Abstract: Regulations introduce significant fixed costs and add to operating leverage. Fixed regulatory costs that contribute to operating leverage should generate a risk premium. To explore whether such a premium exists, we introduce a measure of “regulatory operating leverage” that reflects the importance of fixed regulatory costs in a firm’s cost structure. Regulatory operating leverage predicts stock returns in the cross-section, and a zero-cost high-low regulatory operating leverage strategy generates positive and significant risk-adjusted return. Finally, the impact of regulatory operating leverage on returns is due to the (systematic) risk contribution of fixed regulatory costs.

Abstract: We consider markets with heterogeneously ambiguous assets and heterogeneously ambiguity-averse investors whose preferences are a parsimonious extension of the mean–variance framework. We study portfolio choice and trade upon arrival of public information, and show systematic departures from the predictions of standard theory, that occur in the direction of empirical regularities. In particular, our theory speaks to several phenomena in a unified fashion: the asset allocation puzzle, the observation that earnings announcements are followed by significant trading volume with small price change, and that increases in uncertainty are positively associated with increased trading activity and portfolio rebalancing toward safer assets.

Abstract: In this paper, we examine the cyclical dynamics of a Real Business Cycle model with ambiguity averse consumers and investment irreversibility using the smooth ambiguity model of Klibanoff et al. (2005, 2009). Ambiguity of belief about the productivity process arises as agents do not know the process driving variation in aggregate TFP, and they must make inferences regarding the true process at the same time as they infer the behavior of the unobserved temporary component using a Kalman filtering algorithm. Our findings may be summarized as follows. First, the standard business cycle facts hold in our framework, which are not altered significantly by changes in the degree of ambiguity aversion. Second, we demonstrate a role for information and learning effects, and show that lower initial ambiguity or greater confidence coupled with learning dynamics lowers the volatility and increases the persistence in all of the key macroeconomic variables. Third, comparing the performance of our model to the New Keynesian business cycle model of Ilut and Schneider (2014) with maxmin expected utility, we find that the version of their model without nominal and real frictions turns out to have limited success at matching the moments for the quantity variables. In the maxmin expected utility framework, the worst case scenario instills too much caution on the part of agents who, in the absence of a key set of nominal and real frictions, end up excessively reducing their responses to TFP shocks.

- abstracted in the CFA Digest, 2014, 44(2)

- invited summary article in the Finance & Accounting Memos (FAMe), Summer 2016

Abstract: We study the trading behavior of investors in an entire stock market. Using an account level dataset of all trades on the Istanbul Stock Exchange in 2005, we identify investors with similar trading behavior as linked in an empirical investor network (EIN). Consistent with the theory of information networks, we find that central investors earn higher returns and trade earlier than peripheral investors with respect to information events. Overall, our results support the view that information diffusion among the investor population influences trading behavior and returns.

Abstract: We study asset pricing in economies with large information networks. We focus on networks that are sparse and have power law degree distributions, in line with empirical studies of large scale social networks. Our theoretical framework yields a rich set of novel asset pricing implications. We derive closed form expressions for price, volatility, profitability and trading volume, as functions of the network topology. We also study agent welfare and show that the network that optimizes total welfare is typically a uniform one with an intermediate degree of connectedness.

Abstract: The quality of information in financial asset markets is often hard to estimate. Reminiscent of the famous Ellsberg paradox, investors may be unable to form a single probability belief about asset returns conditional on information signals and may act on the basis of ambiguous (or multiple) probability beliefs. This paper analyzes information transmission in asset markets when agents’ information is ambiguous. We consider a market with risk-averse informed investors, risk-neutral competitive arbitrageurs, and noisy supply of the risky asset, first studied by Vives (1995a, 1995b) with unambiguous information. Ambiguous information gives rise to the possibility of illiquid market where arbitrageurs choose not to trade in a rational expectations equilibrium. When market is illiquid, small informational or supply shocks have relatively large effects on asset prices.

Abstract: We study price formation in securities markets, using the sequential trade framework of Glosten and Milgrom (1985). This paper makes one basic methodological advance over previous research on sequential securities trading: we allow traders to choose from n trade sizes in a multi-period market, where n can be arbitrarily large. We examine how trade size multiplicity affects the intertemporal dynamics of trading strategies, bid–ask spreads, and information revelation. We show that price impact, as a function of trade size, is increasing and exhibits (discrete) concavity.

Abstract: We often observe disproportionate reactions to tangible information in large stock price movements. Moreover these movements feature an asymmetry: the number of crashes is more than that of frenzies in the S&P 500 index. This paper offers an explanation for these two characteristics of large movements in which hedging (portfolio insurance) causes amplified price reactions to news and liquidity shocks as well as an asymmetry biased towards crashes. Risk aversion of traders is shown to be essential for the asymmetry of price movements. Also, we show that differential information can enhance both amplification and asymmetry delivered by hedging.

Abstract: The stock market suffers from money illusion, discounting real cash flows at nominal discount rates. Subsequent research has also shown that the cross-section of stock returns is impacted differently by inflation. This cross-sectional variance across risky and safe stocks makes one of the most puzzling anomalies, risk (beta) anomaly, stronger in inflationary periods. This chapter tests the hypothesis that higher inflation leads to stronger mispricing of risk in stock market due to money illusion effect in Turkey, one of the emerging countries afflicted with perennial high inflation. The results show that although money illusion and mispricing were not visibly present in hyper-inflationary period in 1990s, the anomalous pricing of risky securities was remarkably high in inflationary periods over the last two decades, with a distinct mispricing due to the inflationary pressure that commenced with the COVID-19 pandemic. These varying results across the vastly different inflation regimes can be explained by rational inattention and impact of past experience of inflation on investment behavior.

Abstract: This paper models the role of the lender of last resort (LoLR) in a general equilibrium framework. We allow for heterogeneous agents and a risk-averse banking sector, and incorporate the frictions of endogenous default, liquidity, and money. Adverse supply shocks in monetary endowments trigger default, leading to deterioration in the value of bank assets, and subsequent bank illiquidity in some states of the world. LoLR intervention is then assessed with regards to its economy-wide effect on welfare, bank profitability, and the level of default. The results provide a rationalization for constructive ambiguity and the ‘too big to fail’ problem.