The Journal of Finance

Executive Compensation, Strategic Competition, and Relative Performance Evaluation: Theory and Evidence

Published: 12/17/2002   |   DOI: 10.1111/0022-1082.00180

Rajesh K. Aggarwal, Andrew A. Samwick

We examine compensation contracts for managers in imperfectly competitive product markets. We show that strategic interactions among firms can explain the lack of relative performance‐based incentives in which compensation decreases with rival firm performance. The need to soften product market competition generates an optimal compensation contract that places a positive weight on both own and rival performance. Firms in more competitive industries place greater weight on rival firm performance relative to own firm performance. We find empirical evidence of a positive sensitivity of compensation to rival firm performance that is increasing in the degree of competition in the industry.

Sell‐Side School Ties

Published: 07/15/2010   |   DOI: 10.1111/j.1540-6261.2010.01574.x

LAUREN COHEN, ANDREA FRAZZINI, CHRISTOPHER MALLOY

We study the impact of social networks on agents’ ability to gather superior information about firms. Exploiting novel data on the educational background of sell‐side analysts and senior corporate officers, we find that analysts outperform by up to 6.60% per year on their stock recommendations when they have an educational link to the company. Pre‐Reg FD, this school‐tie return premium is 9.36% per year, while post‐Reg FD it is nearly zero. In contrast, in an environment that did not change selective disclosure regulation (the U.K.), the school‐tie premium is large and significant over the entire sample period.

Money Doctors

Published: 07/03/2014   |   DOI: 10.1111/jofi.12188

NICOLA GENNAIOLI, ANDREI SHLEIFER, ROBERT VISHNY

We present a new model of investors delegating portfolio management to professionals based on trust. Trust in the manager reduces an investor's perception of the riskiness of a given investment, and allows managers to charge fees. Money managers compete for investor funds by setting fees, but because of trust, fees do not fall to costs. In equilibrium, fees are higher for assets with higher expected return, managers on average underperform the market net of fees, but investors nevertheless prefer to hire managers to investing on their own. When investors hold biased expectations, trust causes managers to pander to investor beliefs.

A Macrofinance View of U.S. Sovereign CDS Premiums

Published: 05/20/2020   |   DOI: 10.1111/jofi.12948

MIKHAIL CHERNOV, LUKAS SCHMID, ANDRES SCHNEIDER

Premiums on U.S. sovereign credit default swaps (CDS) have risen to persistently elevated levels since the financial crisis. We examine whether these premiums reflect the probability of a fiscal default—a state in which a balanced budget can no longer be restored by raising taxes or eroding the real value of debt by increasing inflation. We develop an equilibrium macrofinance model in which the fiscal and monetary policy stances jointly endogenously determine nominal debt, taxes, inflation, and growth. We show that the CDS premiums reflect the endogenous risk‐adjusted probabilities of fiscal default. The calibrated model is consistent with elevated levels of CDS premiums but leaves dynamic implications quantitatively unresolved.

SOME STUDIES IN MONETARY POLICY, INTEREST RATES, AND THE INVESTMENT BEHAVIOR OF LIFE INSURANCE COMPANIES*

Published: 12/01/1958   |   DOI: 10.1111/j.1540-6261.1958.tb04224.x

Andrew Felton Brimmer

CREDIT CONDITIONS AND PRICE DETERMINATION IN THE CORPORATE BOND MARKET

Published: 09/01/1960   |   DOI: 10.1111/j.1540-6261.1960.tb01600.x

Andrew F. Brimmer

REPLY

Published: 12/01/1972   |   DOI: 10.1111/j.1540-6261.1972.tb03030.x

Andrew F. Brimmer

RECENT DEVELOPMENTS IN THE COST OF DEBT CAPITAL

Published: 06/01/1978   |   DOI: 10.1111/j.1540-6261.1978.tb02027.x

Andrew H. Chen

An Economic Analysis of Interest Rate Swaps

Published: 07/01/1986   |   DOI: 10.1111/j.1540-6261.1986.tb04527.x

JAMES BICKSLER, ANDREW H. CHEN

Interest rate swaps, a financial innovation in recent years, are based upon the principle of comparative advantage. An interest rate swap is a useful tool for active liability management and for hedging against interest rate risk. The purpose of this paper is to provide a simple economic analysis of interest rate swaps. Alternative uses of and the appropriate valuation procedure for interest rate swaps are described.

