Research Paper Prizes

The Jacobs Levy Center Research Paper Prizes are chosen from recent additions to the Jacobs Levy Center’s working paper series. The prizes, established in 2014, include a Best Paper award of $10,000 and one or more Outstanding Paper awards of $5,000.

Topics of the winning papers must fall within the scope of the Jacobs Levy Center’s mission, and hence, must have a focus on enhancing the understanding of financial markets through the study and promotion of quantitative techniques and methods as applied to such fields as the analysis of domestic and international stocks and bonds, and the management of investment portfolios.

2019 Winners

Best Paper

Risk Factors that Matter: Textual Analysis of Risk Disclosures for the Cross-Section of Returns
Alejandro Lopez-Lira

Abstract: What are the fundamental risks in the economy? Which ones are systematic? Which ones are priced? Are they summarized well by existing models? I exploit unsupervised machine learning and natural language processing techniques to identify from the firms’ risk disclosures the types of risks firms face. The risks are described in plain words. I quantify how much each firm is exposed to each risk, design a test to classify them into systematic and idiosyncratic, and construct portfolios proxying for each risk. The portfolios are not spanned by the traditional factors. A factor model formed with the most discussed risks performs at least as well as the traditional ones, while not using any information from past returns.

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Outstanding Papers

Comovement in Arbitrage Limits
Jianan Liu

Abstract: Estimates of mispricing, such as deviations from no-arbitrage relations, strongly comove across five financial markets. One common component the arbitrage gap—explains the majority of variability in mispricing estimates for futures, Treasury securities, foreign exchange, and options. Prominent equity anomalies also comove significantly with the arbitrage gap. Variables affecting arbitrage capital availability, such as the TED spread and hedge-fund flows and returns, explain two-thirds of the arbitrage gap’s variation. During periods of tighter capital constraints, the comovement in mispricings becomes stronger. The findings support theoretical predictions that common sources of funding shocks can cause comovement in mispricings across markets.

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Countercyclical Labor Income Risk and Portfolio Choices over the Life-Cycle
Sylvain Catherine

Abstract: I structurally estimate a life-cycle model of portfolio choices that incorporates the relationship between stock market returns and the skewness of idiosyncratic income shocks. The cyclicality of skewness can explain (i) low stock market participation among young households with modest financial wealth and (ii) why the equity share of participants slightly increases until retirement. With an estimated relative risk aversion of 5 and yearly participation cost of $290, the model matches the evolution of wealth, of participation and of the conditional equity share over the life-cycle. Nonetheless, I find that cyclical skewness increases the equity premium by at most 0.5%.

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Risk Free Interest Rates
Jules van Binsbergen, William Diamond, and Marco Grotteria

Abstract: We estimate risk free rates unaffected by the convenience yield on safe assets by inferring them from risky options and futures prices. Our data provides time-varying estimates of the term structure of convenience yields from maturities of 1 month to 2.5 years at a minutely frequency. The convenience yield on government bonds equals about 40 basis points on average, is larger below 3 months maturity, and grows substantially during periods of financial distress. With our unique intraday estimates of the term structure of convenience yields, we estimate the high frequency response of convenience yields to monetary policy and quantitative easing. Convenience yields respond most strongly to central bank policy in the depths of the financial crisis, and both conventional and unconventional monetary stimulus reduce convenience yields. Additionally, a factor constructed from our measure of the term structure of convenience yields predicts excess bond returns even when controlling for commonly used factors in the literature. Finally, we study the dynamics of a large panel of other arbitrage spreads and find that our implied convenience yields predict other spreads and face the smallest idiosyncratic shocks, suggesting that they are highly informative measures of frictions in financial markets.

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2018

Best Paper

The Macroeconomic Announcement Premium
Jessica Wachter and Yicheng Zhu

Abstract:
Empirical studies demonstrate striking patterns in stock market returns in relation to scheduled macroeconomic announcements. First, a large proportion of the total equity premium is realized on days with macroeconomic announcements, despite the small number of such days. Second, the relation between market betas and expected returns is far stronger on announcement days as compared with non-announcement days. Finally, these results hold for fixed-income investments as well as for stocks. We present a model with rare events that jointly explains these phenomena. In our model, which is solved in closed form, agents learn about a latent disaster probability from scheduled announcements. We quantitatively account for the empirical findings, along with other facts about the market portfolio.

