Competitive Investors Research Articles

A novel state-transition forest: pricing corporate securities with intertemporal exercise policies and corresponding capital structure changes

While ordinary options are wholly exercised at a chosen time to maximize holders' benefits, empirical evidence favors the intertemporal exercise of corporate securities such as convertible bonds and executive/employee stock options. This is because the exercises of these securities can dilute the issuers' equity, inject capital into the issuers' assets, and change the capital structures, which influences the exercise payoffs and the remaining security values. However, the literature simplifies these impacts on exercise policies, leading to biased and even irrational pricing results. We address this via a state-transition forest that partitions the securities into k units and the time span of the forest into n steps. A representative holder can exercise an integral multiple of units at different steps to maximize her benefit, given that the lump sum of the exercise units does not exceed k. It can be further extended to model intertemporal exercises conducted by competitive investors who hold too-small amounts of securities to influence prices. The forest is then composed of k + 1 trees to capture transitions among capital structures due to different lump sums of option exercise units. The intertemporal exercise decision at each forest node is optimally determined by recursively solving the Bellman equation. This carefully designed forest structure reduces the running time complexity from to . We show that ignoring or simplifying intertemporal exercises and corresponding dilutions/injections significantly influences pricing results.

Screening and Monitoring Corporate Loans

We study a dynamic moral hazard problem in which a bank originates a pool of loans that it sells to competitive investors via securitization. The bank controls the default risk of the loans by screening at origination and monitoring after origination, but it is subject to moral hazard. The optimal contract between the bank and investors can be implemented via a time-decreasing stake within the loan pool, so the bank's monitoring incentives decrease and default risk increases over time. We find that screening and monitoring have positive incentive synergies and are complements. Credit ratings distort incentives, potentially increasing credit risk, and are particularly beneficial for high quality and short-maturity loans.

Information Spillovers in Sovereign Debt Markets

We develop a theory of information spillovers in primary sovereign bond markets where governments raise funds from a common pool of competitive in-vestors who may acquire information about default risk and later trade in sec-ondary markets. Strategic complementarities in information acquisition lead to the co-existence of an informed regime with high yields and high volatility, and a Pareto-dominant uninformed regime with low yields and low volatility. Small shocks to default risk in a single country may trigger information acquisition, retrenchment of capital flows, and sharp yield increases within and across coun-tries. Competitive secondary markets strengthen information acquisition incen-tives, raise primary market yields, and amplify spillovers.

Financing Capacity Investment Under Demand Uncertainty: An Optimal Contracting Approach

We study the capacity choice problem of a firm whose access to capital is hampered by financial frictions (i.e., moral hazard). The firm optimizes both its capacity investment under demand uncertainty and its sourcing of funds from a competitive investor. Ours is the first study of this problem to adopt an optimal contracting approach: feasible sources of funds are derived endogenously from fundamentals and include standard financial claims (debt, equity, convertible debt, etc.). Thus, in contrast to most of the literature on financing capacity investments, our results are robust to a change of financial contract. We characterize the optimal capacity level under optimal financing. First, we find conditions under which a feasible financial contract exists that leads to the first-best capacity. When no such contract exists, we find that under optimal financing, the choice of capacity sometimes exceeds strictly the efficient level. Furthermore, the firm invests more when its cash is low, and in some cases less when the project’s unit revenue is high. These results run counter to the newsvendor logic and standard finance arguments. We also show that our main results hold in the case of a strategic monopolist investor, and such an investor may invest more then a competitive one. The online appendix is available at https://doi.org/10.1287/msom.2017.0671 . This paper has been accepted for the Manufacturing & Service Operations Management Special Issue on Interface of Finance, Operations, and Risk Management.

Properties of optimal accounting rules in a signaling game

We characterize the properties of optimal accounting rules in a signaling game. An impatient firm sells shares to competitive investors. The firm can signal its private information about the fundamental by retaining a fraction of the shares. In addition, the firm can commit to disclosing information according to a set of accounting rules chosen ex ante. Information disclosure reduces signaling cost so that perfect disclosure is optimal. When perfect disclosure is impossible, the optimal accounting rule features a lower bound and a summary statistic of the fundamental. The interpretation of the lower bound is consistent with accounting conservatism, and the statistic summarizes the information most relevant to the firm׳s valuation. The justification for accounting conservatism relies on the existence of information asymmetry and the infeasibility of perfect accounting disclosure. This is consistent with the conjecture of LaFond and Watts (2008) that information asymmetry calls for accounting conservatism.