A DYNAMIC PROGRAMMING APPROACH TO THE VALUATION OF WARRANTS*

Published: 12/01/1969   |   DOI: 10.1111/j.1540-6261.1969.tb01708.x

Andrew Houng‐Yhi Chen

Covenants and Collateral as Incentives to Monitor

Published: 09/01/1995   |   DOI: 10.1111/j.1540-6261.1995.tb04052.x

RAGHURAM RAJAN, ANDREW WINTON

Although monitoring borrowers is thought to be a major function of financial institutions, the presence of other claimants reduces an institutional lender's incentives to do this. Thus loan contracts must be structured to enhance the lender's incentives to monitor. Covenants make a loan's effective maturity, and the ability to collateralize makes a loan's effective priority, contingent on monitoring by the lender. Thus both covenants and collateral can be motivated as contractual devices that increase a lender's incentive to monitor. These results are consistent with a number of stylized facts about the use of covenants and collateral in institutional lending.

How to Discount Cashflows with Time‐Varying Expected Returns

Published: 11/27/2005   |   DOI: 10.1111/j.1540-6261.2004.00715.x

ANDREW ANG, JUN LIU

While many studies document that the market risk premium is predictable and that betas are not constant, the dividend discount model ignores time‐varying risk premiums and betas. We develop a model to consistently value cashflows with changing risk‐free rates, predictable risk premiums, and conditional betas in the context of a conditional CAPM. Practical valuation is accomplished with an analytic term structure of discount rates, with different discount rates applied to expected cashflows at different horizons. Using constant discount rates can produce large misvaluations, which, in portfolio data, are mostly driven at short horizons by market risk premiums and at long horizons by time variation in risk‐free rates and factor loadings.

Valuation and Control in Venture Finance

Published: 12/17/2002   |   DOI: 10.1111/0022-1082.00337

Andrei A. Kirilenko

This paper presents the model of a relationship between a venture capitalist and an entrepreneur engaged in the formation of a new firm. I assume that the entrepreneur derives private nonpecuniary benefits from having some control over the firm. I show that to separate the entrepreneur's value of control from the firm's expected payoff, the venture capitalist demands disproportionately higher control rights than the size of his equity investment. The entrepreneur is compensated for a greater loss of control through better terms of financing, ability to extract higher rents from asymmetric information, and improved risk sharing.

Is the Real Interest Rate Stable?

Published: 12/01/1988   |   DOI: 10.1111/j.1540-6261.1988.tb03958.x

ANDREW K. ROSE

Univariate time‐series models for consumption, nominal interest rates, and prices each appear to have a single unit root before 1979. If nominal interest rates have a unit root but inflation and inflation forecast errors do not, then ex ante real interest rates have a unit root and are therefore nonstationary. This deduction does not depend on the properties of the unobservable ex post observed real return, which combines the ex ante real interest rate and inflation‐forecasting errors. The unit‐root characteristic of real interest rates is puzzling from at least two perspectives: many models imply that the growth rate of consumption and the real interest rate should have similar time‐series characteristics; also, nominal returns for other assets (e.g., stocks and bonds) appear to have different times‐series properties from those of treasury bills.

