Brown Bag Seminar Past Events

Title: Decomposing Firm Value

**Preliminary work with Vito Gala (Wharton), John Pokorny (U of M) and Juliana Salomao (U of M)

Title: Why can't CEOs foresee a financial crisis?

Abstract: This paper explains why CEOs are unable to curtail risky investments before a crisis. CEOs rely on the advice of their employees to understand the riskiness of their investments. Before a crisis, prots from an investment strategy is usually high, and so it is perceived to be good. If employees receive information that the strategy is bad and should be discontinued, they may not disclose their information to avoid being perceived as pessimistic and lose their job. Multiple employees can convince the CEO to discontinue if they disclose together but not if they disclose alone. This creates strategic complementarities in disclosure strategy and results in coordination problem where in the inefficient equilibrium no employee will disclose and the CEO remaining unaware of the risks goes ahead with bad investments. The paper thus provides an explanation for boom bust cycles and also for why CEO's beliefs were optimistic before the crisis.

Title: Capital Heterogeneity, Time-to-build, and Return Predictability

Abstract:

This paper documents that U.S. equipment investment rate predicts stock market returns better than structures investment rate. This empirical finding is further borne out by industry-level and international data. A general equilibrium model with external habit preference and heterogeneous time-to-build for equipment and structures can explain the empirical findings while matching the salient features of business cycles and asset prices. Equipment investment requires less time to transform into productive capital. It reacts to productivity shocks more timely than structures investment and reflects more information contained in stock prices.

Title:

"Nominal frictions, leverage, and investment"

Abstract:

I find that nominal debt contracts and nominal price stickiness create a channel for inflation to affect real investment and leverage decisions. When debt in is nominal terms, Inflation lowers the real value of current debt, increases the marginal cost of issuing debt, and reduces the optimal amount of leverage. This reduces the degree of debt overhang, increasing investment. Firms with flexible prices invest more. I confirm these predictions empirically using a measure of price stickiness. Firms increase investment and reduce debt when inflation is high. Firms with sticky prices have lower investment and higher debt following inflation shocks.

Presenter:

Chao Ying

Authors:  Hengjie Ai, Anmol Bhandari, Jincheng Tong and Chao Ying

TITLE: "Aggregation in Economies with Homogeneous Decision Rules"

AND

Presenter:

Fangyuan Yu

Title:

"Adverse selection and asset sales"

Abstract:

I consider a dynamic adverse selection problem in OTC markets. One seller with private information about asset quality searches buyers sequentially in the market. Two types of buyers exist in the market (informed and uninformed). Buyers make private offers to sellers if they meet, and sellers decide whether to accept the offer. I find that there exists a unique stationary market belief, and belief will converge to this stationary belief if trading hasn't occurred. When the market belief is unfavorable, the high type seller trades more slowly, and the average trading time for high type seller is longer than low type; when the market belief is favorable, high type seller trades more quickly, and the average trading time for high type seller is shorter than low type seller.

Tracy Wang

Title: "Skilled Labor Risk and Corporate Policies"

Abstract: In 2013, 86% of the U.S. publicly traded companies mentioned potential failure in attracting and retaining skilled labor as a risk factor in their 10-K filings, up from 37% in 1996. The intensity of the discussion on skilled labor risk in 10-Ks also increased sharply over the years. In this study, we measure skilled labor risk by the intensity of such discussions in 10-Ks, and examine its determinants as well as its impact on firms’ compensation design and financial management. We find that both the local mobility of skilled labor and the lack of access to ample supply of educated labor contribute to firms’ skilled labor risk. Consistent with theories on optimal compensation design in the presence of mobile talents, we find that firms facing higher skilled labor risk use more incentive pay with longer duration. Furthermore, those firms pursue more prudent financial management policies, holding more cash and borrowing less, supporting theories arguing that the skilled labor risk adds to a firm’s overall risk.

