Professor of Finance and Business Economics
William A. Fowler Endowed Professor
Foster School of Business
University of Washington
Phone: (206) 543-4377
Peer Effects in Risk Aversion and Trust (with Kenneth Ahern and Tyler Shumway)
Review of Financial Studies 27(11), 3213-3240 (2014)
Existing evidence shows that risk aversion and trust are largely determined by environmental factors. We test whether one such factor is peer influence. Using random assignment of MBA students to peer groups and predetermined survey responses of economic attitudes, we find causal evidence of positive peer effects in risk aversion and no effects in trust. After the first year of the MBA program, the difference between an individual and her peers’ average risk aversion is only 41% as large as the difference was before starting the MBA. Finding no peer effects in trust is consistent with recent research showing that distinct cognitive processes govern risk aversion and trust.
Safer Ratios, Riskier Portfolios: Banks’ Response to Government Aid (with Denis Sosyura)
Journal of Financial Economics 113, 1-28 (2014)
Winner of research grant from Yale University Millstein Center for Corporate Governance, 2010
We study the effect of government assistance on bank risk taking. Using hand-collected data on bank applications for government assistance under the Troubled Asset Relief Program (TARP), we investigate the effect of both application approvals and denials. To distinguish banks’ risk taking behavior from changes in economic conditions, we control for the volume and quality of credit demand based on micro-level data on home mortgages and corporate loans. Our difference-in-difference analysis indicates that banks make riskier loans and shift investment portfolios toward riskier securities after being approved for government assistance. However, this shift in risk occurs mostly within the same asset class and, therefore, remains undetected by the closely-monitored capitalization levels, which indicate an improved capital position at approved banks. Consequently, these banks appear safer according to regulatory ratios, but show a significant increase in volatility and default risk.
Cash Flow Hedging and Liquidity Choices (with David Disatnik and Breno Schmidt)
Review of Finance 18(2), 715-748(2014)
Winner of the 2010 Teva Award for research in corporate finance and financial markets
This paper studies the interaction between corporate hedging and liquidity policies. We present a theoretical model that shows how corporate hedging facilitates greater reliance on cost-effective, externally-provided liquidity in lieu of internal resources. We test the model's predictions by employing a new empirical approach that separates cash flow hedging from other hedging instruments. Using detailed, hand-collected data, we find that cash flow hedging reduces the firm’s precautionary demand for cash and allows it to rely more on bank lines of credit. Furthermore, we find a significant positive effect of cash flow hedging on firm value, where prior evidence is mixed.
Divisional Managers and Internal Capital Markets (with Denis Sosyura)
Journal of Finance 68, 387-429 (2013)
Using hand-collected data on divisional managers at the S&P 500 firms, we provide one of the first studies of their role in capital budgeting. Divisional managers with social connections to the CEO receive more capital. Connections to the CEO outweigh measures of managers’ formal influence, such as seniority and board membership, and affect both managerial appointments and capital allocations. The effect of connections on investment efficiency depends on the tradeoff between agency and information asymmetry. Under weak governance, connections reduce investment efficiency and firm value via favoritism. Under high information asymmetry, connections increase efficiency and value via information transfer.
Riding the Merger Wave: Uncertainty, Reduced Monitoring, and Bad Acquisitions (with Breno Schmidt)
Journal of Financial Economics 107, 69-88 (2013)
We show that acquisitions initiated during periods of high merger activity (‘‘merger waves’’) are accompanied by poorer quality of analysts’ forecasts, greater uncertainty, and weaker CEO turnover-performance sensitivity. These conditions imply reduced monitoring and lower penalties for initiating inefficient mergers. Therefore, merger waves may foster agency-driven behavior, which, along with managerial herding, could lead to worse mergers. Consistent with this hypothesis, we find that the average long-term performance of acquisitions initiated during merger waves is significantly worse. We also find that corporate governance of in-wave acquirers is weaker, suggesting that agency problems may be present in merger wave acquisitions.
