The High-Frequency Trading Arms Race: Implications for Financial Market Design

Eric Budish, Assistant Professor of Economics

Summary: This paper proposes that a function of high-frequency trading is to "combinatorialize" financial markets for separately traded but mechanically and/or economically correlated securities. In our theory, this is inefficient relative to directly using our proposed combinatorial market design – in which traders submit offers on linear combinations of securities for a net price – because of an arms race associated with being faster than the competition. As an illustration of the theory, we examine statistical arbitrage between two different securities tracking the S&P 500 Index: the SPY exchange-traded fund, and the CME E-mini future. In May 2010, a "uniquely infinitely fast" trader would have made on the order of $300k per day on this strategy, rising to over $25mm on the day of the flash crash. By contrast, in our model of a combinatorial market design, Bertrand competition would bid these profits down to zero.

Trade Costs or Taste Differences? Evidence from the Global Car Industry

Kerem Cosar, Assistant Professor of Economics

Summary: The goal of this project is to investigate the sources of international market segmentation. In particular, we want to disentangle the quantitative role of trade costs affecting firms at the supply side from that of preference heterogeneity of consumers at the demand side. Imagine that we observe several firms, each located in a different country, competing internationally in a differentiated oligopolistic industry. Further, firms command a larger share in their domestic than in their foreign markets. There are three possible explanations for this: 1. firms are facing large trade and foreign production costs, 2. the representative consumer of each country has a preference for its national producer (home bias), 3. the representative consumer of each country has heterogeneous preferences with respect to the characteristics of the good, and producers supply a bundle of characteristics (i.e., varieties) that primarily caters to the preferences in their country (home-market effect). Between these extremes, all factors will play a role. Our goal is to use data from the automotive industry to decompose market share gap into its supply- and demand-driven components.

Eurozone Economic Policy Uncertainty Index

Steven Davis, William H. Abbott Professor of International Business and Economics


Measuring Economic Policy Uncertainty and Estimating Its Effects on Aggregate Economic Activity

Steven Davis, William H. Abbott Professor of International Business and Economics

Summary: Many observers argue that uncertainty about U.S. taxes, government spending, regulations, and other policy matters intensified in recent years, deepening the recession of 2007-2009 and slowing the recovery. To investigate this issue and related ones, we develop new ways to measure policy-related economic uncertainty. We use our new measures to quantify the role of policy uncertainty as a source of overall economic uncertainty and to assess its effects on investment, employment, output, and consumer sentiment. Initial results provide evidence that policy uncertainty became an increasingly important source of overall economic uncertainty in the past decade, and that greater policy uncertainty has substantially dampened the U.S. recovery from the recession of 2007-09. Our methods also allow us to quantify the specific policy areas that contribute to policy uncertainty and drive changes in its level and composition over time.

Do Pharmacists Buy Bayer? Sophisticated Shoppers and the Brand Premium

Jean-Pierre Dubé, Sigmond E. Edelstone Professor of Marketing
Matthew Gentzkow, Professor of Economics and Neubauer Family Faculty Fellow
Jesse Shapiro, Professor of Economics

Summary: Many economists have hypothesized that the brand price premium in physically homogeneous product categories such as aspirin or bleach results from consumer misinformation. To test this hypothesis, we estimate how information affects willingness to pay for brands relative to generics across a range of homogeneous goods categories. We identify informed consumers using three proxies: (i) occupational expertise (e.g. pharmacists buying aspirin or chefs buying flour), (ii) education (e.g., engineering majors buying batteries), and (iii) knowledge measured directly with a survey instrument (e.g., bleach purchasers who can correctly identify the active ingredient in bleach). We estimate a demand model that allows us to quantify the impact of information on willingness to pay, and to estimate how the prices, market shares, and profits of branded products would change in a world where all consumers were perfectly informed.

