• Selected
• Entire List

Abstract:
We construct an equally-weighted index of commodity futures monthly returns over the period between July of 1959 and December of 2004 in order to study simple properties of commodity futures as an asset class. Fully-collateralized commodity futures have historically offered the same return and Sharpe ratio as equities. While the risk premium on commodity futures is essentially the same as equities, commodity futures returns are negatively correlated with equity returns and bond returns. The negative correlation between commodity futures and the other asset classes is due, in significant part, to different behavior over the business cycle. In addition, commodity futures are positively correlated with inflation, unexpected inflation, and changes in expected inflation.

Abstract:
Commodity futures risk premiums vary across commodities and over time depending on the level of physical inventories, as predicted by the Theory of Storage. Using a comprehensive dataset on 31 commodity futures and physical inventories between 1969 and 2006, we show that the convenience yield is a decreasing, non-linear relationship of inventories. Price measures, such as the futures basis ("backwardation"), prior futures returns, and prior spot returns reflect the state of inventories and are informative about commodity futures risk premiums. The excess returns to Spot and Futures Momentum and Backwardation strategies stem in part from the selection of commodities when inventories are low. Positions of futures markets participants are correlated with prices and inventory signals, but we reject the Keynesian "hedging pressure" hypothesis that these positions are an important determinant of risk premiums.

Commodity, Futures, Theory of Storage, Inventories, Backwardation, Hedging Pressure, Futures Trading

Abstract:
Understanding the ongoing credit crisis or panic requires understanding the designs of a number of interlinked securities, special purpose vehicles, and derivatives, all related to subprime mortgages. I describe the relevant securities, derivatives, and vehicles to show: (1) how the chain of interlinked securities was sensitive to house prices; (2) how asymmetric information was created via complexity; (3) how the risk was spread in an opaque way; and (4) how trade in the ABX indices (linked to subprime bonds) allowed information to be aggregated and revealed. These details are at the heart of the origin of the Panic of 2007. The events of the panic are described.

Abstract:
Understanding the ongoing credit crisis or panic requires understanding the designs of a number of interlinked securities, special purpose vehicles, and derivatives, all related to subprime mortgages. I describe the relevant securities, derivatives, and vehicles to show: (1) how the chain of interlinked securities was sensitive to house prices; (2) how asymmetric information was created via complexity; (3) how the risk was spread in an opaque way; and (4) how trade in the ABX indices (linked to subprime bonds) allowed information to be aggregated and revealed. These details are at the heart of the origin of the Panic of 2007. The events of the panic are described.

Abstract:
Understanding the ongoing credit crisis or panic requires understanding the designs of a number of interlinked securities, special purpose vehicles, and derivatives, all related to subprime mortgages. I describe the relevant securities, derivatives, and vehicles to show: (1) how the chain of interlinked securities was sensitive to house prices; (2) how asymmetric information was created via complexity; (3) how the risk was spread in an opaque way; and (4) how trade in the ABX indices (linked to subprime bonds) allowed information to be aggregated and revealed. These details are at the heart of the origin of the Panic of 2007. The events of the panic are described.

Banking panic, securitization, off-balance sheet vehicles, ABX index

Abstract:
The 'shadow banking system' at the heart of the current credit crisis is, in fact, a real banking system – and is vulnerable to a banking panic. Indeed, the events starting in August 2007 are a banking panic. A banking panic is a systemic event because the banking system cannot honor its obligations and is insolvent. Unlike the historical banking panics of the 19th and early 20th centuries, the current banking panic is a wholesale panic, not a retail panic. In the earlier episodes, depositors ran to their banks and demanded cash in exchange for their checking accounts. Unable to meet those demands, the banking system became insolvent. The current panic involved financial firms 'running' on other financial firms by not renewing sale and repurchase agreements (repo) or increasing the repo margin ('haircut'), forcing massive deleveraging, and resulting in the banking system being insolvent. The earlier episodes have many features in common with the current crisis, and examination of history can help understand the current situation and guide thoughts about reform of bank regulation. New regulation can facilitate the functioning of the shadow banking system, making it less vulnerable to panic.

financial crisis, banking panic, Panic of 2007, repo markets

Abstract:
The credit crisis was sparked by a shock to fundamentals, housing prices failed to rise, which led to a collapse of trust in credit markets. In particular, the repurchase agreement market in the U.S., estimated to be about $12 trillion, larger than the total assets in the U.S. banking system ($10 trillion), became very illiquid during the crisis due to the fear of counterparty default, leaving lenders with illiquid bonds that they did not want, believing that they could not be sold. As a result, there was an increase in repo haircuts (the initial margin), causing massive deleveraging. I investigate this indirectly, by looking at the breakdown in the arbitrage foundation of the ABX.HE indices during the panic. The ABX.HE indices of subprime mortgage-backed securities are derivatives linked to the underlying subprime bonds. Introduced in 2006, the indices aggregated and revealed information about the value of the subprime mortgage-backed securities and allowed parties to buy protection against declines in subprime value via credit derivatives written on the index or tranches of the index. When the ABX prices plummeted, the arbitrage relationships linking the credit derivatives linked to the index and the underlying bonds broke down because liquidity evaporated in the repo market. This breakdown allows a glimpse of the information problems that led to illiquidity in the repo markets, and the extent of the demand for protection against subprime risk.

Abstract:
The credit crisis was sparked by a shock to fundamentals, housing prices failed to rise, which led to a collapse of trust in credit markets. In particular, the repurchase agreement market in the U.S., estimated to be about $12 trillion, larger than the total assets in the U.S. banking system ($10 trillion), became very illiquid during the crisis due to the fear of counterparty default, leaving lenders with illiquid bonds that they did not want, believing that they could not be sold. As a result, there was an increase in repo haircuts (the initial margin), causing massive deleveraging. I investigate this indirectly, by looking at the breakdown in the arbitrage foundation of the ABX.HE indices during the panic. The ABX.HE indices of subprime mortgage-backed securities are derivatives linked to the underlying subprime bonds. Introduced in 2006, the indices aggregated and revealed information about the value of the subprime mortgage-backed securities and allowed parties to buy protection against declines in subprime value via credit derivatives written on the index or tranches of the index. When the ABX prices plummeted, the arbitrage relationships linking the credit derivatives linked to the index and the underlying bonds broke down because liquidity evaporated in the repo market. This breakdown allows a glimpse of the information problems that led to illiquidity in the repo markets, and the extent of the demand for protection against subprime risk.

Credit Crisis, Panicof 2007, ABX Index, Repo market

Abstract:
This paper analyzes securitization and more generally special purpose vehicles (SPVs), which are now pervasive in corporate finance. The first part of the paper provides an overview of the institutional features of SPVs and securitization. The second part provides a model to analyze the motivations for using SPVs, and the conditions under which SPVs are sustainable. We argue that a key source of value to using SPVs is that they help reduce bankruptcy costs. Off-balance sheet financing involves transferring assets to SPVs, which reduces the amount of assets that are subject to bankruptcy costs, since SPVs are carefully designed to avoid bankruptcy. Off-balance sheet financing is most advantageous for sponsoring firms that are risky or face large bankruptcy costs. SPVs become sustainable in a repeated SPV game, because firms can implicitly commit to subsidize or bail out their SPVs when the SPV would otherwise not honor its debt commitments, despite legal and accounting restrictions to the contrary.