The Politics of Government Investment (with Denis Sosyura)
Journal of Financial Economics 106, 24-48 (2012) Best Paper Award in Corporate
Finance at the Asian Finance Association Best Paper Award in Banking at La Trobe Finance and
paper investigates the relation between
corporate political connections and government
investment. We study various forms of political
influence, ranging from passive connections between firms and politicians,
such as those based on politicians’ voting districts, to active forms, such
as lobbying, campaign contributions, and employment of
connected directors. Using hand-collected data on firm applications for TARP
funds, we find that politically connected firms are more likely to be funded,
controlling for other characteristics. Yet investments in politically
connected firms underperform those in unconnected firms. Overall, we show
that connections between firms and regulators are associated with distortions
in investment efficiency. Journal
of Finance 65, 955-992 (2010) This
paper studies the relation between corporate liquidity and diversification. A
key finding is that multi-division firms hold significantly less cash than
standalone firms because they are diversified in their investment opportunities.
Lower cross-divisional correlations in investment opportunity and smaller
gaps between investment opportunity and cash flow correspond to lower cash
holdings, even after controlling for cash-flow volatility. The effects are
strongest in financially constrained firms and in well-governed firms, and
correspond to efficient fund transfers from low- to high-productivity
divisions. Taken together, these results bring forth an efficient link
between diversification in investment opportunity and corporate liquidity.
Journal of Financial Economics 106, 24-48 (2012)
Best Paper Award in Corporate
Finance at the Asian Finance Association
Best Paper Award in Banking at La Trobe Finance and
This paper investigates the relation between corporate political connections and government investment. We study various forms of political influence, ranging from passive connections between firms and politicians, such as those based on politicians’ voting districts, to active forms, such as lobbying, campaign contributions, and employment of connected directors. Using hand-collected data on firm applications for TARP funds, we find that politically connected firms are more likely to be funded, controlling for other characteristics. Yet investments in politically connected firms underperform those in unconnected firms. Overall, we show that connections between firms and regulators are associated with distortions in investment efficiency.
Journal of Finance 65, 955-992 (2010)
This paper studies the relation between corporate liquidity and diversification. A key finding is that multi-division firms hold significantly less cash than standalone firms because they are diversified in their investment opportunities. Lower cross-divisional correlations in investment opportunity and smaller gaps between investment opportunity and cash flow correspond to lower cash holdings, even after controlling for cash-flow volatility. The effects are strongest in financially constrained firms and in well-governed firms, and correspond to efficient fund transfers from low- to high-productivity divisions. Taken together, these results bring forth an efficient link between diversification in investment opportunity and corporate liquidity.
When Are Outside Directors
When Are Outside Directors Effective?(with John G. Matsusaka and Oguzhan Ozbas)
Journal of Financial Economics 96, 195-214 (2010)
This paper uses recent regulations that have required some companies to increase the number of outside directors on their boards to generate estimates of the effect of board independence on performance that are largely free from endogeneity problems. Our main finding is that the effectiveness of outside directors depends on the cost of acquiring information about the firm: when the cost of acquiring information is low, performance increases when outsiders are added to the board, and when the cost of information is high, performance worsens when outsiders are added to the board. The estimates provide some of the cleanest estimates to date that board independence matters, and the finding that board effectiveness depends on information cost supports a nascent theoretical literature emphasizing information asymmetry. We also find that firms compose their boards as if they understand that outsider effectiveness varies with information costs.
Costly External Finance,
Corporate Investment, and the Subprime Mortgage Credit Crisis
Costly External Finance, Corporate Investment, and the Subprime Mortgage Credit Crisis(with Oguzhan Ozbas and Berk Sensoy)
Journal of Financial Economics 97, 418-435 (2010)
We study the effect of the financial crisis that began in August 2007 on corporate investment. The crisis represents an unexplored negative shock to the supply of external finance for non-financial firms. We find that corporate investment declines significantly following the onset of the crisis, controlling for firm fixed effects and time-varying measures of investment opportunities. Consistent with a causal effect of a supply shock, the decline is greatest for firms that have low cash reserves or high net short-term debt, are financially constrained, or operate in industries dependent on external finance. To address concerns about the endogeneity of firms’ finances to changes in investment opportunities, we measure these financial positions as much as four years prior to the crisis and confirm that we do not find similar results following placebo crises in the summers of 2003-2006. We also do not find similar results following the negative demand shock caused by the events of September 11. These effects weaken considerably beginning in the third quarter of 2008, when the demand-side effects of the crisis became apparent, suggesting that supply constraints may no longer have been binding. Additional analysis suggests an important precautionary savings motive for seemingly excess cash that has not been emphasized in the literature.