Optimal Debt Bias in Corporate Income Taxation

I present a rationale for a government to discriminate between debt and equity financing when taxing corporate income. For risk-averse entrepreneurs, equity generates more surplus than debt, because it provides financing and insurance. A government seeking to extract surplus from entrepreneurs would naturally tax equity-generated income more than debt-generated income. I also establish a less obvious reason why the government might want to extract surplus from entrepreneurs. It is well understood that when the quality of projects is unobservable to investors, risk-averse entrepreneurs with higher-return projects might retain a larger share of equity to signal their type (Leland and Pyle (1977)). I show that in such an adverse selection set-ting, while competitive investors are constrained to offer actuarially fair terms, the government can use taxes to discriminate between types. This degree of freedom allows manipulation of the relevant incentive constraints so that a lower level of debt suffices for separation, and an increase in overall efficiency can be obtained. Since entrepreneurs separate along their debt-to-equity ratios, the optimal non-linear tax schedule to achieve the desired discrimination is isomorphic to one that taxes debt-generated income at a lower rate than equity-generated income.

Turkey’s Strategic Economic Relations with Africa: Trends and Challenges

The Ottoman Empire had extensive economic relations with Africa which provides the structural frameworks for the speedy acceleration of economic partnership and trade interactions between Africa and modern Turkey. This study seeks to examine the structural relevance, challenges and prospects of Turkey’s economic relations and interest in Africa from the traditional period of Ottoman Empire to the contemporary era of competitive interdependence. From a broad perspective, trade interactions between Turkey was driven but the values of economic pluralism and less of colonialist tendencies. Therefore, the greatest challenge that tacitly limits the geometric expansion of trade is the shift in perception of Africa as a hub for disease, economic stagnation, waste and wars. This form of stereotype is a direct input of neo-colonial propaganda adopted by the Western media to keep at bay competitive investors from Africa. So, Africa with an economic growth rate of over 5% offers Turkey new horizon for economic diversification. The consistent use of soft power by Turkey has brought new image and perception of Turkey as a credible economic partner with pragmatic approach promote symbiotic trade relations devoid of the manipulative devices of free market syndrome that benefits only the West at the detriment of Africa. Africa sees Turkey as an economic partner that will assist the continent to intensify the industrialization of its economic base in line with the global economic configuration. Therefore, Turkey-Africa economic partnership and trade volume is likely to expand in future because Turkey’s opening to Africa has created new markets and investment potential that will increase Africa’s participation in global economy and enhance Turkey’s role as a major player in the politics of resource allocation in the international economic system.

Optimal Debt Bias in Corporate Income Taxation

I present a rationale for a government to discriminate between debt and equity financing when taxing corporate income. For risk-averse entrepreneurs, equity generates more surplus than debt, because it provides financing and insurance. A government seeking to extract surplus from entrepreneurs would naturally tax equity-generated income more than debt-generated income. I also establish a less obvious reason why the government might want to extract surplus from entrepreneurs. It is well understood that when the quality of projects is unobservable to investors, risk-averse entrepreneurs with higher-return projects might retain a larger share of equity to signal their type (Leland & Pyle (1977)). I show that in such an adverse selection setting, while competitive investors are constrained to offer actuarially fair terms, the government can use taxes to discriminate between types. This degree of freedom allows manipulation of the relevant incentive constraints so that a lower level of debt suffices for separation, and an increase in overall efficiency can be obtained. Since entrepreneurs separate along their debt-to-equity ratios, the optimal non-linear tax schedule to achieve the desired discrimination is isomorphic to one that taxes debt-generated income at a lower rate than equity-generated income.

An Institutional Theory of Momentum and Reversal

We propose a rational theory of momentum and reversal based on delegated portfolio management. A competitive investor can invest through an index fund or an active fund run by a manager with unknown ability. Following a negative cashflow shock to assets held by the active fund, the investor updates negatively about the manager's ability and migrates to the index fund. While prices of assets held by the active fund drop in anticipation of the investor's outflows, the drop is expected to continue, leading to momentum. Because outflows push prices below fundamental values, expected returns eventually rise, leading to reversal. Fund flows generate comovement and lead-lag effects, with predictability being stronger for assets with high idiosyncratic risk. We derive explicit solutions for asset prices, within a continuous-time normal-linear equilibrium.

