Credit Ratings: Strategic Issuer Disclosure and Optimal Screening

June 2016 (with Jonathan Cohn and Uday Rajan).

We study a model in which an issuer can manipulate information obtained by a credit rating agency (CRA) seeking to screen and rate its financial claim. Better CRA screening leads to a lower probability of obtaining a high rating but makes a high rating more valuable. Over an intermediate range of manipulation cost, improving screening quality can lead to more manipulation, dampening the CRA's incentive to screen. We further show that a CRA's own incentives to inflate ratings constrain its optimal screening intensity. Our model suggests that strategic disclosure by issuers may have played a role in recent ratings failures.

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Transparency and Talent Allocation in Money Management

May 2016 (with Simon Gervais).

We construct and analyze a model of delegated portfolio management in which money managers signal their investment skills via their choice of transparency for their fund. We show that a natural equilibrium is one in which high- and low-skill managers pool in opaque funds, while medium-skill managers separate in transparent funds. In this equilibrium, high-skill managers rely on their eventual performance to separate from low-skill managers over time, saving the monitoring costs associated with transparency. In contrast, medium-skill managers rely on transparency to separate from low-skill managers, especially when it is difficult for investors to tell them apart through performance alone. Low-skill managers prefer mimicking high-skill managers in opaque funds in the hope of replicating their performance and compensation. The model yields several novel empirical predictions that contrast transparent funds (e.g., mutual funds) and opaque funds (e.g., hedge funds).

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Portfolio Size and the Incentives for Shareholder Activism

May 2016 (with Jing Zeng).

We take a portfolio approach to analyze the investment strategy of an activist investor and show that portfolio size affects both the incentive for the managers of the firms in the activist's portfolio to exert effort and the incentive for the activist to intervene in the firms' operations. We show that a highly capable activist optimally chooses to invest in more firms, even if her capacity to intervene is constrained. This model builds on the notion that both the act of intervention and the threat of an intervention can generate value for firms. We demonstrate that given a portfolio size, the activist's attempt to manipulate the market price of the firms in her portfolio leads her to intervene excessively (insufficiently) when her ability to conduct a value-enhancing intervention is low (high). We show that an activist with higher ability can mitigate her lack of incentives to intervene by optimally increasing the number of firms in her portfolio. This is because a larger portfolio dilutes the threat of activism imposed on each manager, compelling the activist to intervene more in equilibrium. Finally, we demonstrate that, when facing an activist with low ability, short-term stock-based incentive compensation has a perverse effect of disincentivizing managerial effort.

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The Effect of Speculative Monitoring on Shareholder Activism

April 2016.

This paper investigates how informed trading in financial markets affects the incentive of a large shareholder to monitor a company. The shareholder engages in costly monitoring activities to the extent that she can profitably trade on her private information about these activities. By making stock prices more informative about these activities, informed trading increases the shareholder's incentive to undertake such value-enhancing activities in case she has to liquidate her stake before their effect is publicly observed. This reduces the size of the stake that the shareholder has to acquire to commit to her desired level of monitoring. At the same time, a more informative stock price reduces the value of the shareholder's private information and hence her benefit from monitoring. If acquiring a large stake is excessively costly to the shareholder, the former effect dominates and an increase in informed trading, which reduces market liquidity, can lead to an increase in monitoring efforts. In this case, there is a complementarity between shareholder activism and informed trading, and multiple equilibria with different levels of ownership concentration and monitoring may coexist.

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Rational Disposition Effects: Theory and Evidence

August 2015 (with Daniel Dorn).

The disposition effect is a longstanding puzzle in financial economics. This paper demonstrates that it is not intrinsically at odds with rational behavior. In a rational expectations model with asymmetrically informed investors, trading strategies as predicted by the disposition effect can arise as an optimal response to dynamic changes in the information structure. The model predicts that the disposition behavior of less-informed investors weakens after events that reduce information asymmetries and are concentrated in stocks with weak return persistence. The data, trading records of 50,000 clients at a German discount brokerage firm from 1995 to 2000, are consistent with these predictions.

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On the Optimal Allocation of Security Listings to Specialists

March 2013.

This paper addresses the question of how securities with correlated payoffs should be allocated to dealers in a specialist system. Using a multi-asset model of an imperfectly competitive market, we examine the effect of alternative security allocations on the specialists' market power and on their adverse selection risk. We demonstrate that specialists are always better off when their portfolios contain securities with highly correlated payoffs, and provide conditions under which risk-averse investors prefer such an allocation as well. Intuitively, this is the case when the investors' order flow is sufficiently informative about the value of the traded securities. We also discuss how the allocation of security listings to specialists affects market liquidity.

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Endogenous Liquidity Cycles

May 2012.

This paper presents a theory of liquidity cycles based on endogenous fluctuations in economic activity and the availability of informed capital. Risky assets are illiquid due to adverse selection. The degree of adverse selection and hence the liquidity of these assets depends on the endogenous information structure in the market. Liquidity provision is modeled as a repeated game with imperfect public monitoring. We construct a trigger-strategy equilibrium along the lines of Green and Porter (1984) that is characterized by stochastic fluctuations in liquidity. Liquidity is procyclical in our economy. Periods of economic growth are associated with more liquid asset markets. However, unlike other explanations in the literature, our results do not rely on exogenous shocks to the economy. Rather, fluctuations in liquidity arise endogenously from the need to create incentives for investors to engage in costly information production.

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Using Price Information as an Instrument of Market Discipline in Regulating Bank Risk

January 2008 (with Alfred Lehar and Duane Seppi).

An important trend in bank regulation is greater reliance on market discipline.  In particular, information impounded in securities prices is increasingly used to complement supervisory activities of regulators with limited resources. The goal of this paper is to analyze the theoretical foundations of market-based bank regulation. We find that price information only improves the efficiency of the regulator's monitoring function if the banks' risk-shifting incentives are not too large. Further, if the regulator cannot commit to an ex ante suboptimal auditing policy, market-based bank regulation can lead to more risk taking in equilibrium, increasing the expected payments by the deposit insurance agency. Finally, we show that the regulatory use of market information can decrease the investors' incentives to acquire costly information, thereby reducing the informativeness of stock prices.

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