Issue 5 of Review of Finance, Volume 26, 2022
September 28, 2022

Dear EFA Member,

As a current or recent EFA member, we are pleased to forward you the contents of the recently published Issue 5 of Volume 26 of the Review of Finance – the EFA’s own journal – along with digests (short summaries) and abstracts.


Authors: Marijn A Bolhuis, Judd N L Cramer, Lawrence H Summers

We study how the recent run-up in housing and rental prices affects the outlook for inflation in the USA. Housing held down the overall inflation in 2021. Despite record growth in private market-based measures of home prices and rents, the government-measured residential services inflation was only 4% for the 12 months ending in January 2022. After explaining the mechanical cause for this divergence, we estimate that, if past relationships hold, the residential inflation components of the Consumer Price Index (CPI) and Personal Consumption Expenditure (PCE) are likely to move close to 7% during 2022. These findings imply that housing will make a significant contribution to overall inflation in 2022, ranging from one percentage point for headline PCE, to 2.6 percentage points for core CPI. We expect residential inflation to remain elevated in 2023.

Authors: Marijn A Bolhuis, Judd N L Cramer, Lawrence H Summers

There have been important methodological changes in the Consumer Price Index (CPI) over time. These distort comparisons of inflation from different periods, which have become more prevalent as inflation has risen to 40-year highs. To better contextualize the current run-up in inflation, this article constructs new historical series for CPI headline and core inflation that are more consistent with current practices and expenditure shares for the post-war period. Using these series, we find that current inflation levels are much closer to past inflation peaks than the official series would suggest. In particular, the rate of core CPI disinflation caused by Volcker-era policies is significantly lower when measured using today’s treatment of housing: only 5 percentage points of decline instead of 11 percentage points in the official CPI statistics.


Authors: Harry DeAngelo, Andrei S Gonçalves, René M Stulz

The empirical corporate finance literature contains two distinct (and enormous) research silos, one focused on capital structure and the other on cash balances, with interactions between leverage and cash largely ignored. This paper reports a broad set of new and empirically important dynamic interactions between leverage (both market and book leverage) and cash-balance ratios (i.e., cash as a fraction of total assets). The evidence indicates a need to treat debt and cash policies as jointly interdependent through the roles they play in corporate funding.

Time-series variation in leverage depends strongly on cash balances, and vice-versa for time-series variation in cash, with leverage and cash ratios interacting approximately as predicted by the internal-versus-external funding regimes in Myers and Majluf (1984). Market and book leverage ratios (defined as debt, divided either by total market value or total assets) are quite volatile when cash-balance ratios are stable and vice-versa, while net-debt ratios (defined as debt minus cash, divided by total assets) are almost always volatile. Most firms increase leverage sharply as cash balances (internal funds) become scarce, despite widespread equity issuances that violate the pecking-order rule for external financing.

We study episodes in which firms move from their historically highest Cash/TA ratio to a later trough, a transition that takes a median of three years in our full sample of Compustat firms. Median Cash/TA declines from 0.298 at the peak to 0.044 at the trough, while median market leverage increases from 0.056 to 0.206. Absent external financing, most of these firms would have run out of cash by the trough year. The median firm raises funds equal to 290% of trough-year cash balances, which means that most of the new funds are used to cover outlays that internal funds cannot cover.

This connection between changes in leverage and cash-balance squeezes (defined as movements from peak Cash/TA to trough) stands out in bold relief when we divide our sample into firms that would have run out of cash absent external financing and firms that did not need outside funds to have positive cash balances. Median market leverage increases markedly from 0.066 to 0.283 for the former group and only slightly from 0.033 to 0.046 for the latter group. In short, the firms that otherwise would have run out of cash tend to increase leverage by large amounts while the remaining firms do not. We also find that cash-balance squeezes are pervasively important when we reverse the sampling approach and analyze levering-up episodes in which a firm moves from its historically lowest leverage to subsequent peak leverage.

We gauge the ability of the models of Gamba and Triantis (2008) and DeAngelo, DeAngelo, and Whited (2011) to explain the within-firm relation between cash-balance squeezes and time-series variation in leverage. We find that these models explain the qualitative link between leverage increases and cash squeezes at real-world firms, but both fall short quantitatively by predicting squeeze-related increases in market-leverage ratios that are far more muted than we observe in the real data.


Authors: Susan K Christoffersen, Donald B Keim, David K Musto, Aleksandra Rzeznik

Active mutual fund managers search for profitable investment opportunities and pay for the liquidity required to execute the trades. But what if a fund’s inflows arrive faster than its profitable buying opportunities, or if its redemptions outrun its profitable selling opportunities? These mismatches can cost the fund’s investors by forcing expensive liquidity-demanding trades. But rather than demanding liquidity in such circumstances, the manager can instead tilt toward supplying liquidity for the trades initiated by others, thereby reducing net trade costs for the fund. We test for this strategic substitution between demanding and supplying liquidity by analyzing the changes over time in the cost and performance of active managers’ trades, relating these changes to the changes in both their fund flows and their inventories of trading ideas.

