Robust Security Design with Uday RajanPresented: European Finance Association (Mannheim, Germany), Northern Finance Association (Halifax, Canada), Corporate Finance Conference (University of Minnesota), The International Monetary Fund (Washington D.C), Finance Theory Group (Imperial College, London), 15th Annual Conference in Financial Economics Research by Eagle Labs (the Arison School of Business, IDC, Herzilia, Israel), 2018 SFS Cavalcade (the Yale School of Management), 2018 Annual Conference on Corporate Finance atWashington University in St. Louis .
Abstract We consider the optimal contract between an entrepreneur and investors in a single-period model when both parties have limited liability, are risk-neutral toward cash flow risk and are ambiguity-averse. Ambiguity aversion is modeled by multiplier preferences for robustness toward model uncertainty, as in Hansen and Sargent (2001). Efficient ambiguity-sharing implies that the first-best contract consists of either convertible debt or levered equity. As is customary, in the second-best contract, moral hazard is alleviated by giving more cash to investors in low cash flow states. Under many settings in our model, the optimal security has an equity-like component in high cash flow states, providing a contrast to the results in Innes (1990). Finally, we derive the optimal contract in which the parties may voluntarily renegotiate the initial contract. We find that convertible debt emerges optimally: the entrepreneur offers risky debt as an initial contract which is later renegotiated to levered equity.
Abstract I derive the optimal capital structure of a firm when its manager is ambiguity-averse. My model predicts substantially lower leverage for such firms, in comparison to traditional static trade-off models. I use the 1982 Voluntary Restraint Agreement (VRA) on steel import quotas between the U.S. government and the European Community as an exogenous reduction in Knightian uncertainty faced by firms in the U.S. steel industry. Using a difference-in-difference methodology, I find that when uncertainty is resolved, a median firm in the U.S. steel industry increases its market and book leverage by approximately 12% relative to a matched control firm from another industry. The results are not explained away by changes in traditional risk factors or by a change in expected future profitability.
Extrapolation Bias and Dynamic Liquidity Management with Alejandro Rivera
Abstract We consider the optimal dynamic liquidity management of a financially constrained firm when its manager is risk-neutral, yet ambiguity-averse toward uncertain future cash-flows. We claim that managers' ambiguity-aversion generates endogenous time-varying beliefs accentuating recent realizations of the cash-flows. It provides a micro-foundation of managers' extrapolation bias. We highlight that managers’ ambiguity-aversion has different effects on firms' liquidity management from risk. Models with risk alone imply higher volatility of cash-flows increase firms' dividend and refinancing thresholds. By contrast, our model predicts when the ambiguity-averse managers face a higher level of long-term cash-flows uncertainty, they optimally reduce the firms' payout and refinancing thresholds.
Abstract I incorporate ambiguity-averse equity-holders who are uncertain about the distribution of a firm’s assets into the dynamic capital structure model of Leland (1994). My model shows the optimal default threshold increases with Knightian uncertainty, whereas it decreases with risk. When the effect of uncertainty dominates that of risk, a firm optimally defaults earlier than predicted by a traditional dynamic model with risk alone. My ambiguity-augmented model predicts substantially lower leverage ratios, in comparison to the benchmark model of Leland (1994).
Work in Progress
Competition and covenants in bank loans with William Mann
We investigate mechanisms by which competition between lenders in good economic conditions can lead to a deterioration in lending standards and loan quality.
Coordination Failures and Blockchain Security with Ing-Haw Cheng
Robust Renegotiation Contract