We relate Schumpeter’s notion of creative destruction to asset pricing, thereby offering a novel explanation of size and value premia. We argue that small-value firms must offer higher expected returns to compensate for the risk posed by serendipitous invention activity, whereas large-growth stocks provide protection against creative destruction and receive expected return discounts. A 2-factor model that accounts for creative-destruction risk effectively explains the cross-sectional return variation of size- and book-to-market-sorted portfolios. The estimated risk compensations associated with creative destruction are substantial and statistically significant, indicating their relevance for asset pricing.

Inside debt compensation held by top officers of U.S. banks is negatively related to risk and risk taking. The evidence reveals a robust and strongly negative relation between end-of-2006 inside debt and 2007–2009 bank-specific risk exposures in terms of lost stock market value, volatility, tail risk, and the probability of financial distress. Banks with managers having large inside debt holdings are also characterized by better-quality assets, more conservative balance sheet management, and a stronger tendency toward traditional banking activities. The results suggest that debt-based compensation limits bank risk and risk taking by encouraging more conservative decision making.

A conditional asset pricing model with risk and uncertainty implies that the time-varying exposures of equity portfolios to the market and uncertainty factors carry positive risk premia. The empirical results from the size, book-to-market, momentum, and industry portfolios indicate that the conditional covariances of equity portfolios with market and uncertainty predict the time-series and cross-sectional variation in stock returns. We find that equity portfolios that are highly correlated with economic uncertainty proxied by the variance risk premium (VRP) carry a significant annualized 8% premium relative to portfolios that are minimally correlated with VRP.

We examine the link between bank competition and financial stability using the recent financial crisis as the setting. We utilize variation in banking competition at the state level and find that banks facing less competition are more likely to engage in risky activities, more likely to face regulatory intervention, and more likely to fail. Focusing on the real estate market, we find that states with less competition had higher rates of mortgage approval, experienced greater inflation in housing prices before the crisis, and experienced a steeper decline in housing prices during the crisis. Overall, our study is consistent with greater competition increasing financial stability.

Models that examine investors’ motivations to trade often make opposite predictions about the relation between trading decisions and past returns. We find that, in the aggregate, both buyer- and seller-initiated trades increase with past returns. The difference between buyer- and seller-initiated trades is negatively related to short horizon returns but positively related to returns over longer horizons. Tax-loss-related seller-initiated trades in December and January are accompanied by increased buyer-initiated trades. Past returns significantly affect trading decisions, and these findings are consistent with a number of different models of trading behavior.

Recently, exchanges have been directly selling market data. We analyze how this practice affects price discovery, the cost of capital, return volatility, market liquidity, information production, and trader welfare. We show that selling price data increases the cost of capital and volatility, worsens market efficiency and liquidity, and discourages the production of fundamental information relative to a world in which all traders observe prices. Generally, allowing exchanges to sell price information benefits exchanges and harms liquidity traders. Overall, our results suggest that regulations on selling market data can play an important role in improving market quality and trader welfare.

Efficient contracting predicts that ex ante severance pay contracts are offered to chief executive officers (CEOs) as protection against downside risk and to encourage investment in risky projects with a positive net present value (NPV). Consistent with this prediction, we find that ex ante contracted severance pay is positively associated with proxies for a CEO’s risk of dismissal and costs the CEO would incur from dismissal. Additionally, we show that the contracted severance payment amount is positively associated with CEO risk taking and the extent to which a CEO invests in projects that have a positive NPV. Overall, our findings imply that ex ante severance pay contracts are consistent with efficient contracting.

The literature documents heterogeneity in the delay of stock price reaction to systematic shocks, implying that asset risk depends on investment horizon. We study the pricing of risk factors across investment horizons. Value (liquidity) risk is priced over intermediate (short) horizons. Conditioning horizon-factor exposures on firm characteristics indicates that characteristics, with the exception of momentum, are not priced beyond their contribution to systematic risk. Long-horizon institutional investors overweight assets with high intermediate-horizon exposures to value risk and high short-horizon exposures to liquidity risk. The results highlight the importance of investment horizon in determining risk premia.

The finance literature documents a relation between labor income and the cross section of stock returns. One possible explanation for this is the hedging decisions of investors with relative wealth concerns. This implies a negative risk premium associated with stock returns correlated with local undiversifiable wealth because investors are willing to pay more for stocks that help their hedging goals. We find evidence that is consistent with these regularities. In addition, we show that the effect varies across geographic areas depending on the size and variability of undiversifiable wealth, proxied by labor income.

Efficiency in the capital markets requires that capital flows are sufficient to arbitrage anomalies away. We examine the relation between flows to a quantitative (quant) strategy that is based on capital market anomalies and the subsequent performance of this strategy. When these flows are high, quant funds are able to implement arbitrage strategies more effectively, which in turn leads to lower profitability of market anomalies in the future, and vice versa. Thus, the degree of cross-sectional equity market efficiency varies across time with the availability of arbitrage capital.