The third part of the paper tests two key implications of the model using unique data on credit card securitizations. First, riskier firms should securitize more, ceteris paribus. Second, since investors know that SPV sponsors can bail out their SPVs if there is a need, in pricing the debt of the SPV investors will care about the risk of the sponsor defaulting, above and beyond the risk of the SPVs assets. We find evidence consistent with these implications.

Securitization, Special Purpose Vehicles, Bankruptcy, Consumer Credit, Credit Cards

Abstract:
Firms can finance themselves on- or off-balance sheet. Off-balance sheet financing involves transferring assets to "special purpose vehicles" (SPVs), following accounting and regulatory rules that circumscribe relations between the sponsoring firm and the SPVs. SPVs are carefully designed to avoid bankruptcy. If the firm's bankruptcy costs are high, off-balance sheet financing can be advantageous, especially for sponsoring firms that are risky. In a repeated SPV game, firms can "commit" to subsidize or "bail out" their SPVs when the SPV would otherwise not honor its debt commitments. Investors in SPVs know that, despite legal and accounting restrictions to the contrary, SPV sponsors can bail out their SPVs if there is the need. We find evidence consistent with these predictions using data on credit card securitizations.

Abstract:
How did problems with subprime mortgages result in a systemic crisis, a panic? The ongoing Panic of 2007 is due to a loss of information about the location and size of risks of loss due to default on a number of interlinked securities, special purpose vehicles, and derivatives, all related to subprime mortgages. Subprime mortgages are a financial innovation designed to provide home ownership opportunities to riskier borrowers. Addressing their risk required a particular design feature, linked to house price appreciation. Subprime mortgages were then financed via securitization, which in turn has a unique design reflecting the subprime mortgage design. Subprime securitization tranches were often sold to CDOs, which were, in turn, often purchased by market value off-balance sheet vehicles. Additional subprime risk was created (though not on net) with derivatives. When the housing price bubble burst, this chain of securities, derivatives, and off-balance sheet vehicles could not be penetrated by most investors to determine the location and size of the risks. The introduction of the ABX indices, synthetics related to portfolios of subprime bonds, in 2006 created common knowledge about the effects of these risks by providing centralized prices and a mechanism for shorting. I describe the relevant securities, derivatives, and vehicles and provide some very simple, stylized, examples to show: (1) how asymmetric information between the sell-side and the buy-side was created via complexity; (2) how the chain of interlinked securities was sensitive to house prices; (3) how the risk was spread in an opaque way; and (4) how the ABX indices allowed information to be aggregated and revealed. I argue that these details are at the heart of the answer to the question of the origin of the Panic of 2007.

Abstract:
How did problems with subprime mortgages result in a systemic crisis, a panic? The ongoing Panic of 2007 is due to a loss of information about the location and size of risks of loss due to default on a number of interlinked securities, special purpose vehicles, and derivatives, all related to subprime mortgages. Subprime mortgages are a financial innovation designed to provide home ownership opportunities to riskier borrowers. Addressing their risk required a particular design feature, linked to house price appreciation. Subprime mortgages were then financed via securitization, which in turn has a unique design reflecting the subprime mortgage design. Subprime securitization tranches were often sold to CDOs, which were, in turn, often purchased by market value off-balance sheet vehicles. Additional subprime risk was created (though not on net) with derivatives. When the housing price bubble burst, this chain of securities, derivatives, and off-balance sheet vehicles could not be penetrated by most investors to determine the location and size of the risks. The introduction of the ABX indices, synthetics related to portfolios of subprime bonds, in 2006 created common knowledge about the effects of these risks by providing centralized prices and a mechanism for shorting. I describe the relevant securities, derivatives, and vehicles and provide some very simple, stylized, examples to show: (1) how asymmetric information between the sell-side and the buy-side was created via complexity; (2) how the chain of interlinked securities was sensitive to house prices; (3) how the risk was spread in an opaque way; and (4) how the ABX indices allowed information to be aggregated and revealed. I argue that these details are at the heart of the answer to the question of the origin of the Panic of 2007.

Panic, Capital Markets

Abstract:
In this paper, we present a model of defensive mergers and merger waves. We argue that mergers and merger waves can occur when managers prefer that their firms remain independent rather than be acquired. We assume that managers can reduce their chance of being acquired by acquiring another firm and hence increasing the size of their own firm. We show that if managers value private benefits of control sufficiently, they may engage in unprofitable defensive acquisitions. A technological or regulatory change that makes acquisitions profitable in some future states of the world can induce a preemptive wave of unprofitable, defensive acquisitions. The timing of mergers, the identity of acquirers and targets, and the profitability of acquisitions depend on the size of the private benefits of control, managerial equity ownership, the likelihood of a regime shift that makes some mergers profitable, and the distribution of firm sizes within an industry.

Abstract:
We propose a theory of mergers that combines managerial merger motives with an industry-level regime shift that may lead to value-increasing merger opportunities. Anticipation of these merger opportunities can lead to defensive acquisitions, where managers acquire other firms to avoid losing private benefits if their firms are acquired, or "positioning" acquisitions, where firms position themselves as more attractive takeover targets to earn takeover premia. The identity of acquirers and targets and the profitability of acquisitions depend on the distribution of firm sizes within an industry, among other factors. We find empirical support for some unique predictions of our theory.

Mergers, Merger Waves

Abstract:
We empirically investigate the effects of the adoption of Regulation Fair Disclosure ( Reg FD') by the U.S. Securities and Exchange Commission in October 2000. This rule was intended to stop the practice of selective disclosure,' in which companies give material information only to a few analysts and institutional investors prior to disclosing it publicly. We find that the adoption of Reg FD caused a significant reallocation of information-producing resources, resulting in a welfare loss for small firms, which now face a higher cost of capital. The loss of the selective disclosure' channel for information flows could not be compensated for via other information transmission channels. This effect was more pronounced for firms communicating complex information and, consistent with the investor recognition hypothesis, for those losing analyst coverage. Moreover, we find no significant relationship of the different responses with litigation risks and agency costs. Our results suggest that Reg FD had unintended consequences and that information' in financial markets may be more complicated than current finance theory admits.

Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Abstract:
We empirically investigate the effects of the adoption of Regulation Fair Disclosure (Reg FD) by the U.S. Securities and Exchange Commission in October 2000. This rule was intended to stop the practice of selective disclosure, in which companies give material information only to a few analysts and institutional investors prior to disclosing it publicly. We find that the adoption of Reg FD caused a significant reallocation of information-producing resources, resulting in a welfare loss for small firms, which now face a higher cost of capital. The loss of the selective disclosure channel for information flows could not be compensated for via other information transmission channels. This effect was more pronounced for firms communicating complex information and, consistent with the investor recognition hypothesis, for those losing analyst coverage. Moreover, we find no significant relationship of the different responses with litigation risks and agency costs. Our results suggest that Reg FD had unintended consequences and that information in financial markets may be more complicated than current finance theory admits.

Disclosure, Regulation, Capital Markets, Cost of Capital, Regulation Fair Disclosure, Reg FD, Information Production

Abstract:
Investors face significant barriers in evaluating the performance of hedge funds and commodity trading advisors (CTAs). The only available performance data comes from voluntary reporting to private companies. Funds have incentives to strategically report to these companies, causing these data sets to be severely biased. And, because hedge funds use nonlinear, state-dependent, leveraged strategies, it has proven difficult to determine whether they add value relative to benchmarks. We focus on commodity trading advisors, a subset of hedge funds, and show that during the period 1994-2007 CTA excess returns to investors (i.e., net of fees) averaged 85 basis points per annum over US T-bills, which is insignificantly different from zero. We estimate that CTAs on average earned gross excess returns (i.e., before fees) of 5.4%, which implies that funds captured most of their performance through charging fees. Yet, even before fees we find that CTAs display no alpha relative to simple futures strategies that are in the public domain. We argue that CTAs appear to persist as an asset class despite their poor performance, because they face no market discipline based on credible information. Our evidence suggests that investors' experience of poor performance is not common knowledge.

Commodity Trading Advisors, CTA, Hedge Funds, Performance Measurement

Abstract:
The Panic of 2007-2008 was a run on the sale and repurchase market (the repo market), which is a very large, short-term market that provides financing for a wide range of securitization activities and financial institutions. Repo transactions are collateralized, frequently with securitized bonds. We refer to the combination of securitization plus repo finance as securitized banking, and argue that these activities were at the nexus of the crisis. We use a novel data set that includes credit spreads for hundreds of securitized bonds to trace the path of crisis from subprime-housing related assets into markets that had no connection to housing. We find that changes in the LIB-OIS spread, a proxy for counterparty risk, was strongly correlated with changes in credit spreads and repo rates for securitized bonds. These changes implied higher uncertainty about bank solvency and lower values for repo collateral. Concerns about the liquidity of markets for the bonds used as collateral led to increases in repo haircuts: the amount of collateral required for any given transaction. With declining asset values and increasing haircuts, the U.S. banking system was effectively insolvent for the first time since the Great Depression.

Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Abstract:
The Panic of 2007-2008 was a run on the sale and repurchase market (the “repo” market), which is a very large, short-term market that provides financing for a wide range of securitization activities and financial institutions. Repo transactions are collateralized, frequently with securitized bonds. We refer to the combination of securitization plus repo finance as “securitized banking”, and argue that these activities were at the nexus of the crisis. We use a novel data set that includes credit spreads for hundreds of securitized bonds to trace the path of crisis from subprime-housing related assets into markets that had no connection to housing. We find that changes in the “LIB-OIS” spread, a proxy for counterparty risk, was strongly correlated with changes in credit spreads and repo rates for securitized bonds. These changes implied higher uncertainty about bank solvency and lower values for repo collateral. Concerns about the liquidity of markets for the bonds used as collateral led to increases in repo “haircuts”: the amount of collateral required for any given transaction. With declining asset values and increasing haircuts, the U.S. banking system was effectively insolvent for the first time since the Great Depression.

repo, securitized

Abstract:
This note is a response to a recent paper by Erb and Harvey (2005). We show that diversification returns are mathematical properties of geometric averages of index returns, and not due to rebalancing. We also show how rebalancing affects the performance of the equal-weighted commodity futures index constructed by Gorton and Rouwenhorst (2005). Because rebalancing is an embedded trading strategy, it can be a source of return. Less frequent rebalancing would have increased, rather than lowered the performance of the equally-weighted commodity index.

Commodity, commodities, futures, diversification

Abstract:
Bank regulation has increasingly focused on capital requirements as the primary means of ensuring the "safety and soundness" of the banking system. We evaluate this policy approach by providing a theory of bank capital. Bank capital is beneficial because it reduces the chance of privately and socially costly bank failure. But it is both privately and socially costly because a system-wide increase in bank capital reduces the aggregate amount of bank deposits, which are an efficient medium of exchange, forcing consumers to hold more information-sensitive bank equity, which is a poor liquidity hedge. Recessions increase the risk and thus the information-sensitivity of bank equity, increasing the liquidity-related costs of additional bank capital. As a result, welfare-maximizing bank regulators may engage in "forbearance" ? that is, they may optimally renege on previously tough policies. Private incentives to increase capital are even smaller than social incentives, which may further limit regulators' ability to raise capital standards. Social and private reluctance to increase capital in a recession may in turn cause a "credit crunch."

Abstract:
When confidence is lost, liquidity dries up. We investigate the meaning of confidence and liquidity in the context of the current financial crisis. The financial crisis is a manifestation of an age-old problem with private money creation, banking panics. We explain this and provide some evidence with respect to the current crisis.

Abstract:
When 'confidence' is lost, 'liquidity dries up.' We investigate the meaning of 'confidence' and 'liquidity' in the context of the current financial crisis. The financial crisis is a manifestation of an age-old problem with private money creation, banking panics. We explain this and provide some evidence with respect to the current crisis.

Abstract:
We study the basic properties of an equally-weighted index of U.S. commodity futures from the perspective of a Japanese investor. We find that the returns on the U.S. equally-weighted commodity futures index maintain their basic properties, documented in Gorton and Rouwenhorst (2005), when translated into Yen. In particular, looking at returns on Japanese stocks and bonds, the commodity futures index, translated into Yen, continues to display equity-like returns, but with slightly less volatility. In addition, the Yen-based commodity futures returns show essentially zero correlation with Japanese equities and negative correlation with bonds.

commodity futures

Abstract:
We study the basic properties of an equally weighted index of U.S. commodities futures from the perspective of a Japanese investor. We find that the returns on the U.S. equally-weighted commodity futures index maintain their basic properties documented in Gorton and Rouwenhorst (2005), when translated into Yen. In particular, looking at returns on Japanese stocks and bonds, the commodity futures index, translated into Yen, continues to display equity-like returns, but with slightly less volatility. In addition, the Yen-based commodity futures returns show essentially zero correlation with Japanese equities and negative correlation with bonds.

commodities, futures, commodity, index, diversification

Abstract:
Noise traders are agents whose theoretical existence has been hypothesized as a way of solving certain fundamental problems in Financial Economics. We briefly review the literature on noise traders. This is an entry for The New Palgrave: A Dictionary of Economics, 2nd Edition (Palgrave Macmillan: New York), edited by Steven N. Durlauf and Lawrence E. Blume, forthcoming in 2008.

