Research Interests: Financial Economics, Liquidity, Asset Pricing & Corporate Finance under Frictions
Dynamic Debt Maturity (with Zhiguo He)
Abstract: We study a dynamic setting in which a firm chooses its debt maturity structure endogenously over time without commitment. In our model, the firm keeps its promised outstanding bond face-values constant, but can control the firm’s maturity structure via the fraction of newly issued short-term bonds when refinancing its matured long-term and short-term bonds. As a baseline, we show that when the firm’s cash-flows are constant then it is impossible to have the shortening equilibrium in which the firm keeps issuing short-term bonds and default consequently. Instead, when the cash-flows deteriorate over time so that the debt recovery value is affected by the endogenous default timing, then a shortening equilibrium with accelerated default can emerge. Self-enforcing shortening and lengthening equilibria exist, and the shortening equilibrium may be Pareto-dominated by the lengthening one.
Quantifying Liquidity and Default Risks of Corporate Bonds over the Business Cycle (with Hui Chen, Rui Cui, Zhiguo He)
Abstract: We develop a structural credit risk model with time-varying macroeconomic risks and endogenous liquidity frictions. The model not only matches the average default probabilities, recovery rates, and average credit spreads for corporate bonds across different credit ratings, but also can account for bond liquidity measures including Bond-CDS spreads and bid-ask spreads across ratings. We propose a novel structural decomposition scheme of the credit spreads to capture the interaction between liquidity and default risks in corporate bond pricing, and find that these interaction terms account for about 25%∼40% of observed credit spreads. As an application, we use this framework to quantitatively evaluate the effects of liquidity-provision policies for the corporate bond market, and do a time-series decomposition from 1994 onwards
Maturity Rationing and Collective Short-Termism (with Martin Oehmke)
Forthcoming in Journal of Financial Economics
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
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
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
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)
A Model of the Reserve Asset (with Zhiguo He, Arvind Krishnamurthy)
Link to FTG Chicago 2014 Program below under Subpages