Murray Carlson

This thesis consists of three essays studying the impacts of economic uncertainty on the financial markets. The first essay examines the impact of economic uncertainty on firms’ decisions to go private. Using an instrumental variable approach, I show that firms are more likely to go private following economic uncertainty shocks. The effect is stronger for firms prone to severe agency conflicts. After going private, the cost of debt decreases. These results are consistent with uncertainty exacerbating agency frictions faced by public companies. Firms go private to alter their capital structures to be less prone to agency frictions: ones with a small number of dominant stakeholders with aligned interests. The agency frictions are mitigated through going private, resulting in a decrease in the cost of debt. The second essay examines how the money creation function of banks affects the relative cost of firm financing in the bank loan vs. bond market – the loan-bond spread. Using a sample of loans and bonds issued by the same firm, the essay finds a lower loan-bond spread for firms impacted by positive information cost shocks. We call this decline in the relative cost of bank credit induced by firm information cost shock the opacity discount and show that it is consistent with the “money creation” hypothesis in the financial intermediation theory, which suggests that banks need to keep information about their assets secret to produce private money. The third essay studies how firms use earnout, a contingent payment contract in M&A, to manage valuation risks under uncertainty. I find that the usage of earnouts positively correlates with target uncertainty. The likelihood of deal completion increases significantly with earnouts. Despite the benefits of bridging the valuation gap, an earnout can introduce incentive misalignment problems in the post-transaction period. After the transaction, the acquirer’s objective is to maximize firm value, while the target’s objective is to maximize earnout payments. Such incentive misalignments can destroy firm value. The essay documents a negative impact on acquirer wealth gains when earnouts are not used to manage valuation risks.

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This dissertation is a collection of three essays that explore new directions in empirical asset pricing. The first essay studies the role of textual information in analyst reports. I show that analysts use the report text to convey soft information that has not yet been incorporated into their numerical forecasts. A simple tone measure predicts forecast revisions and forecast errors several periods ahead. Market prices quickly and adequately absorb the soft earnings information in analyst tone after the report publication. I demonstrate that analyst tone can be used to measure the saliency of upside or downside risks. The second essay proposes a novel deep learning approach to identify predictors of announcement returns from text. The method reveals that stock returns on earnings announcement days are predictable using analyst reports published weeks before the announcements. The identified predictors perform well for several years out-of-sample but eventually vanish. The predictability arises from a persistent underreaction to firm-specific news. A portfolio strategy based on out-of-sample announcement predictions earns large significant alpha. The findings are consistent with biased expectations and not in line with common risk-based explanations. The third essay studies the pricing of technological innovators in the stock market. It shows that technological innovators are priced differently, earning high stock returns controlling for standard factors, with less punishment for high capital investment and weak profitability. We create the persistent new firm variable patent intensity (PI), patents received divided by market capitalization, available from 1926. Aged PI portfolios and standard factors show high alpha and low profitability lasting more than a decade past formation for firms with high patenting intensity. Adding an expected growth factor, alphas become insignificant at most horizons, and loadings show large but declining growth, aggressive and increasing investment, and weak but improving profitability. The essay discusses partly unifying interpretations of some important factor models and the essential role of expected growth.

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The relationship between information and stock returns is one of the most fundamental questions in finance and economics. This thesis aims to enhance our understanding of this relationship by using novel datasets and methods. In particular, I present a collection of three essays on the impacts of information on stock returns. I study both traditional sources of information, such as earnings announcements, macroeconomic news, and media coverage, as well as non-traditional sources of information, such as online employee reviews. The first essay “Asset Pricing in the Information Age: Employee Expectations and Stock Returns” studies the investment value of employees' information in financial markets, using a novel dataset of nearly one million employee reviews. This essay shows that employee expectations of their employers' business prospects predict future returns. I find that employee reviews are related to firms' fundamentals because they predict cash flow news. This essay highlights the importance of online information about firms' fundamentals, which is beyond traditional information sources such as analyst forecasts. Investors often face multiple types of news at the same time. Thus, the interaction between different types of news is crucial for understanding how information is incorporated into stock prices. My second essay “Macro News, Micro News, and Stock Prices” investigates interactions between macro-announcements and the processing of earnings news. Existing theories suggest that macro-news should crowd out attention to firm-level news, implying less efficient pricing. However, I find the opposite: on macro-news days price efficiency of earnings announcements is better when macroeconomic announcements are released on the same day. The news text is a new source of data which allows us to measure intangible but important variable, such as investor attention. In my third essay, “Media Attention, Macroeconomic Fundamentals, and the Stock Markets” (co-authored with Adlai Fisher and Charles Martineau), we construct indices of media attention to macroeconomic risks including employment, growth, and monetary policy. We study the properties of these attention indices and link them to stock markets. We conclude that media attention to macroeconomic fundamentals provides market-relevant information beyond the contents and dates of macroeconomic announcements.

