Working Paper Abstracts – 2008

Working Paper Abstracts – 2008

The Reaction of Consumer Spending and Debt to Tax Rebates – Evidence from Consumer Credit Data
Sumit Agarwal, Chunlin Liu and Nicholas Souleles

We use a new panel dataset of credit card accounts to analyze how consumers responded to the 2001 Federal income tax rebates. We estimate the monthly response of credit card payments, spending, and debt, exploiting the unique, randomized timing of the rebate disbursement. We find that, on average, consumers initially saved some of the rebate, by increasing their credit card payments and thereby paying down debt. But soon afterwards their spending increased, counter to the canonical Permanent-Income model. Spending rose most for consumers who were initially most likely to be liquidity constrained, whereas debt declined most (so saving rose most) for unconstrained consumers. More generally, the results suggest that there can be important dynamics in consumers’ response to “lumpy” increases in income like tax rebates, working in part through balance sheet (liquidity) mechanisms.

Net Worth Housing Equity in Retirement
Todd Sinai and Nicholas Souleles

This paper documents the trends in the life-cycle profiles of net worth and housing equity between 1983 and 2004. The net worth of older households significantly increased during the housing boom of recent years. However, net worth grew by more than housing equity, in part because of other assets also appreciated at the same time. Moreover, the younger elderly offset rising house prices by increasing their housing debt, and used some of the proceeds to invest in other assets. We also consider how much of their housing equity older households can actually tap, using reverse mortgages. This fraction is lower at younger ages, such that young retirees can consume less than half of their housing equity. These results imply that ‘consumable’ net worth is smaller than standard calculations of net worth.

03-08 (Revised 11-07)
Predictive Systems: Living with Imperfect Predictors 
Lubos Pastor and Robert Stambaugh

We develop a framework for estimating expected returns – a predictive system – that allows predictors to be imperfectly correlated with the conditional expected return. When predictors are imperfect, the estimated expected return depends on the past returns in a manner that hinges on the correlation between unexpected returns and innovations in expected returns. We find empirically that prior beliefs about this correlation, which is most likely negative, substantially affect estimates of expected returns as well as various inferences about predictability, including assessments of a predictor’s usefulness. Compared to standard predictive regressions, predictive systems deliver difference and more precise estimates of expected returns.

Levered Returns
Joao Gomes and Lukas Schmid

In this paper, we revisit the theoretical relation between financial leverage and stock returns in a dynamic world where both the corporate investment and financing decisions are endogenous. We find that the link between leverage and stock returns is more complex than the static textbook examples suggest and will usually depend on the investment opportunities available to the firm. In the presence of financial market imperfections leverage and investment are generally correlated so that highly levered firms are also mature firms with relatively more (safe) book assets and fewer risky growth opportunities. We use a quantitative version of our model to general empirical predictions concerning the empirical relationship between leverage and returns. We test these implications in actual data and find support for them.

A Multiplicative Model of Optimal CEO Incentives in Market Equilibrium
Alex Edmans, Xavier Gabaix and Augustin Landier

Existing compensation models typically assume that effort has additive effects on CEO utility. This paper considers multiplicative specifications for the principal-agent problem, and further embeds the problem into a talent assignment model. The result is a unified framework endogenizing both incentives and total pay levels in competitive market equilibrium. The predictions generated by multiplicative specifications match a number of stylized facts inconsistent with an additive model. First, the negative relationship between the CEOs effective equity stake and firm size can be quantitatively explained by an optimal contracting model and thus need not reflects rent extraction. Second, our multiplicative setting predicts that the dollar change in wealth for a percentage change in firm value, scaled by annual pay, is independent of firm size and thus a desirable empirical measure. This independence is confirmed in the data. Third, incentive compensation is effective at solving large agency problems, such as strategy choice, but smaller issues such as perk compensation are best addressed through direct monitoring.