Abstract:
Noise traders are agents whose theoretical existence has been hypothesized as a way of solving certain fundamental problems in Financial Economics. We briefly review the literature on noise traders. The is an entry for The New Palgrave: A Dictionary of Economics, 2nd Edition (Palgrave Macmillan: New York), edited by Steven N. Durlauf and Lawrence E. Blume, forthcoming in 2008.

Noise Traders, Financial Markets, Market Efficiency

Abstract:
Private information about prospective borrowers produced by a bank can affect rival lenders due to a "winner's curse" effect. Strategic interaction between banks with respect to the intensity of costly information production results in endogenous credit cycles, periodic "credit crunches." Empirical tests are constructed based on parameterizing public information about relative bank performance that is at the root of banks' beliefs about rival banks' behavior. Consistent with the theory, we find that the relative performance of rival banks has predictive power for subsequent lending in the credit card market, where we can identify the main competitors. At the macroeconomic level, we show that the relative bank performance of commercial and industrial loans is an autonomous source of macroeconomic fluctuations. We also find that the relative bank performance is a priced risk factor for both banks and nonfinancial firms. The factor-coefficients for non-financial firms are decreasing with size.

Abstract:
A bank determines whether potential borrowers are credit-worthy, that is, whether they meet the bank's credit or lending standards. In making this determination, each bank is in competition with other banks, but without knowing the competitor banks' credit standards. The resulting unique form of competition leads to endogenous credit cycles, periodic "credit crunches." Empirical tests of this repeated bank lending game are constructed based on parameterizing public information about relative bank performance that is at the root of banks' beliefs about rival banks' lending standards. The relative performance of rival banks has predictive power for subsequent lending in the credit card market, where we can identify the main competitors. At the macroeconomic level, the relative bank performance of commercial and industrial loans is an autonomous source of macroeconomic fluctuations. In an asset pricing context, the relative bank performance is a priced risk factor for both banks and nonfinancial firms. The factor-coefficients for non-financial firms are decreasing with size, consistent with smaller firms being more bank-dependent.

credit cycles, credit crunches

Abstract:
We analyze the interaction between managerial decisions and firm value/asset prices by embedding the standard agency model of the firm into an otherwise standard asset pricing model. When the manager-agent's compensation depends on the firm's stock price performance, stock prices are set to induce the creation of future cash flows, instead of representing the discounted value of exogenous cash flows, as in the standard model. In our case, stock prices are formed via trading in the market to induce the managers to hold the number of shares consistent with the optimal effort level desired by the outside investors. We compare two price formation mechanisms, corresponding to two firm ownership structures. In the first, stock prices are formed competitively among a continuum of dispersed investors. In the second, stock prices are set by a single block shareholder, as a bargaining solution. Under both mechanisms there are persistent, dynamic, patterns of asst prices, The level of the equity premium and the return volatility depend on the risk aversion of the agents in the economy and the ownership structure of firms.

Abstract:
Entrenched managers can be disciplined by stock prices in a limited way. When a manager cannot be perfectly controlled via optimal contracting, the canonical asset pricing model must be integrated with corporate finance to produce a pricing kernel which simultaneously discounts the firm's cash flows and sets incentives for the risk averse manager to produce those same cash flows. In equilibrium the stock price is set to provide an incentive, via managerial shareholdings, for the manager to make an effort to produce the cash flows. This is complicated by risk sharing considerations. In this context, we study the equity premium, the excess volatility of equity returns, and share price dynamics. We study two polar cases of outside share ownership: completely dispersed shareholders and a single blockholder. We also propose a Markovian equilibrium concept that enables us to use dynamic programming in both of these settings.

Agency Problem, Corporate Governance, Asset Pricing, Price Formation

Abstract:
For this study of the simple properties of commodity futures as an asset class, an equally weighted index of monthly returns of commodity futures was constructed for the July 1959 through December 2004 period. Fully collateralized commodity futures historically have offered the same return and Sharpe ratio as U.S. equities. Although the risk premium on commodity futures is essentially the same as that on equities for the study period, commodity futures returns are negatively correlated with equity returns and bond returns. The negative correlation is the result, primarily, of commodity futures' different behavior over a business cycle. Commodity futures are positively correlated with inflation, unexpected inflation, and changes in expected inflation.

Derivative Instruments, Commodity Derivatives, Alternative Investments, Commodities, Portfolio Management, Asset Allocation

Abstract:
We construct an equally-weighted index of commodity futures monthly returns over the period between July of 1959 and March of 2004 in order to study simple properties of commodity futures as an asset class. Fully-collateralized commodity futures have historically offered the same return and Sharpe ratio as equities. While the risk premium on commodity futures is essentially the same as equities, commodity futures returns are negatively correlated with equity returns and bond returns. The negative correlation between commodity futures and the other asset classes is due, in significant part, to different behavior over the business cycle. In addition, commodity futures are positively correlated with inflation, unexpected inflation, and changes in expected inflation.

Abstract:
We study the "efficient markets" paradigm in the context of agency relations: principal-investors want to monitor and compensate their agent-traders using market security prices in "mark-to-market" contracts. The view of each principal is that market prices aggregate the information from other market participants so they can be used to monitor agent-traders. If the market is dominated by such delegated traders, then these traders can attempt to manipulate the market price by shirking jointly and buying or selling in the same direction. In this way, traders provide market "proof" that they have worked hard and deserve high compensation. We show that markets dominated by delegated traders are less efficient than other markets. The extent of "market efficiency," indexed by the delegated traders' propensity of joint shirking, is endogenized.

agency problem, mark to market, market efficiency

Abstract:
Agency problems in firms are prevalent because of a scarcity of wealthy principals with corporate govern-ance ability, whom we call "restructuring specialists". We investigate how this scarce resource, "agency cost-free capital," is allocated. We show that the restructuring specialists may acquire blocks only in those states of the world in which they can increase firm value the most, which corresponds to a takeover. Firms with dispersed ownership and firms with a financial intermediary as a blockholder can coexist, although they are otherwise identical. The model can explain differences in corporate ownership structures and re-structuring mechanisms across economies.

Blockholders, Takeovers, Corporate Ownership Structures

Abstract:
We consider the problem of moral hazard in the team of managers employed in a firm when the principal/firm owner can play an active role in determining team output. Unless the principal's compensation is non-decreasing in firm value there is an additional moral hazard problem since the principal will have an incentive to reduce output. In this context we determine team, and hence firm, size and solve for the form of optimal managerial compensation contracts. In particular we determine conditions under which optimal contracts will have option-like features.

