2011 Working Papers

Papers are listed alphabetically by UCLA Anderson faculty. To search by keyword, use the Find feature on your browser.

Coping with Gray Markets: The Impact of Market Conditions and Product Characteristics
F. Iravani, H. Mamani, R. Ahmadi
Gray markets, also known as parallel imports, are marketplaces for trading genuine products that are diverted from authorized distribution channels. They have created fierce competition for manufacturers in many industries and each year billions of dollars worth of products are traded in these markets. Using a game-theoretic model, we analyze the impact of parallel importation on a price-setting manufacturer that serves two markets with uncertain demand. We characterize the optimal joint price and quantity decisions of the manufacturer which determine whether the manufacturer should ignore, block, or allow parallel importation. We also show that parallel importation forces the manufacturer to reduce her price gap while demand uncertainty forces her to lower prices in both markets. Moreover, we observe that parallel importation may force the manufacturer to exit the low-profit market. Through extensive numerical experiments, we explore the impact of market conditions (size and price elasticity) and product characteristics (a fashion item or a commodity) on the manufacturer's reaction to parallel importation. In addition, we provide interesting insights about the value of strategic pricing for coping with gray markets versus the uniform pricing policy that has been adopted by some companies to eliminate gray markets.

A Model of Optimal Corporate Bailouts
Antonio E. Bernardo, Eric Talley, and Ivo Welch
We analyze incentive-efficient government bailouts within a canonical model of intra-firm moral hazard. Bailouts exacerbate the moral hazard of firms and managers in two ways. First, they make them less averse to failing. Second, the taxes to fund bailouts dampen their incentives. Nevertheless, if third-party externalities from keeping the firm alive are strong, bailouts can improve welfare. Our model suggests that governments should use bailouts sparingly, where social externalities are large and subsidies small; eliminate incumbent owners and managers to improve a priori incentives; and finance bailouts through redistributive taxes on productive firms instead of forcing recipients to repay in the future.

A Simple Method for Assessing Project Risk by Adjusting for Growth Options Leverage
Antonio E. Bernardo
, Bhagwan Chowdhry & Amit Goyal
Capital budgeting methods require estimates of project betas which, using the Capital Asset Pricing Model (CAPM), allow us to estimate the cost of capital used for discounting expected future cash flows. In practice, equity betas are estimated using stock returns of comparable firms which are then unlevered for financial leverage to estimate asset betas. We show that asset betas estimated in this way overestimate project risk because they include growth options leverage. We show a simple method for unlevering asset betas for growth options leverage which can then be used to properly value investment projects. A similar problem arises when estimates of stock return volatility are used to estimate project volatility, an important input in "real options" models. Our method for unlevering asset betas can be applied to stock return volatility to derive project volatility which can then be used to properly value real options.

Leverage and Preemptive Selling of Financial Institutions
Antonio Bernardo & Ivo Welch
In our model, financial firms' leverage choices and asset sales impose negative externalities on other financial firms. This means that individual firms cannot determine their optimal capitalizations in isolation, but have to take the aggregate financial sector characteristics into account. In particular, they become more aggressive when their peers are more conservative. Furthermore, financial firms over-consume liquidity in equilibrium. For some parameter regions, small parameter changes can induce large differences in the equilibrium allocation of risk. Historical experience is not necessarily a good guide as to whether the prevailing equilibrium is fragile or not.

An Analysis of the Amihud Illiquidity Premium
Michael Brennan, Sahn-Wook Huh & Avanidhar Subrahmanyam
This paper analyzes the Amihud (2002) measure of illiquidity and its role in asset pricing. It is shown first that the (firm) size element of the measure is priced differently from the element that is constructed by dividing absolute returns by share turnover: the effect of firm size on asset returns is much less than is implied by the simple Amihud measure. Secondly, when we separate the Amihud measure into elements that correspond to positive (up) and negative (down) return days, we find that only the down day element commands a return premium. Further analysis of the up- and down-day elements using order flows provides evidence that a tendency for orders to cluster on the sell side on down days is associated with a higher return premium than the other components of the Amihud measure.

Sell-Order Liquidity and the Cross-Section of Expected Stock Returns
Michael Brennan, Tarun Chordia, Avanidhar Subrahmanyam & Qing Tong
We argue that, since market makers face funding constraints for their long inventory positions, and since insiders tend to be net long their company's shares, sell orders are likely to have bigger price impacts than buy orders. Further, since the demand for immediacy is likely to be greater for sellers than for buyers, the premium for illiquidity is likely to be more strongly associated with the price impact of sell orders than the price impact of buy order. We test these predictions by estimating buy- and sell-order measures of illiquidity for a comprehensive sample of NYSE stocks. We find that the average difference between sell- and buy-order illiquidity is generally positive throughout our sample period. In the cross-section of equity returns, we find that sellorder liquidity is priced far more strongly than buy-order liquidity. Indeed, the evidence indicates that the liquidity premium in equities emanates almost entirely from the sell-order side.

Behavior-Based Price Discrimination by a Patient Seller
Sushil Bikhchandani and Kevin McCardle
We investigate a model in which one seller and one buyer trade in each of two periods. The buyer has demand for one unit of a non-durable object per period. The buyer's reservation value for the good is private information and is the same in both periods. The seller commits to prices in each of two periods. Prices in the second period may depend on the buyer's first-period behavior. Unlike the equal discount factor case studied in earlier papers, we show that when the seller is more patient than the buyer, second-period prices increase after a purchase. In particular, the optimal dynamic pricing scheme is not a repetition of the optimal static pricing scheme.