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In this thesis, I present two essays on corporate defined benefit pension claimants and Chapter 11 bankruptcy. First, defined benefit claimants are related to a lower likelihood that the firm files for Chapter 11 bankruptcy. Second, defined benefit claimants influence the bankruptcy reorganization process beyond the role played by the firm's traditional creditors.In the first essay, I examine the role of defined benefit claimants in times leading up to bankruptcy. Defined benefit claimants are less diversified and face higher costs of Chapter 11 bankruptcy than traditional lenders. I show that these differences have implications for the likelihood that firms file for Chapter 11 bankruptcy: the higher the share of defined benefit liabilities relative to overall liabilities, the lower the likelihood of Chapter 11 bankruptcy. These results indicate that defined benefit claimants' incentives to keep the firm as a going concern matter for the firm's decision to file for Chapter 11 and should be considered in studies of debt renegotiation between the firm and its creditors.In the second essay, I focus on defined benefit claimants in bankruptcy and their impact on the reorganization process. I provide evidence that pension claimants influence the Chapter 11 restructuring beyond the impact of traditional lenders. In particular, defined benefit claimants play a role in the decision to terminate a pension plan in bankruptcy, in the likelihood that firms refile for bankruptcy, and in the amounts that unsecured creditors recover in bankruptcy. These results highlight a role for pension claimants in bankruptcy restructuring beyond that of traditional creditors. Additional tests indicate that one channel through which defined benefit claimants influence the Chapter 11 process and its outcomes is by accepting cuts in their pension liabilities which cannot be explained by the average reductions experienced by other creditors. These findings highlight the role of defined benefit claimants as an important player in bankruptcy restructuring.

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Firm leverage is a slow-moving, persistent variable. This persistence remains after controlling for leverage determinants. When firms are sorted into portfolios on the basis of residuals from a regression of leverage on various factors, and then tracked for 20 years, the mean leverage level of these portfolios still exhibits long-term persistence and slow convergence over time, as documented by Lemmon et al. (2008).My thesis focuses on measurement error in the explanatory variables as a possible driver behind this long-run persistence. I show theoretically in Chapter 2 that if a firm's leverage dynamics are driven by a persistent explanatory variable that is measured with error, using the mismeasured explanatory variable in a regression can create persistence in residual-sorted portfolios: conditional on an observed residual, future expectations of leverage are no longer equal to the unconditional mean. Instead, a large positive residual will forecast above average future leverage. This is because the estimated residual is correlated with the unobservable explanatory variable, which in turn predicts leverage.In Chapter 3, I quantify the amount of measurement error that is consistent with the documented persistence of leverage in residual-based portfolio sorts. If we assume that a single factor drives leverage (we can think of this factor as a composite of many tradeoff theory-based explanatory variables), then the measurement error variance of this single “composite" variable needs to be 42% larger than its cross-sectional variance. While this seems large, even smaller levels of measurement error produce a remarkable level of persistence in residual-based portfolio sorts. I then examine several explanatory variables used in regressions in the literature, namely a firm's profitability, the tangibility of its assets, the market-to-book ratio, and industry leverage. I find that low quantities of measurement error in profitability, tangibility, and industry leverage, coupled with a measurement variance equal to about 80% of the cross-sectional variation in the market to book ratio, produce a good fit of simulated sample data moments to empirical moments. This is an interesting finding, since it suggests that unobserved investment opportunities may play an important role in explaining leverage ratios.