Title: Debt Structure as a Strategic Bargaining Tool

Abstract: This paper studies the strategic role of debt structure in improving the bargaining position of a firm's management relative to its non-financial stakeholders. Debt structure is essential for strategic bargaining since it affects the ease of debt contract renegotiation and thus the credibility of bankruptcy threats. Using airline industry as the empirical setting, we first show that the degree of wage concessions is strongly related to a firm's debt structure. Debt structure is further shown to be adjusted as a response to an increase in non-financial stakeholders' negotiation power. Using NLRB labor union election as a laboratory setting and employing a regression discontinuity design, we find that passing a labor union election leads to an increase in the ratio of public debt to total assets and a decrease in the ratio of bank debt to total assets in the following three years after elections, while there is no significant change in the level of total debt. Syndication size of newly issued bank loans increases while creditor ownership concentration decreases once the vote share for unions passes the winning threshold. Various tests confirm that the debt structure adjustments after union certification are more likely driven by strategic concerns of management rather than more constrained access to bank loans.
 

Location: CSOM 1-142

Title: Mobility of Skilled Labor and Capital Structure

Abstract: Firms that rely on relatively more high skill and high mobility employees at the same time, operate with lower financial leverages, to reduce the risk of losing their talents in financial distress. To quantify the importance of this channel, I estimate a dynamic model in which a firm hires skilled labor and finances investment by issuing equity and defaultable debt. Wages are not paid in default states and are only partially paid when the firm is distressed. If future wages are expected to be less than a reservation value, not only new workers cannot be hired, but the current workers also leave the firm at a rate that depends on their mobility. The estimated model generates same cross-sectional patterns in leverage as in actual data. Also, model identification is confirmed in a natural experiment using unexpected changes in labor mobility. The model predicts that if firms were not constrained by labor concerns, net debt to asset ratio would increase by 38%, from 0.124 to 0.171. This can be partially achieved if firms pay wages by their bonds, instead of cash or equity
 

Location: CSOM 1-142

Title: Dynamic-Agency Based Asset Pricing in a Production Economy

Author: Jincheng Tong & Chao Ying

Abstract: We present an asset pricing model in a production economy where neither firms nor workers can fully commit to labor compensation contracts. We embed optimal dynamic contracting in our general equilibrium setup to provide a unified explanation of macroeconomic quantity dynamics and asset market returns. With a risk aversion of four, our model generates an un-levered equity premium of 4% per year, a volatility of the stock market return of 14% per year, and a low and smooth risk-free rate. On the quantities side, it successfully replicates the empirical evidence of the low volatility of aggregate consumption growth and large variations in aggregate investment over the business cycle.

Location: CSOM L-114

Title: A Race of Unicorns

Abstract: In an emerging industry, successful start-ups, also known as “Unicorns”, compete both in the product market as well as capital markets. The product market condition does not only influence the oligopoly profits, but also influences the investor’s belief on company future growth opportunity in the capital market. In this paper, we model a dynamic competition game between a good unicorn and a bad one. Both companies can choose to raise capitals by IPO and expand the current profit, or to be acquired by the other one. The unicorns time their financing decisions by balancing the adverse selection cost with the loss in expansion. In the model, market condition uniquely divides the financing decisions into three regions: IPO wave, burning money or M&A wave. Good unicorns optimally choose to suffer underpricing if they pool with bad ones in IPO, to give up expansion temporally, or to acquire the bad ones, signal their type and become the monopoly. The model can explain several empirical phenomena like volume fluctuations and market-timing in IPO. Also, the model has some empirical predictions in both pre-IPO competitions and post-IPO wave performance.
 

Location: CSOM L-114

Title: The Market for Conflicted Advice
Author: Martin Szydlowski, Briana Chang

Presenter: Martin Szydlowski
Abstract:     
We study decentralized markets in which advisers have conflicts of interest and compete for customers via information provision. We show that competition partially disciplines conflicted advisers. The equilibrium features information dispersion and sorting of heterogeneous customers and advisers: advisers with expertise in more information sensitive assets attract less informed customers, provide worse information, and earn higher profits. We further apply our framework to the market for financial advice and establish new insights: it is the underlying distribution of financial literacy that determines the consumers’ welfare. When advisers are scarce, the fee structure of advisers is irrelevant for the welfare of consumers.
 

Location: CSOM L-114

Title: The Effect of Taxation on Corporate Financing and Investment
Author: Hong Chen and Murray Frank

Presenter: Murray Frank
Abstract:     
This paper studies the impact of taxation on corporate investment, debt, equity, and dividends. There is a classical tax code in which the firm pays tax on profits and the investor pays taxes on dividends, interest, and capital gains. We find that small increases in the dividend tax (or the capital gains tax) has no effect on consumption, production or government revenue.  Instead, the firm alters the dividends and share issuance policies. A small increase in the corporate profits tax (or a cut in the tax on interest) reduces consumption, increases government revenue, and for realistic tax parameters increases production.  There is one approximate symmetry between the impact of corporate profits tax and interest tax, and another between dividend tax and capital gains tax.
 