Mechanism Design with Information Acquisition: Efficiency and Full Surplus Extraction
Sushil Bikhchandani & Ichiro Obara
Consider a mechanism design setting in which agents acquire costly information about an unknown, payoff-relevant state of nature. Information gathering is covert and the agents' information is correlated. We investigate conditions under which (i) efficiency and (ii) full surplus extraction are Bayesian incentive compatible and interim individually rational.

Electoral Incentives and Public Education Spending: Evidence from Brazil
Leonardo Bursztyn
This paper provides evidence against the argument that the rich prevent the poor from obtaining public education in low-income democracies. In Brazilian municipalities with low median incomes, voters are significantly less likely to reelect incumbent candidates from parties that increased the number of local public primary schools during their terms. This is not true for municipalities with high median incomes. A new survey asking subjects directly whether improving public education or increasing cash transfers is more important for the government to achieve shows that the poor are significantly more likely to choose cash transfers than are higher-income individuals. We introduce randomized information shocks in the same survey to respondents on how their local government allocated resources in previous years. One of the information shocks reports increases in public education spending accompanied by decreases in public expenditures associated with cash transfers. That shock is shown to make subjects associate the local government more with improvements in public education and less with increases in cash transfers. The shock significantly worsens the assessment of the local government for respondents with low incomes, while it significantly improves it for those with high incomes. These findings suggest that many democratic developing countries might have low levels of public education spending because the poor prefer the government to allocate resources elsewhere.

The Schooling Decision: Family Preferences, Intergenerational Conflict, and Moral Hazard in the Brazilian Favelas
Leonardo Bursztyn & Lucas C. Coffman
This paper experimentally analyzes the schooling decisions of poor households with adolescent children in urban Brazil. Parents in our study were being paid large monthly transfers by the local government conditional upon their children attending school. We elicit parents' incentivized choices between such conditional monthly payments and guaranteed, unconditional monthly payments of varying relative sizes. In the baseline treatment, an overwhelming majority of parents prefer conditional transfers to larger unconditional transfers. However, parents reveal much weaker preferences for the conditionality if either (i) their child is not informed that the conditionality would be dropped or (ii) if parents are offered to receive free text-message notifications whenever their child misses school. These findings suggest important intergenerational conflicts in these schooling decisions and a lack of parental control and observability of school attendance. Further experimental treatments are consistent with parental preferences not just to keep the children in the classroom but also off the streets.

Investment in Organization Capital
Bruce Ian Carlin, Bhagwan Chowdhry & Mark Garmaise
We study a firm's investment in organization capital by analyzing a dynamic model of language development and intrafirm communication. We show that firms with richer internal language (i.e., more organization capital) have lower employee turnover, and higher diversity in skill and wages among incumbents who are promoted from within the firm. Our results also suggest that firms in rapidly changing industries are less likely to invest in organization capital, and are more likely to have high managerial turnover. Finally, our model shows that employment protection regulations lead to more investment in organization capital but less innovation.

The Regulation of Financial Products
Bruce Ian Carlin & Shaun William Davies
We explore a theoretical model of product regulation in which the social planner chooses an optimal level of market complexity, given that people have varied sophistication. We study whether we can depend on the most qualified planners to implement regulation. To do so, we characterize the effect of lobbying and voting behavior on product regulation, and show that it is usually the case that both sophisticated and unsophisticated market participants have incentives to elect the least informed and educated planners. Based on this, well-intended regulation may not achieve first-best. Finally, we show that improving clarity in the market (e.g., more disclosure or better education) and enforcing simplicity (i.e., limiting differentiation) are strict substitutes from a welfare standpoint. Based on this, a fully informed social planner optimally trades off between better decision support and standardizing products in the market.

Trading Complex Assets
Bruce Ian Carlin, Shimon Koganz & Richard Lowery
We perform an experimental study of complexity to assess its effect on trading behavior, price volatility, liquidity, and trade efficiency. Subjects were asked to deduce the value of a particular asset from information they were given about the composition and price of several portfolios. Following that, subjects traded with each other anonymously in a well-defined, simple bargaining process. Portfolio composition ranged from requiring simple analysis to more complicated computation in order to deduce the value of the asset. Complexity altered subjects' bidding strategies, decreased liquidity, increased price volatility, and decreased trade efficiency. However, in follow-up experiments, we show that uncertainty over private values does not lead to the same changes in trading behavior. Therefore, while complexity induces estimation errors and higher uncertainty, this is not what drives our results.

What Does Financial Literacy Training Teach Us?
Bruce Ian Carlin & David T. Robinson
This paper uses data from a finance-related theme park located at Junior Achievement in Los Angeles to explore how financial education changes investment, financing, and consumer behavior. In the Finance Park, students were assigned fictitious life situations and asked to create household budgets for these roles. Some students received a 19-hour financial literacy curriculum before going to the park, and some did not. After controlling for demographic variables, we show that the treatment effects of the financial literacy program are strong. Students who experienced training were more frugal, delayed gratification, paid off debt faster, and relied less on credit financing. However, these same students purchased less comprehensive health insurance, exposing themselves to greater financial risk and wealth volatility in the future. This implies that training may not be extrapolated to related circumstances, and may lead to unintended consequences. Students who had attended training showed greater up-take of decision support that was offered in the park, which indicates that decision support and financial literacy training are complements, not substitutes.

