Forthcoming, Journal of Finance
Abstract: Buyout booms form in response to declines in the aggregate risk premium. We document that the equity risk premium is the primary determinant of buyout activity rather than credit-specific conditions. We articulate a simple explanation for this phenomenon: a low risk premium increases the present value of performance gains and decreases the cost of holding an illiquid investment. A panel of U.S. buyouts confirms this view. The risk premium shapes changes in buyout characteristics over the cycle, including their riskiness, leverage, and performance. Our results underscore the importance of the risk premium in corporate finance decisions.
Revise and Resubmit, Review of Economic Studies
Abstract: Investors can choose to hold diversified or levered, concentrated portfolios of risky assets. This paper studies the dynamics of asset prices in an economy in which both investment styles coexist in equilibrium even though all agents are ex-ante identical. I capture the tradeoff between risk sharing and productivity gains by introducing what I call “active capital.” People who participate in such investments are restricted in their outside opportunities but receive extra compensation for the productivity gains they bring to the corresponding enterprises. I show that fluctuations in the quantity of active capital increase the volatility of asset prices relative to a standard economy. Not all shocks shift the distribution of ownership: risk considerations determine the willingness to provide active capital, whereas current and expected future economic activity do not play a role. Therefore, active capital fluctuates jointly with risk premia, amplifying their variations. As a consequence, the price of volatility risk exposure can be large, and return volatility is mainly induced by fluctuations in future expected returns. These results are particularly strong when fundamental volatility is low, because at such times, a large number of concentrated owners are likely to exit their positions and sell off their assets.
Revise and Resubmit, American Economic Review
Revised 05/15; Online appendix with proofs
Abstract: We propose a theory of inattention solely based on preferences, absent cognitive limitations or external costs of information. Under disappointment aversion, agents are intrinsically information averse. In a consumption-savings problem, we study how information averse agents cope with their fear of information, to make better decisions: they acquire information at infrequent intervals only, and inattention increases when volatility is high, consistent with the empirical evidence. Adding state-dependent alerts following sharp downturns improves welfare, despite the additional endogenous information costs. Our framework accommodates a broad range of applications, suggesting our approach can explain many observed features of decision under uncertainty.
Detail Disagreement and Innovation Booms (with Paul Ho and Erik Loualiche)
Draft available upon request
Abstract: It is natural for investors in financial markets to disagree on precisely which types of innovations are likely to be successful in a specific field. We call this type of heterogenous priors detail disagreement. Detail disagreement in financial markets profoundly affects the innovative process. Our model predicts the presence of detail disagreement creates a form of competition neglect. This mechanism entails higher asset prices that subsequently crash, more investment, firm creation, and specifically to our approach, more diversity in innovation. We show investors’ portfolios, asset prices, and both the quantity and nature of firm creation during the tech boom of the early 2000s as well as the last few years are consistent with our approach. We discuss the potential welfare implications of such speculative episodes.
Abstract: Banks' exposure to fluctuations in interest rates strongly forecasts excess bond returns. This result is consistent with a bank-centric view of the market for interest rate risk. Banks' activities — accepting deposits and making loans — naturally exposes their balance sheets to changes in interest rates. In equilibrium, the bond risk premium compensates banks for bearing these fluctuations: for instance, when consumers demand for fixed rate mortgages increases, banks have to scale up their exposure to interest rate risk and are compensated by an increase in bond risk premium. A key insight is that the net exposure of banks, rather than quantities of particular types of loans or deposits, reveals the risk premium.
Abstract: We propose that financial institutions can act as asset insulators, creating value by holding illiquid assets for the long run and insulating those assets from transitory fluctuations in market prices. We illustrate the empirical relevance of this theory for the balance sheet behavior of a large class of intermediaries, life insurance companies. The pass-through from assets to equity is an especially informative metric for distinguishing the asset insulator theory from Modigliani-Miller or other standard models. We estimate the pass-through using security-level data on insurers' holdings matched to corporate bond returns. Uniquely consistent with the insulator view, outside of the 2008-2009 crisis insurers lose as little as 10 cents in response to a dollar drop in asset values, while during the crisis the pass-through rises to roughly 1. The rise in pass-through highlights the fragility of insulation exactly when it is most valuable.
Changing Risk: Volatility or Persistence?