The Demand for Noninstrumental Information

Alexander Frankel, Assistant Professor of Economics
Emir Kamenica, Associate Professor of Economics

Summary: Suppose voters enjoy political news for its value as pure entertainment, following politics as if they are observing a sporting event. Watching the news teaches them about the various positions and policies of the competing candidates and informs their political participation, but all of this is merely a side effect of the consumption of news as entertainment. How should we design a political process – the order of primary elections, or the structure of candidate debates – if we seek to keep voters maximally engaged? By keeping the political race competitive and exciting, citizens in a democracy will follow election news more closely and will be more informed as voters. Formally, we study the problem of designing information environments to maximize an observer's "surprise" or "suspense". Surprising or suspenseful information processes will maintain the audience's attention over time.

Partisanship in Congressional Speech: 1872-2010

Matthew Gentzkow, Professor of Economics and Neubauer Family Faculty Fellow Jesse Shapiro, Professor of Economics
Matthew Taddy, Assistant Professor of Econometrics and Statistics and Neubauer Family Faculty Fellow

Summary: We propose to study the evolution of partisan language using a new corpus of legislative speech that consists of the full text of the US Congressional Record from 1873 to the present. We will apply recent advances in statistics to estimate a model that allows speech to depend on both the speaker's party and the topic under discussion. We will use the fitted model to study the evolution of partisanship over time, and to separate strategic use of language from differences in topic emphasis. Preliminary results suggest that partisanship in speech has risen dramatically since the 1970s, but that many earlier periods saw partisanship at a similar level to what we observe today.

Empirical Studies of Determinants of Innovation

Michael Gibbs, Clinical Professor of Economics

Summary: Innovation is a poorly understood outcome of organizational design, partly because relevant data are difficult to collect and thus rarely available. In this study we collect and analyze unique data on new ideas generated by employees at a global technology services company based in India. The company uses unusual and interesting policies to encourage employees to suggest new ideas, and collects data on those ideas via its Intranet. They have agreed to let us conduct a controlled experiment to study the effects of a change in organizational policy on the quantity and quality of new ideas generated by employees. In addition to the controlled experiment, we will study general determinants of new idea generation, including employee demographics, organizational position, and social network characteristics.

Public Versus Private Provision of Information Goods: Efficiency, Competition, and Bias in Weather Forecasting

Austan D. Goolsbee, Robert P. Gwinn Professor of Economics

Summary: This project will compare the efficiency and performance of private weather forecasters against the government provided National Weather Service forecast to see if public provision of an information good is different than public provision in more conventional economic services that have been well studied. It will also look for evidence of competitive pressures or a desire to hype up extreme weather events to generate viewership among private weather forecasters nationally or in local television stations. The area of weather forecasting is an interesting form of news where objective truth can be compared and where it is possible to test various theories from the literature on the economics of media on the impact of competition.

Corporate Cash Holding and Investment

Austan D. Goolsbee, Robert P. Gwinn Professor of Economics
Anil K Kashyap, Edward Eagle Brown Professor of Economics and Finance

Summary: At first glance there are several widely known facts about recent corporate behavior that appear contradictory. On the one hand, corporate cash holdings and corporate performance (measured by both Tobin’s Q and profits) are high. On the other, investment is low. We try to reconcile these observations. We use historical data on both the U.S. and other countries to determine the extent to which these patterns are new and attempt to distinguish between leading alternative explanations that have been proposed (policy uncertainty, self-insurance because of credit crunch concerns, and tax avoidance).

The Life-Cycle of Plants in India and Mexico

Chang-Tai Hsieh, Professor of Economics

In the U.S., manufacturing plants grow or die. In contrast, surviving Indian plants exhibit little growth in terms of either employment or output. Indian plants start smaller and stay smaller. Most Indian manufacturing employment is at informal plants with fewer than 10 workers. In the U.S. most workers are at plants with more than 800 workers. Mexico is intermediate to India and the U.S. in these respects. The divergence in plant dynamics could reflect lower investments by Indian and Mexican plants in accessing markets (at home and abroad) and in process efficiency, quality, and variety. In simple GE models, we find that the difference in life cycle dynamics could lower aggregate manufacturing productivity on the order of 25%.

