Konstantin W. Milbradt
Associate Professor of Finance
Faculty Research Fellow, NBER

E-mail: milbradt(at)northwestern.edu

Fax: 847.491.5719

Kellogg School of Management
Northwestern University
2001 Sheridan Rd #435 Evanston, IL 60208

Financial Economics, Liquidity, Asset Pricing & Corporate Finance under Financial Frictions

Curriculum Vitae

7. A Model of Safe Asset Determination (with Zhiguo He, Arvind Krishnamurthy)
Revise & Resubmit at American Economic Review [bibtex] [slides]
Previously circulated under the title: “A model of the reserve asset”
Abstract: What makes an asset a “safe asset”? We study a model where two countries each issue sovereign bonds to satisfy investors’ safe asset demands. The countries differ in the float of their bonds and their resources/fundamentals available to rollover debts. A sovereign’s debt is more likely to be safe if its fundamentals are strong relative to other possible safe assets, but not necessarily strong on an absolute basis. Debt float can enhance or detract from safety: If global demand for safe assets is high, a large float can enhance safety. The large float offers greater liquidity which increases demand for the large debt and thus reduces rollover risk. If demand for safe assets is low, then large debt size is a negative as rollover risk looms large. When global demand is high, countries may make fiscal/debt-structuring decisions to enhance their safe asset status. These actions have a tournament feature, and are self-defeating: countries may over-expand debt size to win the tournament. Coordination can generate benefits. The model sheds light on the effects of “Eurobonds” – i.e. a coordinated Euro-area-wide safe 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.

6. Quantifying Liquidity and Default Risks of Corporate Bonds over the Business Cycle (with Hui Chen, Rui Cui, Zhiguo He) [bibtex] [old slides] [internet appendix]
Conditionally Accepted at Review of Financial Studies
Abstract: We develop a structural credit risk model to examine how the interactions between default and liquidity affect corporate bond pricing. The model features debt rollover and bond-price dependent holding costs for illiquid corporate bonds. Both over the business cycle and in the cross section (across ratings), our model does a good job matching the average default rates and credit spreads in the data, and it captures important variations in bid-ask spreads and bond-CDS spreads. A structural decomposition reveals that the default-liquidity interactions can account for 10% to 24% of the level of credit spreads and 16% to 46% of the changes in spreads over the business cycle. We also apply our framework to evaluate the impact of liquidity frictions on the aggregate costs of corporate bond financing and the impact of liquidity-provision policies for the bond market.

5. Dynamic Debt Maturity (with Zhiguo He)
Review of Financial Studies (2016), 29(10): 2677-2736 [bibtex] [slides]
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.

4. Maturity Rationing and Collective Short-Termism (with Martin Oehmke)
Journal of Financial Economics (2015), 118(3): 553-570 [bibtex] [slides]
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.

3. Endogenous Liquidity and Defaultable Debt (with Zhiguo He)
Winner Best Paper Award, Utah Winter Finance Conference 2013
Econometrica (2014), 82(4): 1443-1508 [bibtex] [slides]
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 between 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.

2. The Hazards of Debt: Rollover Freezes, Incentives, and Bailouts (with Ing-Haw Cheng)
Review of Financial Studies (2012), 25(4): 1070-1110 [bibtex] [slides]
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.

1. Level 3 Assets: Booking Profits, Concealing Losses
Review of Financial Studies (2012), 25(1): 55-95 [bibtex] [slides]
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.

What makes US government bonds safe assets? (with Zhiguo He, Arvind Krishnamurthy)
American Economic Review P&P (2016), 106(5): 519-523 [bibtex] [slides]
Abstract: US government bonds are considered to be the world's safe store of value, especially during periods of economic turmoil such as the events of 2008. But what makes US government bonds “safe assets”? We highlight coordination among investors, and build a model in which two countries with heterogeneous sizes issue bonds that may be chosen as safe asset. Our model illustrates the benefit of a large absolute debt size as safe asset investors have “nowhere else to go” in equilibrium, and the large country’s bonds are chosen as the safe asset. Moreover, the effect becomes stronger in crisis periods.

Volatility, volume, and liquidity in OTC markets
Multiple equilibria in bond default models (with Zhiguo He and Fabrice Tourre)
Cash and Dynamic Agency (with Barney Hartman-Glaser)

Link to FTG Chicago 2014 Program
Link to NBER Summer Institute 2015 Asset Pricing Program

A Theory of Operational Risk
by Suleyman Basak and Andrea Buffa
AFA SF 2016 [discussion]

Risk Management Failures
by Matthieu Bouvard and Samuel Lee
AFA SF 2016 [discussion]

Dynamic Adverse Selection: Time-varying Market Conditions and Endogenous Entry
by Pavel Zryumov
MIT Sloan Junior Conference 2015 [discussion]

Benchmarks in Search Markets
by Duffie, Dworczak and Zhu
WFA Seattle 2015 [discussion]

Delegated Investment in a Dynamic Agency Model
by Hoffmann and Pfeil
AFA Boston 2015 [discussion]

Efficient Contracting in Network Financial Markets
by Duffie and Wang
AEA Boston 2015 [discussion]

Dynamic Dispersed Information and the Credit Spread Puzzle
by Albagli, Hellwig and Tsyvinski
NYU Microstructure Conference 2014 [discussion]

On the design of contingent capital with market trigger
by Suresh Sundaresan and Zhenyu Wang
UBC Summer Conference 2012 [discussion]

Endogenous Liquidity Cycles
by Gunter Strobl
19th Mitsui Finance Symposium 2012 [discussion]

A Theory of Bank Liquidity Requirements
by Charles Calomiris, Florian Heider and Marie Hoerova
Federal Reserve Board Liquidity Regulation Meeting 2011 [discussion]

Maturity Rat Race
by Markus Brunnermeier and Martin Oehmke
Bank of Portugal Conference Madeira 2011 [discussion]

Evaporating Liquidity
by Stefan Nagel
AFA Atlanta 2010 [discussion]

Margin-Based Asset Pricing and Deviations from the Law of One Price
by Nicolae Garleanu and Lasse Pedersen
AFA Atlanta 2010 [discussion]

Is Mark-to-Market Accounting destabilizing?
by Heaton, Lucas and McDonald
Carnegie-Rochester Conference 2009 [discussion]

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