Laurence D. and Lori W. Fink Endowed Chair in Finance
Risk and Return in Segmented Markets with Expertise
Complex assets appear to earn persistent high average returns, and to display high Sharpe ratios. Despite this, investor participation is very limited. Eisfeldt and co-authors Hanno Lustig and Lei Zhang provide an explanation for these facts using a model of the pricing of complex securities by risk-averse investors who are subject to asset-specific risk in a dynamic model of industry equilibrium. Investor expertise varies, and the investment technology of investors with more expertise is subject to less asset-specific risk. Expert demand lowers equilibrium required returns, reducing participation, and leading to endogenously segmented markets. Among participants, portfolio decisions and realized returns determine the joint distribution of financial expertise and financial wealth. This distribution, along with participation, then determines market-level risk bearing capacity. The authors show that more complex assets deliver higher equilibrium returns to expert participants. They explain why complex assets can have lower overall participation despite higher market-level alphas and Sharpe ratios. Finally, they show how complexity affects the size distribution of complex asset investors in a way that is consistent with the size distribution of hedge funds.
Professor of Finance
Learning Millennial Style
The growing use of online educational content and related video services has changed the way people access education, share knowledge, and possibly make life decisions. In this paper, Carlin and co-authors Li Jiang and Stephen A. Spiller characterize how video content affects individual decision-making and willingness to share in the context of a personal financial decision. They find that misleading advertising curtails the time people invest in searching for the best alternative and causes worse decisions. Content geared toward giving better instructions helps to overcome this effect. Such actionable content improves both search quality and financial decisions. However, including such content may decrease sharing unless it is perceived to be sufficiently useful. As such, there is a potential risk to adding actionable content to videos. This work has important implications for policies guiding financial literacy training, and also has broader impact for education in the information age.
How Should Firms Hedge Market Risk?
Consider a firm whose stock returns are affected by market returns and an idiosyncratic market-orthogonal factor. The level of the firm’s cash flows depends on the level of the market and the level of the idiosyncratic factor multiplicatively because of compounding. Although a large hedge against the market index minimizes the variance of cash flows, such a hedge does not minimize the costs of financial distress associated with low cash flow realizations below a debt threshold. A hedge ratio based on asset-rate-of-return regression estimates is then incorrect. This holds even in continuous time and with dynamic hedging policies. Chowdhry and Schwartz provide a simple heuristic for corporations wishing to hedge out the adverse consequences of market risk.