Disclosure Drifts in Investor Networks
Judson Caskey, Michael Minnis & Venky Nagar
This study develops a model of information diffusion in a setting where investors are linked in a social network. We develop a model in which a rm's disclosure initially reaches only a subset of the investor base. Examples include investor relations conferences and settings where nite attention and cognitive skills limit the set of investors who monitor the firm's disclosures. While investors can learn from prices in our model, we focus on how the initially uninformed investors receive the information through the investor network. The price and trading reactions to disclosure depend on both the structure of the network and which investors initially receive the information. In particular, investors who are most connected play a key role in driving the price response to disclosure, and the ability of the disclosure transmission mechanism to reach these investors becomes crucial. Our model offers a simple way to consolidate and extend the ndings of several recent empirical papers that highlight the importance of the disclosure transmission mechanism (i.e., broadcast disclosures via press and electronic channels, or targeted disclosures via investor conferences and investor relations), and is a departure from the traditional accounting disclosure models that focus on the disclosed information itself and are largely silent on the properties of the underlying transmission mechanism.

Dividend Policy at Firms Accused of Accounting Fraud
Judson Caskey & Michelle Hanlon
We examine whether firms accused by the SEC of accounting fraud are less likely to pay dividends and/or increase dividends less often than similar firms not accused of accounting fraud. Our results are consistent with the alleged fraud firms being less likely to pay dividends immediately prior to the alleged fraud years and less likely to increase dividends during the fraud period, relative to a matched group of firms not accused of accounting fraud. In addition, we estimate Fama-Babiak regressions and find that the earnings-dividends relation is weaker for the alleged fraud firms relative to the non-fraud firms during the fraud period. Finally, using propensity score match tests, the data provide evidence that fraud causes firms to increase dividends less often, consistent with fraud firms not being able to keep pace with non-fraud firms in terms of dividend policy.

The Pricing Effects of Securities Class Action Lawsuits and Litigation Insurance
Judson Caskey
This study models a securities market in which investors can file securities class action lawsuits following a firm's release of news that contradicts earlier reports. Investors have rational expectations and buyers of the firm's shares anticipate litigation, which reduces the price they are willing to pay and amplifies the price reaction to bad news. Thus, when price price reactions to corrective disclosures serve as a benchmark for legal settlements, the amplification creates a feedback effect that exacerbates the price reaction. Litigation insurance provides value in this setting by reducing the need for investors to price the effects of anticipated litigation. Insurance also affects how changes in the litigation environment impact the firm, with some changes having an opposite effect on the frequency of lawsuits of uninsured and insured firms. Similar to dividends, the pricing behavior of rational investors eliminates the valuation impact of the portion of settlements paid to investors. The valuation impact of litigation, and therefore the ability of litigation to deter misreporting, arises from transaction costs, such as attorney fees, that the firm can mitigate by constraining misreporting and by purchasing insurance.

Investment in Energy Efficiency by Small and Medium-Sized Firms: An Empirical Analysis of the Adoption of Process Improvement Recommendations
S. Muthulingam, C.J. Corbett, S. Benartzi, B. Oppenheim
We investigate the adoption of energy efficiency initiatives using information on over 100,000 recommendations provided to more than 13,000 small and medium sized firms under the Industrial Assessment Centers (IAC) program of the US Department of Energy (DOE). We build on an earlier study by Anderson and Newell (2004) that explored the impact of economic factors on the adoption of energy efficiency initiatives, by investigating the role of behavioral factors on the adoption of energy efficiency initiatives. Using a probit instrumental variable model, we investigate three behavioral factors that could affect investment in energy efficiency. First, we find that adoption of a recommendation depends not only on its characteristics but also on the order in which the recommendations are presented. Adoption rates are higher for initiatives appearing early in a list of recommendations. We find evidence that this may in part be due to anchoring effects. Second, we find that adoption is not influenced by the number of options provided to decision makers. Third, we find that adoption is higher for recommendations that need lower managerial effort. Additionally, we identify conditions under which these behavioral factors are mitigated. We draw implications for enhancing adoption of energy efficiency initiatives and for other decision contexts where a collection of process improvement recommendations are made to firms.

Is Pay-for-Performance Detrimental to Innovation?
Florian Ederer & Gustavo Manso
Previous research has argued that compensation plans based on the pay-for-performance principle are effective in inducing higher levels of effort and in avoiding diversion of funds by managers. How should managerial compensation be structured if the goal is to induce managers to pursue more innovative business strategies? In a controlled laboratory setting, we provide evidence that the combination of tolerance for early failure and reward for long-term success is successful in motivating innovation. Subjects under such an incentive scheme explore more and are more likely to discover a novel business strategy than subjects under fixed-wage and standard pay-for-performance incentive schemes. We also find evidence that the threat of termination can undermine incentives for innovation, while golden parachutes can alleviate these innovation-reducing effects.

Time to Decide: Information Search and Revelation in Groups
Arthur Campbell, Florian Ederer & Johannes Spinnewijn
We analyze costly information acquisition and information revelation in groups in a dynamic setting. Even when group members have perfectly aligned interests the group may inefficiently delay decisions. When deadlines are far away, uninformed group members freeride on each others' efforts to acquire information. When deadlines draw close, informed group members stop revealing their information in an attempt to incentivize other group members to continue searching for information. Surprisingly, setting a tighter deadline may increase the expected decision time and increase the expected accuracy of the decision in the unique equilibrium. As long as the deadline is set optimally, welfare is higher when information is only privately observable to the agent who obtained information rather than to the entire group.

