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.
Banks can reduce frictions in the credit market through monitoring. To be a credible monitor, a bank needs to retain a fraction of its loans; we study the credit market dynamics when it cannot commit to do this. Loan prices drop in anticipation of loan sales and reductions in monitoring. With commitment, intermediation is irrelevant if the bank certifies it will monitor. Without commitment, a bank that only certifies sells its loans over time. By contrast, an intermediating bank that issues short-term deposits internalizes the externalities from monitoring, and therefore retains its loans. While intermediation leads to more lending, an entrepreneur with high net-worth may choose certification.
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.
We study strategic trading by a blockholder who may both monitor a firm and trades its shares over time. We study the effects of the blockholder having access to private information. In the presence of private information, the blockholder faces an illiquid market. We show that private information leads to a larger block size in good states, but might lead to a lower block size in bad states, by increasing the blockholder's trading speed. Despite the heterogeneous impact on expected block size, and unlike in static settings, we show that private information leads to a Pareto improvement: it not only increases the stock price, and benefits small uninformed investors, but also benefits the blockholder, notwithstanding its negative impact on liquidity. We apply our model to study the optimal IPO mechanisms. We show that post-IPO trading significantly modifies the IPO design, sometimes exacerbating aftermarket volatility.
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.
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.
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.
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.
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.
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.
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).
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.
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.
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.