Working Papers
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.
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)
Accepted, Management Science
2018 SFS Cavalcade North America; 2019 American Finance Association Annual Meeting; 2020 Financial Intermediation Research Society Annual Meeting (Canceled); 2020 European Finance Association Annual Meeting
We study the impact of the Patient Protection and Affordable Care Act (PPACA, or Obamacare) on firm employment and performance using hand-collected firm-level employee health insurance data. PPACA is associated with a significant increase in health insurance premia for employees in company-sponsored health insurance plans. We show theoretically and empirically that employers with higher employee coverage on their health insurance plans prior to the PPACA reduce enrollment in these plans after the law was enacted. In addition, the reduction in employer-sponsored health insurance plan enrollment is more pronounced for employers that used to offer basic, low cost health insurance plans to their employees. We also find suggestive evidence that firms reduce enrollment by shifting their employment composition from full-time employees to part-time, temporary, or seasonal workers, who are not covered in employer-sponsored health insurance plans. We do not find any evidence of deterioration in performance at companies that were more exposed to PPACA.
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 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.
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.
Put Credit Rating Agency's Money Where Its Mouth Is (With Alexei Tchistyi)
2022 Finance Theory Group Spring Meeting; 2023 American Finance Association Annual Meeting (Scheduled)
We derive an optimal compensation contract that incentivizes a credit rating agency (CRA) to exert effort and issue unbiased ratings. The contract rewards CRA when its credit rating is matched by the subsequent bond performance and penalizes it otherwise. The optimal contract can be implemented by giving CRA options to buy bonds or credit default swaps. In a competitive environment, the contract is part of a procurement auction. Our empirical findings show that the credit rating industry remains problematic. Compared to incumbent CRAs, new entrants are consistently issuing more favorable ratings and are willing to rate more CMBS tranches.
Efficiency or Resiliency? Choosing between Operational and Financial Hedging (With Viral Acharya, Heitor Almeida, Yakov Amihud)
2021 ASSA Annual Meeting; 2021 China International Finance Conference; 2021 University of Connecticut Finance Conference Keynote Address; 2023 American Finance Association Annual Meeting (Scheduled)
We propose that firms face two potential defaults: Financial default on their debt obligations and operational default such as a failure to deliver on obligations to customers. Hence, firms with limitations on outside financing substitute between saving cash for financial hedging to mitigate financial default risk, and spending on operational hedging, which mitigates operational default risk. Whereas corporate financial hedging increases in leverage, operational hedging declines in leverage. This results in a positive relationship between operational spread (markup) and financial leverage or credit risk, which is stronger for firms with financing difficulty. We present empirical evidence supporting this relationship.
Executive Pay-for-Performance Sensitivity and Stochastic Volatility (With Shuaiyu Chen, Yan Liu)
2022 SFS Cavalcade Asia (Scheduled)
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
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.