CEO Turnover in a Competitive Assignment Framework
Andrea L. Eisfeldt & Camelia M. Kuhnen
There is widespread concern about whether CEOs are appropriately punished for poor performance. While CEOs are more likely to be forced out if their performance is poor relative to the industry average, overall industry performance also matters. This seems puzzling if termination is disciplinary, however, we show that both absolute and relative performance driven turnover can be natural and efficient outcomes of a competitive assignment model in which CEOs and firms form matches based on multiple characteristics. The model also has new predictions about replacement managers' equilibrium pay and performance. We document CEO turnover events during 1992-2006 and provide empirical support for our model.

Corporate Capital Allocation: A Behavioral Perspective
David Bardolet, Craig R. Fox & Dan Lovallo
Previous research on capital investment has identified a tendency in multi-business firms toward cross-subsidization from well performing to poorly performing divisions, a phenomenon that has previously been attributed to principal-agent conflicts between headquarters and divisions (Stein, 2003). In this paper we argue that cross-subsidization reflects a more general tendency toward even allocation over all divisions in multi-business firms that is driven at least in part by the cognitive tendency to naïvely diversify when making investment decisions (Benartzi and Thaler, 2001). We observe that this tendency also leads to partition dependence in which capital allocations vary systematically with the divisions and subdivisions into which the firm is organized or over which capital is allocated. Our first study uses archival data to show that firms' internal capital allocations are biased toward equality over the number of business units into which the firm is partitioned. Two further experimental studies of experienced managers examine whether this bias persists when participants are asked to allocate capital to various divisions of a hypothetical firm. This methodology eliminates the possibility of agency conflicts. Nevertheless, allocations varied systematically with the divisional and subdivisional structure of the firm, and whether capital was allocated in a centralized or decentralized manner.

Controlling Unknown Risks Through Organizational Design
Mark J. Garmaise
Financial institutions can best mitigate unknown risks by having employees specialize while rotating them through relationships with suppliers. I document a specific form of personal asset misrepresentation by borrowers in the mortgage market that was undiscovered by a bank in the 2004-2008 sample period. Empirically, two strategies reduce the severity of this unknown risk. First, the limited attention of loan officers necessitates that they be assigned a set of geographically-focused mortgages from familiar areas. Second, banks should ensure that employee relationships with outside firms are not too extended.

Family Values and the Regulation of Labor
Alberto Alesina, Yann Algan, Pierre Cahuc & Paola Giuliano
Flexible labor markets require geographically mobile workers to be efficient. Otherwise firms can take advantage of the immobility of workers and extract monopsony rents. In cultures with strong family ties, moving away from home is costly. Thus, individuals with strong family ties rationally choose regulated labor markets to avoid moving and limiting the monopsony power of firms, even though regulation generates lower employment and income. Empirically, we do find that individuals who inherit stronger family ties are less mobile, have lower wages, are less often employed and support more stringent labor market regulations. We find positive correlations between labor market rigidities at the beginning of the twenty first century and family values prevailing before World War II, and between family structures in the Middle Ages and current desire for labor market regulation. Both results suggest that labor market regulations have deep cultural roots.

On the Origins of Gender Roles: Women and the Plough
Alberto F. Alesina, Paola Giuliano & Nathan Nunn
This paper seeks to better understand the historical origins of current differences in norms and beliefs about the appropriate role of women in society. We test the hypothesis that traditional agricultural practices influenced the historical gender division of labor and the evolution and persistence of gender norms. We find that, consistent with existing hypotheses, the descendants of societies that traditionally practiced plough agriculture, today have lower rates of female participation in the workplace, in politics, and in entrepreneurial activities, as well as a greater prevalence of attitudes favoring gender inequality. We identify the causal impact of traditional plough use by exploiting variation in the historical geo-climatic suitability of the environment for growing crops that differentially benefited from the adoption of the plough. Our estimates, based on this variation, support the findings from OLS. To isolate the importance of cultural transmission as a mechanism, we examine female labor force participation of second-generation immigrants living within the US.

The Right Amount of Trust
Jeffrey Butler, Paola Giuliano, Luigi Guiso

We investigate the relationship between individual trust and individual economic performance. We find that individual income is hump-shaped in a measure of intensity of trust beliefs. Heterogeneity of trust beliefs in the population, coupled with the tendency of individuals to extrapolate beliefs about others from their own levels of trustworthiness, could generate this non-monotonic relationship: highly trustworthy individuals tend to form overly optimistic beliefs, to assume too much social risk and to be cheated more often, ultimately performing less well than those with a belief close to the mean trustworthiness of the population. On the other hand, less trustworthy individuals form overly pessimistic beliefs and avoid being cheated, but give up profitable opportunities, therefore underperforming. The cost of either too much or too little trust is comparable to the income lost by foregoing college. Our findings in large-scale survey data are supported and extended with experimental findings. In the trust game, own trustworthiness and beliefs about others' trustworthiness are strongly correlated and persistent. Earning losses due to incorrect beliefs are comparable to those in the survey data.

Brand Performance Volatility Arising from Marketing Spending Behavior under Competition
Marc Fischer, Hyun Shin & Dominique M. Hanssens
While volatile marketing spending, as opposed to even-level spending, may improve a brand's financial performance, it can also increase the volatility of performance, which is not a desirable outcome. This paper analyzes how revenue and cash-flow volatility are influenced by own and competitive marketing spending volatility, by the level of marketing spending, by the responsiveness of own marketing spending, and by competitive reactivity. From market response theory, we derive propositions about the influence of these variables on revenue and cash-flow volatility. Based on a broad sample of 99 pharmaceutical brands in four clinical categories and four European countries, the authors test for the empirical relevance of the propositions and assess the magnitude of the different sources of marketing-induced performance volatility. The authors find broad support for the predicted volatility effects. The results suggest that volatile marketing spending may incur negative financial side effects such as greater financing costs or higher opportunity costs of cash holdings. Thus common volatility-increasing marketing practices such as advertising pulsing may be effective at the top-line, but could turn out to be ineffective after all costs are taken into account.

