Counterparty Risk: Implications for Network Linkages and Asset Prices

  With Yunzhi Hu and Gill Segal

Review of Financial Studies, 2023, 36(2), 814–858. https://doi.org/10.1093/rfs/hhac044

- See the Internet Appendix and the Data for the R/S Spread here

- See Kenan Institute Business Insight

We study the relation between trade credit, asset prices, and production-network linkages. Empirically, firms extending more trade credit earn 7.6% p.a. lower risk premia and maintain longer relationships with customers. Using a production-based model, we quantitatively explain these novel facts. Trade credit reduces the departure probability of high-quality customers, thereby reducing firms’ exposures to systematic costs incurred in finding new customers. The mechanism predicts that the aggregate amount of trade credit proxies for customer-search costs, and that suppliers with shorter-duration links to customers command higher expected returns. We confirm these and other novel predictions in the data.

Presentations: WFA (2021), CICF (2021), WSIR (2021), NBER SI Capital Market and the Economy (2020), SITE Asset Pricing, Macro Finance, and Computation (2020), European FA (2020), FIRS (2020), Kentucky Bourbon Conference (2020), UConn Finance Conference (2020), Boston College (2020), Northeastern University (2020), Ball State University (2020), Triangle Macro-Finance Workshop (2020), Midwest FA (2020), COAP (2019), Kelley Finance Junior Conference (2019), CIRANO Conference on Networks in Trade and Finance (2019), UNC-Chapel Hill (2019)

The Utilization Premium

  With Gill Segal

Management Science, 2024, 70(1), 207-224. https://doi.org/10.1287/mnsc.2022.4647

- See the Internet Appendix and the Code and Data here

We study the interaction of flexible capital utilization and depreciation for expected returns and investment of firms. Empirically, an investment strategy that buys (sells) equities with low (high) utilization rates earns 5% p.a. Utilization predicts excess returns beyond other production-based variables. We reconcile this novel utilization premium quantitatively using a production model. The model suggests that flexible utilization is important for matching the cross-sectional distribution of investment and stock prices jointly. A model without flexible utilization yields many counterfactuals that flexible utilization addresses by making depreciation fluctuate endogenously. Overall, utilization tightens the link between firms’ production and valuations.

Presentations: RCFS/RAPS Winter Conference (2020), ANU Asset Pricing Conference (2020), UT Dallas Finance Conference (2019), NFA (2019), MFA (2019), UNC-Chapel Hill (2017)

Real-time Forecasts of State and Local Government Budgets with an Application to COVID-19

  With Eric Ghysels and Nazire Özkan

National Tax Journal, 2022, 75(4), 731–763. https://doi.org/10.1287/mnsc.2022.4647

- See the Internet Appendix here

Using a sample of the 48 contiguous US states, we consider the problem of forecasting state governments’ revenues and expenditures in real time using models that feature mixed-frequency data. We find that mixed-data sampling (MIDAS) regressions that predict low-frequency fiscal outcomes using high-frequency macroeconomic and financial market data outperform traditional fiscal forecasting models in both a relative and an absolute sense. We also consider an application of forecasting fiscal outcomes in the face of the economic uncertainty induced by the coronavirus pandemic. Overall, we show that MIDAS regressions provide a simple tool for predicting fiscal outcomes in real time.

Presentations: UNC-Chapel Hill (2017)

Investment under Up- and Downstream Uncertainty

  With Gill Segal

- See Kenan Institute Business Insight

Revise and resubmit at The Journal of Finance

We study the transmission of uncertainty shocks in production networks and find that their impact on corporate investment depends on their source in the supply-chain. A real-option framework with time-to-build predicts that only upstream uncertainty suppresses firms’ investments, since upstream uncertainty from suppliers affects the shorter-run, while downstream uncertainty from customers affects the longer-run. Consistently, we use production-network data to show that, at the micro-level, upstream uncertainty has a strong downstream propagation and affects firm-level investment rates and valuations negatively. In contrast, downstream uncertainty propagates upstream more weakly, but typically affects firm-level outcomes positively. At the macro-level, these two uncertainties predict aggregate consumption, output, investment, and asset prices with opposite signs. In all, micro- and macro-level downstream uncertainty has an expansionary effect, in contrast to other facets of uncertainty.

