By Vibhuti Giltrap
Authors: Martin Oehmke and Adam Zawadowski
Using novel position data for single-name credit default swaps (CDS), this paper investigates the determinants of the amount of credit protection bought (or equivalently sold) in the CDS market. Our results support the view of CDS markets as `alternative trading venues’ that are used by investors for both hedging and speculation. CDS markets are more likely to emerge and more heavily used when the bonds of the underlying firm are fragmented and hard to trade. CDS positions are increasing in insurable interest (a proxy for hedging needs) and disagreement (a proxy for speculation). These effects are stronger when the underlying bond is hard to trade. We also find that firms which have a more negative CDS-bond basis (i.e., the bond is undervalued relative to the CDS) have more CDS outstanding, suggestive of arbitrage activity.
Authors: Yrjo Koskinen and Joril Maeland
In a real options framework, we provide a model of innovative activity where multiple agents compete against each other by submitting investment proposals to the principal. Competition helps to speed up innovation not only because multiple agents are working on the same problem, but also because competition helps to solve the agency problems involved. In our model the principal asks proposals from n-number of agents and contracts with the agent who comes up with the best proposal. Agents will have to provide costly and unobservable effort. While working on the proposal agents will also privately learn the quality of their proposals. Multiple proposals make it easier to elicit truthful information from the agents, but all the efforts put into those proposals have to be compensated for. A key insight from the model is that the principal has less need to delay investments because competition among agents makes lying about the quality less profitable for the agents. We show that when the number of agents is endogenous, agents’ information rents are completely dissipated and the agency problem is reduced to a pure moral hazard problem. As a consequence the first best investment policy is always achieved and innovations are implemented earlier.
Authors: Bernard Dumas and Andrew Lyasoff
(forthcoming in Journal of Finance)
Because of non-traded human capital, real-world financial markets are massively incomplete. The modeling of imperfect, dynamic financial markets is a wide-open and difficult field, as yet barely ploughed. Following Cox, Ross and Rubinstein (1979), who calculated the prices of derivative securities on an event tree by simple backward induction, we show how a similar formulation can be utilized in computing heterogeneous-agents, incomplete-market equilibrium prices of primitive securities. Extant methods work forward and backward, requiring a guess of the way investors forecast the future. In our method, the future is part of the current solution of each backward time step.
Asset Pricing Bubbles and Portfolio Constraints—Dynamic Equilibrium with Heterogeneous Agents and Risk Constraints
Author: Rodolfo Prieto
We examine the impact of risk-based portfolio constraints on asset prices in an exchange economy. Constrained agents scale down their portfolio and behave locally like power utility investors with risk aversion that depends on current market conditions. In contrast to previous results in the literature, we show that the imposition of constraints dampens fundamental shocks, challenging the notion that risk management rules amplify aggregate fluctuations. We also show that risk constraints may give rise to bubbles in asset prices, and connect these results to portfolio imbalances generated by the constraints and the heterogeneity across agents.
Authors: Edward Riedl and George Serafeim
Using a sample of US financial institutions, we exploit recent mandatory disclosures of financial instruments designated as fair value level 1, 2, and 3 to test whether greater information risk in financial instrument fair values leads to higher cost of capital. We derive an empirical model allowing asset-specific estimates of implied betas, and find evidence that firms with greater exposure to level 3 financial assets exhibit higher betas relative to those designated as level 1 or level 2. We further find that this difference in implied betas across fair value designations is more pronounced for firms with ex ante lower quality information environments: firms with lower analyst following, lower market capitalization, higher analyst forecast errors, or higher analyst forecast dispersion. Overall, the results are consistent with a higher cost of capital for more opaque financial assets, but also suggest that differences in firm’s information environments can mitigate information risk across the fair value designations.
Authors: Evgeny Lyandres and Berardino Palazzo
In this paper we examine theoretically and empirically the determinants of cash holdings by innovating firms. Our model highlights an important strategic role that cash plays in affecting the development and implementation of innovation in the presence of competition in the market for R&D-intensive products. Firms’ equilibrium cash holdings are shown to depend on the degree of innovation efficiency in firms’ industries, on the intensity of competition in post-R&D output markets, on the structure of industries in which firms innovate, and on the interactions of these factors with the costs of obtaining external financing. In addition, the model provides a possible explanation for the temporal increase in cash holdings, particularly among R&D-intensive firms. Our empirical evidence demonstrates that financing costs, innovation efficiency, intensity of competition, and industry structure are indeed associated with firms’ observed cash-to-assets ratios in ways that are generally consistent with the model’s predictions.