Title:  The Effect of Cash Injections: Evidence from the 1980s Farm Debt Crisis

Authors:  Nittai Bergman, Rajkamal Iyer, Richard Thakor

Abstract:  What is the effect of cash injections during financial crises? Exploiting county-level variation arising from random weather shocks during the 1980s Farm Debt Crisis, we analyze and measure the effect of local cash flow shocks on the real and financial sector. We show that such cash flow shocks have significant impact on a host of economic outcomes, including land values, loan delinquency rates, and the probability of bank failure. Further, we measure how cash injections affect local labor markets, analyzing the impact on employment and wages both within and outside of the sector receiving a positive cash flow shock. Estimates of the effect of local cash flow shocks on county income levels during the financial crisis yield a multiplier of 1.63.

Title: Moral Hazard and Investment-cash-flow sensitivity, with Rui Li (University of Massachusetts) and Kai Li (HKUST)

Abstract: We present a dynamic model of investment with moral hazard. We show that the optimal contract with moral hazard gives rise to endogenous financing constraints and results in investment-to-cash flow sensitivity. In addition, the magnitude of invest-to-cash flow sensitivity does not increase with the tightness of financing constraints and therefore cannot be used as a quantitative measure of such. Our calibrated model replicates the failure of Q-theory, provides an explanation for the existence of investment-cash flow sensitivity, and accounts for the robust
positive relationship between investment-to-cash flow sensitivity and firm size and age in the data.

Abstract:

This paper studies the strategic role of debt structure in improving the bargaining position of a firm's management relative to its non-financial stakeholders. Debt structure is essential for strategic bargaining since it affects the ease of debt contract renegotiation and thus the credibility of bankruptcy threat. We first document that the degree of wage concessions is indeed strongly related to a firm's debt structure ex post in the airline industry and the effect is reduced when bankruptcy threat is less credible for employees. Debt structure is further shown to be adjusted ex ante as a response to an increase in non-financial stakeholders' negotiation power. Utilizing NLRB labor union election as a laboratory setting and employing a regression discontinuity design, we find that passing a union election leads to an increase in the ratio of public debt to total asset and a decrease in the ratio of bank debt to total asset in the following three years after elections, while there is no significant change in the level of debt. Syndication size of newly issued bank loans increases while creditor ownership concentration decreases once vote share for unions passes the winning threshold. Various tests confirm that the debt structure adjustment after new unionization is more likely driven by strategic concerns of management rather than more constrained access to bank loans.

TITLE: Asset Pricing and Risk Sharing with Limited Enforcement and heterogeneous Preferences

Abstract:
We introduce heterogeneous preferences (heterogeneity in risk aversion and time discount factor) into a two-agent endowment economy with enforcement constraints, aggregate and idiosyncratic uncertainty (Alvarez and Jermann (2001 RFS)), and study the corresponding asset pricing and risk sharing implications. We show that the relative time discount factor and the interaction between heterogeneous risk aversion and aggregate uncertainty affect the evolution of the relative Pareto weight of agents. The more patient agent tends to obtain a higher Pareto weight, and the less risk averse agent tends to do so in booms and the reverse in recessions. We demonstrate that preference heterogeneity can generate a positive equity premium with only idiosyncratic uncertainty present since the conditional pricing kernel is time-varying depending on which agent is the marginal pricer. We show that preference heterogeneity boosts the mean and volatility of equity premium quantitatively in a calibrated model, because the more risk averse and/or the more patient agent cannot trade away most of his income risk with the other agent.

Title: Why do banks ignore the warnings?

Abstract:

Although the recent financial crisis came as a surprise to many, there were some employees who had warned against these risks. These warnings were ignored by the CEOs of the banks and the employees were fired. In my paper, I provide a theory of when will a CEO fire the employees and go ahead with risky strategies. Under the condition that one may get fired, the decision of the employees to disclose his concerns leads to a coordination problem among the employees. In a global games setting I show that, banks are more likely go ahead with the risky strategies when they seem to be more profitable.