Key to this analysis is our unique database that connects the individual transactions of Canadian mutual funds to their fund flows, as well as other fund- and trade-related characteristics. Through these connections we test whether funds make liquidity-motivated trades when flows outpace trading ideas, and costlier but more profitable liquidity-demanding trades when trading ideas outpace available flows when fund turnover is higher. We also explore the impact of asymmetric information on supplying liquidity by testing whether adverse selection limits the fund’s liquidity provision to the stocks it already owns and for which it has more accurate information.

Our main finding is a large and systematic role for supplying liquidity in active fund management. Funds supply liquidity and pay less for trades when inflows have been higher, when turnover is lower, when trading larger quantities, when they hold more stocks, and when buying stocks they already hold. Tracking these trades forward, the expensive trades perform better than the lower-cost trades. Lower cost and poorer prospects are the distinctive features of liquidity-supplying trades, so we conclude that active funds economize when trade ideas run out by supplying liquidity where they have the latitude and the knowledge.

Finally, we explore the impact of strategic liquidity provision on the overall performance of active funds. Prior research does not find a consistent relation between active fund performance and average trade costs. But if funds pay up only for valuable trades then we should separate buy costs from sell costs, because high buy costs are good news about the similar stocks the fund already holds, and high sell costs are bad news. When we separate buys from sells, this is what we find: fund performance is strongly positive in buy costs, and strongly negative in sell costs.


Authors: Raymond Fisman, April Knill, Sergey Mityakov, Margarita Portnykh

Using a portfolio theory framework, we introduce the concept of “political beta” to model firm-level export diversification in response to global political risk. Our model predicts that firms are less responsive to changes in political relations with lower beta countries—those that contribute less to the firm’s total political risk. We document patterns consistent with our model using disaggregated Russian firm-by-destination-country data during 2001–2011: Trade is positively correlated with political relations, though the effect is far weaker for trading partners whose political relations with Russia are relatively uncorrelated with those of other partners in a firm’s export portfolio.


Authors: John Bizjak, Swaminathan Kalpathy, Zhichuan Frank Li, Brian Young

Relative performance (RPE) awards have become an important component of executive compensation. We examine whether RPE awards, particularly the peer group, are structured in a manner consistent with economic theory. For RPE awards using a custom peer group, we find that the custom group is significantly more effective than four plausible alternative peer groups at filtering out common shocks, lowering the cost of compensation, and increasing managerial incentives. For RPE awards using a market index, we find some evidence that firms could have selected a custom set of peers with better filtering properties at a lower cost with similar incentives. For example, firms could have saved around $118,000 in present value terms, on average, for an RPE award had they chosen a custom group comprising of their product market peers instead of a market index.


Authors: John Y Zhu

The emergence of disagreement is a significant friction in long-term financing relationships. This paper studies a long-term optimal contracting problem between a financier and an entrepreneur, in which it is anticipated that, at some point in the future, disagreement might emerge about which action the entrepreneur should take. The financier is uncertain about the nature of future disagreement and is averse to this uncertainty.

The financier’s uncertainty-aversion to anticipated disagreement has a differential impact on asset prices. The financier’s valuation of debt is uniquely immune to anticipated disagreement, and when the set of anticipated disagreements is sufficiently rich, this immunity causes the optimal contract to give the financier debt. In contrast, the financier’s valuations of other contracts, including equity, decline as anticipated disagreement becomes more severe. This suggests a channel through which an increase in the severity of anticipated disagreement increases the equity premium and the debt-to-equity ratio.


Authors: Yazhou Ellen He, Tao Li

We study the role of social networks in hedge fund activism. Actively managed funds whose managers are socially connected to activists are more likely than unconnected managers to invest in target stocks; their investment decisions are profitable. Importantly, such effects are greater for funds facing more severe information asymmetry. Connected funds are 14.2 percentage points more likely to support activists in proxy contests and contribute to reducing proxy contest costs. Our evidence shows that social ties benefit both connected investors and activists, and suggests that social networks reduce information asymmetry around activist campaigns by facilitating information exchange and increasing trust.


NOTE: This and previous issues of Review of Finance [ISSN 1572-3097 | EISSN 1573-692X] are freely available to current EFA members as a benefit of annual membership.  For information on how to submit a manuscript to Review of Finance, please visit the RF Editorial Office website revfin.org.  Follow us on LinkedIn.

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