Marketing and the Evolution of Customer Equity of Frequently Purchased Brands
Shijin Yoo, Dominique M. Hanssens & Ho Kim
The customer equity paradigm is readily implemented in relationship businesses where the distinction between a prospect and an existing customer is unambiguous. That enables firms in such industries to be customer and long-term focused in the allocation of their marketing resources. This is not the case in frequently purchased product categories, where customers may switch back and forth between competing brands, and even consume multiple brands in the same time period. However, by using stochastic models for purchase quantity and purchase frequency, we demonstrate that measures of customer equity may still be obtained in such categories, using readily available scanner panel data. We illustrate our approach for the leading national and private-label brands in two CPG categories and show that the brands' sources of customer equity and the impact of their marketing activities are different. As a result, the brands' customer equity levels may be evolving in different directions that are not readily apparent from their revenue or market share positions. We discuss the managerial implications of our findings and offer several areas for future research.

Positive vs. Negative Online Buzz as Leading Indicators of Daily Price Fluctuation
Hyun S. Shin, Dominique M. Hanssens & Bharath Gajula
Online buzz describes the quality of products in a positive or negative way, but we do not know if and how such customers' quality perceptions, often referred to as "e-sentiment," influence the products' market value. This paper investigates the relationship between e-sentiment and the market price fluctuation in a high-technology category, MP3 players. Econometric time-series modeling reveals that e-sentiment is a leading indicator of brands' daily price fluctuation. Furthermore, the effect is moderated by customers' expectation level: negative online buzz has a stronger adverse impact for well-known brands and high-ticket items, and positive online buzz has a greater beneficial effect on lesser-known brands and low-priced items. These findings establish the predictive relevance of e-sentiment information and suggest that e-retailers should monitor e-sentiment surrounding high-tech products since today's customers' quality perceptions is a signal of change in their profitability in the near future, i.e., within next 1-2 days.

Systemic Sovereign Credit Risk: Lessons from the U.S. and Europe
Andrew Ang & Francis A. Longstaff
We study the nature of systemic sovereign credit risk using CDS spreads for the U.S. Treasury, individual U.S. states, and major European countries. Using a multifactor affine framework that allows for both systemic and sovereign-specific credit shocks, we find that there is considerable heterogeneity across U.S. and European issuers in their sensitivity to systemic risk. U.S. and Euro systemic shocks are highly correlated, but there is much less systemic risk among U.S. sovereigns than among European sovereigns. We also find that U.S. and European systemic sovereign risk is strongly related to financial market variables. These results provide strong support for the view that systemic sovereign risk has its roots in financial markets rather than in macroeconomic fundamentals.

Common Risk Factors in Currency Markets
Hanno N. Lustig, Nikolai L. Roussanov & Adrien Verdelhan
We identify a 'slope' factor in exchange rates. High interest rate currencies load more on this slope factor than low interest rate currencies. This factor accounts for most of the cross-sectional variation in average excess returns between high and low interest rate currencies. A standard, no-arbitrage model of interest rates with two factors - a country-specific factor and a global factor - can replicate these findings, provided there is sufficient heterogeneity in exposure to global or common innovations. We show that our slope factor identifies these common shocks, and we provide empirical evidence that it is related to changes in global equity market volatility. By investing in high interest rate currencies and borrowing in low interest rate currencies, US investors load up on global risk.

How Does the U.S. Government Finance Fiscal Shocks?
Antje Berndt, Hanno N. Lustig & Sevin Yeltekin
We develop a method for identifying and quantifying the fiscal channels that help finance government spending shocks. We define fiscal shocks as surprises in defense spending and show that they are more precisely identified when defense stock data are used in addition to aggregate macroeconomic data. Our results show that in the postwar period, about 9% of the U.S. government's unanticipated spending needs were financed by a reduction in the market value of debt and more than 70% by an increase in primary surpluses. Additionally, we find that long-term debt is more effective at absorbing fiscal risk than short-term debt.

Too-Systemic-To-Fail: What Option Markets Imply About Sector-Wide Government Guarantees
Bryan T. Kelly, Hanno N. Lustig & Stijn Van Nieuwerburgh
Investors in option markets price in a substantial collective government bailout guarantee in the financial sector, which puts a floor on the equity value of the financial sector as a whole, but not on the value of the individual firms. The guarantee makes put options on the financial sector index cheap relative to put options on its member banks. The basket-index put spread rises fourfold from 0.8 cents per dollar insured before the financial crisis to 3.8 cents during the crisis for deep out-of-the-money options. The spread peaks at 12.5 cents per dollar, or 70% of the value of the index put. The rise in the put spread cannot be attributed to an increase in idiosyncratic risk because the correlation of stock returns increased during the crisis. The government's collective guarantee partially absorbs financial sector-wide tail risk, which lowers index put prices but not individual put prices, and hence can explain the basket-index spread. A structural model with financial disasters quantitatively matches these facts and attributes as much as half of the value of the financial sector to the bailout guarantee during the crisis. The model solves the problem of how to measure systemic risk in a world where the government distorts market prices.

