The Benchmark Inclusion Subsidy

47 Pages Posted: 12 Dec 2018

See all articles by Anil K. Kashyap

Anil K. Kashyap

University of Chicago, Booth School of Business; National Bureau of Economic Research (NBER); Federal Reserve Bank of Chicago

Natalia Kovrijnykh

Arizona State University (ASU) - Economics Department

Jian Li

University of Chicago

Anna Pavlova

London Business School; Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 4 versions of this paper

Date Written: December 12, 2018

Abstract

We study the impact of evaluating the performance of asset managers relative to a benchmark portfolio on firms’ investment, merger and IPO decisions. We introduce asset managers into an otherwise standard asset pricing model and show that firms that are part of the benchmark are effectively subsidized by the asset managers. This “benchmark inclusion subsidy” arises because asset managers have incentives to hold some of the equity of firms in the benchmark regardless of the risk characteristics of these firms. Contrary to what is usually taught in corporate finance, we show that the value of an investment project is not governed solely by its own cash-flow risk. Instead, because of the benchmark inclusion subsidy, a firm inside the benchmark would accept some projects that an identical one outside the benchmark would decline. The two types of firms’ incentives to undertake mergers or spinoffs also differ and the presence of the subsidy can alter a decision to take a firm public. We show that the higher the cash-flow risk of an investment, the larger the benchmark inclusion subsidy; the subsidy is zero for safe projects. Benchmarking also leads fundamental firm-level cash-flow correlations to rise. We review a host of empirical evidence that is consistent with the implications of the model.

JEL Classification: G12, G23, G31, G32

Suggested Citation

Kashyap, Anil K. and Kovrijnykh, Natalia and Li, Jian and Pavlova, Anna, The Benchmark Inclusion Subsidy (December 12, 2018). University of Chicago, Becker Friedman Institute for Economics Working Paper No. 2018-83. Available at SSRN: https://ssrn.com/abstract=3299782 or http://dx.doi.org/10.2139/ssrn.3299782

Anil K. Kashyap (Contact Author)

University of Chicago, Booth School of Business ( email )

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National Bureau of Economic Research (NBER) ( email )

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Natalia Kovrijnykh

Arizona State University (ASU) - Economics Department ( email )

Tempe, AZ 85287-3806
United States

HOME PAGE: http://www.public.asu.edu/~nkovrijn

Jian Li

University of Chicago ( email )

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Chicago, IL 60637
United States

Anna Pavlova

London Business School ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom
+44 20 7000 8218 (Phone)

HOME PAGE: http://faculty.london.edu/apavlova

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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