The Journal of Finance

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.

Implementing Option Pricing Models When Asset Returns Are Predictable

Published: 03/01/1995   |   DOI: 10.1111/j.1540-6261.1995.tb05168.x

ANDREW W. LO, JIANG WANG

The predictability of an asset's returns will affect the prices of options on that asset, even though predictability is typically induced by the drift, which does not enter the option pricing formula. For discretely‐sampled data, predictability is linked to the parameters that do enter the option pricing formula. We construct an adjustment for predictability to the Black‐Scholes formula and show that this adjustment can be important even for small levels of predictability, especially for longer maturity options. We propose several continuous‐time linear diffusion processes that can capture broader forms of predictability, and provide numerical examples that illustrate their importance for pricing options.

THE EFFECTS OF TAX POLICY ON CAPITAL FORMATION, CORPORATE LIQUIDITY AND THE AVAILABILITY OF INVESTIBLE FUNDS: A SIMULATION STUDY

Published: 05/01/1976   |   DOI: 10.1111/j.1540-6261.1976.tb01887.x

Andrew F. Brimmer, Allen Sinai

The Size and Incidence of the Losses from Noise Trading

Published: 07/01/1989   |   DOI: 10.1111/j.1540-6261.1989.tb04385.x

J. BRADFORD DE LONG, ANDREI SHLEIFER, LAWRENCE H. SUMMERS, ROBERT J. WALDMANN

Recent empirical research has identified a significant amount of volatility in stock prices that cannot easily be explained by changes in fundamentals; one interpretation is that asset prices respond not only to news but also to irrational “noise trading.” We assess the welfare effects and incidence of such noice trading using an overlapping‐generations model that gives investors short horizons. We find that the additional risk generated by noise trading can reduce the capital stock and consumption of the economy, and we show that part of that cost may be borne by rational investors. We conclude that the welfare costs of noise trading may be large if the magnitude of noise in aggregate stock prices is as large as suggested by some of the recent empirical litrature on the excess volatility of the market.

The “Market Model” In Investment Management

Published: 05/01/1980   |   DOI: 10.1111/j.1540-6261.1980.tb02192.x

ANDREW RUDD, BARR ROSENBERG

Multimarket Trading and Liquidity: Theory and Evidence

Published: 09/04/2007   |   DOI: 10.1111/j.1540-6261.2007.01272.x

SHMUEL BARUCH, G. ANDREW KAROLYI, MICHAEL L. LEMMON

We develop a new model of multimarket trading to explain the differences in the foreign share of trading volume of internationally cross‐listed stocks. The model predicts that the trading volume of a cross‐listed stock is proportionally higher on the exchange in which the cross‐listed asset returns have greater correlation with returns of other assets traded on that market. We find robust empirical support for this prediction using stock return and volume data on 251 non‐U.S. stocks cross‐listed on major U.S. exchanges.

Frailty Correlated Default

Published: 09/28/2009   |   DOI: 10.1111/j.1540-6261.2009.01495.x

DARRELL DUFFIE, ANDREAS ECKNER, GUILLAUME HOREL, LEANDRO SAITA

The probability of extreme default losses on portfolios of U.S. corporate debt is much greater than would be estimated under the standard assumption that default correlation arises only from exposure to observable risk factors. At the high confidence levels at which bank loan portfolio and collateralized debt obligation (CDO) default losses are typically measured for economic capital and rating purposes, conventionally based loss estimates are downward biased by a full order of magnitude on test portfolios. Our estimates are based on U.S. public nonfinancial firms between 1979 and 2004. We find strong evidence for the presence of common latent factors, even when controlling for observable factors that provide the most accurate available model of firm‐by‐firm default probabilities.

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.

Estimating Private Equity Returns from Limited Partner Cash Flows

Published: 05/10/2018   |   DOI: 10.1111/jofi.12688

ANDREW ANG, BINGXU CHEN, WILLIAM N. GOETZMANN, LUDOVIC PHALIPPOU

We introduce a methodology to estimate the historical time series of returns to investment in private equity funds. The approach requires only an unbalanced panel of cash contributions and distributions accruing to limited partners and is robust to sparse data. We decompose private equity returns from 1994 to 2015 into a component due to traded factors and a time‐varying private equity premium not spanned by publicly traded factors. We find cyclicality in private equity returns that differs according to fund type and is consistent with the conjecture that capital market segmentation contributes to private equity returns.