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Outstanding Papers

Anomalies Abroad: Beyond Data Mining
Xiaomeng Lu, Robert Stambaugh, and Yu Yuan

Abstract: A pre-specified set of nine prominent U.S. equity return anomalies produce significant alphas in Canada, France, Germany, Japan, and the U.K. All of the anomalies are consistently significant across these five countries, whose developed stock markets afford the most extensive data. The anomalies remain significant even in a test that assumes their true alphas equal zero in the U.S. Consistent with the view that anomalies reflect mispricing, idiosyncratic volatility exhibits a strong negative relation to return among stocks that the anomalies collectively identify as overpriced, similar to results in the U.S.

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Cyclical Dispersion in Expected Defaults
Joao Gomes, Marco Grotteria, and Jessica Wachter

Abstract: A growing literature shows that credit indicators forecast aggregate real outcomes. While researchers have proposed various explanations, the economic mechanism behind these results remains an open question. In this paper, we show that a simple, frictionless, model explains empirical findings commonly attributed to credit cycles. Our key assumption is that firms have heterogeneous exposures to underlying economy-wide shocks. This leads to endogenous dispersion in credit quality that varies over time and predicts future excess returns and real outcomes.

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Political Connections and the Informativeness of Insider Trades
Alan Jagolinzer, David Larcker, Gaizka Ormazabal, and Daniel Taylor

Abstract: We examine the relation between political connections and informed trading by corporate insiders at leading financial institutions during the Financial Crisis. We find strong evidence of a relation between political connections and informed trading, that the relation is strongest during the period in which TARP funds were disbursed, and strongest among TARP recipients. Notably, we find evidence of abnormal trading by politically connected insiders 30 days in advance of TARP infusions, and that these trades predict the market reaction to the infusion. Our results suggest that politically connected insiders had a significant information advantage during the Crisis and opportunistically timed their trades to exploit this advantage.

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2017

Best Paper

Fund Tradeoffs 
Lubos Pastor, University of Chicago Booth School of Business
Robert Stambaugh, The Wharton School
Lucian Taylor, The Wharton School


Abstract: 
We derive equilibrium relations among active mutual funds’ key characteris- tics: fund size, expense ratio, turnover, and portfolio liquidity. As our model predicts, funds with smaller size, higher expense ratios, and lower turnover hold less liquid portfolios. A portfolio’s liquidity, a concept introduced here, depends not only on the liquidity of the portfolio’s holdings but also on the portfolio’s diversification. We derive simple, theoretically motivated measures of portfolio liquidity and diversification. Both measures have trended up over time. We also find larger funds are cheaper, funds trading less are larger and cheaper, and excessively large funds underperform, as our model predicts.

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Outstanding Papers

Using Stocks or Portfolios in Tests of Factor Models
Andrew Ang, Columbia University
Jun Liu, University of California San Diego
Krista Schwarz, The Wharton School 

Abstract: We examine the efficiency of using individual stocks or portfolios as base assets to test asset pricing models using cross-sectional data. The literature has argued that creating portfolios reduces idiosyncratic volatility and allows more precise estimates of factor loadings, and con- sequently risk premia. We show analytically and empirically that smaller standard errors of portfolio beta estimates do not lead to smaller standard errors of cross-sectional coefficient es- timates. Factor risk premia standard errors are determined by the cross-sectional distributions of factor loadings and residual risk. Portfolios destroy information by shrinking the dispersion of betas, leading to larger standard errors.

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Real Anomalies
Jules van Binsbergen, The Wharton School
Christian Opp, The Wharton School

Abstract: We examine the importance of asset pricing anomalies for the real economy. When firms interpret public information in the way it is reflected in market prices, informational inefficiencies manifesting in financial markets as anomalies can cause material real inefficiencies. We estimate the joint dynamic distribution of firm characteristics that have been linked to anomalies and other firm variables, such as investment, capital, and value added. Based on a model that matches these joint dynamics, we then evaluate the counterfactual dynamic distribution of these quantities in an informationally efficient economy, and find significant deviations. Our results suggest that if financial- and academic institutions helped reduce and/or eliminate such anomalies they could provide large value added to the economy. We show that informational inefficiencies are particularly destructive for high Tobin’s q firms, and that the persistence and the amount of mispriced capital are major determinants of the real economic consequences.

