christopher hennessy | professor of finance | london business school

my research interest is in assessing the meaning and content of empirical tests. a good way to assess "credibility" is to create a model laboratory and mimic the tests performed by empiricists in seemingly-ideal settings free of the types of noise found in econometrics texts and argued about obsessively in seminars. what are we actually learning from the accumulation of all this "credible evidence"-- even that achieving the "gold standard" of randomization? my goal is to clearly articulate challenges to the present-day state-of-the-art one by one by way of parable economies, with some agents being employed as econometricians who exploit ideal randomized evidence.

theory-based empirical testing and theory of empirical testing

Double-blind RCTs are viewed as the gold standard in eliminating placebo effects and identifying non-placebo physiological effects. Expectancy theory posits that subjects have better present health in response to better expected future health. We show that if subjects Bayesian update about efficacy based upon physiological responses during a single-stage RCT, expected placebo effects are generally unequal across treatment and control groups. Thus, the difference between mean health across treatment and control groups is a biased estimator of the mean non-placebo physiological effect. RCTs featuring low treatment probabilities are robust: Bias approaches zero as the treated group measure approaches zero.

even if randomization is granted, how severe are biases due to dynamic policy uncertainty? we offer analytically tractable formulae for bias signs/probabilities. we also derive a set of identifying assumptions for correct causal effect signs and magnitudes. the assumption of unanticipated permanent shocks is neither necessary nor sufficient. a weaker condition, martingale policy, is necessary and sufficient.

evidence from randomization is contaminated by ex post endogeneity if it is used to set policy endogenously in the future. measured effects depend on objective functions into which experimental evidence is fed and prior beliefs over the distribution of parameters to be estimated. endowed heterogeneous effects generates endogenous belief heterogeneity making it difficult/impossible to recover causal effects. observer effects arise even if agents are measure zero, having no incentive to change behavior to influence outcomes. 

empiricists analyzing corporate responses to tax reforms have been forced to rely on comparative statics from constant tax rate models--which do not speak to the data generating processes being exploited. such comparative statics exercises predict large symmetric responses to tax rate changes. to fill the theoretical void we solve analytically a dynamic model of optimal leverage in which the tax rate follows a two-state markov chain. in this setting, corporations are more responsive to tax rate increases than to decreases. in simulations of ideal diff-in-diff estimation, the known-to-be-false null that taxes do not matter, cannot be rejected roughly half the time. further, regression coefficients decline even as tax-induced deadweight losses rise as we increase bankruptcy cost parameters. this is another paper illustrating the probable problem of false-falsification and the non-obvious interpretation of coefficients. it is premature to reach consensus regarding tax effects.

tobin's q, debt overhang and corporate investment, journal of finance, 2004 [Brattle Prize]
how to take myers (1977) to the data. what regressor does the theory imply?

debt dynamics, journal of finance, 2005 [Brattle Prize], with Toni Whited
illustrates the false-falsification of trade-off theory by running mimicking regressions using a simulated trade-off theoretic firm 

how costly is external financing: evidence from a structural estimation, journal of finance, 2007 [Brattle Prize], with Toni Whited
simulated moment estimation. investment-cash flow sensitivity non-mono in financing costs. economic meaning of constraint proxies.

testing q theory with financing frictions, 2007, journal of financial economics, with toni whited
extending hayashi (ecma, 1982) to incorporate mm violations. how far can we get analytically? functional form assumptions needed?

repeated signaling and firm dynamics, 2010, review of financial studies, with Dima Livdan
how to take a least-costly separating equilibrium (one equilibrium in myers-majluf) to the data. endogenous financing and investment.

model before measurement, 2012, critical finance review (invited essay)
attempts to clarify what the hennessy-whited papers said and meant: we don't know the true theory, if there is one, but verbally plausible arguments are no way to assess what theory predicts about the dynamic behavior of leverage ratios and investment rates.

theories of optimal capital structure and security design

can the tradeoff theory explain debt structure?, review of financial studies, 2007, with dirk hackbarth and hayne leland
optimal debt structure places bank senior to public debt to max flexible debt capacity with junior public debt featuring standard tradeoff.

why does financial structure vary with macroeconomic conditions?, journal of monetary economics, 2007, with amnon levy
ge model with agency problems creating ceiling on leverage and floor on equity stake so internal equity drives dynamics.

taxation, agency conflicts, and the choice between callable and convertible debt, journal of economic theory, 2008, with yuri tserlukevich
stochastic differential game with instantaneous volatility choice and infinite sequence of levered recaps. "modern" extension of green (1984)

debt, bargaining, and credibility in firm-supplier relationships, journal of financial economics, 2009, with dima livdan
debt is bargaining tool depleting bilateral firm-supplier bilateral surplus ex ante, but this compresses the set of credible implicit contracts ex post.

acquisition values and optimal financial inflexibility, journal of financial economics, 2010, with uli hege
there is a cost for incumbent in keeping deep pockets, as it encourages entry for buyout. empty pockets my deter entry but also leaves you defenseless if entry occurs.

a theory of debt market illiquidity and leverage cyclicality, review of financial studies, 2011, with josef zechner
kyle-type debt trading with endogenous uninformed trading. a liquid debt market enables large debt stakes, facilitating ex post renegotiation. multiple equilibria.

skin in the game and moral hazard, journal of finance, 2014, with gilles chemla
bank hidden effort ex ante and hidden information ex post. optimal retentions feature common min jr stake (pooling) or menu of jr stakes (separating).

kyle meets security design (tractable). what way of packaging cash flow minimizes expected trading losses and carrying costs if the uninformed hit with liquidity shocks and trade endogenously? the theory predicts multiple tranches with senior being more liquid. in contrast to claims on corporate cash flows, in abs markets, more senior claims are in fact more liquid, consistent with the theory.

learning and leverage dynamics in general equilibrium, 2016, forthcoming, review of finance
ge setting with tradeoff theoretic firms optimizing in economy with unobserved "disaster" risk. with rational bayesian learning we should expect leverage run-up during great moderations, and sharp reactions to disaster realizations. these are not a priori evidence in favor of government interventions or irrationality.

government as borrower of first resort, 2016, forthcoming, journal of monetary economics
government debt siphons off uninformed demand for corporate debt, reducing endogenous gains to informed trading, lowering info quality and potentially pruning pooling at high debt or increasing welfare in the event of such pooling.