Published: 03/18/2019 | DOI: 10.1111/jofi.12769
We analyze the contribution to price discovery of market and limit orders by high frequency traders (HFTs) and nonHFTs. While market orders have a larger individual price impact, limit orders are far more numerous. This results in price discovery occurring predominantly through limit orders. HFTs submit the bulk of limit orders and these limit orders provide most of the price discovery. Submissions of limit orders and their contribution to price discovery fall with volatility due to changes in HFTs’ behavior. Consistent with adverse selection arising from faster reactions to public information, HFTs' informational advantage is partially explained by public information.
Published: 03/18/2019 | DOI: 10.1111/jofi.12770
This paper studies optimal contracts when managers manipulate their performance measure at the expense of firm value. Optimal contracts defer compensation. The manager's incentives vest over time at an increasing rate, and compensation becomes very sensitive to short‐term performance. This generates an endogenous horizon problem whereby managers intensify performance manipulation in their final years in office. Contracts are designed to encourage effort while minimizing the adverse effects of manipulation. We characterize the optimal mix of short‐ and long‐term compensation along the manager's tenure, the optimal vesting period of incentive pay, and the dynamics of short‐termism over the CEO's tenure.
Published: 03/18/2019 | DOI: 10.1111/jofi.12771
We examine the importance of cross‐sectional asset pricing anomalies (alphas) for the real economy. We develop a novel quantitative model of the cross‐section of firms that features lumpy investment and informational inefficiencies, while yielding distributions in closed form. Our findings indicate that anomalies can cause material real inefficiencies, which raises the possibility that agents that help eliminate them add significant value to the economy. The model shows that the magnitude of alphas alone is a poor indicator of real outcomes, and highlights the importance of the alpha persistence, the amount of mispriced capital, and the Tobin's q of firms affected.
Published: 02/27/2019 | DOI: 10.1111/jofi.12765
Most extant structural credit risk models underestimate credit spreads – a shortcoming known as the credit spread puzzle. We consider a model with priced stochastic asset risk, that is able to fit medium‐ to long‐term spreads. The model, augmented by jumps to help explain short‐term spreads, is estimated on firm‐level data and identifies significant asset variance risk premia. An important feature of the model is the significant time‐variation in risk premia induced by the uncertainty about asset risk. Various extensions are considered, among them optimal leverage and endogenous default.
Published: 02/26/2019 | DOI: 10.1111/jofi.12766
This paper studies the asset pricing implications of a firm's opportunities to replace routine‐task labor with automation. I develop a model in which firms optimally undertake such replacement when their productivity is low. Hence, firms with routine‐task labor maintain a replacement option that hedges their value against unfavorable macroeconomic shocks and lowers their expected returns. Using establishment‐level occupational data, I construct a measure of firms' share of routine‐task labor. Compared to their industry peers, firms with a higher share of routine‐task labor (i) invest more in machines and reduce more routine‐task labor during economic downturns, and (ii) have lower expected stock returns.
Published: 02/20/2019 | DOI: 10.1111/jofi.12761
A risk‐averse entrepreneur with access to a profitable venture needs to raise funds from investors. She cannot indefinitely commit her human capital to the venture, which limits the firm's debt capacity, distorts investment and compensation, and constrains the entrepreneur's risk‐sharing. This puts dynamic liquidity and state‐contingent risk allocation at the center of corporate financial management. The firm balances mean‐variance investment efficiency and the preservation of financial slack. We show that in general the entrepreneur's net worth is overexposed to idiosyncratic risk and underexposed to systematic risk. These distortions are greater the closer the firm is to exhausting its debt capacity.
Published: 02/17/2019 | DOI: 10.1111/jofi.12764
We develop a general equilibrium model of informational interdependence between financial markets and the real economy, linking economic uncertainty to information production and aggregate economic activities. The mutual learning between financial markets and the real economy creates a strategic complementarity in their information production, leading to self‐fulfilling surges in economic uncertainties. In a dynamic setting, our model characterizes self‐fulfilling uncertainty traps with two steady‐state equilibria and a two‐stage economic crisis in transitional dynamics.
Published: 02/13/2019 | DOI: 10.1111/jofi.12756
I show that venture capitalists' motivation to build reputation can have beneficial effects in the primary market, mitigating information frictions and helping firms IPO. Because uninformed reputation‐motivated VCs want to appear informed, they are biased against backing firms—by not backing firms, they avoid taking low‐value firms to market, which would ultimately reveal their lack of information. In equilibrium, reputation‐motivated VCs back relatively few bad firms, creating a certification effect that mitigates information frictions. However, they also back relatively few good firms, and, thus, reputation motivation decreases welfare when good firms are abundant or profitable.