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Capital Flows in Rational Markets

Author

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  • Martin Schmalz

    (University of Michigan)

  • Francesco Franzoni

    (University of Lugano)

Abstract

We provide a rational model of capital allocation to projects with uncertain exposure to a systematic risk factor. We show that signal-to-noise ratios are highest when the factor realization is close to zero. As a result, investors redirect more resources across projects during these times. This finding resonates with the Schumpeterian intuition that downturns have a cleansing effect on the economy by improving the efficiency of capital allocation. We measure the speed of capital reallocation with the sensitivity of mutual fund flows to performance and find supporting evidence for the model's nonlinear and linear predictions.

Suggested Citation

  • Martin Schmalz & Francesco Franzoni, 2014. "Capital Flows in Rational Markets," 2014 Meeting Papers 1012, Society for Economic Dynamics.
    • Handle: RePEc:red:sed014:1012
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