How Stable are Corporate Capital Structures?
Harry DeAngelo & Richard Roll
Capital structure stability is the exception, not the rule. Wide variation in book leverage, market leverage, and the net-debt ratio is the norm at publicly held industrial firms. In panel leverage regressions, firm fixed effects differ significantly across decades. Stability of the leverage cross section is short-lived. Cross-sectional migration is pervasive: 69.5% of firms listed 20-plus years have book leverage in at least three different quartiles, and 30.4% are in all four quartiles at different times over the average 20-year period. Stability occurs infrequently and mainly at low leverage, and is virtually always temporary.

Internationally Correlated Jumps
Kuntara Pukthuanthong and Richard Roll
Stock returns are characterized by extreme observations, jumps that would not occur under the smooth variation typical of a Gaussian process. We find that jumps are prevalent in most countries. This has been noticed before in some countries, but there has been little investigation of whether the jumps are internationally correlated. Their possible inter-correlation is important for investors because international diversification is less effective when jumps are frequent, unpredictable and strongly correlated. Government fiscal and monetary authorities are also interested in jump correlations, which have implications for international policy coordination. We investigate using daily returns on broad equity indexes from 82 countries and for several competing statistical measures of jumps. Various jump measures are not in complete agreement but a general pattern emerges. Jumps are internationally correlated but not as much as returns. Although the smooth variation in returns is driven strongly by systematic global factors, jumps are more idiosyncratic.

Learning from Repetitive Acquisitions: Evidence from the Time Between Deals
Nihat Aktas, Eric de Bodt & Richard Roll
Repetitive acquisitions involve benefits and costs. Benefits accrue from learning about the takeover process while costs involve integrating the combined firms. These benefits and costs are not directly observable from outside the firm but this paper proposes a simple model to infer their relative importance from the time between successive deals. The data requirements are minimal and allow the use of all mergers and acquisitions during 1992-2009 (more than 300,000 deals). The results provide strong and robust evidence that learning dominates integration costs for repetitive acquirers.

Volume in Redundant Assets
Richard Roll, Eduardo Schwartz & Avanidhar Subrahmanyam
Multiple contingent claims on the same asset are common in financial markets, but little is known about the joint time-series of trading activity in these claims. We study volume on the S&P 500 index and four contingent claims on the index, the options, the traditional (legacy) futures contract, the E-mini futures contract and the ETF, over a long time-period of more than 3000 trading days. Legacy futures volume has trended downward while other series have trended upward. Overall futures volume has shown an upward trend, suggesting that the E-mini contract has at least partially supplanted the legacy contract. All series are highly crosscorrelated but do not share time-series regularities; for example, higher January volume occurs only in the cash index market. Vector autoregressions indicate that all series are jointly determined. Consistent with the informational role of derivatives markets, volume innovations in contingent claims lead those in the cash market. There also is evidence that trading activity in contingent claims (specifically, options) predicts absolute shifts in stock market volatility and aggregate state variables such as the term structure and the credit spread, as well as absolute returns around major macroeconomic announcements.

Board Quality and the Cost of Debt Capital: The Case of Bank Loans
L. Paige Fields, Donald Fraser & Avanidhar Subrahmanyam
We analyze the relation between comprehensive measures of board quality and the cost as well as the non-price terms of bank loans. We show that firms with higher quality boards and even a single (non-insider) advisory board member borrow at lower interest rates. This relation exists even after controlling for ownership structure, CEO compensation policy, and shareholder protection as well as the size and financial characteristics of the borrower and of the loan. We also show that board quality and other governance characteristics influence the likelihood that loans will have covenant requirements, but the relations differ by covenant type. Firms with high quality boards are less likely to have loans with financial ratio restrictions, but the firms are more likely to have such restrictions if they have high institutional ownership. Firms with greater diversity on the board are less likely to have collateral requirements, though these covenants are more likely when CEO cash compensation and institutional ownership are high or when the percentage of incentive-based pay or investor protection are low. Overall, the quality of the board plays an important role in lowering the cost of debt.

Decomposing the Effect of Consumer Sentiment News - Evidence from US Stock and Stock Index Futures Markets
Shumi Akhtar, Robert Faff, Barry Oliver & Avanidhar Subrahmanyam
This research examines the effect of the announcement of the consumer sentiment index issued by the University of Michigan on US stock and stock futures markets. First, the results indicate that the consumer sentiment index announcement has valuable information content. Second, an asymmetric response is observed with regard to "good" versus "bad" sentiment news. This asymmetry in the announcement effect is found to be a negativity effect (identified from the psychology literature). Specifically, when a lower (higher) than previous month consumer sentiment index is announced, equity and futures markets experience a significant negative announcement day (no) effect. Third, we document that, contrary to suggestions made in the prior literature, the effect of negative consumer sentiment announcements is not focused in sentiment prone stocks. Rather, we find the effect to be in the more prominent (salient) stocks and futures contracts associated with the index of those stocks. This supports the availability heuristic.

Funding Constraints and Market Efficiency
Ferhat Akbas, Will J. Armstrong, Sorin Sorescu & Avanidhar Subrahmanyam
We explore the premise that the degree of market efficiency changes dynamically as investment funds face time-varying funding constraints to arbitrage capital. We show that the returns to a composite long-short hedge strategy that encompasses relative value, momentum, short-run reversals, and accounting profitability, are higher when past returns to the strategy are low, and past volatility is high, which is when fund managers are particularly likely to be impeded in attracting funds. Furthermore, returns to the strategy also are higher when there are net outflows from funds that load heavily on the returns to the composite strategy. Our results support the notion that the efficiency of stock pricing is not a static concept but varies across time as agents face time varying constraints on arbitrage capital.