Housing Booms, Housing Busts, and the Employment of Low-Skill Men

Erik Hurst, V. Duane Rath Professor of Economics and the John E. Jeuck Faculty Fellow
Matthew Notowidigdo, Neubauer Family Assistant Professor of Economics

Summary: In this study, we assess the importance of "structural" factors on the employment conditions of low-skill men in the U.S. Our specific hypothesis is that the recent housing boom temporarily masked the ongoing deterioration of the labor market for low-skill men by allowing these workers to readily substitute away from the (declining) manufacturing industry to the (temporarily growing) construction industry. If the current skills of low-skill men make them relatively close substitutes across manufacturing and construction employment but relatively poor substitutes across the other major industries (e.g., services, health care, education), then the aftermath of the housing bust has left low-skill men with few employment options. A major goal of the research project is to estimate a flexible model of occupational sorting which can be used to accurately forecast the wage and employment patterns of low-skill men in the near future.

Corporate Savings and Labor Shares

Loukas Karabarbounis, Assistant Professor of Economics
Brent Neiman, Assistant Professor of Economics

Summary: We document a global decline in the share of corporate gross value added accruing to labor from roughly 66 percent in the late 1970s down to roughly 58 percent by the late 2000s. This decline in labor’s share produced a shift in the share of global savings from the household sector to the corporate sector. Whereas roughly 40 percent of global savings came from corporations in the late 1970s, corporations supplied more than 60 percent of the world’s savings by the late 2000s.

Frictions on the flow of funds across sectors, such as dividend taxes, imply that firms and households both prefer to finance investment with savings internal to their sector. We write a model with such frictions to show that changes in the sectoral composition of savings have implications for the path of aggregate savings. This implies that savings investment decisions by households and corporations should be analyzed jointly.

Saving, Investment and Current Accounts: A Multi-Sector Perspective

Loukas Karabarbounis, Assistant Professor of Economics
Brent Neiman, Assistant Professor of Economics

Summary: The behavior of gross savings and investment drives macroeconomic performance over business cycles and over longer horizons. In open economies, their divergence results in international borrowing and lending. Researchers have long aimed to understand heterogeneity in cross-country savings and investment behavior, including differences in the level of savings rates and the cyclical behavior of the current account. Most explanations focus on demographic differences, differences in discount rates, or particular realizations of countries' productivity processes. Models of these cross-country differences, however, rarely include any within-country sectoral heterogeneity.

What Options Markets Imply about Government Guarantees: A Cross-Country Analysis

Bryan Kelly, Assistant Professor of Finance and Neubauer Family Faculty Fellow

Summary: Kelly, Lustig and Van Nieuwerburgh (2011) argue that because guarantees only kick in during a financial crisis, their effect is visible in the prices of assets that mostly reflect tail risk, like put options. They find that investors in option markets price in a substantial collective government bailout guarantee in the U.S. financial sector. Using option prices on European banks, we are able to address new questions about how investors value bailout guarantees. European data introduces three potentially valuable sources of variation. First, it provides a cross section of within-country bailout guarantees. This allows us to evaluate effects of a bailout as a function of country characteristics. Secondly, recent announcements of cross-border bailouts allow us to examine the effects of guarantees between countries. Third, differences in the credibility of bailout guarantees across countries allows us to evaluate how investors to different degrees of credibility. The goal of this project is to understand the simultaneous effects of all three layers of bailouts in the presence of government budget constraints while allowing for inter-European transfers.

Financial Development and Volatility: Is there a Trade-off?

Randall Kroszner, Norman R. Bobins Professor of Economics

Summary: While there is a large literature linking financial development to economic growth, there has been very little work addressing a crucial question: Might there be a trade-off with volatility? That is, to obtain a higher growth "return" through financial development is there a cost in terms of greater "risk" in the system? Following the crisis, this is a critical issue to investigate.