A popular view is that private equity (PE) firms tend to expropriate other stakeholders of their portfolio companies. Bonds offered during 1992–2011 by companies after their initial public offerings (IPOs) do not reflect this view. We find that yield spreads on bonds offered by PE-backed companies are, on average, 70 basis points lower, holding other things constant. We also find that PE-backed companies have more conservative investment and dividend policies after bond offerings compared with non-PE-backed companies. These results suggest that PE firms’ reputational concerns dominate their wealth expropriation incentives and help their portfolio companies reduce the costs of debt.

This paper examines heterogeneity in blockholder monitoring across investor types. We document which blockholder types (e.g., mutual funds, hedge funds) are more likely to be associated with active monitoring and show that firms targeted by such blockholders are more likely to increase the equity portion of chief executive officer (CEO) pay. Further, using market-wide and exogenous shocks to liquidity to identify differences in efficacy across blockholder types, we observe greater operating-performance improvements in actively monitored firms when passive monitoring is less effective, suggesting causal impact. We propose differences in compensation arrangements across blockholder types as a mechanism underlying blockholders’ heterogeneous role.

Recent empirical studies have shown that during the financial crisis of 2007–2008, banks that were more heavily exposed to liquidity risk contracted their supply of credit more sharply. I contribute to the identification of this effect by relying on the use of micro-level data on U.S. mortgage loan applications, which allows me to identify liquidity risk as an important determinant of the contraction of credit in the mortgage market but as separate from the precipitous fall in credit demand, disruptions in the securitization and subprime markets, shifts in asset risk, and changing risk aversion among loan officers.

Internal finance leads to a stalemate in innovation games; each firm wants to free-ride on the others’ costly experimentation. When instead innovation is financed externally (e.g., with venture capital or initial public offerings), there is an endogenous cost to delay. Waiting to make risky irreversible investment conveys pessimistic information. I characterize the relative sizes of waves of leaders and followers in innovation cycles, and the endogenous, intertemporal distribution of quality as each wave builds and crashes. Finally, old waves leave an adverse selection “hangover,” such that too much early innovation can cause the market for future innovation to break down.

We study the investment–cash flow sensitivities of U.S. firms from 1971–2009. Our tests extend the literature in several key ways and provide strong evidence that cash flow explains investment beyond its correlation with q. A dollar of current- and prior-year cash flow is associated with $0.32 of additional investment for firms that are the least likely to be constrained and $0.63 of additional investment for firms that are the most likely to be constrained, even after correcting for measurement error in q. Our results suggest that financing constraints and free-cash-flow problems are important for investment decisions.

In this article, we examine the extent to which firm fundamentals can explain the cross-sectional variation in credit default swap (CDS) spreads. We construct a fundamental CDS valuation by combining the Merton distance-to-default measure with a long list of firm fundamentals via a Bayesian shrinkage method. Regressing CDS quotes against the fundamental valuation cross-sectionally generates an average R2 of 77%. The explanatory power is stable over time and robust in out-of-sample tests. Deviations between market quotes and the valuation predict future market movements. The results highlight the important role played by firm fundamentals in differentiating the credit spreads of different firms.

We show that business microloans to U.S. subprime borrowers have a very large impact on subsequent firm success. Using data on startup loan applicants from a lender that employed an automated algorithm in its application review, we implement a regression discontinuity design assessing the causal impact of receiving a loan on firms. Startups receiving funding are dramatically more likely to survive, enjoy higher revenues, and create more jobs. Loans are more consequential for survival among subprime business owners with more education and less managerial experience.

This paper examines the style-based feedback trading behavior of U.S. mutual fund managers. We provide an empirical version of Barberis and Shleifer’s style-switching model. We find style-based feedback trading for 77% of the funds, half of which is positive (negative) feedback trading. There is evidence for “twin style” switching, where capital is channeled between value and growth, and between large- and small-cap. Growth (value) funds apply more positive (negative) feedback trading. Funds that switch more aggressively are younger and have higher expense ratios. Finally, we find that positive (negative) feedback trading yields positive (negative) alpha.

We demonstrate theoretically and empirically that strategic considerations are important in shaping the cash policies of innovative firms. In our model, firms compete in product markets with uncertain structure using cash as a commitment device to invest in innovation. We show that firms’ equilibrium cash holdings are related to the expected intensity of competition. The sign and magnitude of this relation depends on firms’ financial constraints. Consistent with the strategic motive for hoarding cash, we show that firms’ cash holdings are negatively affected by their rivals’ cash-holding choices, even more so when competition is expected to be intense.

We use data from 2005–2009 that uniquely identify categories of traders to test how speculators such as hedge funds and swap dealers relate to volatility and price changes. In examining various subperiods where price trends are strong, we find little evidence that speculators destabilize financial markets. To the contrary, hedge fund position changes are negatively related to volatility in corn, crude oil, and natural gas futures markets. Additionally, swap dealer activity is largely unrelated to contemporaneous volatility. Our evidence is consistent with the hypothesis that hedge funds provide valuable liquidity and largely serve to stabilize futures markets.