Sentiment and Momentum
Constantinos Antoniou, John A. Doukas & Avanidhar Subrahmanyam
This paper sheds empirical light on whether sentiment affects the profitability of price momentum strategies. We hypothesize that news that contradicts investors' sentiment causes cognitive dissonance, which slows the diffusion of signals that oppose the direction of sentiment. This phenomenon tends to cause underpricing of losers under optimism and underpricing of winners under pessimism. While the latter phenomenon can be corrected by arbitrage buying, short-selling constraints impede arbitraging of losers under optimism, causing momentum to be stronger in optimistic periods. Our empirical analysis supports this argument by showing that momentum profits arise only under optimism, and are driven principally by strong momentum in losing stocks. This result survives a host of robustness checks including controls for market returns, firm size and analyst following. An analysis of net order flows from small and large trades indicates that small (but not large) investors are slow to sell losers during optimistic periods. Momentum-based hedge portfolios formed during optimistic periods experience longrun reversals.

Whither Cross-Sectional Return Predictability?
Tarun Chordia, Avanidhar Subrahmanyam & Qing Tong
We examine recent shifts in cross-sectional return predictability for a comprehensive sample of NYSE/AMEX and Nasdaq stocks. Our analysis is motivated by the notion that dramatic improvements in trading technology, reductions in trading costs, and the emergence of hedge funds should be associated with increased arbitrage activity, and thus greater pricing efficiency. We consider a large set of previously identified predictors, and find that cross-sectional predictability has decreased considerably in recent years, both statistically and economically. Though illiquid stocks exhibit more predictability than liquid ones in the first half of the sample period, both liquid and illiquid NYSE/AMEX stocks have evolved to exhibit none of the well-known cross-sectional effects such as momentum, analyst dispersion, earnings drift, or accounting accruals. Cross-sectional predictability in Nasdaq stocks has also sharply diminished in recent years. Overall, the evidence is consistent with the notion that cross-sectional pricing efficiency of equities has significantly increased in recent years.

Female Leadership and Gender Equity: Evidence from Plant Closure
Geoffrey Tate & Liu Yang
We use unique worker-plant matched panel data to measure the impact of female leadership on the relative pay of men and women. We measure differences in the wage changes experienced by newly hired men and women displaced from closing plants. We correct for endogenous selection of both the original and new employer, comparing the wage changes of men and women who move from the same closing plant to the same new firm. We observe larger wage losses among women than men immediately upon reentering the workforce and continuing for the following three years. These differences exist throughout the wage and age distributions. However, we find a significantly smaller gap between men and women who move to a new firm with a higher fraction of female managers: the magnitude of the extra losses to women is cut in half. Moreover, we observe significant changes in the relative treatment of newly hired men and women when the gender composition of the firm's leadership team changes. Our results suggest an important externality to having women in leadership positions: they improve the prospects of other women inside their firms. To the extent that gender wage differences are not driven by differences in productivity, removing these distortions can improve firm value.

The Bright Side of Corporate Diversification: Evidence from Internal Labor Markets
Geoffrey Tate & Liu Yang
We estimate the labor market consequences of corporate diversification using novel worker-firm matched data from the U.S. Census Bureau. We find evidence that workers in diversified firms have more general skills than workers in focused firms. Displaced workers experience significantly smaller losses when they switch jobs or industries internally and when they move to a new firm in a new industry in which their old firm also operates. We find a significant wage premium among workers in diversified firms, consistent with their more attractive outside options. We also find more active internal labor markets in diversified firms. We find that diversified firms exploit the option to redeploy workers internally: Diversified firms redeploy workers from declining industries to expanding industries at a higher rate than the external market. Overall, our analysis suggests a bright side to corporate diversification.

Profits and Competition: An Analysis of Profit-Increasing Entry
Amit Pazgal & Raphael Thomadsen
This paper demonstrates that in differentiated industries, profits of all incumbent firms can increase with the entry of new competitors even without complementarities or externalities between the products. While profits are never above those of a monopolist, the entry of an additional competitor can increase profits when there are initially two or more firms in the market. We demonstrate that new entry can increase profits through both a direct effect causing a firm's competitors to price more softly, and an indirect effect, where competitors' incentives are not changed but the entry commits the firm to respond less aggressively in price, leading to scenarios where each firm's profits increase. We also examine the relationship between profits and the number of firms in the market, finding that profits can have a downup-down relationship with the number of firms. Further, we show conditions under which profitincreasing entry is consistent with endogenous location choice. Finally, we examine a similar phenomenon and show that firms may profit as consumers exit the market, even if no firms exit.

Seeking an Expanding Competitor: How Product Line Expansion Can Increase All Firms' Profits
Raphael Thomadsen
This paper examines conditions under which one firm's product-line expansion can cause all firms to be more profitable in horizontally-differentiated markets. While one may expect that a firm's profits would decrease when a competitor expands its product line because the firm loses some sales to the new product, this intuition is incomplete because a competitor's product-line expansion can also soften price competition. We first provide an example using the Hotelling model that demonstrates the possibility and mechanism of profit-increasing competitor entry. We then present conditions under which a competitor's product-line expansion increases profits under the mixed-logit model. We find that firms benefit from a rival's entry most when a moderate number of customers are unserved before the new-product introduction, and when the new product is positioned such that both of the rival's products appeal to similar sets of customers. As extensions, we demonstrate that the result continues to hold when firms choose product attributes endogenously, and that a manufacturer's profits can increase from a rival's product-line expansion even when the firms sell through a retailer.

