The Effect of Incomplete Markets on Security Valuation
When agents are unable to insure against idiosyncratic income shocks, they will attempt to self-insure by trading in financial markets. A component of asset demand is therefore related to idiosyncratic factors which will in turn affect equilibrium returns. This research project studies the ability of such models to account for asset market phenomenon which are anomalous from the point of view of the standard frictionless (i.e, full-insurance) model. Important components of the research are the development of computational solution algorithms for decentralized general equilibrium models, examination of Hansen-Jagannathan bounds in incomplete markets economies and, ultimately, characterization of the underlying private information economy which gives rise to the market incompleteness due to moral hazard.
Asset Pricing and Investor Risk Preferences
The asset-pricing kernel is the stochastic process that, given the payoff process, determines the arbitrage-free price of any asset. Knowledge of this kernel, therefore, is central to research on equilibrium asset pricing. Research in this area works toward gaining insights about the pricing of assets in both theoretical models and empirical applications. The problem is addressed from two different directions. One approach is to study this process directly by explicitly modeling the decision problem of investors facing uncertainty. In particular, the research looks at ways of generalizing standard time-additive, expected-utility models to obtain risk preferences that better capture the way investors perceive risky opportunities, and examines the role played by the structure of markets for determining the pricing kernel. This work requires the use of frontier methods in econometrics and computational methods. Another approach is to derive the properties of the pricing kernel indirectly from observed asset-market behavior. Fixed-income securities, for example, provide a wealth of information for this "reverse engineering" approach.
The Valuation Of Mortgage Loans
In the presence of refinancing costs, a borrower's optimal refinancing strategy reflects the immediate refinancing costs incurred upon refinancing, as well as the future benefits and costs expected under a dynamic optimal refinancing policy, where additional refinancing can be advantageous in the future. By constructing a synthetic security that incorporates the present value of the refinancing costs on the optimal path, the optimal refinancing policy is solved while simultaneously valuing the marketed loan. The effect of refinancing costs on the optimal refinancing decision is studied in order to examine the determinants of high premiums on callable debt and the relative pricing of securities with different coupon rates. This research also demonstrates how a mortgage borrower's pre-contract private information about his future moving likelihood influences his choice of mortgage instrument and the resulting mobility and prepayment data and loan pricing. In addition, the relationship among loan contract terms that are robust to the specific information of the borrowers and the assumed interest rate dynamics is characterized.
Tax Effects in the Relative Pricing of Treasury Bonds
For investors with different tax rates, the relative values of treasury bonds will appear different because the after-tax cash flows they obtain from one bond versus another will look dramatically different. For example, where a tax exempt institution or a securities dealer might view two bonds as perfect substitutes, an individual investor might only purchase them at differing prices because of their different tax treatment. Which clientele ends up determining the relative pricing of the bonds then becomes an empirical issue. Research in this area develops econometric methods for discerning the presence of such tax effects in the relative pricing of default-free bonds. The findings show dramatic evidence of a shift in the importance of tax effects in relative pricing around the time of the 1986 Tax Reform in the United States.
Term and Tax Effects in the Pricing of Municipal Bonds
The municipal bond market has always been of special interest to scholars in financial economics, because it affords the chance to observe the pricing of bonds that are very similar to treasuries or corporates, except for their tax treatment. Coupon income on municipals is tax-exempt. Traditional theories predict that the yields on par taxable and tax-exempt bonds should be related in a simple way. The tax-exempt yield should be the taxable yield times one minus the tax rate of a representative investor. This relationship explains the relative pricing of the two types of bonds fairly well for short maturities, but is grossly violated in the data for long maturity bonds. This research provides a simple theory which predicts such behavior as a consequence of taxable investors' attempts to minimize their tax burden in the construction of their portfolios of taxable bonds. The theory is tested using data though the post-war period, and explains the relative yields on taxables and tax exempts quite well.
The Effect of Capital Gains Taxation on the Optimal Trading and Equilibrium Pricing of Financial Assets
Capital gains and losses on financial assets are not taxed until the asset is sold, giving investors the option to time their asset sales so as to minimize the present value of the taxes paid to the government. The first purpose of this research is to investigate the optimal tax-trading policies of investors in the presence of capital gains taxation and transaction costs. The optimal tax-trading policy is characterized by an optimal cutoff level above which all capital gains are deferred and below which all capital gains and losses are realized. The optimal cutoff level depends upon the magnitude of the long-term and short-term capital gains tax rates, the length of the investor's holding period, and length of time before the investor's holding period becomes long-term, and the volatility of the asset. The second purpose of this research is to investigate the equilibrium pricing implications of investors' optimal tax-trading strategies. If the tax-timing option is valuable to investors, then it should be reflected in equilibrium asset prices. The equilibrium prices of financial assets are derived theoretically and tested empirically using methods developed at the Tepper School of Business. The insights learned from this research are being used to develop new insights concerning the optimal management of mutual funds.