In theory, greater financial depth and development could either increase or decrease stability. On the one hand, a larger and more developed financial sector could improve risk sharing and diversification and thereby reduce volatility. On the other, a larger and more developed financial sector could allow greater concentrations of risk and generate interconnections and thereby make the entire system more fragile and vulnerable to shocks. We propose to analyze data across countries over time to assess whether there is evidence of a tradeoff and whether particular institutional or regulatory conditions may make such a trade-off more or less important.

How Tax Efficient are Equity Styles?

Tobias Moskowitz, Fama Family Professor of Finance

Summary: We examine the after-tax performance, tax exposure, and tax efficiency of size, value, growth, and momentum equity styles. On an after-tax basis, value and momentum outperform, and growth underperforms, the market. Decomposing the tax exposure of each style, we find that turnover is a misleading indicator of tax efficiency. Momentum, despite having more than five times the turnover of value, has the same tax rate as value, because momentum generates substantial short-term losses while value has high dividend income. In addition, tax optimization through capital gain and loss realization incurs less tracking error than avoiding dividend income. Hence, momentum, whose tax exposure is primarily driven by capital gains, while value and growth's taxes are more sensitive to dividends, is the only style that allows significant tax reduction without incurring significant style drift. The differential effects of taxes across equity styles are magnified within a broader asset allocation framework and in down markets.

Economic Effects of the U.S. Federal Disaster Relief Programs

Tobias Moskowitz, Fama Family Professor of Finance

Summary: The effectiveness of government spending is a hotly debated economic policy issue. Yet, empirical evidence on government spending multipliers is relatively thin, and is mainly identified by fluctuations in federal military spending (e.g., Barro and Redlick (2010), Fisher and Peters (2010), and Ramey (2011)). Military expenditure might not be representative of other types of government spending, however. Distortionary economic policies tend to increase during wartime, and relative to spending on public infrastructure, positive spillovers from military spending are likely to be comparatively low. In this paper we will examine novel state-level evidence on the government spending multiplier by considering the return on post-disaster expenses by the Federal Emergency Management Agency (FEMA) and its predecessor agencies using a set of exogenous variables to instrument for post-disaster spending that is otherwise unrelated to economic outcomes. This is one of the first attempts at quantifying the effectiveness of federal disaster relief programs.

Is Enrollment Enough? Enrollment, Attendance and Educational Achievement in India

Emily Oster, Assistant Professor of Economics

Summary: In many developing countries government education policy has been heavily focused on achieving universal primary enrollment. In India, some recent studies have suggested that this goal has been largely achieved: only about 5% of children aged 6-14 report being "out of school". However, basic skills in this age group are often very limited and, in addition, recorded attendance at schools tends to be fairly low. This leads to the concern that actual school enrollment is lower than "nominal" enrollment: students may state they are "in school" but actually attend so infrequently that learning is minimal. This project proposes to do a detailed accounting of the school experience among children aged 5-14 in two areas of India (Bihar and Tamil Nadu). Using both a household survey and school-based verification we hope to more accurately measure school enrollment. Our hope is to inform what policies would be most effective in achieving not only universal stated "enrollment" but universal learning.

Bank Failures and Liquidation Values

Raghuram G. Rajan, Eric J. Gleacher Distinguished Service Professor of Finance and the Charles M. Harper Faculty Fellow

Summary: We have collected data on the failures of national banks in different counties of the United States in the 1920s. The Comptroller of Currency Annual Reports describe what the liquidation value of the assets of failed banks were estimated to be at the time of failure, and the subsequent recovery rate. We want to see how the recovery rates on failed bank assets varied with the extent of subsequent bank failures in nearby areas (focusing on the liquidity effect of lower local lending capacity). The obvious reason for there to be a correlation is that terrible local conditions affected both the recovery rate on assets and the bank failure rate (call this the fundamental effect). To isolate the liquidity effect from the fundamental effect, we will examine the difference in effect on recoveries of bank failures in nearby in-state counties and nearby out-of-state counties. Since both counties are nearby, the fundamental effect should be similar. But since out-of-state banks could not lend in the county of interest, the liquidity effect should be absent for bank failures in nearby out-of-state counties. Preliminary results seem promising. We also will examine the effect of bank failures on local land prices, and then try and examine the relationship between the value of the underlying collateral (land) and bank asset values.

