Working Papers

• Imperfect Financial Integration and Asymmetric Information: Competing Explanations of the Home Bias Puzzle?, with Thomas Wu

ABSTRACT:

This paper shows that imperfect financial integration and informational asymmetries are not competing theories but rather complementing ideas to a single explanation of the home bias puzzle. We develop a rational expectations model of asset prices with investors that face informational constraints and find that informational advantages arise endogenously as a response to small financial frictions. We also present empirical evidence that (i) international financial frictions are correlated to observed patterns of US investors' attention and that (ii) the attention US investors allocate to foreign stocks helps explain home bias towards those countries, even after controlling for financial integration levels.
Keywords: Home bias, Rational inattention, Financial integration, Asymmetric information.
JEL Codes: F30, D82, G11.
Canadian Journal of Economics 46 (1), pp. 310–337, 2013
Paper: Link to journal and Local file

• Asymmetric Information, Portfolio Managers, and Home Bias, with Wioletta Dziuda

ABSTRACT:

We propose a model of delegated asset management that can explain the following empirical regularities in international markets: the presence of home bias, the lower proportion of mutual funds investing domestically, and the higher market value of mutual funds investing domestically. In the model, fund managers choose whether to specialize in domestic or foreign assets. Individual investors are uncertain about managers' abilities, and they are more informed about domestic markets. This makes domestic investments less risky and generates home bias. Home bias is magnified because higher ability managers specialize in domestic assets, making them even more attractive to the investors.
Review of Financial Studies 25 (7), 2109-2154, 2012
Paper: Link to journal and Local file

• Financial Contagion and Attention Allocation, with Climent Quintana-Domeque

ABSTRACT:

This paper explains financial contagion between two stock markets with uncorrelated fundamentals by fluctuations in international investors' attention allocation. We model the process of attention allocation that underlies portfolio investment in international markets using investors who face information processing constraints. Investors optimally allocate more attention to a region hit by a financial crisis, to the detriment of other markets. The resulting endogenous increase in uncertainty causes a reduction in the capacity to bear risks by international investors that induces them to liquidate their positions in all risky assets. Hence, there is a collapse in stock prices around the world. We show that the degree of (non)anticipation of a crisis is crucial for the existence of contagion. Using data from the East Asian crisis and the number of news stories about Thailand in the Financial Times relative to news stories about Argentina, Brazil and Chile as a proxy for the relative attention allocated to the Asian stock market, we find evidence consistent with two key predictions of our model: first, the higher the volatility of the originator market, the more relative attention allocated to this market; and second, the more relative attention allocated to the originator market, the higher the volatility of the other markets. Our findings support the attention reallocation channel as a transmission mechanism of financial crises between regions during the period from January 1997 to July 1998.
Keywords: Financial Crisis, Asset Pricing, Portfolio Choice, Information Choice, News.
JEL Codes: F30, D82, G12, G11.
Economic Journal 123 (568), pp. 429-454, 2012
Paper: Link to journal and Local file

• Introducing Managerial Attention Allocation in Optimal Incentive Contracts, with Ricard Gil

ABSTRACT:

This paper introduces and studies the role of managerial attention allocation constraints in incentive contracts. We extend the traditional moral-hazard benchmark model with multi-tasking and linear incentive contracts by letting the principal choose the amount of monitoring allocated across tasks. In our model, more attention allocated to a task improves the task contractibility and consequently increases the effort provided by the agent. Our findings show that, even under symmetry, in the presence of increasing returns to scale in either production or monitoring the principal may optimally offer an unbalanced incentive contract while allocating different amounts of attention across tasks. Finally, we comment on the empirical content of our model.
Keywords: Agency Problems, Monitoring, Inattentiveness.
JEL Codes: D86, D82.
SERIEs:  Journal of the Spanish Economic Association 2 (3), 335-358, 2011
Paper: Link to journal and local copy

• Portfolio Choice, Attention Allocation, and Price Comovement,
  

ABSTRACT:

This paper models the attention allocation of portfolio investors. Investors choose the composition of their information subject to an information flow constraint. Given their expected investment strategy in the next period, which is to hold a diversified portfolio, in equilibrium investors choose to observe one linear combination of asset payoffs as a private signal. When investors use this private signal to update information about two assets, changes in one asset affect both asset prices and may lead to asset price comovement. The model also has implications for the transmission of volatility shocks between two assets.
Keywords: Rational Inattention, Asset Pricing, Portfolio Choice.
JEL Codes: D82, G12, G11.
Journal of Economic Theory 145 (5), 1837-1864, 2010
Paper: Link to journal and local copy

• The Determinants of International Investment and Attention Allocation: Using Internet Search Query Data,
  with Thomas Wu and Yi Zhang

ABSTRACT:

This paper explores the joint determination of home bias and attention allocation. We overcome the typical challenge associated with evaluating attention allocation theories by using a new internet search query dataset to measure how much information investors decide to process. Employing an instrumental variables approach, we find empirical evidence of a two-way causality between home bias and attention. Our estimates suggest that if all countries were to receive the same level of attention as the U.S., then the average home bias by U.S. investors would fall from 85.2% to 57.3%.
Keywords: Home Bias, Asymmetric Information, Attention Allocation , Internet Search Query.
JEL Codes: F30, D82, G11.
Journal of International Economics 82 (1), 85-95, 2010
Paper: Link to journal and local copy

• The Puzzling Evolution of the Home Bias, Information Processing and Financial Openness, with Thomas Wu

ABSTRACT:

This paper explains the home equity bias and its puzzling evolution in a model where investors face an information constraint and have an initial local informational advantage. After financial liberalization, local investors have a magnified informational advantage since information processed under autarky remains useful after liberalization. A gradual shift towards foreign assets occurs as the relevance of autarkic information declines over time. In the long run, home bias remains large due to the interaction between information and portfolio choices. Empirical evidence supports the main predictions of our model, namely that bias increases with information capacity and decreases with financial openness.
Keywords: Home Bias, Rational Inattention, Asymmetric Information, Portfolio Choice.
JEL Codes: F30, G15, D82, G11.
Journal of Economic Dynamics and Control 34 (5), 875-896, 2010
Paper: Link to journal and local copy

• Asymmetric Attention and Stock Returns, with Peter Cziraki and Thomas Wu

ABSTRACT:

This paper constructs a new measure of attention allocation by local investors relative to nonlocals using aggregate search volume from Google. We first present a conceptual framework in which local investors optimally choose to focus their attention on local stocks when they receive private news, leading to an asymmetric allocation of attention between local and nonlocal investors. Consistent with the main prediction of this framework, we find that firms attracting abnormally high asymmetric attention from local relative to nonlocal investors earn higher returns. A portfolio that goes long in stocks with high asymmetric attention and short in stocks with low asymmetric attention has an alpha of 32 basis points per month. The results are stronger for stocks with a greater degree of information frictions. The new measure of asymmetric attention allows one to infer the arrival of unobservable private information by observing investors' attention allocation behavior.
Keywords: Rational Inattention, Asymmetric Information, Stock Returns, Geography.
JEL Codes: G12, G14, D82.
Management Science 67(1), pp. 48-71, 2021
Paper: Link to journal, local file and online appendix

• Quality Uncertainty and Intermediation in International Trade, with Kunal Dasgupta

ABSTRACT:

Uncertainty about product quality is endemic in international trade. We develop a dynamic, two-country model, where home producers differ in terms of the quality of their products. Quality is not fully observed by foreign consumers initially but known once the product is consumed. We show that this lack of information generates an Äúinformation costÄù of exporting, over and above the usual fixed costs used in standard heterogeneous firm models. We use the model to examine the role played by intermediaries in alleviating quality uncertainty. In the process, we uncover a positive externality of using intermediaries. The model generates a novel prediction about price dynamics that finds support in the data.
KEYWORDS : Intermediaries, quality, uncertainty, screening, asymmetric information.
JEL Classification : D83, F10, F19, L15.
European Economic Review 104, pp. 68 - 91, 2018
Paper: Link to journal and local copy

• Pareto-improving import tariffs, with Kunal Dasgupta

ABSTRACT:

We study the role of import tariffs model when the quality of imported products is not observable. We consider a two-country model where Foreign consumers do not observe the quality of Home products. Home exporters use price to signal the quality of their products. We show that when the Foreign country imposes an import tariff, its welfare can rise. This result is driven by the ability of the tariff to reduce a signalling distortion. More surprisingly, a Foreign import tariff can also raise welfare in the Home country. We go on to examine the robustness of our results when quality is endogenous and when firms have alternate signalling devices.
KEYWORDS : Quality, uncertainty, asymmetric information, signaling, trade cost.
JEL Classification : D83, F10, F19, L15.
Paper: Local file

• Familiarity and Surprises in International Financial Markets: Bad news travels like wildfire, good news travels slow, with Thomas Wu and Xin Wang

ABSTRACT:

In this paper, we decompose attention allocation in two components -- the familiar and the surprising -- with opposite implications for US purchases of foreign stocks. On one hand, familiarity-induced attention leads to an increase in US holdings of foreign equities. On the other hand, surprise-induced attention is associated with net selling of foreign stocks because US investors tend to pay more attention to negative than to positive economic surprises from foreign countries. Our findings suggest that information asymmetries between locals and non-locals are more pronounced when it comes to good news, with information regarding bad news being relatively symmetric.
Keywords: US Purchases of Foreign Stocks, Attention Allocation, Asymmetric Information, Geography, Economic Surprises.
JEL Codes: F30, D82, G11.
Journal of International Money and Finance, 115, 102390, 2021
Paper: Link to journal and Local file

• Inattentive Importers, with Kunal Dasgupta

ABSTRACT:

Information frictions prevent importers from observing the price of a good in every market. In this paper, we seek to explain how the presence of such frictions shapes the flow of goods between countries. To this end, we introduce rationally inattentive importers in a multi-country Ricardian trade model. The amount of information importers process is endogenous and reacts to changes in observable trade costs. Unlike traditional trade costs, changes in information processing costs have non-monotonic and asymmetric effects on bilateral trade flows. The model generates a novel prediction regarding the relationship between information processing costs and concentration of imports that finds support in the data. We calibrate the model, perform counterfactuals and show quantitatively how the response of trade flows to exogenous trade shocks gets magnified under inattention.
Keywords: Rational inattention, information costs, magnification effect.
JEL Codes: D83, F10, F19, L15.
Journal of International Economics 112, pp. 150-165, 2018
Paper: Link to journal and local copy

 

• The Asset Pricing and Real Implications of Relationship Intensity Disclosure, with Xu Jiang and Liyan Yang

ABSTRACT:

In many scenarios, investors in financial markets are uncertain about the relationship intensity between two firms and have to rely on firms' disclosure of such relationship intensity. We develop a theory to study the asset pricing implications of this relationship intensity uncertainty and how such relationship intensity uncertainty affects firms' incentives to form and disclose their relationship intensities to the public in the first place (i.e., the real implications). We find that while such disclosure has a positive price impact by increasing the expected cash flow, it also has a negative price impact by reducing the diversification benefit (or, equivalently, increasing the diversification cost) of investing in multiple firms that have more correlated cash flows. The price impact upon relationship intensity disclosure is therefore not monotone: it increases with the expected benefit of relationship and decreases with the risk of the underlying relationship. One main policy implication of our analysis is that mandatory disclosure of firm relationship intensities may both destroy relationship development and reduce investor welfare. In other words, disclosing relationship intensity information can have real consequences on cash flows through affecting firm relationships at both the intensive and the extensive margins. The results are robust to a battery of extensions.

Keywords: Firm relationships, asset prices, disclosure, matching quality, collaboration intensity.
JEL Codes: G12, G14, D83
Paper: Local file

 

• Costly Interpretation of Asset Prices, with Xavier Vives and Liyan Yang

ABSTRACT:

We propose a model in which investors cannot costlessly process information from asset prices. At the trading stage, investors are boundedly rational and their interpretation of prices injects noise into the price, generating a source of endogenous noise trading. Our setup predicts price momentum and yields excessive return volatility and excessive trading volume. In an overall equilibrium, investors optimally choose sophistication levels by balancing the benefit of beating the market against the cost of acquiring sophistication. There can exist strategic complementarity in sophistication acquisition, leading to multiple equilibria.

Keywords: Investor sophistication, price momentum, asset prices, complementarity.
Management Science, forthcoming
Paper: Link to journal and local copy

 

• News Selection and Asset Pricing, with Charles Martineau

ABSTRACT:

We build a theoretical framework to endogenize the editorial decisions of media and analyze their asset pricing implications. The media outlet optimally reports man-bites-dog signals by choosing to report about firms that generate more uncertainty for investors. The model has three implications. First, the editorial choice is state-dependent and has asset pricing implications for reported and non-reported firms. Second, it generates an asymmetric response of asset prices to positive and negative news. Finally, public information does not necessarily crowd out the acquisition of private information. Ignoring the information implications of editorial decisions can result in misspecified asset pricing models.

JEL Codes: G10, G12, G14
Keywords: News, Media, Asset Prices, Information Acquisition, Public Information
Paper: Local file

 

• The Disconnect Between Market Capital Gains and the Dividend Yield in Asset Pricing, with Michael Di Carlo and Ilias Tsiakas

ABSTRACT:

The rate of capital gains of the market portfolio is vastly more volatile than the dividend yield. As a result, standard CAPM betas capture exposure only to market capital gains. We propose a two-factor CAPM that includes a separate market dividend yield factor and find that this factor carries a significant negative premium in the post-1978 period that coincides with the persistent decline in the number of US dividend-paying firms. We motivate this finding by proposing a theoretical model, which shows that the predictive information of the dividend yield can be high when investors have a behavioural bias against dividends.

Keywords: CAPM, Dividend Yield, Capital Gains, Dividend Disconnect, Factor Models.
JEL Codes: G11, G12
Paper: Local file

 

• Social Media-Driven Noise Trading: Liquidity Provision and Price Revelation Ahead of Earnings Announcements, with Edna Lopez Avila and Charles Martineau

ABSTRACT:

Social media attention before earnings announcements is overly optimistic, fails to predict fundamentals, and generates buying pressure, leading to a 58 bps stock return as intermediaries seek higher returns for providing liquidity. Such price pressure distorts price informativeness ahead of announcements. A return reversal occurs immediately following announcements as markets correct mispricing. How stock prices respond to earning news is endogenous to the effect of social media in the pre-announcement price formation. A pre-announcement trading strategy based on expected social media attention yields 40 bps monthly alphas. When noise trading is systematically driven, liquidity provision becomes more costly and worsens price revelation.

Keywords: Attention, Earnings Announcements, Price Efficiency, Price Impact, Retail Trading, Social Networks, Stocktwits, Seeking Alpha, WallStreetBets, Wishful Thinking.
JEL Codes: G11, G12
Paper: Local file