Felipe Varas

Research

Working Papers

"Debt Maturity Management" with Yunzhi Hu and Chao Ying.


Abstract

How does a borrower choose between long- and short-term debt when she has no commitment to future issuance policy? Short-term debt protects creditors from future dilution; long-term debt allows the borrower to share losses with creditors in a downturn by effectively reducing her payments. We develop a theory of debt maturity that highlights the tradeoff between commitment and risk management. Borrowers far from default value risk management and use a combination of long- and short-term debt. By contrast, distressed borrowers exclusively issue short-term debt. Our model predicts pro-cyclical leverage, debt maturity, and long-term debt issuance.

"Bargaining in Securities" with Isaías N. Chaves.

Abstract

Many corporate negotiations involve contingent payments or securities, yet the bargaining literature overwhelmingly focuses on pure cash transactions. We characterize equilibria in a continuous-time model of bargaining in securities. A privately informed buyer and a seller negotiate the terms of a joint project. The buyer's private information affects both his standalone value and the net returns from the project. The seller makes offers in a one-dimensional family of securities (e.g., equity splits). We show how outcomes change as the underlying security becomes more sensitive to the buyer's information, and we apply the framework to mergers and acquisitions under financial constraints.

Publications

"Intermediary Financing without Commitment" with Yunzhi Hu.
Accepted at Journal of Financial Economics

Abstract

Intermediaries reduce agency problems through monitoring, but credible monitoring requires sufficient retention until the loan matures. We study credit markets when intermediaries cannot commit to retention. Two structures are examined: investors lending alongside an all-equity bank and investors lending through the bank via short-term debt. With a commitment to retention, they are equivalent. Without commitment, the all-equity bank sells loans and reduces monitoring over time. Short-term debt encourages the intermediary to retain loans and incentivizes monitoring. Our analysis explains intermediaries' reliance on short-term debt - it enables the intermediary to internalize monitoring externalities.

"Strategic Trading and Blockholder Dynamics" with Iván Marinovic.
Accepted at RAND Journal of Economics

Abstract

We study strategic trading by a privately informed blockholder who monitors a company and trades its shares. Private information results in larger block sizes in good states, but by increasing the speed of the blockholder's selling, it can result in lower block sizes in bad states. Despite the heterogeneous impact on expected block size, we show that asymmetric information leads to Pareto improvements: it raises stock prices, benefits small uninformed shareholders, and benefits the block owner, despite the negative impact on liquidity.

"The Dynamics of Concealment" (2022) with Jeremy Bertomeu, Iván Marinovic, and Stephen Terry, Journal of Financial Economics, Volume 143(1).

Abstract

Firm managers likely have more information than outsiders. If managers strate- gically conceal information, market uncertainty will increase. We develop a dynamic corporate disclosure model, estimating the model using the management earnings fore- casts of US public companies. The model, based on the buildup of reputations by managers over time, matches key facts about forecast dynamics. We find that 80% of firms strategically manage information, that managers have superior information around half of the time, and that firms conceal information about 40% of the time. Concealment increases market uncertainty by just under 8%, a sizable information loss.

"A Theory of Zombie Lending" (2021) with Yunzhi Hu, Journal of Finance, Volume 76(4).

Abstract

This paper studies the dynamics of relationship-bank lending and market financing. Bank lending facilitates private learning over time but introduces an information monopoly. We show the entrepreneur starts with bank financing and subsequently refinances with the market. Asymmetric information is developed over time, while the entrepreneur also accumulates reputation. For sufficiently reputable entrepreneurs, banks will extend loans even after bad news, for the prospect of future market financing. Moreover, this incentive to pretend gets mitigated when the entrepreneur faces financial constraints. We further endogenize learning as the bank's costly decision and show banks stop learning when entrepreneurs become sufficiently reputable.

"Random Inspections and Periodic Reviews: Optimal Dynamic Monitoring" (2020) with Iván Marinovic and Andrzej Skrzypacz, Review of Economic Studies, Volume 87(6).
Link to Online Appendix.

Abstract

This paper studies the design of monitoring policies in dynamic settings with moral hazard. The firm benefits from having a reputation for quality, and the principal can learn the firm's quality by conducting costly inspections. Monitoring plays two roles: An incentive role, because the outcome of inspections affects the firm's reputation, and an informational role because the principal values the information about the firm's quality. We characterize the optimal monitoring policy inducing full effort. It can be implemented by dividing firms into two types of lists: recently inspected and not, with random inspections of firms in the latter.

"CEO Horizon, Optimal Duration and the Escalation of Short-Termism" (2019) with Iván Marinovic, Journal of Finance, Volume 74(4).

Abstract

This paper studies optimal contracts when managers manipulate their performance measure at the expense of firm value. Optimal contracts defer compensation. The manager's incentives vest over time at an increasing rate, and compensation becomes very sensitive to short-term performance. This generates an endogenous horizon problem whereby managers intensify performance manipulation in their final years in office. Contracts are designed to encourage effort while minimizing the adverse effects of manipulation. We characterize the optimal mix of short- and long-term compensa- tion along the manager's tenure, the optimal vesting period of incentive pay, and the dynamics of short-termism over the CEO's tenure.