Abstract:
Central banking is intimately related to liquidity provision to banks during times of crisis, the lender-of-last-resort function. This activity arose endogenously in certain banking systems. Depositors lack full information about the value of bank assets so that during macroeconomic downturns they monitor their banks by withdrawing in a banking panic. The likelihood of panics depends on the industrial organization of the banking system. Banking systems with many small, undiversified banks, are prone to panics and failures, unlike systems with a few big banks that are heavily branched and well diversified. Systems of many small banks are more efficient if the banks form coalitions during times of crisis. We provide conditions under which the industrial organization of banking leads to incentive compatible state contingent bank coalition formation. Such coalitions issue money that is a kind of deposit insurance and examine and supervise banks. Bank coalitions of small banks, however, cannot replicate the efficiency of a system of big banks.

Banking Panics, Clearinghouses, Central Banking

Abstract:
Central banking is intimately related to liquidity provision to banks during times of crisis, the lender-of-last-resort function. This activity arose endogenously in certain banking systems. Depositors lack full information about the value of bank assets so that during macroeconomic downturns they monitor their banks by withdrawing in a banking panic. The likelihood of panics depends on the industrial organization of the banking system. Banking systems with many small, undiversified banks, are prone to panics and failures, unlike systems with a few big banks that are heavily branched and well diversified. Systems of many small banks are more efficient if the banks form coalitions during times of crisis. We provide conditions under which the industrial organization of banking leads to incentive compatible state contingent bank coalition formation. Such coalitions issue money that is a kind of deposit insurance and examine and supervise banks. Bank coalitions of small banks, however, cannot replicate the efficiency of a system of big banks.

Abstract:
If the price system is superior to central planning, why do firms exist with sub-economies that are very large, approximating small capitalist economies? In a principal-agent setting we compare a market, in which two principal-agent pairs trade, to a corporation in which a single principal hires both agents. In a market principals motivate their agents to make efforts by writing contracts contingent on observed prices, some of which are negotiated between the agents themselves. These prices may be informative, allowing principals to induce high effort at a lower cost. But, principals in different firms cannot coordinate their contract choices since each lacks authority over the other's agent. Authority over both agents' efforts occurs when a corporation is formed, where one principal contracts directly with both agents, a sub-economy. Information from market prices is then lost and cannot be replicated by internally generated "transfer prices." Whether a market or a firm is optimal is determined by the relative value of managerial authority over agents (the "visible" hand) versus information from market prices (the "invisible" hand).

theory of the firm, information, coordination

Abstract:
The savings/investment process in capitalist economies is organized around financial intermediation, making them a central institution of economic growth. Financial intermediaries are firms that borrow from consumer/savers and lend to companies that need resources for investment. In contrast, in capital markets investors contract directly with firms, creating marketable securities. The prices of these securities are observable, while financial intermediaries are opaque. Why do financial intermediaries exist? What are their roles? Are they inherently unstable? Must the government regulate them? Why is financial intermediation so pervasive? How is it changing? In this paper we survey the last fifteen years' of theoretical and empirical research on financial intermediation. We focus on the role of bank-like intermediaries in the savings-investment process. We also investigate the literature on bank instability and the role of the government.

Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Abstract:
Stock prices are more informative when the information has less social value. Speculators with limited resources making costly (private) information production decisions must decide to produce information about some firms and not others. We show that producing and trading on private information is most profitable in the stocks of firms with poor corporate governance -- precisely because it will not be acted upon -- and less profitable at firms with better corporate governance. To the extent that the information in the stock price is used for disciplining the CEO by the board of directors, the informed trader has a reduced incentive to produce the information in the first place. We test our model using the probability of informed trading (PIN) and the probability of forced CEO turnover in a simultaneous-equation system. The empirical results support the model predictions. Stock prices are efficient, but there is a limit to the disciplining role they can fulfill. We apply the model to evaluate the effects of the Sarbanes-Oxley Act of 2002.

Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Abstract:
Stock prices are more informative when the information has less social value. Speculators with limited resources making costly (private) information production decisions must decide to produce information about some firms and not others. We show that producing and trading on private information is most profitable in the stocks of firms with poor corporate governance - precisely because it will not be acted upon - and less profitable at firms with better corporate governance. To the extent that the information in the stock price is used for disciplining the CEO by the board of directors, the informed trader has a reduced incentive to produce the information in the first place. We test our model using the probability of informed trading (PIN) and the probability of forced CEO turnover in a simultaneous-equation system. The empirical results support the model predictions. Stock prices are efficient, but there is a limit to the disciplining role they can fulfill. We apply the model to evaluate the effects of the Sarbanes-Oxley Act of 2002.

Abstract:
Commodity futures risk premiums vary across commodities and over time depending on the level of physical inventories, as predicted by the Theory of Storage. Using a comprehensive dataset on 31 commodity futures and physical inventories between 1969 and 2006, we show that the convenience yield is a decreasing, non-linear relationship of inventories. Price measures, such as the futures basis, prior futures returns, and spot returns reflect the state of inventories and are informative about commodity futures risk premiums. The excess returns to Spot and Futures Momentum and Backwardation strategies stem in part from the selection of commodities when inventories are low. Positions of futures markets participants are correlated with prices and inventory signals, but we reject the Keynesian hedging pressure hypothesis that these positions are an important determinant of risk premiums.

Abstract:
In recent years, there has been a large literature on how stock exchange specialists set prices when there are investors who know more about the stock than they do. An important assumption in this literature is that there are "liquidity traders" who are equally likely to buy or sell for exogenous reasons. It is plausible that some buyers have cash needs and are forced to sell their stock. However, buyers will usually be able to choose the time at which they trade. It will be optimal for them to minimize the probability of trading with informed investors by choosing an appropriate time to trade and clustering at that time. This asymmetry means that when liquidity buyers are not clustering, purchases are more likely to be by an informed trader than sales so the price movement resulting from a purchase is larger than for a sale. As a result, profitable manipulation by uninformed investors may occur. A model where the specialist takes account of the possibility of manipulation in equilibrium is presented.

Abstract:
We determine firms' equity ownership structures and provide a theory of hostile takeovers by distinguishing the roles of two types of blockholders: rich investors and institutional investors. We also distinguish the roles of two types of stock markets: the block market and the market with small investors. Rich investors have their own money at stake while institutional investors are run by professional managers and hence face agency conflicts. Because rich investors face no agency problems they are better at monitoring managers. If their wealth is insufficient to control all corporations, then agency-cost free' capital is scarce. We investigate the allocation of this scarce resource. A hostile takeover is the consequence of a state-contingent allocation of agency-cost free capital. We show that only rich investors engage in hostile takeovers. Institutional investors instead are either permanent blockholding monitors or facilitate takeovers by selling blocks to rich investors. Even though all firms are ex ante identical, some may rely on the takeover mechanism while others rely on permanent institutional monitoring. We characterize the ownership structure of firms showing, in particular, that (ex ante) identical firms can have different ownership structures. Some can have initially dispersed ownership while others have an institutional blockholder.