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2016

BEST PAPER

Commodity Trade and the Carry Trade: A Tale of Two Countries
Robert Ready, Simon School of Business, University of Rochester
Nikolai Roussanov, The Wharton School, University of Pennsylvania
Colin Ward, Carlson School of Management, University of Minnesota

Abstract:
 Persistent differences in interest rates across countries account for much of the profitability of currency carry trade strategies. The high-interest rate “investment” currencies tend to be “commodity currencies,” while low interest rate “funding” currencies tend to belong to countries that export  finished goods and import most of their commodities. We develop a general equilibrium model of international trade and currency pricing in which countries have an advantage in producing either basic input goods or final consumable goods. The model predicts that commodity-producing countries are insulated from global productivity shocks through a combination of trade frictions and domestic production, which forces the final goods producers to absorb the shocks.  As a result, the commodity country currency is risky as it tends to depreciate in bad times, yet has higher interest rates on average due to lower precautionary demand, compared to the final-good producer. The carry trade risk premium increases in the degree of specialization, and the real exchange rate tracks relative technological productivity of the two countries. The model’s predictions are strongly supported in the data. Read the full paper and a feature story from Knowledge@Wharton on the research.

OUTSTANDING PAPER

Equilibrium Asset Pricing with Leverage and Default
Joao Gomes, The Wharton School, University of Pennsylvania
Lukas Schmid, The Fuqua School of Business, Duke University

Abstract: We develop a general equilibrium model linking the pricing of stocks and corporate bonds to endogenous movements in corporate leverage and aggregate volatility. The model has heterogeneous firms making optimal investment and financing decisions and connects fluctuations in macroeconomic quantities and asset prices to movements in the cross-section of firms. Empirically plausible movements in leverage produce realistic asset return dynamics.   Countercyclical leverage drives predictable variation in risk premia, and debt-financed growth generates a high value premium. Endogenous default produces countercyclical aggregate volatility and credit spread movements that are propagated to the real economy through their effects on investment and output. Read the full paper.

2014

BEST PAPER

Scale and Skill in Active Management
Lubos Pastor, The University of Chicago Booth School of Business
Robert Stambaugh, The Wharton School, University of Pennsylvania
Lucian Taylor, The Wharton School, University of Pennsylvania

Abstract: We empirically analyze the nature of returns to scale in active mutual fund management. We find strong evidence of decreasing returns at the industry level: As the size of the active mutual fund industry increases, a fund’s ability to outperform passive benchmarks declines. At the fund level, all methods considered indicate decreasing returns, though estimates that avoid econometric biases are insignificant. We also find that the active management industry has become more skilled over time. This upward trend in skill coincides with industry growth, which precludes the skill improvement from boosting fund performance. Finally, we find that performance deteriorates over a typical fund’s lifetime. This result can also be explained by industry-level decreasing returns to scale. Read the full paper and a feature story from Knowledge@Wharton on the research presented.

OUTSTANDING PAPERS

Good and Bad Uncertainty: Macroeconomic and Financial Market Implications
Gill Segal, The Wharton School, University of Pennsylvania
Ivan Shaliastovich, The Wharton School, University of Pennsylvania
Amir Yaron, The Wharton School, University of Pennsylvania

Abstract: Does macroeconomic uncertainty increase or decrease aggregate growth and asset prices? To address this question, we decompose aggregate uncertainty into ‘good’ and ‘bad’ volatility components, associated with positive and negative innovations to macroeconomic growth. We document that in line with our theoretical framework, these two uncertainties have opposite impact on aggregate growth and asset prices. Good uncertainty predicts an increase in future economic activity, such as consumption, output, and investment, and is positively related to valuation ratios, while bad uncertainty forecasts a decline in economic growth and depresses asset prices. Further, the market price of risk and equity beta of good uncertainty are positive, while negative for bad uncertainty. Hence, both uncertainty risks contribute positively to risk premia, and help explain the cross-section of expected returns beyond cash flow risk. Read the full paperand a feature story from Knowledge@Wharton on the research presented.

Risk Premia, Volatilities, and Sharpe Ratios in a Nonlinear Term Structure Model
Peter Feldhutter, London Business School
Christian Heyerdahl-Larsen, London Business School
Philipp Illeditsch, The Wharton School, University of Pennsylvania

Abstract: We introduce a new reduced form term structure model where the short rate and market prices of risk are nonlinear functions of Gaussian state variables but yields are nevertheless given in closed form. Empirically, our three-factor nonlinear Gaussian model matches both the time-variation in expected excess returns and yield volatilities of U.S. Treasury bonds. During low volatility periods Treasury bonds are more attractive investments than standard Gaussian models predict. A significant part of expected excess returns in the nonlinear model is not explained by a linear combination of yields. This suggests that more information about expected excess returns is contained in the yield curve than previously thought, but in a nonlinear way. Read the full paper.