This paper explores the determinants of corporate failure and the pricing of financially distressed stocks whose failure probability, estimated from a dynamic logit model using accounting and market variables, is high. Since 1981, financially distressed stocks have delivered anomalously low returns. They have lower returns but much higher standard deviations, market betas, and loadings on value and small-cap risk factors than stocks with low failure risk. These patterns are more pronounced for stocks with possible informational or arbitrage-related frictions. They are inconsistent with the conjecture that value and size e¤ects are compensation for the risk of financial distress.

This paper documents that carry traders are subject to crash risk: i.e. exchange rate movements between high-interest-rate and low-interest-rate currencies are negatively skewed. We argue that this negative skewness is due to sudden unwinding of carry trades, which tend to occur in periods in which risk appetite and funding liquidity decrease. Funding liquidity measures predict exchange rate movements, and controlling for liquidity helps explain the uncovered interest-rate puzzle. Carry-trade losses reduce future crash risk, but increase the price of crash risk. We also document excess co-movement among currencies with similar interest rate. Our findings are consistent with a model in which carry traders are subject to funding liquidity constraints.

We investigate whether prospect theory preferences can predict a disposition effect. We consider two implementations of prospect theory: in one case, preferences are defined over annual gains and losses; in the other, they are defined over realized gains and losses. Surprisingly, the annual gain/loss model often fails to predict a disposition effect. The realized gain/loss model, however, predicts a disposition effect more reliably. Utility from realized gains and losses may therefore be a useful way of thinking about certain aspects of individual investor trading. ONE OF THE MOST ROBUST FACTS ABOUT THE TRADING of individual investors is the “disposition effect”: when an individual investor sells a stock in his portfolio, he has a greater propensity to sell a stock that has gone up in value since purchase than one that has gone down. The effect has been documented in all the available large databases of individual investor trading activity and has been linked to important pricing phenomena such as post-earnings announcement drift and stock-level momentum. Disposition effects have also been uncovered in other settings—in the real estate market, for example, and in the exercise of executive stock options. 1 While the disposition effect is a fundamental feature of trading, its underlying cause remains unclear. Why do individual investors have a greater propensity to

Forward-looking agents care about expected future utility flows, and hence have higher current felicity if they are optimistic. This paper studies utility-based biases in beliefs by supposing that beliefs maximize average felicity, optimally balancing this benefit of optimism against the costs of worse decision making. A small optimistic bias in beliefs typically leads to first-order gains in anticipatory utility and only second-order costs in realized outcomes. In a portfolio choice example, investors overestimate their return and exhibit a preference for skewness; in general equilibrium, investors ’ prior beliefs are endogenously heterogeneous. In a consumption-saving example, consumers are both overconfident and overoptimistic. (JEL D1, D8, E21, G11, G12) Modern psychology views human behavior as a complex interaction of cognitive and emotional responses to external stimuli that sometimes results in dysfunctional outcomes. Modern economics takes a relatively simple

Incorporating preference for social status into a simple model of portfolio choice helps to explain a range of qualitative and quantitative stylized facts about the heterogeneity in asset holdings among U.S. households. I specify preferences for status parsimoniously as a function of a household’s wealth relative to aggregate wealth. In the model, investors hold concentrated portfolios, suggesting, in particular, a possible explanation for the apparently small premium for undiversified entrepreneurial risk. Consistent with empirical evidence, the wealthier households own a disproportionate share of risky assets, particularly private equity, and experience more volatile consumption growth. The model is calibrated to match the empirical level of risky asset holdings without generating excessive volatility of consumption growth and crosssectional wealth mobility. I am grateful to John Cochrane, John Heaton, Tobias Moskowitz, and Pietro Veronesi for their advice