Disagreement, Portfolio Optimization and Excess Volatility (with Moshe Levy)
Journal of Financial and Quantitative Analysis 45, 623-640 (2010)
A central task facing investors who believe in market efficiency is that of portfolio optimization. As it is far from obvious how to best estimate the ex-ante expected returns and covariances, it is quite plausible that investors would hold different beliefs regarding these parameters, and that the degree of disagreement about the parameters may change over time. Levy, Levy and Benita (2006) have shown that in the portfolio context disagreement regarding the expected returns does not affect asset prices. In this paper we study the pricing effects of disagreement regarding return variances. We show that disagreement about variances has systematic and significant pricing effects. Even if the average belief about the variance is constant, tiny fluctuations in the disagreement about the variance lead to substantial price fluctuations. This result may offer an explanation for the excess volatility puzzle: small changes in the degree of disagreement are very likely to occur, and they induce relatively large price changes. Yet, the changes in disagreement may be hard to directly detect empirically, leading to apparent “excess volatility”.
Selected Working Papers
(with Jonathan Brogaard and Matthew Denes), 2017
We use contract-level data to study the effect of corporate political influence on the allocation, design, and real outcomes of government contracts. To isolate the treatment effect of political influence, we focus on campaign contributions in close elections and the 2009 American Recovery and Reinvestment Act. Firms with political influence win more contracts, with larger amounts, weaker competition, and looser oversight, and successfully renegotiate contract terms. While preferred access to government contracts improves performance and output, contractual laxity exacerbates agency problems and erodes efficiency. Overall, we provide estimates of the dual effect of political influence on firm outcomes.
Dissecting Conglomerates (with Oliver Boguth and Mikhail Simutin), 2018
We develop a method to calculate valuation multiples of conglomerate divisions that does not rely on standalone firms. These valuations differ considerably from commonly used industry multiples, and range across industries from deep discounts to large premiums relative to standalone _rms. Contrary to prior studies, conglomerate investment is highly sensitive to investment opportunities as measured by division multiples. Consistent with theory, non-core divisions and those in weak or capital-intensive industries have higher valuations, whereas divisions in innovative or competitive industries have lower valuations. Overall, we provide first estimates of intra-conglomerate multiples that shed new light on conglomerate investment and value.
The Origins and Real Effects of the Gender Gap: Evidence from CEOs’ Formative Years (with Mikhail Simutin and Denis Sosyura), 2018
CEOs allocate more investment capital to male than female division managers. Using data from individual Census records, we find that this gender gap is driven by CEOs who grew up in male-dominated families—those where the father was the only income earner and had more education than the mother. The gender gap also increases for CEOs who attended all-male high schools and grew up in neighborhoods with greater gender inequality. The effect of gender on capital budgeting introduces frictions and erodes investment efficiency. Overall, the gender gap originates in CEO preferences developed during formative years and produces significant real effects.
The Timing and Consequences of Seasoned Equity Offerings: A Regression Discontinuity Approach (with Amy Dittmar and Shuran Zhang), 2018
The likelihood of seasoned equity offerings (SEOs) jumps discontinuously when the stock price equals the most recent equity offer price. Using a fuzzy regression discontinuity design around this cutoff, which exploits local randomness in stock prices, we investigate the consequences of market timing in SEOs. We find significant increases in cash holdings, executive compensation, and acquisitions of lower quality, with no real effects on investment or employment. Overall, we find that market timing plays a role in 23% of SEOs and provide some of the cleanest estimates, to date, of the determinants and causal effects of market timing in SEOs.
