Financial Economics, Liquidity, Asset Pricing & Corporate Finance under Frictions
[NEW 06/15] A Model of the Reserve Asset (with Zhiguo He, Arvind Krishnamurthy) [bibtex]
[UPDATED 09/15] Dynamic Debt Maturity (with Zhiguo He) [bibtex]
Abstract: A firm chooses its debt maturity structure and default timing dynamically, both without commitment. Via the fraction of newly issued short-term bonds, equity holders control the maturity structure, which affects their endogenous default decision. A shortening equilibrium with accelerated default emerges when cash-flows deteriorate over time so that debt recovery is higher if default occurs earlier. Self-enforcing shortening and lengthening equilibria may co-exist, with the latter possibly Pareto-dominating the former. The inability to commit to issuance policies can worsen the Leland-problem of the inability to commit to a default policy---a self-fulfilling shortening spiral and adverse default policy may arise.
Abstract: A portion of the global wealth portfolio is directed towards a safe and liquid reserve asset, which recently has been the US Treasury bond. Our model links the determination of reserve asset status to relative fundamentals and relative debt sizes, by modeling two countries that issue sovereign bonds to satisfy investors’ reserve asset demands. A sovereign’s debt is more likely to be the reserve asset if its fundamentals are strong relative to other possible reserve assets, but not necessarily strong on an absolute basis. Debt size can enhance or detract from reserve asset status. If global demand for the reserve asset is high, a large-debt sovereign which offers a savings vehicle with better liquidity is more likely to be the reserve asset. If demand for the reserve asset is low, then large debt size is a negative as it carries more rollover risk, leading to a riskier vehicle for saving. When global demand is high, countries may make fiscal/debt- structuring decisions to enhance their reserve asset status. These actions have a tournament feature, and are self-defeating: countries may over-expand debt size to win the reserve asset tournament. Coordination can generate benefits. We use our model to study the benefits of “Eurobonds” – i.e. a coordinated common Europe-wide sovereign bond design. Eurobonds deliver welfare benefits only when they make up a sufficiently large fraction of countries’ debts. Small steps towards Eurobonds may hurt countries and not deliver welfare benefits.
[UPDATED 07/15] Quantifying Liquidity and Default Risks of Corporate Bonds over the Business Cycle (with Hui Chen, Rui Cui, Zhiguo He) [bibtex]
Abstract: By modeling debt rollover and endogenizing holding costs via collateralized financing, we develop a structural credit risk model to examine how the interactions between liquidity and default affect corporate bond pricing. The model captures realistic time variation in default risk premia and the default-liquidity spiral over the business cycle. Across different credit ratings, we simultaneously match the average default probabilities, credit spreads, and bid-ask spreads observed in the data. A structural decomposition reveals that the default-liquidity interactions account for 10∼24% of the observed credit spreads. We apply this framework to evaluate the liquidity-provision policies in the corporate bond market.
Maturity Rationing and Collective Short-Termism (with Martin Oehmke)
Forthcoming in Journal of Financial Economics [bibtex]
Abstract: Financing terms and investment decisions are jointly determined. This interdependence, which links firms’ asset and liability sides, can lead to short-termism in investment. In our model, financing frictions increase with the investment horizon, such that financing for long-term projects is relatively expensive and potentially rationed. In response, firms whose first-best investments are long-term may adopt second-best projects of shorter maturities. This worsens financing terms for firms with shorter-maturity projects, inducing them to change their investments as well. In equilibrium, investment is inefficiently short-term. Equilibrium asset-side adjustments by firms can amplify shocks and, while privately optimal, can be socially undesirable.
Endogenous Liquidity and Defaultable Debt (with Zhiguo He)
Winner Best Paper Award, Utah Winter Finance Conference 2013
Econometrica (2014), 82(4): 1443-1508 [bibtex]
Abstract: This paper studies the interaction between default and liquidity for corporate bonds that are traded in an over-the-counter secondary market with search frictions. Bargaining with dealers determines a bond’s endogenous liquidity, which depends on both the firm fundamental and the time-to-maturity of the bond. Corporate default decisions interact with the endogenous secondary market liquidity via the rollover channel. A default-liquidity loop arises: Assuming a relative illiquid secondary bond market in default, earlier endogenous default worsens a bond’s secondary market liquidity, which amplifies equity holders’ rollover losses, which in turn leads to earlier endogenous default. Besides characterizing in closed form the full inter-dependence be- tween liquidity and default for credit spreads, our calibrated model can jointly match empirically observed credit spreads and liquidity measures of bonds across different rating classes.
The Hazards of Debt: Rollover Freezes, Incentives, and Bailouts (with Ing-Haw Cheng)
Review of Financial Studies (2012), 25(4): 1070-1110 [bibtex]
Abstract: We investigate the trade-off between incentive provision and inefficient rollover freezes for a firm financed with short-term debt. First, debt maturity that is too short-term is inefficient, even with incentive provision. The optimal maturity is an interior solution that avoids excessive rollover risk while providing sufficient incentives for the manager to avoid risk-shifting when the firm is in good health. Second, allowing the manager to risk-shift during a freeze actually increases creditor confidence. Debt policy should not prevent the manager from holding what may appear to be otherwise low-mean strategies that have option value during a freeze. Third, a limited but not perfectly reliable form of emergency financing during a freeze - a “bailout” - may improve the terms of the trade-off and increase total ex-ante value by instilling confidence in the creditor markets. Our conclusions highlight the endogenous interaction between risk from the asset and liability sides of the balance sheet.
Level 3 Assets: Booking Profits, Concealing Losses
Review of Financial Studies (2012), 25(1): 55-95 [bibtex]
Abstract: Fair value accounting forces institutions to revalue their inventory whenever a new transaction price is observed. An institution facing a balance sheet constraint can have incentives to suspend trading in Level 3 assets (traded on opaque over-the-counter markets) to avoid marking-to-market. This way the asset's book valuation can be kept artificially high, thereby relaxing the institution's balance sheet constraint. But, the institution loses direct control of its asset holdings, leading to possible excessive risk exposure. A regulator trying to reign in risk-taking faces ambiguous tools of increasing fines for mismarking and tightening capital requirements: although both make no-trading less like, conditional on no-trading they increase risk-taking. Random audits in general decrease risk-taking. Outside investors, who do not know at what price the asset would trade, reduce their valuation of the bank's balance sheet the longer the asset has not traded. Their expected discount from reported book value is convex in time since last trade.
Work in progress:
Asset Heterogeneity in OTC markets
Cash and Dynamic Agency (with Barney Hartman-Glaser)
Link to FTG Chicago 2014 Program