Annual Review of Financial Economics - Volume 16, 2024

We compare and contrast production economies exposed to long-run uncertainty with investors that have possibly different preferences and/or access to financial markets. We study the macroeconomic and asset-pricing properties of these models, identify common features, and highlight areas where these models depart from each other. Our framework allows us to investigate more fully the impact of investor heterogeneity, capital heterogeneity, and fluctuations of the growth components to the capital evolution as they affect the dynamics of macroeconomic quantities and asset prices. In our comparisons, we employ an array of diagnostic tools to explore time variation and state dependencies in nonlinear environments.

In this article, we review recent developments in macroeconomics and finance on the relationship between financial risk and the real economy. We focus on three specific topics: (a) the term structure of uncertainty, (b) time variation—specifically, the long-term decline—in the variance risk premium, and (c) time variation in conditional skewness. We also introduce two new data series: implied volatility from one-day options on grains for the period 1906–1936 and prices of cliquet options, which provide insurance against single-day crashes on the S&P 500. Both series give some context to the recent rise in trade in extremely short-dated options. Finally, we discuss new avenues for future research.

We review the academic findings from psychology and economics on disagreement—specifically, the effect of disagreement on asset prices. We discuss measurement of disagreement and how disagreement, coupled with constraints on short selling, can sideline pessimistic investors and result in overpricing. We review the literature on short selling in financial markets, paying particular attention to how and why some issues become hard-to-borrow and what factors go into the determination of borrowing costs, and we discuss the evolution of borrowing costs over the last several decades. We show how an examination of the prices and borrowing costs for constrained stocks can lead to an improved understanding of how disagreement in financial markets arises and is resolved, and we discuss directions for future research.

The rapid growth in index funds and significant consolidation in the asset-management industry over the past few decades has led to higher levels of common ownership and increased attention on the topic by academic researchers. A consensus has yet to emerge from the literature regarding the consequences of increased common ownership on firm behavior and market outcomes. Given the potential implications for firms and investors alike, it is perhaps not surprising that policy makers, legal scholars, finance and accounting academics, and practitioners have all taken a keen interest in the subject. In this article, we provide an overview of the theoretical underpinnings of common ownership and critically review the empirical literature. Measurement issues and identification challenges are detailed, and a discussion of plausible causal mechanisms is provided. Across the newest papers employing the most credible identification techniques, relatively little evidence has been found that common ownership causes lower competition. However, further research is necessary before broad conclusions can be reached.

We survey the growing literature emphasizing the role that supply and demand forces play in shaping the term structure of interest rates. Our starting point is the Vayanos and Vila model of the term structure of default-free bond yields, which we present in both discrete and continuous time. The key friction in the model is that the bond market is partially segmented from other financial markets: The prices of short-rate and bond supply risks are set by specialized bond arbitrageurs who must absorb shocks to the supply and demand for bonds from other preferred-habitat agents. We discuss extensions of this model in the context of default-free bonds and other asset classes.

Margin—collateral or funds that investors deposit with their counterparties—is a crucial component of the practice of borrowing money to fund investment. While margin offers the potential for enhanced returns, it also exposes investors to the risk of escalated losses, thereby necessitating stringent regulatory oversight. Delving into the regulatory framework governing margin trading, we provide historical insights into the origins and dynamics of various margin requirements, and we review academic studies that illuminate the implications of these regulations for asset pricing, financial stability, and the design of margin rules. With an eye to the future, we also outline recent advancements in the evolving landscape of margin rules, such as portfolio margin and central clearing.

In this article, we summarize empirical research on the interaction between monetary policy and asset markets and review our previous theoretical work that captures these interactions. We present a concise model in which monetary policy impacts the aggregate asset price, which in turn influences economic activity with lags. In this context, the following occurs: (a) the central bank (the Fed, for short) stabilizes the aggregate asset price in response to financial shocks, using large-scale asset purchases if needed (the Fed put); (b) when the Fed is constrained, negative financial shocks cause demand recessions; (c) the Fed's response to aggregate demand shocks increases asset price volatility, but this volatility plays a useful macroeconomic stabilization role; (d) the Fed's beliefs about the future aggregate demand and supply drive the aggregate asset price; (e) macroeconomic news influences the Fed's beliefs and asset prices; (f) more precise news reduces output volatility but heightens asset market volatility; and (g) disagreements between the market and the Fed provide a microfoundation for monetary policy shocks and generate a policy risk premium.

