Research

Credit Ratings: Strategic Issuer Disclosure and Optimal Screening, with Jonathan Cohn and Uday Rajan, Review of Finance, forthcoming.

We consider a model in which a security issuer can manipulate information observed by a credit rating agency (CRA). We show that stricter screening by the CRA can sometimes lead to increased manipulation by the issuer.  Accounting for the issuer's behavior pulls optimal CRA screening towards the extremes of laxness or stringency. Surprisingly, an improvement in prior asset quality can result in more rating errors. In a two-period version of the model, stricter screening can result in more short-run rating errors. Our results suggest complex interplay between issuer and CRA behavior, complicating the evaluation of CRA policy effectiveness.

Lying to Speak the Truth: Selective Manipulation and Improved Information Transmission, with Paul Povel, Journal of Finance, 2024, Vol. 79 (6), pp. 4303-4352.

We analyze a principal-agent model in which an effort-averse agent can manipulate a publicly observable performance report. The principal cannot observe the agent's cost of effort, her effort choice, and whether she manipulated the report. An optimal contract links compensation to the realized output and the (possibly manipulated) report. Manipulation can be beneficial to the principal because it can make the report more informative about the agent's effort choice, thereby reducing the agent's information rent. This is achieved through a contract that incentivizes the agent to selectively engage in manipulation based on her effort choice.

Online Appendix

Rational Disposition Effects: Theory and Evidence, with Daniel Dorn, Journal of Banking & Finance, 2023, Vol. 153, 106858.

The disposition effect is a longstanding puzzle in financial economics. This paper demonstrates that it is not intrinsically at odds with rational behavior. In a rational expectations model with asymmetrically informed investors, trading strategies as predicted by the disposition effect can arise as an optimal response to dynamic changes in the information structure. The model predicts that the disposition behavior of uninformed investors weakens after events that reduce information asymmetries. The data, trading records of 50,000 clients at a German discount brokerage firm from 1995 to 2000, are consistent with this prediction.

A Theory of Procyclical Market Liquidity, Journal of Economic Dynamics and Control, 2022, Vol. 138, 104326.

This paper presents a theory of liquidity cycles based on endogenous fluctuations in economic activity and the availability of informed capital. Risky assets are illiquid due to adverse selection. The degree of adverse selection and hence the liquidity of these assets depends on the endogenous information structure in the market. Liquidity provision is modeled as a repeated game with imperfect public monitoring. We construct a trigger-strategy equilibrium along the lines of Green and Porter (1984) that is characterized by stochastic fluctuations in liquidity. Liquidity is procyclical in our economy. Periods of economic growth are associated with more liquid asset markets.

Transparency and Talent Allocation in Money Management, with Simon Gervais, Review of Financial Studies, 2020, Vol. 33 (8), pp. 3889-3924.

We construct and analyze the equilibrium of a model of delegated portfolio management in which money managers signal their investment skills via fund transparency. To lower the costs of transparency, high-skill managers rely on their performance to separate from low-skill managers over time. In contrast, medium-skill managers rely on transparency to separate, especially when it is difficult for investors to tell them apart through performance alone. Low-skill managers mimic high-skill managers in opaque funds, hoping to replicate their performance and compensation. The model yields several novel empirical predictions that contrast transparent and opaque funds.

Online Appendix

The Economics of Solicited and Unsolicited Credit Ratings, with Paolo Fulghieri and Han Xia, Review of Financial Studies, 2014, Vol. 27 (2), pp. 484-518.

This paper develops a dynamic rational expectations model of the credit rating process, incorporating three critical elements of this industry: (i) the rating agencies' ability to misreport the issuer's credit quality, (ii) their ability to issue unsolicited ratings, and (iii) their reputational concerns. We analyze the incentives of credit rating agencies to issue unsolicited credit ratings and the effects of this practice on the agencies' rating strategies. We find that the issuance of unfavorable unsolicited credit ratings enables rating agencies to extract higher fees from issuers by credibly threatening to punish those that refuse to acquire a rating. Also, issuing unfavorable unsolicited ratings increases the rating agencies' reputation by demonstrating to investors that they resist the temptation to issue inflated ratings. In equilibrium, unsolicited credit ratings are lower than solicited ratings, because all favorable ratings are solicited; however, they do not have a downward bias. We show that, under certain conditions, a credit rating system that incorporates unsolicited ratings leads to more stringent rating standards. 

Stock-Based Managerial Compensation, Price Informativeness, and the Incentive to Overinvest, Journal of Corporate Finance, 2014, Vol. 29, pp. 594-606 (Special Issue on Corporate Finance Theory). 

