Asset Pricing

October 28, 2016
Valentin Haddad of University of California at Los Angeles and Motohiro Yogo of Princeton University, Organizers

Tarek Alexander Hassan, University of Chicago and NBER; Thomas Mertens, Federal Reserve Bank of San Francisco; and Tony Zhang, University of Chicago

Currency Manipulation

Hassan, Mertens, and Zhang propose a novel, risk-based transmission mechanism for the effects of currency manipulation: policies that systematically induce a country's currency to appreciate in bad times, lower its risk premium in international markets and, as a result, lower the country's risk-free interest rate and increase domestic capital accumulation and wages. Currency manipulations by large countries also have external effects on foreign interest rates and capital accumulation. Applying this logic to policies that lower the variance of the bilateral exchange rate relative to some target country ("currency stabilization"), the researchers find that a small economy stabilizing its exchange rate relative to a large economy increases domestic capital accumulation and wages. The size of this effect increases with the size of the target economy, offering a potential explanation why the vast majority of currency stabilizations in the data are to the U.S. dollar, the currency of the largest economy in the world. A large economy (such as China) stabilizing its exchange rate relative to a larger economy (such as the U.S.) diverts capital accumulation from the target country to itself, increasing domestic wages, while decreasing wages in the target country.

Hanno Lustig, Stanford University and NBER, and Adrien Verdelhan, MIT and NBER

Does Incomplete Spanning in International Financial Markets Help to Explain Exchange Rates? (NBER Working Paper No. 22023)

Compared to the predictions of complete market models, actual exchange rates are puzzlingly smooth and only weakly correlated with macro-economic fundamentals, suggesting that market incompleteness plays a key role in exchange rate dynamics. Incompleteness in international financial markets introduces a stochastic wedge between the growth rates of marginal utility at home and abroad, and the change in the exchange rate. Lustig and Verdelhan derive a preference-free upper bound on the effects of the FX wedges. Even if domestic agents can invest only in the foreign risk-free asset, incomplete spanning fails to simultaneously match the exchange rate volatility, cyclicality and the FX risk premia in the data.

Harrison Hong, Columbia University and NBER; Weikai Li, Hong Kong University of Science and Technology; and Jiangmin Xu, Princeton University

Climate Risks and Market Efficiency

Hong, Li, and Xu investigate whether stock markets efficiently price risks brought on or exacerbated by climate change. The researchers focus on drought, the most damaging natural disaster for crops and food-company cash flows. They show that prolonged drought in a country, measured by the Palmer Drought Severity Index (PDSI) from climate studies, forecasts both declines in profitability ratios and poor stock returns for food companies in that country. A portfolio short food stocks of countries in drought and long those of countries not in drought generates a 9.2% annualized return from 1985 to 2015. This excess predictability is larger in countries having little history of droughts prior to the 1980s. These findings support regulatory concerns of markets inexperienced with climate change underreacting to such risks and calls for disclosing corporate exposures.

Stephan Jank and Christoph Roling, Deutsche Bundesbank, and Esad Smajlbegovic, University of Mannheim

Flying Under the Radar: The Effects of Short-Sale Disclosure Rules on Investor Behavior and Stock Prices

This paper analyzes how newly introduced transparency requirements for short positions affect investors' behavior and security prices. Employing a unique data set, which contains both public positions above and confidential positions below the regulatory disclosure threshold, Jank, Roling, and Smajlbegovic offer several novel insights. Positions accumulate just below the threshold, indicating that a sizable fraction of short sellers avoid disclosing their positions publicly. The decision to cross the disclosure threshold appears to be persistent, with investors sticking to their secretive behavior. Short positions held by these secretive investors are associated with stronger negative returns compared to their peers, suggesting that secretive investors possess superior information. Furthermore, the researchers document that negative information is incorporated more slowly into stock prices, when a secretive investor is just below the disclosure threshold. Overall, these findings suggest that short sellers' evasive behavior in response to the transparency regulation imposes a negative externality on stock market efficiency.

Terrence Hendershott and Dmitry Livdan, University of California at Berkeley; Dan Li, Federal Reserve Board; and Norman Schurhoff, University of Lausanne

Relationship Trading in OTC Markets

Hendershott, Livdan, Li, and Schurhoff examine the network of bilateral trading relations between insurers and dealers in the over-the-counter corporate bond market. Using comprehensive regulatory data the researchers find that many insurers use only one dealer while the largest insurers have a network of up to eighty dealers. To understand the heterogeneity in network size the researchers build a model of decentralized trade in which insurers trade off the benefits of repeat business against more intense dealer competition. Empirically, large insurers form more relations and receive better prices than small insurers. The model matches both the distribution of insurers' network sizes and how prices depend on insurers' size and the size of their dealer network.

Viral V. Acharya, New York University and NBER; Tim Eisert, Erasmus University Rotterdam; Christian Eufinger, IESE Business School; and Christian Hirsch, Goethe-University Frankfurt

Whatever it takes: The Real Effects of Unconventional Monetary Policy

The ECB's Outright Monetary Transactions (OMT) program, launched in summer 2012, indirectly recapitalized periphery country banks through its positive impact on the value of sovereign bonds. However, the regained stability of the European banking sector has not fully transferred into economic growth. Acharya, Eisert, Eufinger, and Hirsch show that zombie lending behavior of banks that still remained undercapitalized after the OMT announcement is an important reason for this development. As a result, there was no positive impact on real economic activity like employment or investment. Instead, firms mainly used the newly acquired funds to build up cash reserves. Finally, the researchers document that creditworthy firms in industries with a high prevalence of zombie firms suffered significantly from the credit misallocation, which slowed down the economic recovery.

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