Optimal Debt and Profitability in the Trade‐Off Theory

Published: 10/10/2017   |   DOI: 10.1111/jofi.12590

ANDREW B. ABEL

I develop a dynamic model of leverage with tax deductible interest and an endogenous cost of default. The interest rate includes a premium to compensate lenders for expected losses in default. A borrowing constraint is generated by lenders' unwillingness to lend an amount that would trigger immediate default. When the borrowing constraint is not binding, the trade‐off theory of debt holds: optimal debt equates the marginal interest tax shield and the marginal expected cost of default. Contrary to conventional interpretation, but consistent with empirical findings, increases in current or future profitability reduce the optimal leverage ratio when the trade‐off theory holds.

Incentives and Endogenous Risk Taking: A Structural View on Hedge Fund Alphas

Published: 04/08/2014   |   DOI: 10.1111/jofi.12167

ANDREA BURASCHI, ROBERT KOSOWSKI, WORRAWAT SRITRAKUL

Hedge fund managers are subject to several nonlinear incentives: performance fee options (call); equity investors' redemption options (put); and prime broker contracts allowing for forced deleverage (put). The interaction of these option‐like incentives affects optimal leverage ex ante, depending on the distance of fund‐value from the high‐water mark. We study how these endogenous effects influence performance measures used in the literature. We show that reduced‐form measures that do not account for these features are subject to economically significant false discovery biases. The result is stronger for low‐quality funds. We propose an alternative structural methodology for conducting performance attribution in hedge funds.

Model‐Free International Stochastic Discount Factors

Published: 07/31/2020   |   DOI: 10.1111/jofi.12970

MIRELA SANDULESCU, FABIO TROJANI, ANDREA VEDOLIN

We provide a theoretical framework to uncover in a model‐free way the relationships among international stochastic discount factors (SDFs), stochastic wedges, and financial market structures. Exchange rates are in general different from the ratio of international SDFs in incomplete markets, as captured by a stochastic wedge. We show theoretically that this wedge can be zero in incomplete and integrated markets. Market segmentation breaks the strong link between exchange rates and international SDFs, which helps address salient features of international asset returns while keeping the volatility and cross‐country correlation of SDFs at moderate levels.

Incomplete‐Market Equilibria Solved Recursively on an Event Tree

Published: 09/12/2012   |   DOI: 10.1111/j.1540-6261.2012.01775.x

BERNARD DUMAS, ANDREW LYASOFF

Because of non‐traded human capital, real‐world financial markets are massively incomplete, while the modeling of imperfect, dynamic financial markets remains a wide‐open and difficult field. Some 30 years after Cox, Ross, and Rubinstein (1979) taught us how to calculate the prices of derivative securities on an event tree by simple backward induction, we show how a similar formulation can be used 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.

Stronger Risk Controls, Lower Risk: Evidence from U.S. Bank Holding Companies

Published: 05/13/2013   |   DOI: 10.1111/jofi.12057

ANDREW ELLUL, VIJAY YERRAMILLI

We construct a risk management index (RMI) to measure the strength and independence of the risk management function at bank holding companies (BHCs). The U.S. BHCs with higher RMI before the onset of the financial crisis have lower tail risk, lower nonperforming loans, and better operating and stock return performance during the financial crisis years. Over the period 1995 to 2010, BHCs with a higher lagged RMI have lower tail risk and higher return on assets, all else equal. Overall, these results suggest that a strong and independent risk management function can curtail tail risk exposures at banks.

The Effects of Market Segmentation and Investor Recognition on Asset Prices: Evidence from Foreign Stocks Listing in the United States

Published: 12/17/2002   |   DOI: 10.1111/0022-1082.00134

Stephen R. Foerster, G. Andrew Karolyi

Non‐U.S. firms cross‐listing shares on U.S. exchanges as American Depositary Receipts earn cumulative abnormal returns of 19 percent during the year before listing, and an additional 1.20 percent during the listing week, but incur a loss of 14 percent during the year following listing. We show how these unusual share price changes are robust to changing market risk exposures and are related to an expansion of the shareholder base and to the amount of capital raised at the time of listing. Our tests provide support for the market segmentation hypothesis and Merton's (1987) investor recognition hypothesis.