This paper investigates the relationship among a firm's managerial incentive scheme, the informativeness of its stock price, and its investment policy. It shows that the shareholders' concerns about the effectiveness of stock-based compensation can lead to overinvestment. However, unlike other explanations in the literature, our results are neither caused by suboptimal incentive contracts nor do they rely on the assumption that managers are "empire builders." Rather, overinvestment serves to induce information production by outside investors. By accepting positive and negative NPV projects, a firm effectively increases the market's uncertainty about its cash flow, thereby giving traders more incentives to become informed. 

Publicizing Performance, with Edward Van Wesep, Management Science, 2013, Vol. 59 (4), pp. 918-932.

In most employment relationships, the employee's performance at the firm is privately, not publicly, observed. Firms can reward successful employees by publicizing their abilities, for example via a job title, a glowing letter of recommendation, or a resume-worthy award. Firms that establish reputations for hiring young workers and promoting those who succeed lose good workers to competitors, but can pay less to young, inexperienced workers in exchange. We find in a general equilibrium setting that firms with reputations for publicizing performance are able to pay less to employees at every level of tenure and thus earn economic profit, but that these firms will never be the most productive in the economy. In order for such equilibria to exist, the worker-firm match must be important, suggesting that this practice takes place only in human-capital intensive industries.

Earnings Manipulation and the Cost of Capital, Journal of Accounting Research, 2013, Vol. 51 (2), pp. 449-473.

The widespread use of accounting information by investors and financial analysts to help value stocks creates an incentive for managers to manipulate earnings in an attempt to influence short-term stock price performance. This paper examines the role of earnings management in affecting a firm's cost of capital. Using an agency model with multiple firms whose cash flows are correlated, we demonstrate that the extent of earnings manipulation varies across the business cycle. Depending on a firm's earnings profile, it can have stronger incentives to overstate its performance in good times or in bad times. Because of this dependence on the state of the economy, earnings manipulation can influence a firm's cost of capital despite the forces of diversification.

Large Shareholder Trading and the Complexity of Corporate Investments, with Eitan Goldman, Journal of Financial Intermediation, 2013, Vol. 22 (1), pp. 106-122.

This paper investigates how the presence of a large institutional shareholder affects the complexity of corporate investments. Our analysis is based on the observation that the blockholder's planning horizon does not necessarily coincide with the time it takes for the market to correctly evaluate these investments. It demonstrates that this horizon mismatch creates an incentive for the large shareholder to manipulate the firm's stock price. In equilibrium, corporate managers respond to these manipulation attempts by increasing the complexity of their investments. This in turn lowers the large shareholder's incentive to collect costly information, which reduces price informativeness and exacerbates managerial myopia. Thus, our analysis identifies a new cost of block ownership resulting from an increased complexity of corporate investments.

Relative Wealth Concerns and Complementarities in Information Acquisition, with Diego Garcia, Review of Financial Studies, 2011, Vol. 24 (1), pp. 169-207.

This paper studies how relative wealth concerns, in which a person's satisfaction with their own consumption depends on how much others are consuming, affect investors' incentives to acquire information. We find that such externalities can generate complementarities in information acquisition within the standard rational expectations paradigm. When agents are sensitive to the wealth of others, they herd on the same information, trying to mimic each other's trading strategies. We show that there can be multiple herding equilibria in which different communities pursue different information acquisition strategies. This multiplicity of equilibria generates price discontinuities: an infinitesimal shift in fundamentals can lead to a discrete price movement.

Bank Capital Regulation with Random Audits, with Sudipto Bhattacharya, Manfred Plank, and Josef Zechner, Journal of Economic Dynamics and Control, 2002, Vol. 26 (7-8), pp. 1301-1321.

We consider a model of optimal bank closure rules (cum capital replenishment by banks), with Poisson-distributed audits of the bank's asset value by the regulator, with the goal of eliminating (ameliorating) the incentives of levered bank shareholders/managers to take excessive risks in their choice of underlying assets. The roles of (tax or other) subsidies on deposit interest payments by the bank, and of the auditing frequency are examined.

Trade Versus Time Series Based Volatility Forecasts: Evidence from the Austrian Stock Market, with Alfred Lehar and Martin Scheicher, Financial Markets and Portfolio Management, 2001, Vol. 15, pp. 500-515.

This paper compares commonly used predictors for the volatility of stock returns. The techniques studied are Moving Averages of squared returns, GARCH and Stochastic Volatility models, and the implied volatility. We perform this evaluation for the Vienna market, which has low liquidity compared to other exchanges in Europe, North America or Asia. We use a variety of econometric criteria to assess the forecasting performance. Our primary result is that the ranking of the models strongly depends on which criterion is chosen. Among the models we estimate, no clear winner emerges. The implied volatility is found to contain information which is absent in time series based forecasts. We discuss possible explanations for these results. Based on our findings we suggest practical consequences for the purpose of derivatives valuation and risk management.