Institutional Investors, Credit Supply, Uncertainty and the Leverage of the Firm
Massimo Massa, Ayako Yasuda, and Lei Zhang

We examine the effects of institutional investor’s credit supply uncertainty (CSU) on the capital structure of the firm using a novel dataset. We measure CSU as the as the investor’s portfolio churn rate, based on the idea that the higher the portfolio churn rate of bondholders, the higher the issuer’s refinancing risk, i.e., the risk of not being able to roll over its maturing debt because of supply uncertainty. We find that the high CSU leads to lower leverage and lower probability of issuing bonds in the next period, but to higher probability of issuing equity and borrowing from banks. The effects are concentrated in firms whose bond investor base is more prone to credit supply imbalances, as measured by investor geographical concentration, local bond preference, and herding propensity. Furthermore, as a robustness check, we use an alternative measure of CSU based on the prevalence of mutual funds among the firm’s bondholders (as opposed to insurance companies) and find qualitatively similar results on the firm’s incremental issuance decisions and leverage. These findings suggest that the credit supply uncertainty arising from institutional investors’ withdrawal risk significantly affects the firm’s capital structure.

Governance Through Exit and Voice: A Theory of Multiple Blockholders
Alex Edmans and Gustavo Manso

Traditional blockholder theories advocate concentrating outside equity with a single large shareholder, to provide strong incentives to undertake value-enhancing interventions (engage in “voice). However, most firms in reality are held by multiple small blockholders. This paper shows that, while such a structure generates free-rider problems that hinder voice, the same coordination difficulties strengthen a second governance mechanism: disciplining the manager through trading (engaging in “exit”). Since multiple blockholders cannot coordinate to limit their trades and maximize combined trading profits, competition among them impounds more information into the prices. This makes the threat of disciplinary exit more credible, thus inducing higher managerial effort. The optimal blockholder structure depends on the relative effectiveness of manager and blockholder effort, the complementarities in the outputs, liquidity, monitoring costs, and the mangers contract.

Blockholders, Market Efficiency, an Managerial Myopia
Alex Edmans

This paper shows how blockholders can add value even if they cannot intervene in a firm’s operations. Blockholders have strong incentive to monitor the firm’s fundamental value, since they can sell their stakes upon bad news. By Trading on their private information (following the “Wall Street Rule”), they cause prices to reflect fundamental value rather than current earnings. This in turn encourages managers to invest for long-run growth rather than short-term profits. Contrary to the view that the U. S.’s liquid markets and transient shareholders exacerbate myopia, this paper shows that they can encourage investment by impounding its effects into prices.

Portfolio Choice in Retirement: Health Risk and the Demand for Annuities, Housing and Risky Assets
Motohiro Yogo

This paper develops a consumption and portfolio-choice model of a retiree who allocates wealth among four assets: a riskless bond, a risky asset, a real annuity and housing. Unlike previous studies that treat health expenditures as exogenous negative income shocks, this paper builds on the Grossman model to endogenize health expenditures as investment in health. I calibrate the model to explain the joint evolution of health status and the composition of wealth for retires, aged 65 to 96, in the Health and Retirement study. I use the calibrated model to assess the welfare gains of an actuarially fair annuity market. The welfare gain is less than 1% of wealth for the median-health retiree at age 65, and the welfare gain is about 10% of wealth for the healthiest.

Are Stocks Really Less Volatile in the Long Run?
Lubos Pastor and Robert Stambaugh

Stocks are more volatile over long horizons than over short horizons from an investor’s perspective. This perspective recognizes that observable predictors imperfectly deliver true expected return and that parameters are uncertain, even with two centuries of data. Stocks are often considered less volatile over long horizons due to mean reversion induce by predictability. However, mean reversion’s negative contribution to long-horizon variance is more than offset by uncertainly about future expected return, combined with effects of predictor imperfection and parameter uncertainty. Using a predictive system to capture these effects, we find 30-year variance is 21 to 75 percent higher than 1-year variance.

Oil Futures in a Production Economy with Investment Constraints
Leonid Kogan, Dmitry Livdan and Amir Yaron

We document a new stylized fact regarding the term-structure of futures volatility.

We show that the relationship between the volatility of futures prices and the slope of the term structure of prices is non-monotone and has a “V-shape.” This aspect of the data cannot be generated by basic models that emphasize investment constraints or, more generally, time-varying supply elasticity. We develop an equilibrium model in which futures prices are determined endogenously in a production economy in which investment is both irreversible and is capacity constrained. Investment constraints affect firms’ investment decisions, which in turn determine the dynamic properties of their output and consequently imply that the supply-elasticity of the commodity changes over time. Since demand stocks must be absorbed wither by changes in prices, or by changes in supply, time varying supply-elasticity results in time-varying volatility of futures prices. Estimating this model, we show it is quantitatively consistent with the aforementioned “V-shape” relationship between the volatility of futures prices and the slope of the term-structure.

