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New Perspectives on Risk

Paper Session

Saturday, Jan. 5, 2019 8:00 AM - 10:00 AM

Hilton Atlanta, Grand Ballroom B
Hosted By: American Finance Association
  • Chair: Bryan Kelly, Yale University

Firm-Level Political Risk: Measurement and Effects

Tarek Hassan
Boston University
Stephan Hollander
Tilburg University
Ahmed Tahoun
London Business School
Laurence van Lent
Frankfurt School of Finance and Management


We adapt simple tools from computational linguistics to construct a new measure of political risk faced by individual US firms: the share of their quarterly earnings conference calls that they devote to political risks. We validate our measure by showing it correctly identifies calls containing extensive conversations on risks that are political in nature, that it varies intuitively over time and across sectors,
and that it correlates with the firm’s actions and stock market volatility in a manner that is highly indicative of political risk. Firms exposed to political risk retrench hiring and investment and actively lobby and donate to politicians. Interestingly, the vast majority of the variation in our measure is at the firm level rather than at the aggregate or sector level, in the sense that it is neither captured by
time fixed effects and the interaction of sector and time fixed effects, nor by heterogeneous exposure of individual firms to aggregate political risk. The dispersion of this firm-level political risk increases significantly at times with high aggregate political risk. Decomposing our measure of political risk by
topic, we find that firms that devote more time to discussing risks associated with a given political topic tend to increase lobbying on that topic, but not on other topics, in the following quarter.

Can the Market Multiply and Divide? Non-Proportional Thinking in Financial Markets

Kelly Shue
Yale University
Richard Townsend
University of California-San Diego


When pricing financial assets, rational agents should think in terms of proportional price changes, i.e., returns. However, stock price movements are often reported and discussed in dollar rather than percentage units, which may cause investors to think that news should correspond to a dollar change in price rather than a percentage change in price. Non-proportional thinking in financial markets can lead to return underreaction for high-priced stocks and overreaction for low-priced stocks. Consistent with a simple model of non-proportional thinking, we find that total volatility, idiosyncratic volatility, and market beta are significantly higher for stocks with low share prices, controlling for size. To identify a causal effect of price, we show that volatility increases sharply following stock splits and drops following reverse stock splits. The economic magnitudes are large: non-proportional thinking can explain the “leverage effect” puzzle, in which volatility is negatively related to past returns, as well as the volatility-size and beta-size relations in the data. We also show that low-priced stocks drive the long-run reversal phenomenon in asset pricing, and the magnitude of reversals can be sorted by price, holding past returns and size constant. Finally, we show that non-proportional thinking biases reactions to news that is itself reported in nominal-per-share units rather than the appropriate scaled units. Investors react to nominal earnings per share surprises, after controlling for the earnings surprise scaled by share price. The reaction to the nominal earnings surprise reverses in the long run, consistent with correction of mispricing.

Conditional Risk

Niels Gormsen
Copenhagen Business School
Christian Skov Jensen
Copenhagen Business School


We present a new direct methodology to study conditional risk, that is, the extra return compensation for time-variation in risk. We show theoretically that the conditional part of the CAPM can be captured by augmenting the standard market model with a conditional-risk factor, which is a specific market timing strategy. Both in the U.S. and global sample covering 23 countries, all major equity risk factors load on our conditional-risk factor, implying that each factor has a higher conditional market beta when the market risk premium is high or the market variance is low. Accordingly, these factor returns can be partly explained by conditional risk. Studying the economic drivers of these results, we find evidence that conditional risk arises from variation in discount rate betas (not cash flow betas) due to the endogenous effects of arbitrage trading.

Foreseen Risks

Joao Gomes
University of Pennsylvania
Marco Grotteria
University of Pennsylvania
Jessica Wachter
University of Pennsylvania


Financial crises tend to follow rapid credit expansions. In this paper we
show that this phenomenon arises naturally when nancial intermediaries
benet from, and optimally exploit, economic rents that drive their
franchise value. Specically, we explore rents arising from government
subsidies in the form of underpriced insurance on deposits. We show
that the economic value of these rents varies with the business cycle,
which in turn drives bank's incentives to engage in riskier lending as risk
increases, and safer investment strategies as risk vanishes. We use the
model to evaluate the eects of recent government subsidies to banking
sectors in US and EU. We argue that bank lending responded little to
these interventions because government subsidies enhanced franchise
value and thus made the value of safe investments relatively higher.
Asaf Manela
Washington University-St. Louis
Alexander Chinco
University of Illinois
Drew Creal
University of Chicago
Aditya Sunderam
Harvard Business School
JEL Classifications
  • G1 - General Financial Markets