Abstract: If public investment has been inadequate from investors’ perspective, they may value assets that hedge against its declines. This paper takes an asset pricing approach to evaluating the overall (in)adequacy of public investment in the U.S.. I propose a two-sector general equilibrium model that demonstrates how the share of public sector capital may enter the pricing kernel. From this theory I derive a factor pricing model with shocks to the public sector investment share (“PUB shocks”) as a risk factor. I confront the factor model with a variety of test assets and find that PUB shocks are priced and carry a consistently positive price of risk, meaning assets that pay off when public investment declines tend to provide lower returns. I find further support from the analysis of a sample of U.S. government contractors: I postulate that the extent to which a firm depends on government customers for revenue is a relevant proxy for its exposure to changes in public investment. I find that high-dependency firms (that is, firms with greater sales to government relative to their total sales) provide a 7.4% higher average return annually compared to low-dependency firms. A subsample analysis reveals that this return spread is widening as the public sector investment share declines, consistent with the view that the public investment shortfall has become more severe in recent years.
Abstract: Current analysis of macro-prudential policy has largely focused on excessive leverage and fire sales, while abstracting from firm-level risk and portfolio decisions. We show that these matter for the design of optimal interventions. We study a macroeconomic model in which firms make investment decisions in the presence of both aggregate and firm-specific risk. Financial constraints limit access to external funds and tie each firm’s output to its net worth and a firm-specific return on investment. The laissez-faire outcome is constrained inefficient, as individual decisions fail to internalize their consequences on the distribution of risky returns over other agents (a risk externality). Firms are, at the same time, overexposed to aggregate risk and underexposed to idiosyncratic risk. In a quantitative exploration, interventions are shown to be countercyclical in their magnitude and to lead to large increases in aggregate TFP and output.
Abstract: Independent technological glitches forced two separate trading halts on different U.S. exchanges during the week of July 6, 2015. During each halt, all other exchanges remained open. We exploit exogenous variation provided by this unprecedented coincidence, in conjunction with a proprietary data set, to identify the causal impact of Designated Market Maker (DMM) participation on liquidity. When the voluntary liquidity providers on one exchange were removed, liquidity remained unchanged; when DMMs were removed, liquidity decreased market-wide. We find evidence consistent with the idea that these DMMs, despite facing only mild formal obligations, significantly improve liquidity in the modern electronic marketplace.