Risks for the Long Run: Estimation and Inference
Ravi Bansal, Dana Kiku and Amir Yaron

In this paper we empirically evaluate the ability of the long-run risks model to explain asset returns. Exploiting asset pricing Euler equations we develop methods for estimating the long-run risks model, and show that is can successfully account for the market, value, and size sorted returns at reasonable values of risk aversion and the intertemporal elasticity of substitution. Our empirical evidence highlights the importance of low-frequency movements and time-varying uncertainty in economic growth for understanding risk-return tradeoffs in financial markets.

Diversification and its Discontents: Idiosyncratic and Entrepreneurial Risk in the Quest for Social Status
Nikolai Roussanov

Incorporating preference for social status into a simple model of portfolio choice helps to explain a range of qualitative and quantitative stylized facts about the heterogeneity in asset holdings among US households. I specify preferences for status parsimoniously as a function of household’s wealth relative to aggregate wealth. In the model, investors hold concentrated portfolios, suggesting, in particular, a possible explanation for the apparently small premium for undiversified entrepreneurial risk. Consistent with empirical evidence, the wealthier households won a disproportionate share of risky assets, particularly private equity, and experience more volatile consumption growth. The model is calibrated to match the empirical level of risky asset holdings without generating excessive volatility of consumption growth and cross-sectional wealth mobility.

What’s Vol Got to do with it?
Itamar Drechsler and Amir Yaron

Uncertainty plays a key role in economics, finance and decision sciences. Financial markets, in particular derivative markets, provide fertile ground for understanding how perceptions of economic uncertainty and cashflow risk manifest themselves in asset prices. We demonstrate that the variance premium, defined as the difference between the squared VIX index and expected realized variance, captures attitudes toward uncertainty. We show conditions under which the variance premium displays significant time variation and return predictability. A calibrated, generalized Long-Run Risks model generates a variance premium with time variation and return predictability that is consistent with the data, while simultaneously matching the levels and volatilities of the market return and risk free rate. Our evidence indicates an important role for transient non-Gaussian shocks to fundamentals that affect agents’ views of economic uncertainty and prices.

Temporal Risk Aversion and Asset Prices
Skander Van den Heuvel

Agents with standard time-separable preferences do not care about the temporal distribution of risk. This is a strong assumption. For example, it seems plausible that a consumer may find persistent shocks to consumption less desirable than uncorrelated fluctuations. Such a consumer is said to exhibit temporal risk aversion. This paper examines the implication s of temporal risk aversion for asset prices. The innovation is to work with expected utility preferences that (i) are not time-separable, (ii) exhibit temporal risk aversion, (iii) separate risk aversion from the intertemporal elasticity of substitution, (iv) separate short-run from long-run risk aversion and (v) yield stationary asset pricing implications in the context of an endowment economy. Closed form solutions are derived for the equity premium and the risk free rate. The equity premium depends only on a parameter indexing long-run risk aversion. The risk-free rate instead depends primarily on a separate parameter indexing the desire to smooth consumption over time and the rate of time preference.

Can time-varying risk of rare disasters explain aggregate stock market volatility?
Jessica A. Wachter

This paper introduces a model in which the probability of a rare disaster varies over time. I show that the model can account for the high equity premium and high volatility in the aggregate stock market. At the same time, the model generates a low mean and volatility for the government bill rate, as well as economically significant excess stock return predictability. The model is set in a continuous time, assumes recursive preference, and is solved in closed-form. It is shown that recursive preference, as well as time-variation in the disaster probability, are key to the model’s success.

Mergers and Persistence
Jeffrey Jaffe, David Pedersen and Torben Voetmann

Despite the voluminous literature on mergers and acquisitions, little research has investigated whether acquirers exhibit persistence in performance. Nevertheless, this issue should be of interest to academicians, acquirers, their financiers, legislators and regulators. Using a sample of nearly 12,000 mergers announces between 1981 and 2007, this study provides initial evidence that acquirers do indeed demonstrate persistence that is both statistically and economically meaningful. An acquirer that was successful in it last deal earns, on average, 44 basis points more on its next acquisition than does a previously-unsuccessful acquirer. This incremental return is 64% of the average return to acquirers and equivalent to $29 million in value created for the bidders shareholders. The findings are robust to alternative explanations of persistence, including method of payment, target listing status, and managerial ability. In our opinion, these results support the hypothesis that acquirers display differential skill in extracting value from mergers.