Behavioral finance.

The NBER's Working Group on Behavioral Finance met at Yale University on May 3. NBER Research Associates Nicholas Barberis and Robert J. Shiller, both of Yale, organized the meeting. These papers were discussed:

Nicholas Barberis, and Wei Xiong, Princeton University and NBER, "Realization Utility" Discussant: Simon Gervais, Duke University

Ingolf Dittmann, Erasmus University, and Ernst Maug and Oliver Spalt, University of Mannheim, "Sticks or Carrots? Optimal CEO Compensation when Managers are Loss Averse" Discussant: Alex Edmans, University of Pennsylvania

Enrichetta Ravina, New York University "Love and Loans: The Effect of Beauty and Personal Characteristics in Credit Markets" Discussant: Tanya Rosenblat, Wesleyan University

Markus K. Brunnermeier, Princeton University and NBER; Stefan Nagel, Stanford University and NBER; and Lasse H. Pedersen, New York University and NBER, "Carry Trades and Currency Crashes" Discussant: Nikolai Roussanov, University of Pennsylvania

Jialin Yu, Columbia University, "Commonality in Disagreement and Asset Pricing" Discussant: Hongjun Yah, Yale University

Joseph Chen, University of Southern California; Samuel Hanson, Harvard University; Harrison Hong, Princeton University; and Jeremy C. Stein, Harvard University and NBER, "Do Hedge Funds Profit from Mutual Fund Distress?" Discussant: Owen Lamont, DKR Capital

Barberis and Xiong study the possibility that, aside from standard sources of utility, investors also derive utility from realizing gains and losses on individual investments that they own. The researchers propose a tractable model of this "realization utility," derive its predictions, and show that it can shed light on a number of puzzling facts. These include the poor trading performance of individual investors, the disposition effect, the greater turnover in rising markets, the negative premium to volatility in the cross-section, and the heavy trading of highly valued assets. Underlying some of these applications is one of their model's more novel predictions: that, even if the form of realization utility is linear or concave, investors can be risk-seeking.

Dittmann and his co-authors analyze optimal executive compensation contracts when managers are loss averse. They establish the general optimal contract analytically and calibrate the model to the observed contracts of 595 CEOs. They find that the Loss Aversion-model explains the observed structure of executive compensation contracts significantly better than the Risk Aversion-model. This holds especially for the mix of stock and options. The Loss Aversion-model predicts convex contracts with substantial option holdings that provide a stronger upside ("carrots"). By contrast, the optimal contract is concave for the standard Risk Aversion-model where it provides a significant downside ("sticks"). These results suggest that loss aversion is a better paradigm for analyzing design features of stock options and for developing preference-based valuation models than the conventional model used in the literature.

Ravina examines whether easily observable variables, such as the personal characteristics of a loan applicant and the way he presents himself, affect lenders' decisions, once hard financial information about credit scores, employment history, homeownership, and other financial information are taken into account. She studies an online lending market in which 7,321 borrowers posted 11,957 loan requests that included verifiable financial information, photos, an offered interest rate, and related context. Borrowers whose appearance was rated above average are 1.41 percentage points more likely to get a loan and, given a loan, pay 81 basis points less than an average-looking borrower with the same credentials. Black borrowers pay between 139 and 146 basis points more than otherwise similar white borrowers. However, in this sample such personal characteristics are not, all else equal, significantly related to subsequent delinquency rates, with the exception of beauty, which is associated with substantially higher delinquency rates. These findings suggest that the mechanism through which personal characteristics affect loan supply is lenders' preferences and perception, rather than statistical discrimination, based on inferences from previous experience.

Brunnermeier and his co-authors document that carry traders are subject to crash risk: that is, exchange rate movements between high-interest-rate and low-interest-rate currencies are negatively skewed. The researchers argue that this negative skewness is attributable to sudden unwinding of carry trades, which tend to occur in periods in which investor risk appetite and funding liquidity decrease. Carry-trade losses reduce future crash risk, but increase the price of crash risk. The authors also document excess co-movement among currencies with similar interest rate. Their findings are consistent with a model in which carry traders are subject to funding liquidity constraints.

Yu presents a dynamic model to demonstrate that, when differences of opinion over individual securities have a common component, the valuation of the aggregate market can be higher than its fundamental, even if all investors agree on the market fundamental and the common disagreement drives discount rate news. Using analyst forecast dispersion to measure disagreement, Yu finds that: individual stock disagreements co-move and the common component mean-reverts; the common disagreement has substantial explanatory power for the time-series variation of equity premium; and the common disagreement correlates with discount-rate news rather than cash-flow news and has explanatory power for the time-series variation of value premium.

Chen and his co-authors explore the question of whether hedge funds engage in front-running strategies that exploit the predictable trades of others. One potential opportunity for front-running arises when distressed mutual funds--those suffering large outflows of assets under management--are forced to sell stocks they own. The authors document two pieces of evidence that are consistent with hedge funds taking advantage of this opportunity. First, in the time series, the average returns of long/short equity hedge funds are significantly higher in those months when a larger fraction of the mutual-fund sector is in distress. Second, at the individual-stock level, short interest rises in advance of sales by distressed mutual funds.