Presentations: ASSA (2024), SITE Macroeconomics of Uncertainty and Volatility (2023), SITE New Frontiers in Asset Pricing (2023), University of Iowa (2023), North Carolina State University (2023), CFEA (2022), FMA (2022), University of Western Australia (2022), Texas A&M Young Scholars Finance Consortium (2022), Midwest FA (2022), Eastern FA (2022), FMCG (2022), New Zealand Finance Meeting (2021), AFBC (2021), Northern FA (2021), Korea University (2021), Wabash River Finance Conference (2021), European Economic Association (2021), Indian School of Business Summer Research Conference (2021), IU-Bloomington (2021)

  Best Paper Award at 2021 ISB Summer Research Conference

  Best Paper in Asset Pricing -- Runner Up (2021 Financial Markets and Corporate Governance Conference)

  WRDS Best Paper Award (2022 Eastern Finance Assocation Meeting)

Factor and Stock-Specific Disagreement and Trading Flows

  With Christian Heyerdahl-Larsen and Preetesh Kantak

We study how disagreement on both factor and stock-specific risk exposures across many agents and securities impact asset prices. Our theoretical analyses predict that disagreement about factor dynamics drives larger flows into portfolios that are more exposed to the factors. Consequently, these concentrated bets on the factor lead to higher volatility and reduced diversification benefits. We then test these predictions using a novel empirical setting – exchange-traded funds (ETFs). We find that when factor disagreement rises, funds flow into the ETFs that mimic the factor. However, these increased flows induce high forward looking volatility of, and correlation risk within, the ETF.

Presentations: WFA (2024, Scheduled), UNC Kenan-Flagler Finance Ph.D. Alumni Conference (2023), SFS Cavalcade (2022), UT Dallas Finance Conference (2022), UNSW Asset Pricing Workshop (2022), SAFE Asset Pricing Workshop (2022), CICF (2022), FMA Conference on Derivatives and Volatility (2022), SoFiE (2022), Federal Reserve Bank of St. Louis (2021), IU-Bloomington (2021)

Risk from the Inside Out: Understanding Firm Risk through Employee News Consumption

  With Fahiz Baba-Yara, Carter Davis, and Preetesh Kantak

- See the Firm-Level Attention Data here

We use employee news consumption to characterize firms’ exposures to macroeconomic risk, making use of data covering two billion employee-article interactions per day across millions of firms. We find that, in the time-series, employees consume more macroeconomic news following the onset of bad times. In the cross-section, firms whose employees were reading more macroeconomic news ex-ante are more exposed to changing economic conditions ex-post. Consistent with the notion that employee news consumption provides insights into firms’ risk exposures, we show that the more exposed firms hedge more, yet have higher costs of capital and subsequently lower investment and hiring rates.

Presentations: USC Macro-Finance Reading Group (2024), ASU Sonoran Winter Finance Conference (2024), ASSA (2024), Millennium Management, LLC (2024), Financial Research Association (2023), NBER SI Big Data and High-Performance Computing for Financial Economics (2023), SITE Macroeconomics of Uncertainty and Volatility (2023), 5th Federal Reserve Board Conference on Nontraditional Data, Machine Learning, and Natural Language Processing in Macroeconomics (2023), UNC-Chapel Hill (2023), Bocconi University (2023), CFEA (2023), Midwest FA (2023), PanAgora Asset Management (2023), Dolomite Summer Finance Conference (2023), Bristol Financial Markets Conference (2023), FMA (2023), BI Norwegian (2022), IU-Bloomington (2022)

  2023 Crowell Prize Finalist (PanAgora Asset Management)

The Relative Price Premium

  With Christian Heyerdahl-Larsen, Preetesh Kantak, and Yun Joo An

This study shows that relative price dispersion impacts risk premia. Notably, firms associated with goods and services that have increased (decreased) in price relative to the headline inflation rate earn high (low) returns. We refer to this return spread of 0.88% per month as the relative price premium. We rationalize the premium via a consumption-based asset-pricing model that features imperfectly substitutable goods and an investor with preferences for the mix of goods consumed. As shocks to relative prices induce the investor to consume a suboptimal bundle of goods, high price dispersion signals bad times for the investor and the economy.

