The Journal of Finance

Internal Capital Markets and the Competition for Corporate Resources

Published: 04/18/2012   |   DOI: 10.1111/j.1540-6261.1997.tb03810.x

JEREMY C. STEIN

This article examines the role of corporate headquarters in allocating scarce resources to competing projects in an internal capital market. Unlike a bank, headquarters has control rights that enable it to engage in “winner‐picking”—the practice of actively shifting funds from one project to another. By doing a good job in the winner‐picking dimension, headquarters can create value even when it cannot help at all to relax overall firm‐wide credit constraints. The model implies that internal capital markets may sometimes function more efficiently when headquarters oversees a small and focused set of projects.

Information Production and Capital Allocation: Decentralized versus Hierarchical Firms

Published: 12/17/2002   |   DOI: 10.1111/0022-1082.00483

Jeremy C. Stein

This paper asks how well different organizational structures perform in terms of generating information about investment projects and allocating capital to these projects. A decentralized approach‐with small, single‐manager firms‐is most likely to be attractive when information about projects is “soft” and cannot be credibly transmitted. In contrast, large hierarchies perform better when information can be costlessly “hardened” and passed along inside the firm. The model can be used to think about the consequences of consolidation in the banking industry, particularly the documented tendency for mergers to lead to declines in small‐business lending.

Presidential Address: Sophisticated Investors and Market Efficiency

Published: 07/16/2009   |   DOI: 10.1111/j.1540-6261.2009.01472.x

JEREMY C. STEIN

Stock‐market trading is increasingly dominated by sophisticated professionals, as opposed to individual investors. Will this trend ultimately lead to greater market efficiency? I consider two complicating factors. The first is crowding—the fact that, for a wide range of “unanchored” strategies, an arbitrageur cannot know how many of his peers are simultaneously entering the same trade. The second is leverage—when an arbitrageur chooses a privately optimal leverage ratio, he may create a fire‐sale externality that raises the likelihood of a severe crash. In some cases, capital regulation may be helpful in dealing with the latter problem.

Growth versus Margins: Destabilizing Consequences of Giving the Stock Market What It Wants

Published: 05/09/2008   |   DOI: 10.1111/j.1540-6261.2008.01351.x

PHILIPPE AGHION, JEREMY C. STEIN

We develop a model in which a firm can devote effort either to increasing sales growth, or to improving per‐unit profit margins. If the firm's manager cares about the current stock price, she will favor the growth strategy when the market pays more attention to growth numbers. Conversely, it can be rational for the market to weight growth measures more heavily when it is known that the firm is following a growth strategy. This two‐way feedback between firms' strategies and the market's pricing rule can lead to excess volatility in real variables, even absent any external shocks.

The Fed, the Bond Market, and Gradualism in Monetary Policy

Published: 02/12/2018   |   DOI: 10.1111/jofi.12614

JEREMY C. STEIN, ADI SUNDERAM

We develop a model of monetary policy with two key features: the central bank has private information about its long‐run target rate and is averse to bond market volatility. In this setting, the central bank gradually impounds changes in its target into the policy rate. Such gradualism represents an attempt to not spook the bond market. However, this effort is partially undone in equilibrium, as markets rationally react more to a given move when the central bank moves more gradually. This time‐consistency problem means that society would be better off if the central bank cared less about the bond market.

A Unified Theory of Underreaction, Momentum Trading, and Overreaction in Asset Markets

Published: 12/17/2002   |   DOI: 10.1111/0022-1082.00184

Harrison Hong, Jeremy C. Stein

We model a market populated by two groups of boundedly rational agents: “newswatchers” and “momentum traders.” Each newswatcher observes some private information, but fails to extract other newswatchers' information from prices. If information diffuses gradually across the population, prices underreact in the short run. The underreaction means that the momentum traders can profit by trend‐chasing. However, if they can only implement simple (i.e., univariate) strategies, their attempts at arbitrage must inevitably lead to overreaction at long horizons. In addition to providing a unified account of under‐ and overreactions, the model generates several other distinctive implications.

