Due to their low trading costs, exchange‐traded funds (ETFs) are a potential catalyst for short‐horizon liquidity traders. The liquidity shocks can propagate to the underlying securities through the arbitrage channel, and ETFs may increase the nonfundamental volatility of the securities in their baskets. We exploit exogenous changes in index membership and find that stocks with higher ETF ownership display significantly higher volatility. ETF ownership increases the negative autocorrelation in stock prices. The increase in volatility appears to introduce undiversifiable risk in prices because stocks with high ETF ownership earn a significant risk premium of up to 56 basis points monthly.

We amend the conditional CAPM to allow for unobservable long-run changes in risk factor loadings. In this environment, investors rationally "learn" the long-run level of factor loadings from the observation of realized returns. As a consequence of this assumption, we model conditional betas using the Kalman filter. Because of its focus on low-frequency variation in betas, our approach circumvents recent criticisms of the conditional CAPM. When tested on portfolios sorted by size and book-to-market, our learning-augmented conditional CAPM passes the specification tests. * Federal Reserve Bank of New York and Swiss Finance Institute at the University of Lugano, respectively. Fama and French (1992) present compelling evidence that the unconditional captial asset pricing model (CAPM) does not account for returns on portfolios sorted by size and book-to-market (B/M). Since then, the literature on asset pricing has developed alternative theories, which depart from the original model along several dimensions. Promising avenues of research, which preserve the single-factor structure, have been conditional versions of the CAPM. The idea behind this approach is that, even though CAPM holds conditionally on time t information, it does not hold unconditionally. Accordingly, the poor empirical performance of CAPM might be due to its failure to account for time variation in conditional moments.Among the many studies of the conditional CAPM, recent implementations are put forward by Jagannathan and Wang (1996), Ferson and Harvey (1999), and Lettau and Ludvigson (2001). Earlier papers include Ferson, Kandel, and Stambaugh (1987), Harvey (1989). In all cases, the authors explicitly model the evolution of the conditional distribution of returns as a function of lagged state variables.They specify the covariance between the market return and portfolio returns as affine functions of these variables. This specification is estimated as a multifactor model, in which the additional factors are the interactions between the market return and the state variables.A recent paper by Lewellen and Nagel (2006) casts doubts on the empirical success of this approach. While acknowledging that betas vary considerably over time, these authors suggest that the covariation between sample estimates of betas and the market risk premium is not large enough to justify the deviations from the unconditional CAPM observed for value and momentum portfolios (Fama and French (1993); Jegadeesh and Titman (1993)).They argue that the good empirical performance of previous conditional studies is due to their cross-sectional design-which ignores key theoretical restrictions on the estimated slope coefficients-and suggest time-series regressions instead.In this paper, we complement the conditional CAPM literature by modeling a new type of time variation in conditional betas. There is substantial evidence that the risk of some asset classes has experienced long-run movements. For example, CAPM regressions on CRSP 1 data suggest that value stocks had higher be...

Private equity has traditionally been thought to provide diversification benefits. However, these benefits may be lower than anticipated as we find that private equity suffers from significant exposure to the same liquidity risk factor as public equity and other alternative asset classes. The unconditional liquidity risk premium is about 3% annually and, in a four‐factor model, the inclusion of this liquidity risk premium reduces alpha to zero. In addition, we provide evidence that the link between private equity returns and overall market liquidity occurs via a funding liquidity channel.

We study hedge fund trading in the stock market during the financial crisis of 2007-2008 and the surrounding years. We find that in the two quarters around the Lehman collapse (2008Q3-Q4) hedge funds reduced their equity holdings by about 29%, with nearly every fourth hedge fund cutting more than 40% of its equity portfolio in each quarter. We identify two main drivers of this behavior. First, in line with the presence of severe funding constraints, investor withdrawals and lender pressure account for about 78% of equity selloffs. These constraints are more binding for funds with low restrictions on investors' liquidity, and funds with low bargaining power vis-à-vis their brokers. Second, it appears that hedge funds reallocate capital to either cash, in an attempt to time the stock market, or other markets, in pursuit of more profitable investment opportunities. Finally, we find evidence for flight to quality (selloffs of high-volatility stocks) and static liquidity management (selloffs of high-liquidity stocks), which are consistent with distress selling driven by funding constraints.

Mandatory contributions to defined benefit pension plans provide a unique identification strategy to estimate the market's assessment of the value of internal resources controlling for investment opportunities. The price decrease following a pension-induced drop in cash is magnified for firms that appear a priori more financially constrained, suggesting a negative effect of financing frictions on investment. In contrast, low control on managerial discretion attenuates the negative price reaction to contributions consistent with empire-building theories. While overinvestment seems to be the prevalent distortion in a panel of large firms, underinvestment appears to dominate in a sample that is more representative of the cross-section of listed companies. * Francesco Franzoni: Swiss Finance Institute -University of Lugano, 13 Via Buffi, Lugano, 6904, Switzerland. Email: francesco.franzoni@unisi.ch. The author thanks seminar participants at HEC, Paris, University of Lausanne, University of Lugano, and Tilburg University. I am grateful to Giovanni Barone Adesi, Laurent Calvet, Jonathan Lewellen, Sebastien Michenaud, Joshua Rauh, Jeremy Stein, David Thesmar, Toni Whited, and David Zion for helpful comments. A special acknowledgment to François Degeorge for constant help.In interpreting the empirical literature on corporate investment, Stein (2003) argues that while it is hardly questionable that financial slack matters for investment, it is less clear to what extent this relationship is due to financing constraints or to empire building. On the one hand, by raising the costs of external funds, financial frictions may cause a sub-optimal level of investment. 1 This makes investment sensitive to the availability of cheap internal funds. On the other hand, if managers have empire-building preferences, they will use free cash flows to fund investment projects beyond the level that maximizes shareholders ' value (Jensen (1986)). Like costly external finance, this argument also leads to the prediction that investment is increasing in internal resources. Although the two theories are observationally equivalent with respect to the sensitivity of investment to cash flows, their policy implications are obviously different. Furthermore, the two hypothesis may very well coexist in a unified model that admits both under-and overinvestment. Then, the more interesting question is which distortion prevails empirically.The goal of this paper is to shed some light on this issue. More specifically, the paper develops an identification strategy for the impact of costly external finance and empire building on firm value. First, the objective is to test whether there is a significant effect on market value of the implications of these theories. Then, the analysis attempts a comparison of the importance of the two distortions.A simple consideration inspires the methodology of this paper. One obvious dimension along which the empirical predictions of the costly-external-finance and empire-building theories differ is the value that t...