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1. Fund Flows, Liquidity, and Asset Prices
Presentations (selected): WFA 2020; Young Scholars Finance Consortium 2019 at Texas A&M; Federal Reserve Board of Governors.
Abstract: I propose an intermediary asset pricing model, in which expected asset returns depend on fund flow betas: co-movements of returns and liquidity costs with the aggregate fund flow shocks. Using both standard asset pricing tests and identification strategies employing firm-month fixed effects and granular instrumental variables, I show that flow betas possess significant explanatory power for the cross-section of corporate bond returns. Consistent with my model, I demonstrate that bond funds underweight high-flow-risk bonds, hedging against high liquidation costs during outflows. Flow betas also explain cross-sectional stock returns, with equity funds underweighting high-flow-risk stocks, corroborating the mechanism in the model.
2. Hidden Duration: Interest Rate Derivatives in Fixed Income Funds
Co-authors: Jaewon Choi and Oliver Randall.
Presentation scheduled at Federal Reserve Bank of Atlanta & GSU Workshop (Oct 2023).
Abstract: Fixed income funds carry significant duration risk from their use of interest rate derivatives (IRDs), exacerbating their fragility. This duration risk is hidden, as funds typically disclose portfolio duration weighted by market values instead of notionals, concealing their true risk. We find substantial variation in the duration of IRDs, both across funds and over time. Funds use IRDs not only for hedging but also for speculation, often disregarding the risk in their bond portfolios. During interest rate hikes in 2022, funds that increased leverage through IRDs performed particularly poorly and experienced substantial outflows. In contrast, those that increased leverage during interest cuts in 2020 achieved outperformance, potentially reinforcing funds' inclination towards risk-taking in the future. Furthermore, our findings indicate that government-bond funds with speculative IRD positions exhibit higher flow sensitivity to returns, as further evidence of the link between interest rate risk and financial fragility.
3. The Off-Ramp Effect: Temporary Income Shocks and Household Financial Investments
Co-authors: Sehoon Kim, Yoon Lee, and Hoonsuk Park.
Abstract: Temporary income shocks that are quickly resolved have long-lasting impacts on household investment behavior. For up to two years after the resolution of a transitory unemployment shock, households significantly reduce discretionary deposits into their brokerage accounts. The responses to temporary income shocks are stronger among households who were more likely to be constrained ex ante, and more pronounced when the shocks are larger in magnitude. The persistence of the response is driven by the active rather than passive component of deposits within households, and by the active rather than passive subsample of households. Deposits remain persistently lower especially after the stock market had performed well during the shock. We do not find that temporary income shocks have equally persistent effects on consumption or savings, indicating that changes in risk appetites do not explain our results. Rather, our findings are most consistent with psychological anchors creating an "off-ramp" effect, resulting in distorting interactions between transitory labor income fluctuations and long-term household financial decisions.
4. Short of Cash? Convex Corporate Bond Selling By Mutual Funds and Price Fragility
Co-author: Oliver Randall.
Presentations (selected): Federal Reserve Board 5th Short-Term Funding Markets Conference 2022; Australian National University.
Abstract: We show cash shortfall, i.e. outflows in excess of cash holdings, has quantitatively important implications for corporate bond funds’ trading and price fragility. We find corporate bond selling is strongly convex in cash shortfall, while Treasury selling is closer to linear. We solve a theoretical model that explains these patterns from dual effects: a higher cash shortfall today increases both the expected future shortfall and liquidity costs. Consistent with this, we show cash shortfall amplifies the sensitivity of corporate bond selling to outflows. Surprisingly, unless there is a cash shortfall, we find no relationship between corporate bond selling and outflows for investment-grade bond funds. In contrast, Treasury selling depends only on outflows, independent of cash shortfall. We find downward price pressure from shortfall-induced trading in corporate bond returns, particularly large during the Covid-19 crisis. This price fragility is becoming more concerning as we find cash shortfall has trended upward recently.
Publication in Policy Research
1. Liquidity Shocks and Pension Fund Performance: Evidence from Early Access
Co-authors: James Brugler and Zhuo Zhong.
Australian Journal of Management, Forthcoming
Media coverage: Australian Financial Review; The Australian; Financial Standard.
Summary: We study how expectations of fund flows causally affect fund performance by exploiting a quasi-natural experiment in the Australian pension system where an unexpected policy change temporarily allowed fund withdrawals from a prespecified date in the future.
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