Title: Uninsurable Tail Risks, Operating Leverage and the Value Premium

Abstract:
We provide a theory of value premium based on idiosyncratic risk in productivities in a world where markets are endogenously incomplete. In our model, fully-diversified equity owner compensates workers using long-term risk-sharing labor contract but cannot commit to firms that yield negative NPV of dividends. The optimal contract makes adverse idiosyncratic shocks uninsurable. We show that limited commitment constraint endogenously generates a high market price of risk through labor-induced operating leverage channel. Different levels of operating leverage across firms lead to heterogeneous exposures to aggregate risk, thus giving rise to differences in returns between value and growth firms. 

Title: Rational Stock Market Catering

Abstract:

Can the usual tests of the Catering Theory of corporate investment distinguish between behavioral and rational perspectives? Using USA data from 1970 to 2015 we find test result which have been used in support of behavioral Catering Theory. We present a simple rational model of corporate investment and equity issuance. Data generated by the calibrated model produces the same patterns of coefficients as real data. According to behavioral, periods of high market sentiment and booms, are times of overvaluation. Using these periods we find that the patterns of coefficients are consistent with the rational model and not consistent with the behavioral predictions.
 

Cash holdings and technological development: Evidence from IT-mediated improvement in inventory management

Since 1980s US manufacturing firms are holding more cash relative to their assets. In this paper, we investigate whether improvements in information technology (IT) and its use have contributed to this increase. We establish that IT contributed to the improvement through inventory channel. IT has enabled firms redeploy their current assets: substituting cash for inventory, engendering an era of sustained higher level of cash holdings. In addition, we also establish that some observed heterogeneity in cash holdings can be explained by the industries firms operate in, the type of inventories they hold, and the financial constraints they face.

Short- and Long-Run Business Conditions and Expected Returns 

(joint with Qi Liu, Libin Tao, and Weixing Wu)

Numerous studies argue that the market risk premium is associated with economic conditions and show that proxies for business conditions indeed predict aggregate market returns. By directly estimating short- and long-run expected economic growth, we show that short-run expected economic growth is negatively related to future returns, whereas long-run expected economic growth is positively related to aggregate market returns. At an annual horizon, short- and long-run expected growth can jointly predict aggregate excess returns with an R2 of 17-19%. Our findings indicate that the risk premium has both high- and low-frequency fluctuations and highlight the importance of distinguishing short- and long-run economic growth in macro asset pricing models.

A Mechanism Design Model of Firm Dynamics: The Case of Limited Commitment

We present a general equilibrium-mechanism design model with two-sided limited commitment that accounts for the observed heterogeneity in firms'; investment, payout and CEO-compensation policies. In the model, shareholders cannot commit to holding ;negative net present value projects, and managers cannot commit to ;compensation plans that yield life-time utility lower than their outside ;options. Firms operate identical constant return to scale technologies with i.i.d.\ productivity growth. Consistent with the data, the model endogenously generates a power law in firm size and a power law in CEO compensation. ;We also show that the model is able to quantitatively explain the observed negative;relationship between firms' investment rates and size, the positive relationship between firms' size and their dividend and CEO payout, as well as; variation of firms' investment and payout policies across both size and age.

Crash Risk in Currency Returns

We quantify crash risk in currency returns. To accomplish this task, we develop and estimate an empirical model of exchange rate dynamics using daily data for four currencies relative to the US dollar: the Australian dollar, the British pound, the Swiss franc, and the Japanese yen. The model includes (i) normal shocks with stochastic variance, (ii) jumps up and down in the exchange rate, and (iii) jumps in the variance. We identify these components using data on exchange rates and at-the-money implied variances. We find that crash risk is time-varying. The probability of an upward (downward) jump in the exchange rate, associated with depreciation (appreciation) of the US dollar, is increasing in the domestic (foreign) interest rate. The probability of jumps in variance is increasing in the variance but is not related to interest rates. Many of the jumps in exchange rates are associated with macroeconomic and political news, but jumps in variance are not. On average, jumps account for 25% (and can be as high as 40%) of total currency risk, as measured by the entropy of exchange rate changes, over horizons of one to three months. Preliminary analysis suggests that these properties of currency returns correspond to observed option smiles and that jump risk is priced.