The Dark Side of Internal Capital Markets: Divisional Rent‐Seeking and Inefficient Investment

Published: 12/17/2002   |   DOI: 10.1111/0022-1082.00299

David S. Scharfstein, Jeremy C. Stein

We develop a two‐tiered agency model that shows how rent‐seeking behavior on the part of division managers can subvert the workings of an internal capital market. By rent‐seeking, division managers can raise their bargaining power and extract greater overall compensation from the CEO. And because the CEO is herself an agent of outside investors, this extra compensation may take the form not of cash wages, but rather of preferential capital budgeting allocations. One interesting feature of our model is that it implies a kind of “socialism” in internal capital allocation, whereby weaker divisions get subsidized by stronger ones.

A Gap‐Filling Theory of Corporate Debt Maturity Choice

Published: 05/07/2010   |   DOI: 10.1111/j.1540-6261.2010.01559.x

ROBIN GREENWOOD, SAMUEL HANSON, JEREMY C. STEIN

We argue that time variation in the maturity of corporate debt arises because firms behave as macro liquidity providers, absorbing the supply shocks associated with changes in the maturity structure of government debt. We document that when the government funds itself with more short‐term debt, firms fill the resulting gap by issuing more long‐term debt, and vice versa. This type of liquidity provision is undertaken more aggressively: (1) when the ratio of government debt to total debt is higher and (2) by firms with stronger balance sheets. Our theory sheds new light on market timing phenomena in corporate finance more generally.

Simple Forecasts and Paradigm Shifts

Published: 05/08/2007   |   DOI: 10.1111/j.1540-6261.2007.01234.x

HARRISON HONG, JEREMY C. STEIN, JIALIN YU

We study the asset pricing implications of learning in an environment in which the true model of the world is a multivariate one, but agents update only over the class of simple univariate models. Thus, if a particular simple model does a poor job of forecasting over a period of time, it is discarded in favor of an alternative simple model. The theory yields a number of distinctive predictions for stock returns, generating forecastable variation in the magnitude of the value‐glamour return differential, in volatility, and in the skewness of returns. We validate several of these predictions empirically.

Bad News Travels Slowly: Size, Analyst Coverage, and the Profitability of Momentum Strategies

Published: 03/31/2007   |   DOI: 10.1111/0022-1082.00206

Harrison Hong, Terence Lim, Jeremy C. Stein

Various theories have been proposed to explain momentum in stock returns. We test the gradual‐information‐diffusion model of Hong and Stein (1999) and establish three key results. First, once one moves past the very smallest stocks, the profitability of momentum strategies declines sharply with firm size. Second, holding size fixed, momentum strategies work better among stocks with low analyst coverage. Finally, the effect of analyst coverage is greater for stocks that are past losers than for past winners. These findings are consistent with the hypothesis that firm‐specific information, especially negative information, diffuses only gradually across the investing public.

Social Interaction and Stock‐Market Participation

Published: 11/27/2005   |   DOI: 10.1111/j.1540-6261.2004.00629.x

Harrison Hong, Jeffrey D. Kubik, Jeremy C. Stein

We propose that stock‐market participation is influenced by social interaction. In our model, any given “social” investor finds the market more attractive when more of his peers participate. We test this theory using data from the Health and Retirement Study, and find that social households—those who interact with their neighbors, or attend church—are substantially more likely to invest in the market than non‐social households, controlling for wealth, race, education, and risk tolerance. Moreover, consistent with a peer‐effects story, the impact of sociability is stronger in states where stock‐market participation rates are higher.

Thy Neighbor's Portfolio: Word‐of‐Mouth Effects in the Holdings and Trades of Money Managers

Published: 11/10/2005   |   DOI: 10.1111/j.1540-6261.2005.00817.x

HARRISON HONG, JEFFREY D. KUBIK, JEREMY C. STEIN

A mutual fund manager is more likely to buy (or sell) a particular stock in any quarter if other managers in the same city are buying (or selling) that same stock. This pattern shows up even when the fund manager and the stock in question are located far apart, so it is distinct from anything having to do with local preference. The evidence can be interpreted in terms of an epidemic model in which investors spread information about stocks to one another by word of mouth.