Merger Waves and Innovation Cycles: Evidence from Patent Expirations (with Matt Denes and Jarrad Harford), 2018
We investigate the link between innovation cycles and aggregate merger activity using data on patent expirations. To isolate the treatment effect of patent expirations, we focus on term expirations, which occur mandatorily at a pre-specified date. We find strong clustering in industry patent expirations (“patent expiration waves”). These patent waves trigger industry merger waves with lower announcement returns and worse long-term performance for acquirers, but higher announcement returns and larger premiums for targets. We also find that the acquirers in this type of merger waves experience declines in their profit margins, cash holdings and investment opportunities, while cutting costs and boosting investment cut costs in the year prior to a merger. Overall, we put forth a possible link, unexplored in the literature, between merger waves and patenting activity.
Involuntary Political Connections and Firm Outcomes (with Zhenyu Gao and Haibing Shu), 2018
We investigate the role of government in small firms, which lack the resources to cultivate political connections through lobbying, contributions, or board appointments. Exploiting the exogeneity of the geographic distance between small Chinese firms and city governments as a proxy for government involvement, we find that distant firms have better operating performance and higher growth and entry rates. We find similar effects around exogenous government relocations, and weaker effects when the legal system is more developed, when road infrastructure is better, and following adverse economic shocks. Furthermore, distance from government increases firm autonomy, and reduces taxes, protectionism, and anti-competitive behavior.
The Dynamics of Cash (with Amy Dittmar), 2011
Little is known about how firms manage cash policy over time. This paper fills this gap by examining if and how firms manage cash toward a target cash ratio. Estimating partial adjustment models of cash, we find that firms actively adjust their cash toward a target; however, the speed of adjustment is slow and there is large dispersion in the speed of adjustment across firms. We investigate the causes for this and find evidence consistent with the presence of adjustment costs. We also examine the implications of these results for previous interpretations of cross-sectional results. To do this, we simulate firms’ cash paths allowing for costly adjustment and find that the emerging patterns question the interpretation of some of the standard results in the empirical cash literature.
Portfolio Optimization and
the Distribution of Firm Size
Portfolio Optimization and the Distribution of Firm Size(with Moshe Levy), 2010
In the context of portfolio optimization, a firm’s market capitalization reflects the optimal portfolio weight of the firm, and is determined by the return parameters. The empirical distribution of firms’ market capitalizations is in excellent agreement with the lognormal distribution. This distribution is very skewed: the largest firms are about 1000 times larger than the median firm. The empirical distribution of average returns is not nearly as skewed: the maximal average return is only about 6 times larger than the median average return. Can the empirical firm size distribution be consistent with mean-variance portfolio optimization with realistic return parameters? We show that the expected returns implied by the empirical firm size distribution and portfolio optimization are actually in very good agreement with the empirical average returns. Moreover, the portfolio optimization framework can provide a constructive explanation for the exact lognormal functional form empirically observed. Thus, portfolio optimization is not only consistent with the empirical lognormal size distribution, it can actually explain it.
Selected Media Coverage
"Banks with political ties got bailouts, study shows", Reuters
"Did the Banks’ Political Connections Drive TARP?", Wall Street Journal
“Banks With Political Ties Got Bailouts, Study Shows”, New York Times
"US Business Summary", Washington Post
"Missed Payments Vexing to Frank", Boston Globe
"TARP distribution shows political favoritism", San Francisco Examiner
"UM researchers say politics guided bank bailout allocations", Detroit Free Press
“Study: Politically-Connected Banks Were More Likely To Get Bailed Out”, Huffington Post
"Welcome to the Back-Scratching Economy", Smartmoney.com
"US banks with political ties got more bailouts", Press TV
"Banks with political ties got bailouts, study shows", Moneycontrol.com
"Politics Played Major Role in Bailout Choices", Newser.com
"Bailout Banks Make Riskier Loans: Study", Yahoo Finance