Category: Developments in Finance and Accounting
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.