CEO Investment Cycles

This paper documents the existence of a CEO Investment Cycle, in which firms disinvest early in a CEO's tenure and increase investment subsequently, leading to cyclical firm growth in assets as well as in employment over CEO tenure. The CEO investment cycle occurs for both firings and non-performance related CEO turnovers, and for CEOs with different relationships with the firm prior to becoming CEO. The magnitude of the CEO cycle is substantial: The estimated difference in investment rate between the first three years of a CEO's tenure and subsequent years is approximately 6 to 8 percentage points, which is of the same order of magnitude as the differences caused by other factors known to affect investment, such as business cycles or financial constraints. We present a variety of tests suggesting that this investment cycle is best explained by a combination of agency-based theories: Early in his tenure the CEO disinvests poorly performing assets that his predecessor established and was unwilling to give up on. Subsequently, the CEO overinvests when he gains more control over his board. There is no evidence that the investment cycles occur because of shifting CEO skill or productivity shocks. Overall, the results imply that public corporations' investments deviate substantially from the first-best, and that governance-related factors internal to the firm are as important as economy-wide factors in explaining firms' investments.

CEO Compensation and Maturity of Debt Issues: Evidence From IRC 162(M)

This essay shows that CEO incentives provided by option compensation have significant impacts on maturity of newly issued debt. To identity such impacts, we exploit IRC 162(M) as an exogenous shock to new option grant decisions. IRC 162(M), effective since January 1st, 1994, limits corporate tax deductibility of CEO compensation and also has impacts on new option grant decisions in US firms. Our main findings are: First, after introduction of IRC 162(M), number, volatility sensitivity and price sensitivity of newly granted options in affected firm increase more than those in unaffected firms. Second, maturity of newly issued debt decreases (increases) when volatility (price) sensitivity of new option compensation increases. Overall, results in this essay show that CEO option compensation has large impacts on maturity of newly issued debt.

Short Arbitrage and Abnormal Return Asymmetry

This paper studies how constraints on short arbitrage are associated with abnormal return asymmetry of a broad set of anomalies. Using institutional holdings as a proxy for ease of short selling and idiosyncratic volatility for arbitrage risk, We find that the return asymmetry is stronger when short arbitrage is more constrained (low institutional holdings and high idiosyncratic volatility).

Shadow Insurance

Liabilities ceded by life insurers to shadow reinsurers (i.e., less regulated off-balance-sheet entities) grew from $11 billion in 2002 to $363 billion in 2012. Companies that are involved in shadow insurance, which capture 50 percent of the market share, ceded 28 cents of every dollar insured to shadow reinsurers in 2012, up from 2 cents in 2002. Our adjustment for shadow insurance reduces risk-based capital by 49 percentage points (or 3 rating notches) and raises expected loss by at least $15.7 billion for the industry. We develop a structural model to estimate the impact of shadow insurance on the equilibrium supply in the retail market. In the absence of shadow insurance, marginal cost would rise by 1.8 percent, and annual insurance underwritten would fall by $1.4 billion at unit demand elasticity.

Equilibrium Corporate Capital Structure (work-in-progress with Hong Chen, SAIF)

The trade-off theory of corporate capital structure has been studied in partial equilibrium settings, and in dynamic models that require numerical solutions. Separately, as a result of the financial crisis of 2007-2009, there are studies of financial frictions at the bank. These models are used to study "unconventional Fed policy" along the lines of the policies actually adopted during the crisis. We bring a simple financing friction model closer to the trade-off theory, by permitting equity finance. Cases with and without corporate tax, and the financing friction (bank default) are compared. Results similar to Modigliani-Miller (1958 and 1963) emerge naturally as special cases. Allowing for an equity market tends to undermine the policy justifications of "unconventional Fed policy" because investment tends to avoid distorted markets when an undistorted alternative is available. In contrast to the usual trade-off theory models, the corporate tax rate may affect the volume of household savings and hence the scale of firm production, but not the equilibrium leverage ratio in some equilibria.

Amanda Heitz

Hongda Zhong

Estimating Bounds on the Present Discounted Value of Economics of Scale in Large Banks

Continuous Time Agency Problem

Huijun Wang

Tao Shen

Predictability of Excess Returns on Foreign Currency Portfolios and Foreign Equity Portfolios

Replication and Extension: Investment and Value, A Neoclassical Benchmark

Jun Li

Daniil Osipov

Investment-based Asset Pricing

Literature Review on Partial Adjustment Toward Target Capital Structures

Fan Yang

Pedram Nezafat

Literature Review of Commodity Pricing

Literature Review of Asset Prices and Business Cycles