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In the first essay, I empirically investigate the effect of financial frictions and exogenous demand pressure on both prices and returns of options. Historically, observed option returns have been a challenge for no-arbitrage asset pricing models, most notably in the case of out-of-the-money equity index puts. I propose that liquidation risk, defined as the possibility of forced selling of speculative positions following a liquidity shock, is a major driver of the relative price of out-of-the-money put vs. call options (option-implied skewness) in commodity futures options markets and gives rise to a skewness risk premium in option returns. Establishing speculative net long positions in options (OSP) as a key proxy for liquidation risk, I find that the skewness risk premium rises (falls), but realized skewness remains unchanged, when OSP is more positive (negative). I also provide direct evidence of the price effects during such liquidation events. Trading strategies designed to theoretically exploit the skewness premium yield up to 2.5 percent per month and load significantly on risk factors related to the ease of funding for financial intermediaries.In the second essay, I investigate the pricing dynamics of a class of option-like structured products, bank-issued warrants, using a large, high-frequency data set. I provide evidence that issuers extract rents from investors due to 2 key features of these markets: Each issuer is the sole liquidity provider in the secondary market for her products, and short-selling is not possible. As a consequence, I find that warrants are more overpriced the harder they are to value, and the fewer substitutes are available. Second, issuers are able to anticipate demand in the short term and preemptively adjust prices for warrants upwards (downwards) on days when investors are net buyers (sellers). Third, issuers decrease the amount of overpricing over the lifetime of most warrants, lowering returns for investors further. Lastly, while I find a negative relationship between issuer credit risk and overpricing, the effect is generally too small, is absent prior to the Lehman Brothers bankruptcy and does not conform to models of vulnerable options.

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In this thesis, I study the relationship between excess cash holdings of corporations and mutual funds and future performance of these entities. In the first chapter, I document a positive relationship between corporate excess cash holdings and future stock returns. The difference in returns of portfolios of high and low excess cash firms amounts to 5% annually or 6% after standard three-factor risk adjustment. Firms with more excess cash have higher market betas and earn lower returns during market downturns. High excess cash companies invest considerably more in the future than do their low cash peers, but do not experience stronger future profitability. On the whole, this evidence is consistent with the notion that excess cash holdings proxy for risky growth options. In the second chapter, I document a positive relationship between excess cash holdings of actively managed equity mutual funds and future fund performance. The difference in returns of portfolios of high and of low excess cash funds amounts to over 2% annually, or approximately 3% after standard risk adjustment. I study whether this difference in performance can be explained by the differences in managerial stock selection skills, market-timing abilities, fund liquidity needs, and operating costs. I show that managers of high excess cash funds make more profitable stock purchasing decisions, while low excess cash fund managers make better sell decisions. Neither high nor low excess cash groups exhibit significant market-timing skills; however, funds with volatile excess cash holdings are successful market timers. The difference in returns between high and low excess cash groups is particularly pronounced during periods of low fund flows, suggesting that high excess cash funds are better able to anticipate fund outflows. Finally, I show that high excess cash funds incur significantly lower operating expenses than do their low excess cash peers. I additionally document new important determinants of mutual fund cash balances, showing that funds with riskier or less liquid shareholdings, as well as those with higher return gap measures hold more cash. The determinants I consider jointly explain three times more cross-sectional variation in cash positions than variables studied in prior literature.

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This thesis contains three essays. In the first essay, I provide new evidence on the failure ofthe Q theory of investment. The Q theory implies the state-by-state equivalence of stockreturns and investment returns. However in the data, I find that investment and stockreturns are negatively correlated. I also show that a production economy with time-to-buildcan explain these empirical facts. When I compute Q theory based investment returnson simulated data of the time-to-build model, they are uncorrelated with simulated stockreturns, as in the data. Moreover, the model replicates the empirical negative correlationbetween stock returns and investment growth which some researchers have interpreted asevidence for irrational markets.In the second essay, I analyze the equilibrium effects of investment commitment on assetprices when the representative consumer has Epstein-Zin utility. Investment commitmentcaptures the idea that long-term investment projects require not only current expendituresbut also commitment to future expenditures. The general equilibrium effects of investmentcommitment and Epstein-Zin preferences generate endogenously time-varying first andsecond moments of consumption growth and stock returns. As a result, the first andsecond moments of excess returns are endogenously counter-cyclical, excess returns arepredictable, and the equity premium increases by an order of magnitude. This paperalso offers novel empirical findings regarding the predictability of returns. In the real andsimulated data, the lagged investment rate helps to forecast the mean and volatility ofreturns.In the third essay, we embed a structural model of credit risk inside a consumption basedmodel, which allows us to price equity and corporate debt in a single framework.Our key economic assumptions are that the first and second moments of earnings andconsumption growth depend on the state of the economy which switches randomly, creatingintertemporal risk, which agents prefer to resolve quickly because they have Epstein-Zin-Weil preferences. Our model generates co-movement between aggregate stock returnvolatility and credit spreads, consistent with the data, and potentially resolves the equityrisk premium and credit spread puzzles.

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