Predictably Unequal? The Effects of Machine Learning on Credit Markets

Published: 10/28/2021   |   DOI: 10.1111/jofi.13090

ANDREAS FUSTER, PAUL GOLDSMITH‐PINKHAM, TARUN RAMADORAI, ANSGAR WALTHER

Innovations in statistical technology in functions including credit‐screening have raised concerns about distributional impacts across categories such as race. Theoretically, distributional effects of better statistical technology can come from greater flexibility to uncover structural relationships or from triangulation of otherwise excluded characteristics. Using data on U.S. mortgages, we predict default using traditional and machine learning models. We find that Black and Hispanic borrowers are disproportionately less likely to gain from the introduction of machine learning. In a simple equilibrium credit market model, machine learning increases disparity in rates between and within groups, with these changes attributable primarily to greater flexibility.

Optimal Hedging in Futures Markets with Multiple Delivery Specifications

Published: 09/01/1987   |   DOI: 10.1111/j.1540-6261.1987.tb03924.x

AVRAHAM KAMARA, ANDREW F. SIEGEL

Nearly all futures contracts allow delivery of any of several qualities of the underlying asset. Consequently, the price of the futures contract is associated more with the price of the expected cheapest deliverable variety than with the price of the par‐delivery variety. The delivery specifications introduce a delivery risk for every hedger in the market. We derive the optimal hedging strategies in these markets. Their hedging effectiveness is evaluated for wheat futures contracts in Chicago. Hedging optimally would have significantly reduced the variance of the rates of return on hedges while yielding similar mean returns.

Explaining Forward Exchange Bias…Intraday

Published: 09/01/1995   |   DOI: 10.1111/j.1540-6261.1995.tb04061.x

RICHARD K. LYONS, ANDREW K. ROSE

Intraday interest rates are zero. Consequently, a foreign exchange dealer can short a vulnerable currency in the morning, close this position in the afternoon, and never face an interest cost. This tactic might seem especially attractive in times of fixed‐rate crisis, since it suggests an immunity to the central bank's interest rate defense. In equilibrium, however, buyers of the vulnerable currency must be compensated on average with an intraday capital gain as long as no devaluation occurs. That is, currencies under attack should typically appreciate intraday. Using data on intraday exchange rate changes within the European Monetary System, we find this prediction is borne out.

Reputation Effects in Trading on the New York Stock Exchange

Published: 05/08/2007   |   DOI: 10.1111/j.1540-6261.2007.01235.x

ROBERT BATTALIO, ANDREW ELLUL, ROBERT JENNINGS

Theory suggests that reputations allow nonanonymous markets to attenuate adverse selection in trading. We identify instances in which New York Stock Exchange (NYSE) stocks experience trading floor relocations. Although specialists follow the stocks to their new locations, most brokers do not. We find a discernable increase in liquidity costs around a stock's relocation that is larger for stocks with higher adverse selection and greater broker turnover. We also find that floor brokers relocating with the stock obtain lower trading costs than brokers not moving and brokers beginning trading post‐move. Our results suggest that reputation plays an important role in the NYSE's liquidity provision process.

Diagnostic Expectations and Credit Cycles

Published: 09/26/2017   |   DOI: 10.1111/jofi.12586

PEDRO BORDALO, NICOLA GENNAIOLI, ANDREI SHLEIFER

We present a model of credit cycles arising from diagnostic expectations—a belief formation mechanism based on Kahneman and Tversky's representativeness heuristic. Diagnostic expectations overweight future outcomes that become more likely in light of incoming data. The expectations formation rule is forward looking and depends on the underlying stochastic process, and thus is immune to the Lucas critique. Diagnostic expectations reconcile extrapolation and neglect of risk in a unified framework. In our model, credit spreads are excessively volatile, overreact to news, and are subject to predictable reversals. These dynamics can account for several features of credit cycles and macroeconomic volatility.

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.

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.

Is Proprietary Trading Detrimental to Retail Investors?

Published: 02/02/2018   |   DOI: 10.1111/jofi.12609

FALKO FECHT, ANDREAS HACKETHAL, YIGITCAN KARABULUT

We study the conflict of interest that arises when a universal bank conducts proprietary trading alongside its retail banking services. Our data set contains the stock holdings of every German bank and those of their corresponding retail clients. We investigate (i) whether banks sell stocks from their proprietary portfolios to their retail customers, (ii) whether those stocks subsequently underperform, and (iii) whether retail customers of banks engaging in proprietary trading earn lower portfolio returns than their peers. We present affirmative evidence for all three questions and conclude that proprietary trading can, in fact, be detrimental to retail investors.