This article reviews the literature examining how the introduction of a retail central bank digital currency (CBDC) would affect a modern economy, focusing on the implications for the banking sector and for financial stability. A CBDC can improve welfare by reducing financial frictions, countering market power in deposit markets, encouraging financial inclusion, and enhancing the payment system. However, a CBDC also entails noteworthy risks, including the possibility of bank disintermediation and associated contraction in bank credit, as well as potential adverse effects on financial stability. The recycling of the new CBDC liability through asset purchases or lending by the central bank plays an important role in determining the economic consequences of the introduction of a CBDC, raising fundamental questions about the footprint of central banks in the financial system. Ultimately, the effects of a CBDC depend critically on its design features, particularly remuneration.

Bank market power, in both loan and deposit markets, has important implications for credit provision and for financial stability. This article discusses these issues through the lens of a simple theoretical framework. On the asset side, banks choose the quality and quantity of loans. On the liability side, they may be subject to depositor runs whenever they offer demandable contracts. This structure allows us to review the literature on the role of market power for credit provision and stability and also highlight the interactions between the two sides of banks’ balance sheets. Our approach identifies relevant channels that deserve further analysis, especially given the rising importance of bank market power for monetary policy transmission and the rise of the digital economy.

Britain's liability-driven investment crisis in fall 2022 had lessons for other major financial centers that, as evidenced by the US and Swiss banking crises only a few months later, were largely ignored. They are still relevant. In this article, I first discuss what drove the British crisis before identifying lessons for the microregulation of pension funds; for financial stability policy on shadow banking and beyond; for central banking balance sheet regimes, including lending of last resort and market making of last resort; and for monetary policy when fiscal policy makers sit on their hands.

This article reviews research and policy work on nonbank financial intermediation (NBFI), taking a financial stability perspective. It first documents the growth in NBFI, reviews its possible drivers, and documents recent instability episodes. NBFI now often surpasses traditional bank financing, and research on it has increased, including research on its financial stability characteristics. Given NBFI's many forms and dimensions, the article focuses on its market-based forms. Taking a cross-country perspective, it reviews the benefits of NBFI, in terms of access to finance and economic impact, and its risks, specifically those related to interconnections, interactions between liquidity and leverage, and procyclicality. It describes policy steps—underway and possible—to reduce these risks, highlights outstanding issues, and suggests further analytical work. It also considers the current state of available data and the means to address remaining gaps.

The fact that internal liquidity is a key source of corporate funding puts the marginal value of cash at the center of a variety of firm decisions, including investment, payout, financing, savings, and risk management policies. The marginal value of cash is inherently a dynamic concept, because a firm facing financing frictions has to be forward-looking, managing its asset and liability structures in a unified framework and carefully trading off the use of liquidity across time and states. We present a dynamic framework for corporate liquidity management and survey the related literature, with a focus on the determinants of the marginal value of cash and its ubiquitous role in firm decisions.

Secured debt—a debt contract that offers security to creditors in the form of collateralized assets—has been a cornerstone of credit markets in most societies since antiquity. The ability to seize and sell collateral reduces the creditor's expected losses when the debtor defaults on a promised payment. Moreover, when a firm borrows from multiple creditors with different seniorities, debt secured by assets has higher priority relative to other creditors and is first in line for payment if the firm is bankrupt. While the benefits of secured debt have been shown in both the theoretical and empirical literature, less is known about the costs associated with secured borrowing. This article surveys the burgeoning empirical literature on secured debt and provides an assessment of the costs and benefits of secured debt.