A mathematical treatment of bank monitoring incentives

In this paper, we take up the analysis of a principal/agent model with moral hazard introduced by Pagès (J. Financ. Intermed. doi: 10.1016/j.jfi.2012.06.001 , 2012), with optimal contracting between competitive investors and an impatient bank monitoring a pool of long-term loans subject to Markovian contagion. We provide here a comprehensive mathematical formulation of the model and show, using martingale arguments in the spirit of Sannikov (Rev. Econ. Stud. 75:957–984, 2008), how the maximization problem with implicit constraints faced by investors can be reduced to a classical stochastic control problem. The approach has the advantage of avoiding the more general techniques based on forward-backward stochastic differential equations described by Cvitanić and Zhang (Contract Theory in Continuous Time Models, Springer 2012) and leads to a simple recursive system of Hamilton–Jacobi–Bellman equations. We provide a solution to our problem by a verification argument and give an explicit description of both the value function and the optimal contract. Finally, we study the limit case where the bank is no longer impatient.

A Mathematical Treatment of Bank Monitoring Incentives

In this paper, we take up the analysis of a principal/agent model with moral hazard, with optimal contracting between a competitive investor and an impatient bank monitoring a pool of long-term loans subject to Markovian contagion. We provide here a comprehensive mathematical formulation of the model and show using martingale arguments in the spirit of Sannikov how the maximization problem with implicit constraints faced by investors can be reduced to a classic stochastic control problem. The approach has the advantage of avoiding the more general techniques based on forward-backward stochastic differential equations and leads to a simple recursive system of Hamilton-Jacobi-Bellman equations. We provide a solution to our problem by a verification argument and give an explicit description of both the value function and the optimal contract. Finally, we study the limit case where the bank is no longer impatient.

Bank monitoring incentives and optimal ABS

Abstract The paper examines a continuous-time delegated monitoring problem between competitive investors and an impatient bank monitoring a pool of long-term loans subject to Markovian “contagion.” Moral hazard induces a foreclosure bias unless the bank is compensated with the right incentive-compatible contract. Fees are paid when the bank’s performance is on target and liquidation arises when the bank’s performance is sufficiently poor. I show that the optimal contract can be implemented with a whole loan sale involving both credit risk retention based on ABS credit default swaps and credit enhancement in the form of a reserve account. The optimal securitization bears out rulemaking recently proposed in the wake of the Dodd-Frank Act on a number of controversial provisions. I argue that further efficiency gains could be reaped by extending the role of the “premium capture” account into a liquidity buffer capturing performance-based compensation as a way of increasing skin in the game over the life of the transaction.

Bank Monitoring Incentives and Optimal Abs

The paper examines a continuous-time delegated monitoring problem between a competitive investor and an impatient bank monitoring a pool of long-term loans subject to Markovian contagion. Moral hazard induces a foreclosure bias unless the bank is compensated with the right incentive-compatible contract. Fees are paid when the bank's performance is on target and liquidation arises when the bank's performance is sufficiently poor. I show that the optimal contract can be implemented with a whole loan sale involving both credit risk retention based on ABS credit default swaps and credit enhancement in the form of a reserve account. The optimal securitization bears out rulemaking recently proposed in the wake of the Dodd-Frank Act on a number of controversial provisions. I argue that further efficiency gains could be reaped by extending the role of the premium capture account into a liquidity buffer capturing performance-based compensation as a way to increase skin in the game over the life of the deal.

Competitive investors, trade timing and price discovery

This study develops a multiple-period, competitive rational expectations model for examining how competitive informed traders time their informed trading and how information is incorporated into prices. It is found that informed traders may choose either to trade early or late on their information, depending on the parameter values of the proposed model. As the mass of informed traders is large and/or the precision of the private information is high, informed traders choose to trade on their information late. Therefore, prices delay reflecting information and market becomes efficiency until the later trading period.

