Lying to Speak the Truth: Selective Manipulation and Improved Information Transmission, with Paul Povel, June 2020.
We show that firms may benefit from allowing some earnings management, because it can make noisy signals more informative. We model a firm that cannot observe a manager's cost of effort, her effort choice, and whether she manipulated a publicly observable signal. An optimal contract links compensation to both the eventually realized firm value and the (possibly manipulated) signal, since both are noisy measures of effort provision. It may be optimal to allow for manipulation of the signal by a manager who exerted a high effort level: Doing so can convert a falsely unfavorable signal into a favorable signal, thereby strengthening the link between effort and compensation.
Credit Ratings: Strategic Issuer Disclosure and Optimal Screening, with Jonathan Cohn and Uday Rajan, July 2018.
We study a model in which an issuer can manipulate information obtained by a credit rating agency (CRA). Better CRA screening reduces the likelihood of a high rating, but increases the value of a rated security. We find that improving the prior quality of assets can have no effect on the quality of a high-rated security, as low-type issuers manipulate more often in equilibrium. The issuer's response to anticipated CRA screening can either amplify or attenuate the effects on accuracy of increased penalties for ratings errors. Our model highlights the importance of strategic issuer disclosure in recent ratings failures.
The Effect of Speculative Monitoring on Shareholder Activism, February 2018.
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 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.
Rational Disposition Effects: Theory and Evidence, with Daniel Dorn, August 2015.
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.
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.
Endogenous Liquidity Cycles, September 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.