The Effect of Retailer Stocking Decisions on National Brand Performance across U.S. Supermarkets
Minha Hwang & Raphael Thomadsen
This paper examines the extent to which major national-brand market shares are dependent upon the stocking decisions of retailers. We first demonstrate the extent to which national-brand market shares vary across chains: chain-level effects account for 23% of the variation in market shares across stores, even after controlling for market-level variation. These chain-level differences correlate closely with the variation in the assortments different chains offer. We demonstrate that this association between market shares and assortment shares is causal, and that a chain's assortment decisions explain, on average, 38% of the variance in market shares that can be attributed to chainlevel components. These results shed light on the importance of supply-side stocking decisions on market shares, and have implications on demand estimation strategies.

Long-Term Barriers to the International Diffusion of Innovations
Enrico Spolaore & Romain Wacziarg
We document an empirical relationship between the cross-country adoption of technologies and the degree of long-term historical relatedness between human populations. Historical relatedness is measured using genetic distance, a measure of the time since two populations' last common ancestors. We find that the measure of human relatedness that is relevant to explain international technology diffusion is genetic distance relative to the world technological frontier ("relative frontier distance"). This evidence is consistent with long-term historical relatedness acting as a barrier to technology adoption: societies that are more distant from the technological frontier tend to face higher imitation costs. The results can help explain current differences in total factor productivity and income per capita across countries.

The Democratic Transition
Fabrice Murtin & Romain Wacziarg
Over the last two centuries, many countries experienced regime transitions toward democracy. We document this democratic transition over a long time horizon. We use historical time series of income, education and democracy levels from 1870 to 2000 to explore the economic factors associated with rising levels of democracy. We find that primary schooling, and to a weaker extent per capita income levels, are strong determinants of the quality of political institutions. We find little evidence of causality running the other way, from democracy to income or education.

Advertising Agency Selection Contest with Partial Reimbursements of Participation Costs
Dan Horsky, Sharon Horsky & Robert Zeithammer
We model the contest among full-service advertising agencies as a score auction. The score auction allows the advertiser to select the agency that offers the best combination of creative quality and media cost, and to determine the contract price. To participate in the contest, each agency needs to incur an upfront bid-preparation cost arising from the development of a customized creative. Industry literature often calls for the advertiser to reimburse such costs to all agencies that enter the contest. We show that reimbursing bid-preparation costs in full is never optimal for the advertiser. However, a partial reimbursement of the costs can be profitable under two conditions we find to be necessary: First, a sufficiently large difference must exist between the bid-preparation cost of the incumbent agency currently serving the account and that of a competitor agency wishing to replace it. Second, the population of agencies must not contain too many weak agencies that can only deliver a very small profit to the advertiser.

An Efficiency Ranking of Markets Aggregated from Single-Object Auctions
Eric Budish & Robert Zeithammer
In a wide variety of economic contexts, collections of single-object auctions are used to allocate multiple substitutable goods. This paper studies how such collections of auctions aggregate into a multi-object auction market. We identify two features of auction-market design that enhance expected market efficiency: the individual auctions should be conducted in sequence, and information about all of the objects in the sequence should be revealed up front to the bidders. We then show that such an auction market is approximately efficient: specifically, its expected inefficiency is bounded above by the expected efficiency gain associated with adding one more bidder.

The Hesitant Hai Gui: Return-migration preferences of U.S.-educated Chinese scientists and engineers
Robert Zeithammer & Ryan Kellogg
Managers, administrators of research institutions, and policy makers need a greater understanding of the factors that drive return migration decisions of foreign STEM (science, technology, engineering, and mathematics) doctoral graduates of U.S. universities. To address this need, we conducted a large-scale multi-school revealed-preference survey of job preferences among U.S. STEM PhD students and postdocs from China-the source country of the most foreign doctoral students. The survey presents the respondents with choices of potential job offers, and yields individual-level estimates of each respondent's indirect utility of a job as a function of location, job status, public versus private nature of the employer, and salary. The estimated preferences imply that Chinese doctoral graduates currently tend to remain in the United States because of a large salary disparity between the two countries rather than because of an inherent preference for locating in the United States. The return rate is quite elastic in the salary gap, and many more graduates will return to China if the gap continues to narrow. We provide return-probability estimates for all possible counterfactual levels of the gap. For example, we find that if the gap narrowed to half of today's level, the return migration would increase threefold to about 27% of graduates. To counteract this potential reverse brain drain, the U.S. managers and policy makers can provide relatively modest monetary incentives and exploit the heterogeneity in job preferences across different student demographics. We also estimate the additional returns due to potential reduced job availability in desirable U.S. coastal cities and due to greater availability of managerial positions in China, and we find that neither change would increase return migration more than a few percentage points.

Vertical Differentiation with Variety-Seeking Consumers
Robert Zeithammer & Raphael Thomadsen
We analyze price and quality competition in a vertically differentiated duopoly in which consumers have a preference for variety. The variety-seeking preferences are a consequence of diminishing marginal utility for repeated consumption experiences of the same product. We find that variety-seeking preferences can either soften or intensify price competition, depending on the range of feasible qualities and the strength of consumer preference for variety. When the range of feasible qualities is small enough, prices are higher than would be obtained in the absence of variety seeking-leading to higher profits-and competing firms choose to minimally differentiate themselves from each other. On the other hand, if qualities are exogenously set to be different enough from each other then stronger preferences for variety are associated with moreintense price competition and lower profits.