Australian equity mutual fund size effects

AbstractBerk and Green propose a model of a superannuation fund industry, with a limited population of superior fund managers and a competitive investor market. In this market, superior fund managers capture the value they generate, leaving investors with a normal return on their investment. Furthermore, it is argued that previous period returns, age of the fund and management costs explain variation in net cash flow paid into a fund over time. The Berk and Green predictions find some support in empirical tests, reported in the present paper, based on Australian Morningstar retail and wholesale equity fund data over the period 1995–2005.

Reputation and Managerial Truth-Telling as Self-Insurance

We investigate truth-telling by an informed insider, or manager, who repeatedly forecasts cash flows to competitive investors in a standard message game. The insider cannot trade on or sell private information, but faces imperfectly hedgeable nonwage income shocks. When compensation depends on the current stock price, a partially revealing equilibrium may exist in which the manager manipulates his reports, and hence the stock price, to reduce consumption variance. Intuitively, the manager builds reputation in good times when honesty is affordable, and exploits reputation in times of need. Endogenous reputation for honesty thus follows from a self-insurance motive.

Reputation and Managerial Truth‐Telling as Self‐Insurance

We investigate truth‐telling by an informed insider, or manager, who repeatedly forecasts cash flows to competitive investors in a standard message game. The insider cannot trade on or sell private information, but faces imperfectly hedgeable nonwage income shocks. When compensation depends on the current stock price, a partially revealing equilibrium may exist in which the manager manipulates his reports, and hence the stock price, to reduce consumption variance. Intuitively, the manager builds reputation in good times when honesty is affordable, and exploits reputation in times of need. Endogenous reputation for honesty thus follows from a self‐insurance motive.

Australian Equity Mutual Fund Size Effects

The relative performance of small versus large funds has generated some interest in the literature yet there is little empirical evidence to support the existence of superior small fund performance relative to large fund performance. Berk and Green (2004) provide one explanation. They argue that, with a limited population of superior fund managers and a competitive investor market, the superior fund managers capture the value they generate while the funds pay a normal return to their investors. Empirical tests in this paper generally support the Berk and Green (2004) arguments. In particular, tests using Australian Morningstar retail and wholesale equity fund data from 1995 to 2005 identify a positive correlation between previous period returns and asset growth and a negative correlation between asset growth and fund age.

Institutional investors and the information content of earnings announcements: the case of Poland

This paper investigates the relationship between market reaction to earnings surprises and institutional concentration in the firm’s shareholders base. We use data from the Polish stock market where pension funds form a homogenous and highly competitive investor class with an increasing share in the market capitalization and trading volume. We find evidence that higher pension funds’ holding in a company tends to reduce the magnitude of market reaction around public disclosures. We interpret these findings as an information advantage that funds have over individual investors, which may result from scale economies in gathering and processing public information, or access to privileged information in the interim period. We also find that company mangers are selective as to the type of information they provide to the market prior to their scheduled disclosures.

Protecting against Inflation--and Maximizing Yield, by John M. Bragg: Reviewer's Reply

The chief disagreement between Mr. Bragg and me concerns our divergent attitudes about the efficacy of efficient markets theory, and whether or not the costs of an active investment philosophy are more than compensated by the uncertain benefit of abnormal returns. For example, Bragg's of the Economic is dependent on the notion that social psychological moods can be determined, and that a resolute state of social psychology is associated with an optimal portfolio mix which enables investors to maximize yield. My contention with Bragg is not in the accurate gauging of the state of social psychology. In fact, assume that the psychological mood of society can be ascertained. Then the semi-strong version of efficient markets theory would argue that if one investor, or a set of investment experts can sense a mood, and the costs of sensing are low, then other competitive investors must be able to sense a mood as well; therefore, abnormal returns would be non-existent. 1 Certainly the debate between Bragg and me is not new. Since the work on models of equilibrium in capital markets began (Sharpe, 1964; Lintner, 1965; Mossin, 1966), there has been much discussion between advocates of the traditional approach to investment analysis and efficient market theorists. Academic researchers have shown that anomalies such as the small firm effect (Banz, 1981) and the January effect (Keim, 1983) exist, and that markets may not be perfectly efficient. The unresolved question directly related to Bragg's thesis is whether the costs of his active investment strategy are more or less than the benefits of returns in excess of the return on a well-diversified market portfolio; a return that may be obtained with inconsequential transaction costs. If the answer to this question is that the Theory of Economic Series produces superior returns, then one must ask why Bragg would ever let such valuable, proprietary information into the public forum?