"Managerial Short-Termism, Turnover Policy, and the Dynamcis of Incentives" (2018), Review of Financial Studies, Volume 31(9).

Abstract

I study managerial short-termism in a dynamic model of project development with hidden effort and imperfect observability of quality. The manager can complete the project faster by reducing quality. To preempt this behavior, the principal makes payments contingent on long-term outcomes. I analyze the dynamics of the optimal contract and its implications for the level of managerial turnover. I show that optimal contracts might be stationary and entail no termination. In general, I show that the principal reduces the manager's temptation to behave myopically by reducing the likelihood of termination and deferring compensation. The model predicts a negative relation between the rate of managerial turnover and the use of deferred compensation that is consistent with evidence of managerial compensation contracts.

"Dynamic Certification and Reputation for Quality" (2018) with Iván Marinovic and Andrzej Skrzypacz, America Economic Journal: Microeconomics, Volume 10(2).

Abstract

We study firm's incentives to build and maintain reputation for quality, when quality is persistent and can be certified at a cost. We characterize all reputation-dependent MPEs. They vary in frequency of certification and payoffs. Low payoffs arise in equilibria because of over-certification traps. We contrast the MPEs with the highest payoff equilibria. Industry certification standards can help firms coordinate on such good equilibria. The optimal equilibria allow firms to maintain high quality forever, once it is reached for the first time. They are either lenient or harsh, endowing firms with multiple or one chance to improve and certify quality.

"The Credibility of Financial Reporting: A Reputation-Based Approach" (2018) with Iván Marinovic and Ying Liang, The Accounting Review, Volume 93(1).

Abstract

This paper studies the reliability of financial reporting when the credibility of the manager, represented by his misreporting propensity, is unknown. We show that credibility concerns affect the time-series of reported earnings, book values, and stock prices in ways that seem consistent with empirical evidence. When investors are uncertain about the credibility of the reporting process, earnings response coefficients, as well as market-to-book values (MTB), are random and time-varying; relatively low MTB reflect poor credibility of financial reporting; stock prices are s-shaped in earnings surprises and relatively insensitive to bad news. Finally, when the manager is more likely to have reporting discretion, discretionary accruals tend to be larger and more volatile. We estimate the model using U.S. earnings announcement data during 2002–2012 and find that the probability of misreporting is 7 percent. A counterfactual analysis reveals that ignoring the possibility of misreporting leads to overestimation of the mean (3.5 percent), volatility (13 percent), and persistence of earnings (17 percent).

"No News is Good News: Voluntary Disclosure in the Face of Litigation" (2016) with Iván Marinovic, RAND Journal of Economics, Volume 47(4).

Abstract

We study disclosure dynamics when the firm value evolves stochastically over time. The presence of litigation risk, arising from the failure to disclose unfavorable information, crowds out positive disclosures. Litigation risk mitigates firms’ tendency to use inefficient disclosure policies. From a policy perspective, we show that a stricter legal environment may be an efficient way to stimulate information transmission in capital markets, particularly when the nature of information is proprietary. We model the endogeneity of litigation risk in a dynamic setting and shed light on the empirical controversy regarding whether disclosure preempts or triggers litigation.

"Equity Issues and Return Volatility" (2013) with Borja Larraín, Review of Finance, Volume 17.

Abstract

We show that the repurchaser–issuer return spread is stronger among stocks with high return volatility. Rational and behavioral theories predict that this finding is the product of risk volatility and sentiment volatility, respectively. However, our results are inconsistent with these theories as they currently stand. Loadings on standard risk factors do not follow the dynamics that would explain the return predictability related to issuance decisions. If we sort on a stock's beta with respect to the aggregate sentiment index of Baker and Wurgler (2006, J. Finance, 61, 1645–1680), which proxies for sentiment volatility, the results are weaker—economically and statistically—than when sorting on return volatility.

"Optimal Close-to-Home Biases in Asset Allocation" (2011) with Eduardo Walker, Journal of Business Research, Volume 64, Conference on Strategic Management in Latin America.

Abstract

This article studies optimal portfolio decisions with (long-term) liabilities for small open economy based investors, including the optimality of currency hedging (Walker (2008a). Chile is the home country of the representative investor, but results are likely to hold more generally. The problem is set up as in Sharpe and Tint (1990) and Hoevenaars, Molenaar, Schotman and Steenkamp (2007). Hedging the liabilities and the consumption currency may imply optimal close-to-home biases, defined as overweighting asset classes which are highly correlated with local ones. The implementation challenges include: developing a methodology to estimate expected returns in local (real) currency; estimating the covariance matrix allowing for serial and crossed-serial correlations; and checking the results' robustness using a resampling method. The findings are: (i) portfolios always have optimal close-to-home biases, beyond the investment in local fixed income to hedge liabilities; (ii) currency hedging reduces investment in close-to-home asset classes, (iii) but has ambiguous effects on welfare — detected with the resampling method; (iv) currency hedged long-term US bonds are useful for hedging local interest rate risk; and (v) liabilities give access to high risk-return portfolios, not affecting otherwise the overall shape of the efficient regions. This article can be useful to investors based on small open economies, including pension funds, insurance companies, sovereign wealth funds and Central Banks.