Abstract:  We study a dynamic moral hazard setting where the manager has private evidence that predicts the firm’s cash flows. Bad-news disclosure is rewarded by a lower borrowing cost relative to the no-evidence case, while no disclosure leads to higher borrowing costs. Given a capital structure, disclosure reduces the firm’s de-fault risk by lowering its pay-for-performance sensitivity. However, disclosure may lower both firm value and managerial rents at the financing stage, as it induces a reduction in the firm’s initial liquidity. The model reconciles the empirical evidence on the causes and effects of providing earnings guidance, especially for loss firms.

Abstract:  Classical security design papers equate competitive capital markets to securities being fairly priced in expectation. We revisit Nachman and Noe’s (1994) adverse selection setting, modeling capital market competition as free entry of investors and allowing firms to propose prices for their securities, as happens in private securities placements and bank lending. We identify equilibria in which high types issue underpriced debt, which yields positive expected profits to uninformed lenders, while low types issue steeper securities, such as equity. In addition, pooling equilibria exist in which all firms issue underpriced debt. Introducing pre-existing capital structures provides further foundations for pecking-order theories of external finance.

Abstract:  We show that in the limited-commitment framework of Donaldson et al. (2019), firm value always increases in the fraction of cash flows that can be pledged as collateral. That is, pledgeability increases investment efficiency and relaxes a firm’s financing constraint. We derive this conclusion using the same contracts considered by the authors and generalize the result to an arbitrary number of states. We also show that the first best can always be implemented by a non state-contingent secured debt contract, which differs from the ones they consider.

Abstract:  We consider a model of external financing in which entrepreneurs are privately informed about the quality of their projects and seek funds from competitive financiers. The literature restricts attention to monotonic, or “manipulation proof,” securities and finds that straight debt is the uniquely optimal contract. Monotonicity is commonly justified by the argument that it would endogenously arise if the entrepreneur can window dress the realized earnings before contract maturity. We explicitly characterize the optimal contracts when entrepreneurs engage in window dressing and/or output diversion and derive necessary and sufficient conditions for straight debt to be optimal. Contrary to conventional wisdom, debt is often suboptimal, and it is never uniquely optimal. Optimal contracts are non-monotonic and induce profit manipulation in equilibrium. They can be implemented as performance-sensitive debt.

Abstract: We study the impact of political risk on exchange rates. We focus on the Brexit Referendum as it provides a natural experiment where both ex- change rate expectations and a time-varying political risk factor can be measured directly. We build a simple portfolio model which predicts that an increase in the Leave probability triggers a depreciation of the British Pound, both on account of exchange rate expectations and of political risk. We estimate the model for multilateral and bilateral British Pound exchange rates. The results confirm the model’s main implications. 

Abstract: We show that short-term debt in a firm’s optimal capital structure reduces investment under asymmetric information. Investors’ interpretation of underinvestment as a positive signal about the quality of the assets in place allows the equity holders to profit from short-term debt repricing at the rollover stage. Thus, underinvestment is more pronounced at shorter maturities, in contrast to Myers (1977). Low types' incentives to mimic put an endogenous constraint on high types' underinvestment payoff via a duration floor. Perhaps most strikingly, because cash lowers the duration floor, an increase in a firm’s retained earnings can decrease investment.

Abstract: We show that demandable debt provides an effective solution to the leverage ratchet effect without requiring any additional information beyond that assumed in the existing literature. Demandable debt-holders have an option to request full repayment of debt at any time. If the firm's leverage exceeds its target debt ratio, debt-holders will exercise their option and sell this excess debt back to the firm. This mechanism efficiently disciplines the firm to maintain the target debt ratio, except under extreme negative shocks leading to inevitable bankruptcy. Furthermore, we show that as the model's time intervals shorten, the firm can asymptotically achieve the full tax shield benefits without incurring any bankruptcy risk.

Abstract:  We develop a theory that explains why banks are optimally designed to have fragile liabilities, consisting in runnable deposits, and opaque assets, the value of which is privately observed by the bank itself. We show that fragility and opacity are jointly necessary to implement efficient, second-best allocations in the presence of asymmetric information between borrowers and lenders. Specifically, opacity and fragility work together to prevent banks from facing a soft budget constraint problem whenever the credit market is sufficiently risky. In contrast, more transparent intermediaries, such as fintech lenders, dominate bank lending whenever the credit market is sufficiently safe. Our new channel for why opacity and fragility are central in banking activities generates novel, testable implications, and overturns standard intuition from existing models prevalent in the banking literature.

Abstract:  Does competition for equity capital influence dividend policies? This paper examines this question using the historical setting of the 1862 Companies Act in the United Kingdom. The Act, for the first time, allowed firms to incorporate with limited liability without Parliamentary approval, triggering an unprecedented wave of joint-stock company entries. We show that this surge intensified competition for capital and led incumbent firms to raise dividends. Dividend yields and payout initiations increased, particularly in areas with greater entry potential. Dividends thus emerged as strategic signals in the contest for capital, linking financial markets and corporate policies. Using recent data from US equity markets, we find suggestive evidence that similar forces might continue to play a significant role in shaping present payout policies.

