(New) Feedback effect and Agency problems   with Jesse Davis (Draft coming soon)

Abstract: Financial markets reveal information which firm managers utilize to increase shareholder value, e.g., by improving the quality of investment projects undertaken. In the presence of risky debt, however, these investment decisions are not necessarily socially efficient.  We show that investors' endogenous information acquisition attenuates risk shifting but amplifies debt overhang. Investors acquire more information regarding more inefficient cases of risk-shifting; the increased feedback lessens risk-shifting's impact. However, when debt overhang is possible, investors acquire less information about more efficient projects, minimizing the feedback effect. Our model provides a novel channel through which financial markets impact agency frictions between firm stakeholders.

(New) Funding constraints and Informational Efficiency  with Sergei Glebkin and John Kuong (Draft coming soon)

Abstract: We develop a tractable REE model with general portfolio constraints. In application, we study the effect of endogenous margin constraints on information efficiency and identify a novel amplification mechanism. A small negative wealth shock tightens margin constraint which reduces incentives to acquire information. Prices become less informationally efficient and more volatile. Higher price volatility increases margins, further reducing information acquisition incentives and information efficiency. This information spiral exacerbates the effect of wealth shocks on price informativeness, risk premium and volatility. Our model uncovers a new, information-based rationale why the equity capital of investors is important and derive some testable empirical implications. 

When Transparency Improves, Must Prices Reflect Fundamentals Better? with Snehal Banerjee and Jesse Davis, Conditionally accepted at Review of Financial Studies

Abstract: To ensure asset prices better reflect fundamentals, public policy often aims to improve access to information. We show that such policy can be counterproductive. We study the optimal decision of arbitrageurs who choose to learn about asset fundamentals and the intensity of feedback trading by others, subject to an information capacity constraint. Making learning easier, even if exclusively about fundamentals, can make prices less efficient. In fact, when investors' information capacity is sufficiently high, we show that increasing this capacity further always decreases efficiency. Providing public information directly, either about fundamentals or about other traders, can have a similar effect.


Rational Inattention, Misallocation, and Asset Prices
2016 Cubist Systematic Strategies Award at WFA
Abstract: I develop a highly tractable general equilibrium model in which firms face attention constraints, and study the effect of rational inattention on misallocation, asset prices and real quantities. I allow for two types of uncertainty, firm-specific and economywide. Managers have a finite information processing capacity to reduce uncertainty about these two types of shocks. An increase in aggregate uncertainty leads to a reallocation of capacity from learning about firm-specific shocks to learning about the aggregate state, leading to higher misallocation of resources across firms and lower output. An increase in idiosyncratic uncertainty has the converse effect and results in an economic expansion. My model delivers testable predictions regarding the degree of aggregate resource misallocation, the relation between uncertainty and output, and the comovement of production inputs and stock prices across firms, which I confirm in the data.

Coordination Risk and Limits to arbitrage

Abstract: Why doesn't price move back to the fundamental value after a non-fundamental demand/supply shock? In this paper, I present a model in which all the rational arbitragers know that the asset is mis-priced and still are not willing to exploit it. I argue that investors have to coordinate and invest to push price back to the fundamental. I allow heterogeneous opportunity costs in the standard dynamic global games. Because of the information asymmetry about the opportunity cost of other investor, each investor invests less than the optimal. But over time, they learn about others' opportunity costs endogenously (through trading volume) and invest more which brings back the price to fundamental level. This leads to delayed arbitrage. Additional testable implications on the delay are also suggested.

Optimal Debt Maturity and Refinancing risk - A Dynamic model, with Jesse Davis (in progress)


Naveen Reddy,
Apr 13, 2017, 5:36 AM