Abstract:
A defining characteristic of bank loans is that they are not resold once created. Yet, in 1989 about $240 billion of commercial and industrial loans were sold, compared to trivial amounts five years earlier. Selling loans without explicit guarantee or recourse is inconsistent with theories of the existence of financial intermediation. What has changed to make bank loans marketable? In this paper we test for the presence of implicit contractual features of bank loan sales contracts that could explain this inconsistency. In addition, the effect of technological progress on the reduction of information asymmetries between loan buyers and loan sellers is considered. The paper tests for the presence of these features and effects using a sample of over 800 recent loan sales.

Abstract:
Empirical evidence suggests that banks play a unique role in the savings-investment process, affecting firms' cost of capital and the level of investment. We argue that bank uniqueness is related to how the design of bank loan contracts allows banks to affect borrowers' choice of project risk. Unlike corporate bonds, bank loans are typically secured senior debt which contain embedded options allowing the bank to "call" the loan. The option allows the bank to control borrowers' risk-taking activity via renegotiation of the loan. We analyze the renegotiation outcomes and show that: (1) debt forgiveness occurs; (2) monitoring by the bank is not always successful in preventing the borrower from increasing risk; (3) renegotiated interest rates are not monotonic in borrower type; (4) inefficient liquidation can occur. In renegotiation seniority and collateral are crucial because they allow the bank to threaten the borrower and liquidate inefficient projects. We show that when a prepayment option is included in the bank loan contract, bank debt is more valuable (ex ante) to borrowing firms than corporate debt; it lowers the cost of capital.

Abstract:
We study a model of renegotiation between a borrower and lender in which there is the potential for moral hazard on each side of the relationship. The borrower may add risk to the project, while the lender may opportunistically hold-up the borrower by threatening to demand early payment. The result is a model in which banks play a unique role in monitoring borrower's activities, and in which risk is endogenous and state-dependent. The model also yields explicit predictions about renegotiation outcomes, and conditions under which bank loans add value to the firm.

Abstract:
In the last ten to fifteen years financial derivative securities have become an important, and controversial, product for commercial banks. The controversy concerns whether the size, complexity, and risks associated with these securities, the difficulties with accurately reporting timely information concerning the value of firms' derivative positions, and the concentration of activity in a small number of firms, has substantially increased the risk of collapse of the world banking system. Despite the widespread attention to derivatives, there has been little systematic analysis. We estimate market values and interest-rate sensitivities of interest rate swap positions of U.S. commercial banks to empirically address the question of whether swap contracts have increased or decreased systematic risk in the U.S. banking system. We find that the banking system as a whole faces little net interest-rate risk from swap portfolios.

Abstract:
In the last ten to fifteen years financial derivative securities have become an important, and controversial, product for commercial banks. The controversy concerns whether the size, complexity, and risks associated with these securities, the difficulties with accurately reporting timely information concerning the value of firms' derivative positions, and the concentration of activity in a small number of firms, has substantially increased the risk of collapse of the world banking system. Despite the widespread attention to derivatives, there has been little systematic analysis. We estimate the market values and interest-rate sensitivity of interest rate swap positions of U.S. commercial banks to empirically address the question of whether swap contracts have increased or decreased systemic risk in the U.S. banking system. We find that the banking system as a whole faces little net interest-rate risk from swap portfolios.

Abstract:
Why do governments bailout banking systems in distress? We argue that the government can efficiently provide liquidity. We present a general equilibrium model in which not all assets can be used to purchase all other assets at every date. At some dates agents want to sell projects or securities. The only buyers are agents who have previously opportunistically invested in otherwise dominated assets because only these ('liquid') assets can be used to purchase the projects or securities. The market price of the projects or securities sold depends on the supply of liquidity, which is determined in general equilibrium. The supply of liquidity is not perfectly elastic so asset prices can deviate from 'efficient market' prices, that is, the conditional expectation of the asset payoff. While private liquidity provision is socially beneficial since it allows valuable reallocations, it is also socially costly since liquidity suppliers could have made more efficient investments ex ante. As a result, there is a potential role for the government to supply liquidity by issuing government securities, backed by tax revenue. Government bailouts of banking systems are an example of such public liquidity provision.

Abstract:
In a capitalist economy prices serve to equilibrate supply and demand for goods and services, continually changing to reallocate resources to their most efficient uses. However, secondary stock market prices, often viewed as the most 'informationally efficient' prices in the economy, have no direct role in the allocation of equity capital since managers have discretion in determining the level of investment. What is the link between stock price informational efficiency and economic efficiency? We present a model of the stock market in which: (i) managers have discretion in making investments and must be given the right incentives; and (ii) stock market traders may have important information that managers do not have about the value of prospective investment opportunities. In equilibrium, information in stock prices will guide investment decisions because managers will be compensated based on informative stock prices in the future. The stock market indirectly guides investment by transferring two kinds of information: information about investment opportunities and information about managers' past decisions. The fact that stock prices only have an indirect role suggests that the stock market may not be a necessary institution for the efficient allocation of equity. We emphasize this by providing an example of a banking system that performs as well.

Abstract:
In a capitalist economy prices serve to equilibrate supply and demand for goods and services, continually changing to reallocate resources to their most efficient uses. However, secondary stock market prices, often viewed as the most "informationally efficient" prices in the economy, have no direct role in the allocation of equity capital since managers have discretion in determining the level of investment. What is the link between stock price informational efficiency and economic efficiency? We present a model of the stock market in which: (i) managers have discretion in making investments and must be given the right incentives; and (ii) stock market traders may have important information that managers do not have about the value of prospective investment decisions because managers will be compensated based on informative stock prices in the future. The stock market indirectly guides investment by transferring two kinds of information: information about investment opportunities and information about managers' past decisions. The fact that stock prices only have an indirect role suggests that the stock market may not be a necessary institution for the efficient allocation of equity. We emphasize this by providing an example of a banking system that performs as well.

Abstract:
We study whether the socially optimal level of stability of the banking system can be implemented with regulatory capital requirements in a multi-period general equilibrium model of banking. We show that: (i) bank capital is costly because of the unique liquidity services provided by demand deposits, so a bank regulator may optimally choose to have a risky banking system; (ii) even if the regulator prefers more capital in the system, the regulator is constrained by the private cost of bank capital, which determines whether bank shareholders will agree to meet capital requirements rather than exit the industry.

Abstract:
We study whether the socially optimal level of stability of the banking system can be implemented with regulatory capital requirements in a multi-period general equilibrium model of banking. We show that: (i) bank capital is costly because of the unique liquidity services provided by demand deposits, and so a bank regulator may optimally choose to have a risky banking system; (ii) even if the regulator prefers more capital in the system, the regulator is constrained by the private cost of bank capital, which determines whether bank shareholders will agree to meet capital requirements rather than exit the industry. This constraint is tighter when the regulator faces an existing banking system than when the regulator is designing ex ante capital requirements for a new banking system. However, because bank capital is socially costly, optimal ex ante capital requirements may allow some ex post situations in which banks are risky and unwilling to raise additional capital.