Capital Structure And Corporate Control
In modern capitalist corporations, the control over a firm's resources is delegated to a management team which is responsible for day-to-day decisions. Therefore, firm value depends on both managerial ability and incentives to allocate resources to different activities. Consequently, mechanisms that both allocate resources to the best managers and motivate these managers are important. There are both external and internal mechanisms to control a firm's manager. External control refers to the market for corporate control where takeovers take place. Internal control refers to arrangements within the firm, like the control of the board of directors over the management team and other contracts such as covenants that are attached to different securities. Because a firm's capital structure has an important impact on the effectiveness of these control mechanisms, capital structure is driven by control considerations. Specifically, this research agenda includes studying: i) the effects of a firm's capital structure on its position in the market for corporate control; a firm's debt level affects the ability of its management team to fend off takeover attempts, thereby, it affects the likelihood and the price of the takeover, ii) the design of internal control; the allocation of control rights to shareholders, debtholders, and the management team combined with the right amount of debt can be chosen to affect future strategic decisions of the firm, and iii) the design of securities; the optimal allocation of cash flow and voting rights to securities determines the incentives and the ability of incumbent managers to resist value increasing changes in control.
Optimal Bankruptcy Law
The ultimate goal of the bankruptcy research agenda is to characterize an optimal bankruptcy law. There are two types of fundamental considerations that are potentially the main determinants of an optimal bankruptcy law. First, the investment distortion of financially distressed and/or bankrupt firms. Bankruptcy law defines the most important alternative for the manager and the claimants of a firm in financial distress. Therefore, the investment incentives of managers of financially distressed firms, their incentives to initiate and pursue workout negotiations between the firm's various claimants, and all other choices the firm's manager and claimants make in financial distress are dictated by the bankruptcy law. Second, the effects of the bankruptcy law on the choices made by managers of healthy firms that have a non-trivial chance of becoming financially distressed in the future. When managers decide how to allocate a firm's resources, they are concerned with their own position and welfare if and when the firm faces financial difficulties. Different bankruptcy laws will result in different outcomes for managers of financially distressed firms, and, therefore, in different allocations of a firm's resource. As a first step towards the ultimate goal of characterizing an optimal bankruptcy law, a large body of bankruptcy research has been focusing on the implications of existing bankruptcy laws around the world on the behavior of financially distressed and bankrupt firms. For example, this research can provide hypotheses about how financially distressed firms behave under a given bankruptcy law. These hypotheses can than be tested by looking at data on the behavior of financially distressed firms.
The Design Of Financial Markets
This research examines the design of markets for trading financial securities in settings in which traders possess private information. While much of the research in finance examines the properties of asset prices in various contexts, this research program focuses upon the mechanisms for trading assets. For example, the efficiency of selling initial public offerings through a posted price mechanism in conjunction with non-binding pre-play communication and participation restrictions is demonstrated. The role of different features of this trading structure in enforcing the incentives of bidders for the security is also studied. The theory of private information is used to study the organization of security markets, the diverse roles of market-makers, and the basis for restrictions on traders and the market-maker. For example, many of the features of the design of the trading system on the New York Stock Exchange can be viewed from the perspectives of private information and strategic recommitment. An understanding of the rules underlying the financial markets is important for understanding the evolution of prices, the dynamics of behavior in financial markets and the strategies of traders.
The Role Of Limit And Market Orders
Investors trade stocks and other securities using a variety of different types of orders. Two of the most important market orders (unconditional orders to buy or sell at the best available price) and limit orders (conditional orders to buy or sell only at a prespecified price). Thus, market and limit orders represent different trade-offs between execution price (uncertain vs. fixed) and execution probability (certain vs. random). From a market microstructure point of view, market orders demand liquidity from financial markets while limit orders supply it (along with trading by specialists and other market makers with whom they compete). Understanding how uninformed liquidity traders or how insiders with private information might use these orders and how information is revealed to markets by the resulting order flows presents a number of mathematical challenges for theory and is also an area of great interest for empiricists.
Empirical Analyses Of Trading Strategies And Market Equilibrium In A Limit Order Market
This research project focuses upon the empirical determination of investor order strategies and the resulting market equilibrium. Focusing upon the Paris Bourse allows the entire order flow to be captured from a centralized and computerized limit order market. In the first portion of the project, the interaction between the order flow and order book dynamics is analyzed, using descriptive methods to capture the richness of the data. The order flow is concentrated near the quote, while the book is somewhat thinner than at nearby valuations. A variety of informational and liquidity effects are documented in the data. Time priority and timing effects also are studied. The price formation process in which agents provide orders prior to the opening of the market also is being analyzed, along with the use of invisible orders and other strategies to limit price impact and improve order execution prior to the opening of trading and during the trading day.
Risk Premia in Currency Markets
One of the most puzzling features of foreign exchange markets is the tendency for the rate of depreciation on major currencies vis-à-vis the U.S. dollar to be inversely related to the forward premium. Equivalently, countries with relatively high nominal interest rates tend to have currencies that appreciate, thus providing an investor with an additional return premium, above and beyond that offered in money markets. This research examines the extent to which this incremental return premium is attributable to a time-varying risk premium. The project examines both the implications of general equilibrium theory for this risk premium as well as those of standard models of the term structure on interest rates.
The Valuation of Swedish Lottery Bonds
Swedish lottery bonds provide a unique laboratory for evaluating the pricing of idiosyncratic risk. The coupons on these securities are determined by lottery, with a known sampling distribution. Since the lottery risk is by construction idiosyncratic, it can be eliminated by diversification, and should not, according to asset pricing theory, be priced. Moreover, the structure of the lottery allows one to evaluate separately the prices of portfolios that differ only in the amount of lottery risk they bear. Since the bonds are actively traded in secondary markets, the price of this extra idiosyncratic risk can be directly measured. There is clear evidence that it is, in fact, priced, contrary to the predictions of asset pricing theory.