RESEARCH INTERESTS:

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

Curriculum Vitae

WORKING PAPERS:

13. Interest Rate Risk and Bank Hedging (with Zhiguo He, Arvind Krishnamurthy)

Coming soon [bibtex] [slides]

Abstract: How do banks hedge their business risk due to interest rate fluctuations, which naturally drive both cash-flow risk and discount rate risk simultaneously? To answer this question we build a model where a bank’s profitability is determined by the spreads on its loans and deposits, while its balance sheet growth is governed by equity and deposit flows, both of which depend on interest rates. Furthermore, the balance sheet growth is also affected by a maximum leverage ratio — defined using either accounting-based or market-based measures — imposed by a regulator. Interest rate movement affects the tightness of this leverage constraint through its impact on profitability, on balance-sheet growth, and even on the (endogenous) discounted value of bank equity. Ultimately, a bank’s optimal hedging strategy stabilizes the marginal value of cash for bank equity. On one hand, a bank would like to allocate an additional dollar to the state with higher interest rate if that state has a greater profitability and/or a higher balance sheet growth, which concerns the cash-flow effect. However, that state is also with a higher discount rate, and the optimal hedging policy trades off these two discount and cash-flow effects. We show that a bank optimally hedges away the entire interest rate risk — so that the resulting equity value is independent of interest rate — when its deposit rate beta, loan rate beta, and deposit growth beta are zero. Otherwise, the bank retains some optimal net exposure to interest rate risk, aiming to stabilize its leverage ratio to avoid regulatory intervention versus exploiting a shifting investment opportunity set driven by the interest rate environment.

12. Refinancing Frictions, Mortgage Pricing and Redistribution (with David Berger, Joe Vavra, Fabrice Tourre)

Reject & Resubmit Journal of Political Economy [bibtex] [slides] [short slides]

Abstract: There are large cross-sectional differences in how often US borrowers refinance mortgages. In this paper, we develop a tractable equilibrium mortgage pricing model that allows us to explore the consequences of this heterogeneity. We show that equilibrium forces imply important cross-subsidies from borrowers who rarely refinance to those who refinance often. Mortgage reforms can potentially reduce these regressive cross-subsidies, but the equilibrium effects of these reforms can also have important distributional consequences. For example, many policies which lead to more frequent refinancing lead to higher equilibrium mortgage rates and reduce residential mortgage credit access for a large number of borrowers.

11. Asset heterogeneity in OTC markets

[bibtex] [slides]

Abstract: A cross-section of assets of heterogenous and stochastic characteristics is traded via a dealer-intermediated OTC. Liquidity shocked holders are subject to asset-specific holding costs (either assumed or induced by boundary conditions) and naturally want to sell assets to buyers who are not liquidity shocked but have holding limits. Under costly random search, market prices (and thus volatility), liquidity and volume are jointly determined in equilibrium. The equilibrium is unique, and can feature a new form of intermediation (“asset exchanges”) between holders of different assets when the natural buying capacity of investors on the sideline is too small. Considering holding costs that are linked to asset volatility via haircuts in collateralized borrowing, a feedback loop between the volatility of asset prices and holding costs arises, amplifying price volatility. Cross-margining can improve asset prices and reduce volatility by weakening this link. Finally, the model delivers a reason why firms want to issue heterogenous instead of homogenous bonds as they lead to a more efficient allocation of cross-sectional liquidity.

PUBLISHED & FORTHCOMING PAPERS:

10. A Theory of Cash Flow-Based Financing with Distress Resolution (with Barney Hartman-Glaser, Simon Mayer)

Accepted at Review of Economic Studies [bibtex] [slides] [short slides]

(Previously circulated under the title: “A Theory of Asset- and Cash Flow-Based Financing”)

Abstract: We develop a dynamic contracting theory of asset- and cash flow-based financing that demonstrates how firm, intermediary, and capital market characteristics jointly shape firms’ financing constraints. A firm with imperfect access to equity financing covers financing needs through costly sources: an intermediary and retained cash. The firm’s financing capacity is endogenously determined by either the liquidation value of assets (asset-based) or the intermediary’s going-concern valuation of the firm’s cash flows (cash flow-based). The optimal contract is implemented with defaultable debt — specifically unsecured credit lines and senior-secured debt — and features risk-sharing via bankruptcy. When the firm does well, it repays its debt in full. When it does poorly, distress resolution mirrors U.S. bankruptcy procedures (Chapter 7 and 11). Secured and unsecured debt are complements because risk-sharing via unsecured debt increases secured debt capacity. Debt and equity are dynamic complements because future access to equity financing increases current debt capacity.

9. Optimal Mortgage Refinancing with Inattention (with David Berger, Joe Vavra, Fabrice Tourre)

Accepted at American Economic Review: Insights [bibtex]

Abstract: We build a model of optimal fixed-rate mortgage refinancing with fixed costs and inattention and derive a new sufficient statistic that can be used to measure inattention frictions from simple moments of the rate gap distribution. In the model, borrowers pay attention to rates sporadically so they often fail to refinance even when it is profitable. When paying attention, borrowers optimally choose to refinance earlier than under a perfect attention benchmark. Our model can rationalize almost all errors of “omission” (refinancing too slowly) and a large fraction of the errors of “commission” (refinancing too quickly) previously documented in the data.

8. Mortgage Prepayment and Path-Dependent Effects of Monetary Policy (with David Berger, Joe Vavra, Fabrice Tourre)

American Economic Review (2021), 111(9): 2829-2878 [bibtex] [slides]

Abstract: How much ability does the Fed have to stimulate the economy by cutting interest rates? We argue that the presence of substantial debt in fixed-rate, prepayable mortgages means that the ability to stimulate the economy by cutting interest rates depends not just on their current level but also on their previous path. Using a household model of mortgage prepayment matched to detailed loan- level evidence on the relationship between prepayment and rate incentives, we argue that recent interest rate paths will generate substantial headwinds for future monetary stimulus.

7. A Model of Safe Asset Determination (with Zhiguo He, Arvind Krishnamurthy)

Winner Best Paper Award, Utah Winter Finance Conference 2018

American Economic Review (2019), 109(4): 1230-1262 [bibtex] [slides] [internet appendix]

(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) 

Review of Financial Studies (2018), 31(3): 852-897 [bibtex] [old slides] [internet appendix]

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 and 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.

OTHER PUBLICATIONS:

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.

WORK IN PROGRESS:

Multiple equilibria in bond default models (with Zhiguo He, Fabrice Tourre)

ORGANIZED CONFERENCES:

Link to NBER Spring 2019 Asset Pricing Program

Link to FTG Chicago 2018 Program

Link to NBER Summer Institute 2015 Asset Pricing Program

Link to FTG Chicago 2014 Program

DISCUSSIONS:

Short-Term Debt and Incentives for Risk-Taking

by Marco Della Seta, Erwan Morellec, Francesca Zucchi

AFA Atlanta 2019 [discussion]

Long-Term Finance and Investment with Frictional Asset Markets

by Julian Kozlowski

UCSB LAEF 2018 [discussion]

Monetary Easing, Investment, and Financial Instability

by Viral Acharya and Guillaume Plantin

Bank of Portugal Conference Lisbon 2017 [discussion]

A Dynamic Theory of Mutual Fund Runs and Liquidity Management

by Yao Zeng

Utah Winter Finance Conference 2017 [discussion]

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]