Working Papers
Automated Market Making and Liquidity Provision in Prediction Markets (With Zhan Pang)
2026 Wabash River Finance Conference
We model an automated market maker's liquidity as the price of information. Under the logarithmic market scoring rule the market maker pays that liquidity, in expectation, for each unit of entropy a trader resolves. Bearing that subsidy and valuing the accuracy the trade delivers, the market maker prices as a monopsonist: a deeper liquidity buys more information but raises the bill on every unit, so it marks the liquidity down below the marginal value it places on accuracy. Under sequential arrival, free entry decides how much the market learns, and need not reward early arrival when the market opens where the information acquisition barely covers its cost through trading.
Put Credit Rating Agency's Money Where Its Mouth Is (With Zhan Pang, Alexei Tchistyi)
Revise and Resubmit, Management Science
2022 Finance Theory Group Spring Meeting; 2023 American Finance Association Annual Meeting
We derive an optimal compensation contract that incentivizes credit rating agency (CRA) to exert effort and issue unbiased ratings. Modeling the regulator’s distress cost as a general convex function, we show that under a standard noise-density monotonicity condition, the optimal contract is a single-threshold payment rule. Under the optimal contract, CRA is not paid directly. Instead, CRA is given an opportunity to profit from its superior knowledge about future bond performance. The optimal contract can be implemented through a clearinghouse-mediated chooser option on credit default swaps: the issuer pays an upfront premium to the clearinghouse, which assigns CRA the right to choose between selling and buying default protection on the rated bond. In a competitive environment, the contract is part of a procurement auction. We also solve the problem of minimizing the worst-case transfer (the min-max case), which we prove to be a limiting case of the convex distress-cost objective.
Rare Disaster Information Paradox (With Peter DeMarzo and Alexei Tchistyi)
2022 American Finance Association Annual Meeting; 2022 SFS Cavalcade North America
This paper studies optimal contracting in a two-dimensional moral hazard environment, in which an agent with limited liability could increase the firm profit by exerting costly hidden effort and/or gambling on rare disaster. In addition, he can privately learn about the likelihood of the disaster state. When the disaster outcome results in sufficiently high losses, private learning by the agent lowers the principal's expected payoff and makes disaster outcome more likely compared to the case in which such information acquisition is not possible. This result holds even if the signal about the disaster likelihood is public. Our paper demonstrates a rare disaster information paradox: More information hurts the principal and makes the disaster outcome more likely. Our model generates a number of novel policy implications with respect to risk management.
A Model of Capital Structure Under Labor Market Search
2018 SFS Cavalcade North America; 2018 Wabash River Finance Conference; 2019 Finance Theory Group Summer School; 2020 Midwest Finance Association Annual Meeting
I develop a competitive search equilibrium model of capital structure and labor outcomes. In the model, employers design capital structures and compete for workers subject to idiosyncratic productivity shocks and labor search frictions. The capital structure policy reflects the trade-off between the “strategic benefit" of debt in wage bargaining and the cost of debt in labor hiring. The model generates rich comparative static implications regarding the impacts of productivity, credit and labor market factors on leverage and labor outcomes. A calibration yields a large wage dispersion and a highly elastic labor market tightness with respect to productivity.
The Private and Social Cost of Equity-Maximizing Debt Policy (with Tim Johnson, Chelsea Yu)
(Previously titled: The Private and Social Value of Capital Structure Commitment)
2018 UBC Winter Finance Conference; 2018 SFS Cavalcade North America; 2018 Western Finance Association Annual Meeting; 2018 North Finance Association Annual Meeting
We analyze dynamic models of capital structure and asset prices in general equilibrium when managers follow equity maximizing debt policies. The model permits us to quantify both the private cost to firms of being unable to achieve firm-value maximization and the aggregate welfare cost due to increased default risk. Our setting encompasses time-varying economic conditions, as well as valuation under generalized preferences. The model provides an explanation for the procyclical use of unprotected debt: the cost to firms of the contracting friction increases in bad times. Likewise, expropriation incentives rise when firm valuations are low. Hence, without constraints on debt polices, leverage can be countercyclical, which amplifies the effect of excess debt on aggregate risk. In our baseline calibration, the social cost of unprotected debt is equivalent to 25% of the representative agent's income. This cost can exceed the private cost by a factor of two or more, and excess cyclicality accounts for half of the social cost.