Preliminary and incomplete. Please do not quote or cite. We use a sample of option prices, and the method of Bakshi, Kapadia and Madan (2003), to estimate the ex ante higher moments of the underlying individual securities ’ risk-neutral returns distribution. We find that individual securities ’ volatility, skewness and kurtosis are strongly related to subsequent returns. Consistent with Ang, Hodrick, Xing and Zhang (2006), we find a negative relation between cross-sectional volatility and returns. We also find a significant relation between skewness and returns, with more negatively (positively) skewed returns associated with subsequent higher (lower) returns, while kurtosis is positively related to returns. We analyze the extent to which these returns relations represent compensation for risk. We use data on index options and the underlying market return to estimate the stochastic discount factor over the 1996-2005 sample period, and allow the stochastic discount factor to include higher moments. We find evidence that, even after controlling for differences in co-skewness, individual securities ’ skewness matters. All errors are the responsibility of the authors. We thank Robert Battalio, Patrick Dennis, and Stewart Mayhew for providing data and computational code. We thank seminar participants at Babson College,

In this paper, we intend to explain an empirical finding that distressed stocks delivered anomalously low returns. We show that in a model with heterogeneous investors where idiosyncratic skewness is priced, the expected return of risky assets depends on idiosyncratic coskewness betas, which measure the covariance between idiosyncratic variance and the market return. We find that there is a negative (positive) relation between idiosyncratic skewness and equity returns when idiosyncratic coskewness betas are positive (negative). We construct two idiosyncratic coskewness factors to capture market-wide effect of idiosyncratic coskewness betas. When we control for these two idiosyncratic coskewness factors, the return difference for distress-sorted portfolios becomes insignificant. High stressed firm earn low returns because high stressed firms have high idiosyncratic coskewness betas when idiosyncratic coskewness betas are positive, and low idiosyncratic coskewness betas when idiosyncratic coskewness betas are negative. 1

This paper analyzes takeover announcements for public US targets from 1987 to 2008. Consistent with the hypothesis that gambling attitudes matter for takeover decisions, both acquiror announcement returns and expected synergies are lower in acquisitions where the target’s stock has characteristics similar to those of attractive gambles. Offer price premium and target announcement returns are higher in these deals. The effects are stronger in companies where managers are more entrenched, where the disciplining force of product market competition is lower, where recent acquiror performance has been poor, during economic downturns, for younger CEOs in the acquiring firm, and for acquirors headquartered in areas in which local gambling propensity is higher. Targets with lottery features are more likely to be taken over and direct evidence from hand-collected synergy disclosure data shows that the market reacts less favorably to higher synergy forecasts if they are issued in the context of a lottery acquisition. Overall, our results suggest that corporate acquisitions are influenced by managerial gambling attitudes and that value destruction for acquirors in gambling-related transactions is substantial.

We use a sample of option prices, and the method of Bakshi, Kapadia and Madan (2003), to estimate the ex ante higher moments of the underlying individual securities ’ risk-neutral returns distribution. We find that individual securities ’ volatility, skewness and kurtosis are strongly related to subsequent returns. Specifically, we find a negative relation between volatility and returns in the cross-section. We also find a significant relation between skewness and returns, with more negatively (positively) skewed returns associated with subsequent higher (lower) returns, while kurtosis is positively related to subsequent returns. To analyze the extent to which these returns relations represent compensation for risk, we use data on index options and the underlying index to estimate the stochastic discount factor over the 1996-2005 sample period, and allow the stochastic discount factor to include higher moments. We find evidence that, even after controlling for differences in co-moments, individual securities ’ skewness matters. However, when we combine information in the risk-neutral distribution and the stochastic discount factor to estimate the implied physical distribution of industry returns, we find little evidence that the distribution of technology stocks was positively skewed during the bubble period–in fact, these stocks have the lowest skew, and the highest estimated Sharpe ratio, of all stocks in our sample. All errors are the responsibility of the authors. We thank Robert Battalio, Patrick Dennis, and Stewart Mayhew for providing data and computational code. We thank Andrew Ang, Leonce Bargeron, and Paul Pfleiderer

I propose an implementation of the q-theory of investment using bond prices instead of equity prices. Credit risk makes corporate bond prices sensitive to future asset values, and q can be inferred from bond prices. The bond market’s q performs much better than the usual measure in standard investment equations. With aggregate data, the fit is three times better, cash flows are driven out and the implied adjustment costs are reduced by more than an order of magnitude. The new measure also improves firm level investment equations. This paper was first circulated under the title "The y-theory of investment". I thank Daron Acemoglu,