Journal of Finance, December 2014
- Winner of the 2015 Journal of Finance Amundi Smith Breeden Prize, Distinguished Paper
Financial intermediaries trade frequently in many markets using sophisticated models. Their marginal value of wealth should therefore provide a more informative stochastic discount factor (SDF) than that of a representative consumer. Guided by theory, we use shocks to the leverage of securities broker-dealers to construct an intermediary SDF. Intuitively, deteriorating funding conditions are associated with deleveraging and high marginal value of wealth. Our single-factor model prices size, book-to-market, momentum, and bond portfolios with an R2 of 77% and an average annual pricing error of 1%— performing as well as standard multi-factor benchmarks designed to price these assets.
- NBER discussion of He, Kelly, Manela (2017), a related paper
Journal of Monetary Economics, December 2016
We use firms' decisions in the cross-section about their sources and uses of funds in order to make inferences about the aggregate cost of external finance. The basic intuition is as follows: Firms which raise costly external finance can invest the issuance proceeds in productive capital assets, or in liquid financial assets with a low physical rate of return. If firms raise costly external finance and allocate some of the funds to liquid assets, either the cost of external finance is relatively low, or the total return to liquidity accumulation, including its value as a hedging asset, is particularly high. We construct and estimate a quantitative, dynamic model of firms' financing and savings decisions. We then use the model's predictions for variation in firm policies and implied cross sectional moments, along with empirical moments from Compustat, to infer the average cost of external finance per dollar raised in the US time series 1980-2010.
Quarterly Journal of Economics, May 2017
I analyze the behavior of risk premia in financial crises, wars, and recessions in an international panel spanning over 140 years and 14 countries. I document that risk premia increase substantially in financial crises, but not in the other episodes. However, drops in consumption and consumption volatility are fairly similar across financial crises and recessions and are largest during wars, so standard macro asset pricing models have trouble matching this variation. Comparing crises to "deep" recessions strengthens these findings further. I also find the net worth of the financial sector forecasts returns. The results suggest that the health of the financial sector is important for understanding why risk premia vary.
Journal of Finance, August 2017
Managed portfolios that take less risk when volatility is high produce large alphas, substantially increase factor Sharpe ratios, and produce large utility gains for mean-variance investors. We document this for the market, value, momentum, profitability, return on equity, and investment factors in equities, as well as the currency carry trade. Volatility timing increases Sharpe ratios because changes in factors' volatilities are not fully offset by proportional changes in expected returns. Our strategy is contrary to conventional wisdom because it takes relatively less risk in recessions and crises yet still earns high average returns. This rules out typical risk-based explanations and is a challenge to structural models of time-varying expected returns.
Journal of Financial Economics, March 2019 [Lead Article]
A long-term investor who ignores variation in volatility gives up the equivalent of 2.4% of wealth per year. This result holds for a wide range of parameters that are consistent with U.S. stock market data and it is robust to estimation uncertainty. We propose and test a new channel, the volatility-composition channel, for how investment horizon interacts with volatility timing. Investors respond substantially less to volatility variation if the amount of mean-reversion in returns disproportionally increases with volatility and also if mean-reversion happens quickly. We find that these conditions are unlikely to hold in the data.
Revise and Resubmit, Journal of Finance
We study the behavior of credit and output across a financial crisis cycle using information from credit spreads. We show the transition into a crisis occurs with a large increase in credit spreads, indicating that crises involve a dramatic shift in expectations and are a surprise. The severity of the subsequent crisis can be forecast by the size of credit losses (change in spreads) coupled with the fragility of the financial sector (as measured by pre-crisis credit growth). We also find that recessions in the aftermath of financial crises are severe and protracted. Finally, we find that spreads fall pre-crisis and appear too low, even as credit grows ahead of a crisis. This behavior of both prices and quantities suggests that credit supply expansions are a precursor to crises. The 2008 financial crisis cycle is in keeping with these historical patters surrounding financial crises.
Poor intermediary health coincides with low asset prices and high risk premia, but it is unclear how much fluctuations in intermediaries' health matter for aggregate asset prices rather than simply being correlated with aggregate risk aversion. We argue that relative predictability of more vs less intermediated asset classes by intermediary health allows to quantify how much variation in risk premia we can ascribe to intermediaries. Intermediary health should matter relatively more for assets that households are less willing to hold directly, whereas frictionless aggregate risk aversion should, if anything, exhibit the opposite pattern. We provide direct empirical evidence that this is the case and hence argue that intermediaries matter for a number of key asset classes including CDS, commodities, sovereign bonds, and FX. Our findings suggest that a large fraction of variation in risk premia in these asset classes is related to intermediary risk appetite.
- Media Coverage: Bloomberg
The financial architecture prior to the recent financial crisis was a system of mobile collateral. Safe debt, whether government bonds or privately-produced bonds, i.e., asset-backed securities, could be traded, posted as collateral, and rehypothecated, moving to its highest value use. Since the financial crisis, regulatory changes to the financial architecture have aimed to make collateral immobile, most notably with the BIS "liquidity coverage ratio" for banks. We evaluate this immobile capital system with reference to a previous regime which had this feature: the U.S. National Banking Era. We find evidence that a system of immobile collateral contributes to scarcity of safe debt and encourages other forms of short term debt to emerge, possibly making the system riskier.
Standard factor pricing models do not capture the common time series or cross sectional variation in average returns of financial stocks well. We propose a five factor asset pricing model that complements the standard Fama French 1993 three factor model with a financial sector ROE factor (FROE) and the spread between the financial sector and the market return (SPREAD). This five factor model helps to alleviate the pricing anomalies for financial sector stocks and also performs well for non-financial sector stocks when compared to the Fama French 2014 five factor or the Hou Xue Zhang 2014 four factor models. We find the aggregate expected return to financial sector equities to correlate negatively with aggregate financial sector ROE, which is puzzling, as ROE is commonly used as a measure of the cost of capital in the financial sector.
Standard risk factors can be hedged with minimal reduction in average return. This is true for "macro" factors such as industrial production, unemployment, and credit spreads, as well as for "reduced form" asset pricing factors such as value, momentum, or profitability. Low beta versions of the factors perform close to as well as high beta versions, hence a long short portfolio can hedge factor exposure with little reduction in expected return. For the reduced form factors this mismatch between factor exposure and expected return generates large alphas. For the macroeconomic factors, hedging the factors also hedges business cycle risk by significantly lowering exposure to consumption, GDP, and NBER recessions. We study implications both for optimal portfolio formation and for understanding the economic mechanisms for generating equity risk premiums.
We study new international data on commercial banks and securities dealers from 1870-2016. Balance sheet expansion of intermediaries negatively predicts asset returns (stocks, bonds, currencies, housing) with high R2. This holds when controlling for macroeconomic predictors, is more concentrated at shorter horizons, and is stronger for intermediaries who participate more in a given security. We find robust predictability outside distress periods, in contrast to models featuring non-linearities during distress. Intermediaries in global financial centers predict asset returns internationally. Our results suggest a strong universal link between intermediaries and asset returns distinct from other macroeconomic channels. We highlight implications for theory.
12. Slides on Intermediary Asset Pricing presented at FMA (overview / survey)