Beyond Random Assignment: Credible Inference and Extrapolation in Dynamic Economies

Hennessy, C and Strebulaev, I A (2020) Beyond Random Assignment: Credible Inference and Extrapolation in Dynamic Economies. Journal of Finance, 75 (2). pp. 825-866. ISSN 0022-1082

Abstract

We derive analytical relationships between shock responses and theory‐implied causal effects (comparative statics) in dynamic settings with linear profits and linear‐quadratic stock accumulation costs. For permanent profitability shocks, responses can have incorrect signs, undershoot, or overshoot depending on the size and sign of realized changes. For profitability shocks that are i.i.d., uniformly distributed, binary, or unanticipated and temporary, there is attenuation bias, which exceeds 50% under plausible parameterizations. We derive a novel sufficient condition for profitability shock responses to equal causal effects: martingale profitability. We establish a battery of sufficient conditions for correct sign estimation, including stochastic monotonicity. Simple extrapolation/error correction formulae are presented.