The Contract Year Phenomenon in the Corner Office: An Analysis of Firm Behavior During CEO Contract Renewals (With Yuhai Xuan)
Minnesota Corporate Finance Conference; Drexel 8th Annual Academic Conference on Corporate Governance; 2015 Red Rock Finance Conference; 2016 American Finance Association Annual Meeting
Many CEOs of corporate America have fixed-term contracts that are subject to renewal at the end of the term. This paper finds large impacts of the career-related incentives created by those fixed-term contracts on firms’ behavior.
Executive Pay-for-Performance Sensitivity and Stochastic Volatility (With Shuaiyu Chen, Yan Liu)
2022 SFS Cavalcade Asia
This paper studies, both theoretically and empirically, the optimal executive compensation when firm performance is a noisy signal of executive’s hidden effort and the volatility of firm performance is stochastic. We build a tractable dynamic principal-agent model and show analytically that pay-for-performance sensitivity (PPS) decreases in both short-run and long-run components of volatility, but the mechanisms are different:1) the short-run volatility directly affects the effort level implemented by the optimal contract, and 2) the long-run volatility affects PPS through its impact on firm value sensitivity to the short-run volatility. Using the short-run and long-run volatilities estimated from stock option data, we find evidence supporting the model’s implications: while both short-run and long-run volatilities are negatively correlated with PPS, firm operating performance, a direct outcome of executive effort in our model, ONLY decreases with the short-run volatility. Our paper highlights the importance, as well as the intricacies, of stochastic volatility in executive compensation design.
Publications, Forthcoming and Conditionally Accepted Papers
Corporate resiliency and the choice between financial and operational hedging (With Viral Acharya, Heitor Almeida, Yakov Amihud)
(Previously titled: Efficiency or Resiliency? Choosing between Operational and Financial Hedging)
Conditionally Accepted, Journal of Financial and Quantitative Analysis
We investigate how firms manage financial default risk (on debt obligations) and operational default risk (on delivery obligations). Financially constrained firms reduce operational hedging through adjustments to inventory and supply chains in favor of cash holdings. Thus, firms’ markup increases with financial default risk because they cut operational hedging costs. We show that markup–credit risk relationship strengthens during adverse aggregate shocks, and that markup reacted more strongly to credit risk for firms that became financially constrained when they were shocked in 2008 Financial Crisis. This relationship, reflecting firms’ strategic adjustments in operational hedging practices, is unexplained by managerial entrenchment and market power.
How Does Health Insurance Affect Firm Employment and Performance? Evidence from Obamacare (With Heitor Almeida, Yuhai Xuan, Ruidi Huang)
(Previously titled: The Impact of Obamacare on Firm Employment and Performance: Theory and Evidence)
Forthcoming, Management Science
This paper studies how mandating employers to provide health insurance of a minimum quality and the associated increases in health insurance premia affect firm employment and performance. Using firm-level employee health insurance data around the passage of the Patient Protection and Affordable Care Act (PPACA), we show that the PPACA is associated with a significant increase in health insurance premia for employees in company-sponsored health insurance plans. In response, employers with greater exposure to the PPACA reduce employee enrollments in their health insurance plans to a larger extent after the law’s enactment. Our analysis suggests that employers achieve this reduction in enrollment by shifting employment composition from full-time employees to part-time, temporary, or seasonal workers, who are not covered in employer-sponsored health insurance plans. Furthermore, we find no evidence of deterioration in performance at companies more exposed to the increase in health insurance premia. Overall, our findings illustrate how firms adapt to and mitigate cost increases associated with regulatory changes through strategic labor practices.
Journal of Accounting Research 51, 165-200
Trading commissions from mutual funds comprise a large share of revenues of brokerage firms. We conjecture that this business tie between mutual funds and brokerage firms might create perverse incentive for the analysts to bragging the stocks heavily held by their mutual fund clients. Data on mutual fund commissions posit a major challenge for this research. We overcome the data restriction by using a unique data set that discloses brokerage firms’ commission income derived from each mutual fund client as well as the shareholdings of these mutual funds. The empirical results confirm our conjecture. We uncover an important yet previously overlooked incentive problem in the sell-side equity research industry.
Journal of Banking and Finance 33, 1144-1155
China’s vibrant and fast expanding commercially oriented economy and Government-controlled banking sector provide a leading counter-example to ‘‘law-finance-growth” theories (La Porta, Lopez-de-Silanes, Shleifer and Vishny). This paper is the result of our examination of this paradox using World Bank survey data.