Abstract:
Who should control the firm? What should be the firm's objective function? If contracts are incomplete, then the group of input providers that most needs their interests protected should be allocated control rights to the firm. Existing theories argue that the suppliers of capital are most in need of protection. We empirically assess this answer by examining the German system of codetermination,' a governance system under which employees are allocated some control rights over corporate assets by law. Codetermination laws require that employees be represented on the (supervisory) board of directors. If codetermination sufficiently empowers employees, and if stockholders' rights cannot be contractually protected, then employees may redistribute the firm's surplus towards themselves. In addition, if employee interests are not contractually protected, then employees' may prefer a different objective function for the firm. For example, employees may hamper capitalist flexibility by resisting restructuring of the firm if that would jeopardize their human capital. We examine this with particular reference to the unification of East Germany and West Germany, a shock that may have caused employees in the former West to resist restructuring; the more so in codetermined firms. We also examine whether shareholders respond to codetermination with more concentrated block holdings, perhaps increasing their bargaining power with employees, or with higher leverage, committing more cash to leave the firm. Finally, we examine the relationship between codetermination and the performance sensitivity of compensation for board members.

Abstract:
Gorton and Huang (2001) argue that private coalitions of banks can act as central banks, issuing private money and providing deposit insurance during times of panic. This lender-of-last-resort role depends upon banking panics occurring threat of liquidation makes the private bank coalition incentive compatible, inducing banks to monitor each other. But, despite the evolution of private bank coalitions, government central banks and government deposit insurance schemes historically replaced the private bank coalitions. In this paper we ask why this transition from private arrangements to public arrangements occurred. We survey the historical and international evidence on panics, suggesting that Gorton and Huang (2001) are consistent with the evidence. Then, we extend Gorton and Huang (2001) to show the welfare improvement brought about by a government central bank replacing private bank coalitions as lender-of-last-resort. In particular, panics, while necessary for private coalitions to function, are costly because they disrupt the use of bank deposits as a medium of exchange. With government deposit insurance, panics do not occur, but the government must monitor banks. Such monitoring by the government is not as effective as private bank coalitions. We provide conditions under which the government can avoid the costs associated with panics by implementing deposit insurance and thereby raise social welfare.

Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Abstract:
Shareholders have imperfect control over the decisions of the management of a firm. We integrate a widely accepted version of the separation of ownership and control - Jensen's (1986) free cash flow theory - into a dynamic equilibrium model and study the effect of imperfect corporate control on asset prices and investment. We assume that firms are run by empire-building managers who prefer to invest all free cash flow rather than distributing it to shareholders. Sharefholders are aware of this problem but it is costly for them to intervene to increase earnings payouts. Our corporate finance approach suggests that the aggregate free cash flow of the corporate sector is an important state variable in explaining asset prices and investment. We show that the business cycle variation in free cash flow helps explain the cyclical behavior of interest rates and the yield curve. The stochastic variation in free cash flow sheds light on risk premia in corporate bonds and out-of-the-money put options. We show that the financial friction causes shocks to affect investment, and causes otherwise i.i.d. shocks to be transmitted from period to period. Unlike the existing macroeconomics literature on financial frictions, the shocks propagate through large firms and during booms.

Abstract:
Firms are more complicated than standard principal-agent theory allows: firms have assets-in-place; firms endure through time, allowing for the possibility of replacing a shirking manager; firms have many managers, constraining the amount of equity that can be awarded to any one manager; and, a firm's owner can transfer some control to a manager, thereby entrenching her. Recognizing these characteristics, we solve for the vesting dates; wage, equity and options components; and control rights of an optimal contract. Managerial entrenchment makes the promise of deferred compensation credible. Deferring compensation by delaying vesting reduces a manager's ability to free-ride on a replacement's effort.

Abstract:
Firms are more complicated than standard principal-agent theory allows: firms have assets-in-place; firms endure through time, allowing for the possibility of replacing a shirking manager; firms have many managers, constraining the amount of equity that can be awarded to any one manager; and, a firm's owner can transfer some control to a manager, thereby entrenching her. Recognizing these characteristics, we solve for the vesting dates; wage, equity and options components; and control rights of an optimal contract. Managerial entrenchment makes the promise of deferred compensation credible. Deferring compensation by delaying vesting reduces a manager's ability to free-ride on a replacement's effort.

Abstract:
There has been a long-running debate about whether stock market prices are determined by fundamentals. To date no consensus has been reached. An important issue in this debate concerns the circumstances in which deviations from fundamentals are consistent with rational behavior. A continuous-time example where there are a finite number of rational traders with finite wealth is presented. It is shown that a finitely-lived security can trade above its fundamental.

Abstract:
Risk management in securities markets refers to the oversight of portfolio managers and professional traders when they trade on behalf of investors in security markets. Monitoring of their trading performance, profit and loss, and risk-taking behavior, is measured by principals using security market prices. We study the optimality of the practice of marking-to-market and provide conditions under which investing principals should optimally monitor their agent traders using market prices to measure traders' performance. Asset prices, however, can be affected by mark-to-market contracts. We show that such contracts introduce an externality when there are many traders. Traders may rationally herd, trading on irrelevant information. Ironically, this causes asset prices to be less informative than they would be without the mark-to-market feature.

Abstract:
When a firm forms a market closes. Resources that were previously allocated via the price system are allocated by managerial authority within the firm. We explore this choice of organizational form using a model of price formation in which agents negotiate prices on behalf of their principals when there is trade in a market. Principals motivate agents to make efforts and form prices by writing contracts contingent on the prices that the agents themselves negotiate. Admitting agency issues into price formation introduces a need for a principal to have the authority to coordinate economic activity. This can be achieved by closing a market and forming a firm, thereby contracting directly with both agents, and centrally directing trade. Closing a market, however, results in a loss of information from market prices, information that can be used to reduce the cost of contracting. This information cannot be replicated by internally generated transfer prices.' Hence, when the market is internalized within the firm, information from market prices is lost. Choice of organizational form, a market or a firm, is then determined by the relative value of central authority over agents (the visible' hand) versus information from market prices (the invisible' hand).

Abstract:
Investors face significant barriers in evaluating the performance of hedge funds and commodity trading advisors (CTAs). The only available performance data comes from voluntary reporting to private companies. Funds have incentives to strategically report to these companies, causing these data sets to be severely biased. And, because hedge funds use nonlinear, state-dependent, leveraged strategies, it has proven difficult to determine whether they add value relative to benchmarks. We focus on commodity trading advisors, a subset of hedge funds, and show that during the period 1994-2007 CTA excess returns to investors (i.e., net of fees) averaged 85 basis points per annum over US T-bills, which is insignificantly different from zero. We estimate that CTAs on average earned gross excess returns (i.e., before fees) of 5.4%, which implies that funds captured most of their performance through charging fees. Yet, even before fees we find that CTAs display no alpha relative to simple futures strategies that are in the public domain. We argue that CTAs appear to persist as an asset class despite their poor performance, because they face no market discipline based on credible information. Our evidence suggests that investors' experience of poor performance is not common knowledge.