A Comparative‐Advantage Approach to Government Debt Maturity

Published: 02/06/2015   |   DOI: 10.1111/jofi.12253

ROBIN GREENWOOD, SAMUEL G. HANSON, JEREMY C. STEIN

We study optimal government debt maturity in a model where investors derive monetary services from holding riskless short‐term securities. In a setting where the government is the only issuer of such riskless paper, it trades off the monetary premium associated with short‐term debt against the refinancing risk implied by the need to roll over its debt more often. We extend the model to allow private financial intermediaries to compete with the government in the provision of short‐term money‐like claims. We argue that, if there are negative externalities associated with private money creation, the government should tilt its issuance more toward short maturities, thereby partially crowding out the private sector's use of short‐term debt.

Banks as Liquidity Providers: An Explanation for the Coexistence of Lending and Deposit‐taking

Published: 12/17/2002   |   DOI: 10.1111/1540-6261.00415

Anil K. Kashyap, Raghuram Rajan, Jeremy C. Stein

What ties together the traditional commercial banking activities of deposit‐taking and lending? We argue that since banks often lend via commitments, their lending and deposit‐taking may be two manifestations of one primitive function: the provision of liquidity on demand. There will be synergies between the two activities to the extent that both require banks to hold large balances of liquid assets: If deposit withdrawals and commitment takedowns are imperfectly correlated, the two activities can share the costs of the liquid‐asset stockpile. We develop this idea with a simple model, and use a variety of data to test the model empirically.

Herd on the Street: Informational Inefficiencies in a Market with Short‐Term Speculation

Published: 09/01/1992   |   DOI: 10.1111/j.1540-6261.1992.tb04665.x

KENNETH A. FROOT, DAVID S. SCHARFSTEIN, JEREMY C. STEIN

Standard models of informed speculation suggest that traders try to learn information that others do not have. This result implicitly relies on the assumption that speculators have long horizons, i.e., can hold the asset forever. By contrast, we show that if speculators have short horizons, they may herd on the same information, trying to learn what other informed traders also know. There can be multiple herding equilibria, and herding speculators may even choose to study information that is completely unrelated to fundamentals.

LDC Debt: Forgiveness, Indexation, and Investment Incentives

Published: 12/01/1989   |   DOI: 10.1111/j.1540-6261.1989.tb02656.x

KENNETH A. FROOT, DAVID S. SCHARFSTEIN, JEREMY C. STEIN

We compare different indexation schemes in terms of their ability to facilitate forgiveness and reduce the investment disincentives associated with the large LDC debt overhang. Indexing to an endogenous variable (e.g., a country's output) has a negative moral hazard effect on investment. This problem does not arise when payments are linked to an exogenous variable such as commodity prices. Nonetheless, indexing payments to output may be useful when debtors know more about their willingness to invest than lenders. We also reach new conclusions about the desirability of default penalties under asymmetric information.

Risk Management: Coordinating Corporate Investment and Financing Policies

Published: 12/01/1993   |   DOI: 10.1111/j.1540-6261.1993.tb05123.x

KENNETH A. FROOT, DAVID S. SCHARFSTEIN, JEREMY C. STEIN

This paper develops a general framework for analyzing corporate risk management policies. We begin by observing that if external sources of finance are more costly to corporations than internally generated funds, there will typically be a benefit to hedging: hedging adds value to the extent that it helps ensure that a corporation has sufficient internal funds available to take advantage of attractive investment opportunities. We then argue that this simple observation has wide ranging implications for the design of risk management strategies. We delineate how these strategies should depend on such factors as shocks to investment and financing opportunities. We also discuss exchange rate hedging strategies for multinationals, as well as strategies involving “nonlinear” instruments like options.