Navigating the Autonomy-Interdependence Paradox: Achieving Temporal Flexibility through Workplace Relationships in Professional Services
Authors: Emily Heaphy and Spela Trefalt
Research on how professionals achieve temporal flexibility—the ability of individuals to adjust their work schedules to accommodate their personal needs and interests—has emphasized the benefits of formal organizational policies, yet typically such policies are underutilized or even resisted. In a qualitative study of a team-based professional services firm, we investigate how professionals achieve temporal flexibility outside of formal organizational policies. We find that professionals must navigate what we call the autonomy-interdependence paradox, in which a rhetoric of individual autonomy conflicts with the reality of highly interdependent work. Professionals manage this paradox by drawing on their workplace relationships. Consultants carefully architected opportunities to work with others with whom they knew they would be able to experience temporal flexibility, while avoiding those with whom they knew they would not, thereby constructing a relational context that supported temporal flexibility. Once in those relationships, they co-constructed temporal flexibility through practices of interpersonal treatment, project management, and signaling temporal flexibility. This study contributes to research on temporal flexibility, relational perspectives on professional work, and the sociology of work time.
Helping Consumers Get Out of Debt Faster: How Debt Repayment Strategies Affect Motivation to Repay Debt
Authors: Remi Trudel, Keri Kettle, and Gerald Haubl
The US Federal Reserve estimates that US consumers have $791 billion in revolving debt, 98% of which is credit card debt. It is clear that consumer debt is a problem. Moreover, consumers with problematic levels of debt—i.e., those of greatest concern—tend to have their financial liabilities distributed across multiple debt accounts. Consumers with multiple debts can choose among different strategies for paying down their debt accounts. In particular, they can repay their accounts sequentially (one at a time) or simultaneously (allocating money to each account). We believe that there is a consequence to this decision and examine how the order in which debt is repaid influences the motivation of consumers to pay off their debts. Across 4 experimental studies, we demonstrate that paying down debt accounts sequentially (versus simultaneously) increases the motivation of low self-control consumers—precisely those who have difficulty achieving long-term goals (Baumeister et al. 2007) and are most likely to have debt in the first place (Meier & Sprenger 2012). This effect persists whether the strategy is chosen or assigned, is strengthened by expert recommendation, and is moderated by the attainability of getting out of debt. The results are compelling and have important public policy implications.
Expectations as Endowments: Evidence on Reference-Dependent Preferences from Exchange and Valuation Experiments
Keith M. Marzilli Ericson
Markets, Public Policy and Law
Authors: Keith M. Marzilli Ericson and Andreas Fuster
Evidence from a variety of settings indicates that people are loss averse: they dislike losses much more than they enjoy equal-sized gains. Yet little is known about the determination of the reference points relative to which gains and losses are defined. Kahneman and Tversky’s highly influential prospect theory, where loss aversion was first introduced, left the reference point imprecise. It has often been taken to be the status quo. However, we conduct two experiments that show that reference points are determined, at least in part, by expectations about future outcomes. In an exchange experiment, we endow subjects with an item and randomize the probability they will be allowed to trade. Subjects that are less likely to be able to trade are more likely to choose to keep their item. In a valuation experiment, we randomly assign subjects a high or low probability of obtaining an item and elicit their willingness-to-accept for it. The high probability treatment increases valuation of the item by 20–30%. These results imply that firms and policy makers can benefit from “expectations management,” as they may face less resistance against a price or policy change if it was expected than if it comes as a surprise.
Markets, Public Policy and Law
Author: William Samuelson
This paper considers the incidence of out-of-court negotiated settlements versus adjudicated outcomes as predicted by a number of game-theoretic models. A number of questions are addressed: How do varying offer and acceptance methods effect the terms of out-of-court settlements? In favor of which side? Which kinds of cases settle and which go to court? How does the expected court outcome (including legal costs and possibly reputation costs) affect the terms and likelihood of an out-of-court settlement? How does private information about the case merits held by one or more sides affect player strategies and outcomes? Among other results, we show that the strategic behavior of the disputants combined with asymmetric information about the value of the case constitutes a road block to achieving a first-best, ideal settlement mechanism. There is an inevitable trade-off between efficiency and equity. In equilibrium, out-of-court settlements can save all or some part of the costs of going to court, but are unable to mimic perfectly those court outcomes.