Abstract:
No abstract is available for this paper.

Abstract:
In the 1980s, U.S. banks became systematically less profitable and riskier as nonbank competition eroded the profitability of banks' traditional activities. Bank failures, insignificant from 1934, the date the Glass-Steagall Act was passed, until 1980, rose exponentially in the 1980s. The leading explanation for the persistence of these trends centers on fixed-rate deposit insurance: the insurance gives bank equityholders an incentive to take on risk when the value of bank charters falls. We propose and test an alternative explanation based on corporate control considerations. We show that managerial entrenchment played a more important role than did the moral hazard associated with deposit insurance in explaining the recent behavior of the banking industry.

Abstract:
We consider a model of the stock market with delegated portfolio management. All agents are rational: some trade for hedging reasons, some investors optimally contract with portfolio managers who may have stock-picking abilities, and portfolio managers trade optimally given the incentives provided by this contract. Managers try, but sometimes fail, to discover profitable trading opportunities. Although it is best not to trade in this case, their clients cannot distinguish 'actively doing nothing,' in this sense, from 'simply doing nothing.' Because of this problem: (i) some portfolio managers trade even though they have no reason to prefer one asset to another (noise trade). We also show that, (ii), the amount of such noise trade can be large compared to the amount of hedging volume. Perhaps surprisingly, (iii), noise trade may be Pareto-improving. Noise trade may be viewed as a public good. Results (i) and (ii) are compatible with observed high levels of turnover in securities markets. Result (iii) illustrates some of the possible subtleties of the welfare economics of financial markets.

Abstract:
No abstract is available for this paper.

Abstract:
No abstract is available for this paper.

Abstract:
No abstract is available for this paper.

Abstract:
No abstract is available for this paper.

Abstract:
Two hypotheses concerning firms issuing debt for the first time are tested. The first is that new firms' debt will be discounted more heavily by lenders, compared to firms which have credit histories (but are otherwise identical), and that this excess discount declines over time as lenders observe defaults. The declining interest rate corresponds tot he formation of a "reputation", a valuable asset which provides an incentive for firms to not choose risky projects. The second hypothesis is that prior to the establishment of a reputation new firms issuing debt are monitored more intensely. The sample studied consists of new banks issuing bank notes for the first time during the American Banking Era (1838-1860). The presence of a reputation effect in debt prices is confirmed: the debt of new banks is discounted more heavily than banks with credit histories. Note holders are then motivated to monitor new banks because the excess discount provides an incentive for notes of new banks to be redeemed. As lenders learn that new banks can redeem their notes, the discount declines as predicted for surviving banks. The precision of learning increases during the period due to technological improvements in information transmission, namely, the introduction of the telegraph and the railroad. The results explain why the pre-Civil War system of private money issuance by banks was not plagued by problems of overissuance (wildcat banking).

Abstract:
The unique characteristics of bank loans emerge endogenously to enhance efficiency in a model of renegotiation between a borrower and a lender in which there is the potential for moral hazard on each side of the relationship. Firm risk is endogenous and renegotiated interest rates on the debt need not be monotone in firm risk. The initial terms of the debt are not set to price default risk but rather are set to efficiently balance bargaining power in later renegotiation. Loan pricing may be nonlinear, involving initial transfers either from the borrower to the bank or from the bank to the borrower.

Abstract:
In efficient markets prices should reflect the arrival of private information. A trader will engage in costly arbitrage if: (1) the information in his order is not immediately reflected in the asset's price; and (2) he can hold the asset until the date when the information is reflected. We study a general equilibrium model of optimizing agents where each period there may be a trader with a limited horizon and private information about a distant event. Whether he, and subsequent informed traders, act on this information is shown to depend on the possibility of a sequence or chain of future informed traders spanning the event date. An arbitrageur who receives good news will buy only if it is likely that a subsequent arbitrageurs' buying will have pushed up the expected price by the time he wishes to sell. We show that limited trading horizons result in inefficient prices because informed traders do not act on their information until the event date is sufficiently close.

Abstract:
We consider a model of the stock market with delegated portfolio management. All agents are rational: some trade for hedging reasons, some investors optimally contract with portfolio managers who may have stock-picking abilities, and portfolio managers trade optimally given the incentives provided by this contract. Managers try, but sometimes fail, to discover profitable trading opportunities. Although it is best not to trade in this case, their clients cannot distinguish "actively doing nothing," in this sense, from "simply doing nothing." Because of this problem: (i) some portfolio managers trade even though they have no reason to prefer one asset to another (noise trade). We also show that, (ii), the amount of such noise trade can be large compared to the amount of hedging volume. Perhaps surprisingly, (iii), noise trade may be Pareto-improving. Noise trade may be viewed as a public good. Results (i) and (ii) are compatible with observed high levels of turnover in securities markets. Result (iii) illustrates some of the possible subtleties of the welfare economics of financial markets.

Abstract:
Efficient banks are essential for capitalist economies, yet bank failures result in costly externalities, leading to a potential conflict between the risk choices of private agents that own banks and socially optimal choices. This conflict is particularly severe in transition economies. Evidence suggests that these economies have banking systems which are both prone to failure and inefficiently small; established banks suffer from an overhang of bad loans, and implicit subsidies often favor continued lending to inefficient state-owned enterprises (SOEs). If a regulator seeks to impose higher capital standards to reduce the odds of bank failure, privately-held banks may instead exit the industry, shrinking a system that is already inefficiently small. If loans to SOEs are subsidized so as to mitigate repercussions from their failure to workers and to banks, established banks may prefer such loans over riskier unsubsidized loans to entrepreneurial firms. Encouraging entry into banking may mitigate this problem, but the new banks will be quite risky and prone to failure. The upshot is that, in transition economies, achieving an efficient banking system is likely to require significant instability.

Abstract:
Two hypotheses concerning firms issuing debt for the first time are tested. The first is that new firms' debt will be discounted more heavily by lenders, compared to firms that have credit histories (but are otherwise identical), and that this excess discount declines over time as lenders observe defaults. The declining interest rate corresponds to the formation of a "reputation," a valuable asset that provides an incentive for firms not to choose risky projects. The second hypothesis is that prior to the establishment of a reputation, new firms issuing debt are monitored more intensely. The sample studied consists of new banks issuing bank notes for the first time during the American Free Banking Era (1838 60). The presence of a reputation effect in note prices is confirmed: the notes of new banks are discounted more heavily than the notes of banks with credit histories. Note holders are then motivated to monitor new banks because the excess discount provides an incentive for the notes of new banks to be redeemed. As lenders learn that new banks can redeem their notes, the discount declines as predicted for surviving banks. The precision of learning increases during the period because of technological improvements in information transmission, namely, the introduction of the telegraph and the railroad. The results explain why the pre Civil War system of private money issuance by banks was not plagued by problems of overissuance ("wildcat banking").