It is widely acknowledged that the finance faculty at Chicago
GSB has been, over the past 40 years, a global leader in
innovative finance research. Indeed, modern finance is
largely built on the work of past and present GSB faculty such
as Eugene Fama and Nobel laureates Merton Miller and Myron
Scholes. This issue of Capital Ideas highlights the contributions
of our young faculty and shows that the future of finance
research at Chicago is secure. In these pages you will read
about research spanning a broad spectrum of issues, including
asset allocation within pension funds, the effect of firms’
financial policy on their investments, tech stock bubbles, and
the use of limit orders.
In the first paper, Joshua Rauh uses a unique laboratory for studying an old question in finance: which is stronger, the incentive stockholders have to shift risk onto bondholders (the“risk-shifting” hypothesis) or their incentive to protect their ability to invest in future projects (the “risk-management” hypothesis)? Rauh observes how firms with defined benefit pension plans allocate the assets in those plans as a function of the financial health of the firm. The risk-shifting hypothesis implies that, as the health of a firm deteriorates, it will tend to allocate more of its pension assets to riskier investments such as equities. The risk-management hypothesis predicts the opposite. Although most finance scholars have focused on risk shifting, Rauh finds strong support for the risk-management hypothesis and none for risk shifting among the investment choices of the pension plans he studies.
The role of stockholders in influencing corporate investment
policy through voting rights and the board of directors
has been widely studied. And, while scholars and practitioners
alike are well aware of the ability of bondholders to affect
investment policy to some extent through bond covenants,
this ability has traditionally been thought to be quite limited.
Amir Sufi and coauthors Greg Nini and David C. Smith find
that syndicates of banks exert significant and beneficial influence
on firms’ investments through restrictions in private
credit agreements.
Why do stock prices of innovative firms tend to exhibit
bubbles during technological revolutions? Why would
investors make the same mistake over and over again? In the
third paper, Lubos Pastor and Pietro Veronesi argue that the
bubble-like price pattern is the rational outcome of the
changing risk profile associated with new technologies.
Before a new technology is widely adopted, its risk is idiosyncratic
and hence diversifiable. If and when the technology is
widely adopted, its risk becomes correlated with the market,
the discount rate of future earnings increases, and stock
prices fall. The seemingly disparate bubbles in the 1990s
internet stocks and the mid-1800s railway stocks support
the Pastor and Veronesi explanation.
Why do we observe the disposition effect—the tendency of investors to sell stocks with capital gains? Why do investors consistently lose money by trading against earnings surprises? In the fourth paper, Juhani Linnainmaa argues that this is the mechanical outcome of uninformed investors correctly placing limit orders rather than market orders, combined with the tendency of these investors to fail to closely monitor and update their limit orders as information arrives in the market. Data from the Finnish stock market and a U.S. discount broker support Linnainmaa’s explanation.
A detailed account of the research highlighted in this issue of Capital Ideas, as well as other exciting finance research being carried out at the GSB, is available on the websites of the individual finance faculty members.