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Want to stay on top of cutting-edge finance research from Wharton? Every two months, the Rodney White Center highlights the latest studies by Wharton’s finance faculty. In this issue: a challenge to the risk-return tradeoff, the sources of wealth inequality, the effects of underfunded state pensions on households, the sensitivity of bank deposits to transparency, and arms sales in financial markets.

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Itamar Drechsler and Luke Taylor

Professor Nick Roussanov challenges the notion of a risk-return tradeoff

The central insight of asset pricing theory is that only systematic risk should be rewarded with high average returns. Challenging this insight, Professor Roussanov shows that a “beta-neutral” stock investment strategy that exploits stock characteristics but avoids systematic risk nevertheless delivers high average returns. Latent systematic risk factors earn negligible risk premia despite explaining virtually all of the common time-series variation in stock returns.

Team of Wharton faculty and doctoral students explore the sources of wealth inequality 

Wealth inequality rose over the last forty years in large part because rich households held more long-term assets. Those assets experienced high returns thanks to a steady decline in interest rates. Professors Sylvain Catherine and Natasha Sarin, together with doctoral students Max Miller and James Paron, explain these patterns using a life-cycle model. According to the model, wealthy households should hold more long-term assets in order to hedge against interest-rate changes. 

Professor Michael Schwert studies the effects of state pension funding on house prices

The massive underfunding of state pensions puts a large burden on households: as governments balance their budgets, they will either raise taxes or provide fewer public goods and services. By studying state pension windfalls, Professor Schwert evaluates the value that households place on improvements in their states’ pension funds. The study finds that one dollar of plausibly exogenous variation in pension asset returns increases house prices by approximately two dollars, implying that households place a large value on their state pension funds’ health. 

Professor Itay Goldstein analyzes how bank transparency affects depositors’ behavior

How much do depositors really care about how transparent their banks are? Should we invest a lot of effort in regulating bank transparency? Is transparency even desirable? Professor Goldstein contributes to this debate by analyzing 25 years of depositors’ behavior (1994-2019) and showing that depositors do react to the transparency of banks’ data, particularly regarding the banks’ performance. Transparency, in turn, interacts with important variables such as deposit rates, investment patterns, and profitability. Intuitively, deposits that are not insured by the FDIC are those impacted by bank transparency.

Professor Vincent Glode studies arms sales in financial markets

Many financial transactions are of a fixed-sum nature, in the sense that one party gaining implies that another party is losing. This feature has been shown to generate “arms races” that drive the excessive acquisition of trading advantages such as data and collocation services by multiple institutions. As these arms races rage on, other traders, such as retail investors, might however be tempted to exit financial markets instead of participating in these arms races. Professor Glode shows how the entities that sell these trading advantages (e.g., data providers and securities exchanges) maximize their profits by picking prices that lead to inefficiently low levels of market participation and liquidity. These entities benefit from making financial markets look “rigged” to unsophisticated investors.

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