The Impact of Public Ratings Systems on Industry Norms Regarding Pollution and Diversity

Amanda Sharkey, Assistant Professor of Organizations and Strategy

Summary: This projects looks at the effect of information-disseminating institutions, such as public performance measures and rating systems, on shaping norms within business industries. Previous research has shown that rating systems provide powerful incentives for rated organizations to align their actions with the types of activities that are valued by raters. However, research has yet to look at how ratings systems shape norms in a field more generally, including their effect on unrated organizations. In this project, we look at how the KLD rankings on dimensions such as pollution and diversity impact convergence in behaviors among industry participants. We analyze unique data on actual pollution output and the level of diversity in management. We suspect that ratings lead to reduced within industry variance, net of any changes in the mean levels of pollution or diversity. We supplement this with a qualitative analysis of annual reports to look at how the language firms use in these are changes as ratings systems become more prevalent, reflecting shifting norms.

Executive Compensation and the Incentives to Increase Firm Risk

Kelly Shue, Assistant Professor of Finance

Summary: Stock options and other equity-linked pay currently account for more than half of the total compensation of top US executives. Popular media outlets frequently allege that the recent growth in stock options incentivized executives to take on more risk, thereby contributing to economic instability. In this research project, I measure the extent to which executive behavior responds to changes in their annual equity-linked compensation. I isolate the effect of pay on executive behavior by examining large annual variations in stock option grants that are tied to institutional kinks in the design of multi-year compensation plans. I examine the effect of stock options on acquisitions activity, investments, leverage, layoff decisions, and other proxies for risk taking. Supplementary analysis will focus on the financial services sector, where executive risk-taking may have a particularly large impact on economic stability.

On the Mechanisms of China's Export Growth

Zheng Michael Song, Assistant Professor of Economics

Summary: China's manufacturing has been one of the greatest success stories of exports in history. Between 2000 and 2007, the value of China's manufacturing exports more than quadrupled. The comparative advantage may explain the success of labor-intensive industries. However, why have exports from industries such as electrical machinery also been growing by leaps and bounds? In fact, the non-labor-intensive industries account for most of the export growth in China since 2000. Is the success simply a reflection of productivity growth or is it more driven by the demand side due to the China's integration into the world economy? This project will apply state-of-the-art economic modeling with longitudinal firm-level data, enhanced by a pilot survey data, to explore the underlying mechanism played in this success story. In so doing, the project will also lay the foundation to build uniquely rich data to rigorously test hypotheses that explain this success.

Fight or Flight Amount Foreign Investors in an Emerging Market: Reactions to Domestic Instability in Kenya's Nairobi Stock Exchange

Christopher Yenkey, Assistant Professor of Organizations and Strategy

This research studies how investor reactions to exogenous negative shocks to an emerging capital market differ by investor country of origin. Using a unique, investor-level dataset showing all domestic and foreign investors on Kenya's Nairobi Securities Exchange, I am able to model the reactions of foreign and domestic institutional investors to political, civil, and macroeconomic instabilities experienced in Kenya that depress equity prices on the Nairobi Securities Exchange. This research focuses on two generalizable questions. First, under what conditions do foreign and domestic investors see instabilities in developing countries as either opportunities to take advantage of share price discounts or grounds for reducing their exposure to the volatility that often characterizes high growth potential emerging markets? Second, to what extent does the depth of country-level economic and political ties between the developing country and foreign investors' countries of origin create more risk tolerant investment patterns in such environments?