Presentations: Finance Down Under (2024), Korea University / KAIST (2024), Federal Reserve Board (2023), UNSW Asset Pricing Workshop (2023), CICF (2023), SoFiE (2023), AiE Conference in Honor of Joon Y. Park (2023), Eastern FA (2023), UVA-Darden (2022), IU-Bloomington (2022)

  CFA Institute Asia-Pacific Research Exchange Best Paper Award (2024 FDU)

Municipal-Treasury Spreads and Local Stock Returns

This study shows that municipal bond yields are informative about the risk exposures and expected returns of local firms. An investment strategy that buys (sells) firms located in states where the municipal-Treasury spread is high (low) earns a return that exceeds 0.35% per month. This return differential cannot be explained by limits-to-arbitrage, industry agglomeration, or a host of prominent asset-pricing characteristics. Rather, the municipal-Treasury spread predicts stock returns because it serves as an observable proxy of local fundamentals, such as labor productivity. Firms’ risk exposures are higher and state-level fundamentals are weaker in states with higher municipal-Treasury spreads.

Presentations: University of Michigan (2020), Washington University in St. Louis (2020), University of Georgia (2020), IU-Bloomington (2020), Purdue University (2020), University of Alberta (2020), University of South Carolina (2020), Cornerstone Research - NYC (2020), Federal Reserve Board (2020), Midwest FA (2020), Eastern FA (2020), Virtual Municipal Finance Workhop (2020), AFBC PhD Forum (2019), UNC-Chapel Hill (2019)

  The Kuldeep Shastri Outstanding Doctoral Student Paper

  SWFA Best Doctoral Student Paper in Investments

Municipal Bond Yields and Local Economic Conditions [New draft coming soon]

This study shows that the municipal yield curve predicts local economic outcomes. Notably, higher municipal-Treasury spreads forecast lower coincident economic activity and lower gross state product in the future. These results are not only stronger among states with stricter balanced budget restrictions, but evidence from the inter-state trade network also shows that poor economic conditions in one state spill over to that state’s closer trade partners. Moreover, the current level of the municipal-Treasury spread also forecasts a state’’s future tax revenues. Overall, the results indicate that a state’s cost of municipal debt contains valuable information about the local economy’s trajectory.

Presentations: University of Michigan (2020), Washington University in St. Louis (2020), University of Georgia (2020), IU-Bloomington (2020), Purdue University (2020), University of Alberta (2020), University of South Carolina (2020), Cornerstone Research - NYC (2020), Federal Reserve Board (2020), Midwest FA (2020), Eastern FA (2020), Virtual Municipal Finance Workhop (2020), AFBC PhD Forum (2019), UNC-Chapel Hill (2019)

  The Kuldeep Shastri Outstanding Doctoral Student Paper

  SWFA Best Doctoral Student Paper in Investments

A New Lease on Firm Behavior

  With Matteo Binfarè, Robert Connolly, and Crocker Liu

- See the ASC842 Leasing Data here

When firms have discretion in valuing their balance sheet debt, how do they make this valuation decision given its impact on firm value? Firms make extensive use of operating leases, but unlike other types of debt, their balance sheet value is set by the firm. Using novel information on operating leases, we examine firm behavior in valuing these leases. We find that 20% of firms report higher-than-expected rates, reflecting their cost of unsecured rather than collateralized borrowing. These firms have poor information quality, operate in competitive markets, and understate lease and debt ratios by 15%.

Presentations: University of Miami (2021), FMA (2021), FMCG (2021), Eastern FA (2021), Midwest FA (2021), Conference on Asia-Pacific Financial Markets (2020), University of Missouri (2020)

  Best Paper in Accounting -- Runner Up (2021 Financial Markets and Corporate Governance Conference)