Over the past two decades, banks have increasingly focused on offering contingent credit in the form of credit lines as a primary means of corporate borrowing. We review the existing body of research regarding the rationales for banks’ provision of liquidity insurance in the form of credit lines, their significance in managing corporate liquidity, and the reasons and circumstances under which firms opt to utilize them. We emphasize that the options for firms to both draw down and repay credit lines are put options issued by banks, which are exercised by firms in a correlated manner during periods of widespread stress, with adverse effects on bank intermediation thereafter. We discuss the bank capital and the bank funding channels that can drive these effects, contrasting their roles during the global financial crisis of 2007–2008 and the COVID-19 outbreak. We conclude by discussing the increasing extension of bank credit lines to nonbank financial intermediaries as well as the role of stress tests and monetary policy in managing the risks of contingent credit under stress.

Governments' powerful imperative to support innovation has only grown more urgent amid slowing growth in the developed world and a rapidly changing climate. In this review, I describe the important role that economics and finance play in rigorously evaluating innovation policy. I organize government intervention in innovation into arenas, agendas, and instruments. The arenas are firms, financial intermediaries, universities, and government laboratories. The key agendas are entrepreneurship, defense, climate, health, and education. The instruments fall into three categories: supply-push, demand-pull, and legal. I provide theoretical rationales for government intervention in innovation and discuss how they intersect with government agendas and empirical evidence in practice. One takeaway is that the government has a key role to play in the type of failure-tolerant, open-ended research that yields breakthrough inventions. In contrast, there is less evidence that subsidizing financial intermediaries is useful.

In this review, we argue that access to financial advice and the quality of this advice are shaped by a broad array of demand-side and supply-side constraints. While the literature has predominantly focused on conflicts of interest between advisors and clients, we highlight that the transaction costs of providing advice, mistaken beliefs on the demand side or supply side, and other factors can have equally detrimental effects on the quality of and access to advice. Moreover, these factors affect how researchers should assess the impact of financial advice across heterogeneous groups of households. While households with low levels of financial literacy are more likely to benefit from advice—potentially including conflicted advice—they are also the least likely to detect misconduct and perhaps the least likely to understand the value of paying for advice. Regulators should consider not only how regulation changes the quality of advice but also the fraction of households who are able to receive it and how different groups would have invested without any advice. Financial innovation has the potential to provide customized advice at low cost but also to embed conflicts of interest in algorithms that are opaque to households and regulators.

We review an empirical literature that studies how political polarization affects financial decisions. We first discuss the degree of partisan segregation in finance and corporate America, the mechanisms through which partisanship may influence financial decisions, and the available data sources used to infer individuals’ partisan leanings. We then describe and discuss the empirical evidence. Our review suggests an economically large and often growing partisan gap in the financial decisions of households, corporate executives, and financial intermediaries. Partisan alignment between individuals explains team and financial relationship formation, with initial evidence suggesting that high levels of partisan homogeneity may be associated with economic costs. We conclude by proposing several promising directions for future research.

The literature on long-run asset returns has continued to grow steadily, particularly since the start of the new millennium. We survey this expanding body of evidence on historical return premia across the major asset classes—stocks, bonds, and real assets—over the very long run. In addition, we discuss the benefits and pitfalls of these long-run data sets and make suggestions on best practice in compiling and using such data. We report the magnitude of these risk premia over the current and previous two centuries, and we compare estimates from alternative data compilers. We conclude by proposing some promising directions for future research.

We study two important questions regarding trading dynamics in China: How do retail and institutional investors trade, and what are the underlying factors for these behaviors? Different from the United States, China's stock market has two prominent features: dominance of retail investors and active participation by the government. After reviewing nearly 100 previous studies, we reach three conclusions. First, there is substantial heterogeneity in retail investors. Small retail investors have low financial literacy, exhibit behavioral biases, and not surprisingly, negatively predict future returns, whereas large retail investors and institutions are capable of processing information and positively predict future returns. Second, the macro- and firm-level information environment in China is slowly but gradually improving, which greatly affects trading behaviors of different investors, especially the more sophisticated institutional investors and large retail investors. Finally, the Chinese government actively adjusts their regulations on the stock market to serve the dual goals of growth and stability. Many regulations are effective, while some may generate unintended consequences.