Abstract:  We show in a two-sided asymmetric information problem of bilateral trade that the first-best outcome obtains as the unique equilibrium when outcomes are observable and verifiable ex post. The allocation of control rights in a corporate takeover game is efficient even when the firm is entirely owned by its manager. The optimal solution features the inclusion of equity earnouts in the contract, which is widely observed in takeover deals. Further, the prediction of our model is consistent with empirical evidence which suggests that the target shareholders retains the full value created from the transaction, while the acquirer's returns are typically close to zero.

Abstract:  We consider an economy with dynamic adverse selection and public, non-contractible news. We show that the full-information first-best allocation can be implemented by including simple return and buy-back options into spot sale contracts. When the signal never fully reveals the underlying private information to the uninformed party, we show that it can be used as a coordination device which enables to screen informed agents and achieve separation at the initial stage. That is, strikingly, the signal’s correlation with private information is critical for implementation even though uninformed agents never learn any information from it. The model is applied to a buyer-seller environment, and can rationalize the pervasive use of return options in retail contracts among online or remote retailers.

Abstract:  We show that the real effects of creditor rights critically depend on the degree of lender competition. To do this, we introduce both lender market power and limited pledgeability of cash flows in an otherwise standard moral hazard problem. The degree of competition does not affect entry at the extensive margin, or the optimality of issuing debt. However, the extent of competition affects the intensive margin. Specifically, with competing lenders, creditor rights relax a firm's financing constraint, inducing higher firm value. In sharp contrast, with market power, creditor rights can reduce both effort and firm value, while increasing lender profit. This lender-competition channel can reconcile the limited, or even negative, effects of creditor rights reforms in developing economies.

Abstract:  In a classical durable-good monopoly environment, we construct mechanisms that implement static monopoly profits while being renegotiation proof. We derive two main results. First, if collective bargaining can be ruled out, then a long-term contract can generate a coordination failure which prevents renegotiation and fully restores monopoly power. Second, with arbitrary renegotiation, a long-term (smart) contract can introduce an asymmetry of information between sellers and potential buyers, which prevents the monopolist from reselling at lower prices. The smart contract approximately achieves static monopoly profits. When the low-valuation customer values the good close to its marginal cost and the discount rate is close to one, the static monopoly allocation can be uniquely implemented, closing the discontinuity between the 'gap' and the 'no-gap' cases.

Abstract: We provide theoretical foundations for positive lender profits in competitive credit markets with asymmetric information, where potential borrowers have scarce collateralizable assets. Strikingly, when some borrowers have negative net present value projects, an equilibrium always exists in which lenders make positive profits, despite their lack of ‘soft’ information and free entry of competitors. We then establish that greater access to collateral for borrowers reduces lender profits, and we relate our findings to the empirical evidence on micro-credit, payday lending, and, more broadly, retail and small business financing.

Abstract: We show that when borrowers are privately informed about their creditworthiness and lenders have a soft budget constraint, efficient investment requires a limit on the fraction of a firm’s cash flows that can be pledged to outsiders. That is, pledgeability should neither be too low nor too high. An increase in pledgeability, or, more broadly, creditor rights, can either promote re-investment in zombie firms, which increases other firms’ cost of capital, or it can lead to inefficient under-investment, depending on the composition of equilibrium credit demand. Thus, greater pledgeability can reduce net social surplus, and even trigger a Pareto loss.

Abstract: I introduce heterogeneous degrees of transparency in a standard costly-state-verification model. I show that the optimal capital structure can be implemented by a simple mixture of debt and equity. Optimal leverage decreases with profitability (both past and expected), in contrast to most competing theories -- such as trade-off models. When firms can choose their degree of transparency at a cost, the model delivers a theory about the decision to go public.

Abstract: We study momentum and its predictability within equities listed at the London Stock Exchange (1820-1930). At the time, this was the largest and most liquid stock market and it was thinly regulated, making for a good laboratory to perform out-of-sample tests. Cross-sectionally, we find that the size and market factors are highly profitable, while long-term reversals are not. Momentum is the most profitable and volatile factor. Its returns resemble an echo: they are high in long- term formation portfolios, and vanish in short-term ones. We uncover momentum in dividends as well. When controlling for dividend momentum, price momentum loses significance and profitability. In the time-series, despite the presence of a few momentum crashes, dynamically hedged portfolios do not improve the performance of static momentum. 

Abstract: We study a costly-state-verification model with limited commitment. We characterize the optimal amount of strategic default and micro-found the frequency with which default turns into bankruptcy, as opposed to triggering an out-of-court restructuring.

Abstract:  This paper derives conditions under which the introduction of a third-party agent solves the renegotiation-proofness problem of Moore and Repullo (1988)-type mechanisms, without introducing the potential for other agents to collude with the third-party. The key novelties of our mechanism are: (i) the introduction of a third-party agent only off-equilibrium and with some probability; (ii) the fact that both its existence and its identity are unknown to the other agents. We show that under these conditions, which are satisfied in many empirical applications, a hidden third-party agent can restore the implementation of the efficient allocation. If this agent does not observe the state of the world, we provide a sufficient condition for implementation to succeed.