written communications. Overall, we find that investors neglected risks in the purportedly safe assets before the crisis.

Optimal Asset Location and Allocation with Taxable and Tax‐Deferred Investing

Published: 11/27/2005   |   DOI: 10.1111/j.1540-6261.2004.00655.x

Robert M. Dammon, Chester S. Spatt, Harold H. Zhang

We investigate optimal intertemporal asset allocation and location decisions for investors making taxable and tax‐deferred investments. We show a strong preference for holding taxable bonds in the tax‐deferred account and equity in the taxable account, reflecting the higher tax burden on taxable bonds relative to equity. For most investors, the optimal asset location policy is robust to the introduction of tax‐exempt bonds and liquidity shocks. Numerical results illustrate optimal portfolio decisions as a function of age and tax‐deferred wealth. Interestingly, the proportion of total wealth allocated to equity is inversely related to the fraction of total wealth in tax‐deferred accounts.

Capital Gains Taxes and Asset Prices: Capitalization or Lock‐in?

Published: 04/01/2008   |   DOI: 10.1111/j.1540-6261.2008.01329.x

ZHONGLAN DAI, EDWARD MAYDEW, DOUGLAS A. SHACKELFORD, HAROLD H. ZHANG

This paper demonstrates that the equilibrium impact of capital gains taxes reflects both the capitalization effect (i.e., capital gains taxes decrease demand) and the lock‐in effect (i.e., capital gains taxes decrease supply). Depending on time periods and stock characteristics, either effect may dominate. Using the Taxpayer Relief Act of 1997 as our event, we find evidence supporting a dominant capitalization effect in the week following news that sharply increased the probability of a reduction in the capital gains tax rate and a dominant lock‐in effect in the week after the rate reduction became effective.

Subprime Mortgage Defaults and Credit Default Swaps

Published: 10/27/2014   |   DOI: 10.1111/jofi.12221

ERIC ARENTSEN, DAVID C. MAUER, BRIAN ROSENLUND, HAROLD H. ZHANG, FENG ZHAO

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.