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Abstract:
The Internet technology reduces the cost of transmitting and exchanging information. ECNs exploit this opportunity to enable investors to place quotes at very little cost and compete with incumbent stock exchanges. Does this quasi-free entry situation lead to competitive liquidity supply? We analyze trades and order book dynamics on Nasdaq and Island. The Nasdaq touch is frequently undercut by Island limit orders, using the finer tick size prevailing on that ECN. Before decimalization, the coarse tick size constrained Nasdaq spreads, and undercutting Island limit order traders earned oligopoly rents. After decimalization, the hypothesis that liquidity suppliers do not earn rents cannot be rejected.

financial markets, liquidity supply, ECN, Island, NASDAQ

Abstract:
We analyze politically-motivated privatization design in a bipartisan environment where politicians lack commitment power. When the median class favors redistributive policies, a strategic privatization program allocating them enough shares can induce a voting shift away from left wing parties whose policy would reduce the values of shareholdings. To induce median class voters to buy enough shares to shift political preferences, strategic rationing and underpricing is often necessary. In the extreme, this may lead to free share distribution and voucher privatization. Shifting voting preferences becomes impossible when strong ex-ante political constraints require large upfront transfers to insiders, reducing the value which may be distributed through the privatization program, or when social inequality is extreme.

privatization, underpricing, political economy, re-election, IPOs, political risk

Abstract:
We analyze politically-motivated privatization design in a bipartisan environment where politicians lack commitment power. When the median class favors redistributive policies, a strategic privatization program allocating them enough shares can induce a voting shift away from left wing parties whose policy would reduce the values of shareholdings. To induce median class voters to buy enough shares to shift political preferences, strategic rationing and underpricing is often necessary. In the extreme, this may lead to free share distribution and voucher privatization. Shifting voting preferences becomes impossible when strong ex-ante political constraints require large upfront transfers to insiders, reducing the value which may be distributed through the privatization program, or when social inequality is extreme.

privatization, underpricing, political economy, re-election, IPOs, political risk

Abstract:
We analyze theoretically and empirically the implications of heterogeneous information for equilibrium asset pricing and portfolio choice. Our theoretical framework, directly inspired by Admati (1985), implies that with partial information aggregation, portfolio separation fails, buy-and-hold strategies are not optimal, and investors should structure their portfolios using the information contained in prices in order to cope with winner's curse problems. We implement empirically such a price-contingent portfolio allocation strategy and show that it outperforms economically and statistically the passive/indexing buy-and-hold strategy. We thus demonstrate that prices reveal information, in contrast with the homogeneous information CAPM, but only partially, consistent with a Noisy Rational Expectations Equilibrium. The success of our pricecontingent strategy does not proxy for the success of trading strategies based purely on historical performance, such as momentum investment.

Abstract:
Innovative ideas are novel combinations of productive resources potentially addressing an economic need (Schumpeter, 1926). Even promising ideas can be unprofitable if the proposed combination fails on at least one dimension, e.g., it is technically unfeasible or does not respond to a genuine customer need. To screen good ideas the entrepreneur needs to hire experts who evaluate the idea along their dimensions of expertise. Yet sharing the idea creates the risk that an expert would steal it. In this case, the idea-thief cannot contact any other expert, lest he should in turn steal the idea. Thus idea stealing leads to incomplete screening and is unattractive if the information of the other expert is critical or highly complementary. In such cases the entrepreneur can form a partnership with the experts. Yet very valuable ideas cannot be shared because it is too tempting to steal them.

Entreprenuership, innovation, experts, information aggregation, venture capital, ideas

Abstract:
Innovative ideas are novel combinations of productive resources potentially addressing an economic need (Schumpeter, 1926). Even promising ideas can be unprofitable if the proposed combination fails on at least one dimension, e.g., it is technically unfeasible or does not respond to a genuine customer need. To screen good ideas the entrepreneur needs to hire experts who evaluate the idea along their dimensions of expertise. Yet sharing the idea creates the risk that an expert would steal it. In this case, the idea-thief cannot contact any other expert, lest he should in turn steal the idea. Thus idea stealing leads to incomplete screening and is unattractive if the information of the other expert is critical or highly complementary. In such cases the entrepreneur can form a partnership with the experts. Yet very valuable ideas cannot be shared because it is too tempting to steal them.

Entreprenuership, innovation, experts, information aggregation, venture capital, ideas

Abstract:
Much academic literature on privatization has focused on the question of the efficiency gains associated with private property rights, the appropriate regulatory framework for privatized firms. There has been a more recent literature on the optimal design of the sale given the general uncertainty and the political risk inherent in the transaction (Perotti, 1995; Schmidt, 1998).

The empirical evidence on sales has confirmed the importance of political factors in the design of the sales. In this paper we take a radically different view from the usual normative approach about how privatization should be done and analyse an explicit political economy context to determine how politicians prefer to design sale programs.

We show that a privatization sale may be structured by a market-oriented, right wing government in order to ensure participation by the median class, in order to modify its voting preferences vis a vis the opposition, which favors more income redistribution. If appropriately designed, the share allocation at the sale align the interests of the median class with capitalists and thus make privatization politically feasible (and irreversible).

Specifically, a targeted share allocation the party will be re-elected to power because the median class becomes ex post averse to redistributive policies which would reduce the value of their shares. As it is in general illegal to target share allocations in large sales to specific groups of investors and not to others, the government has to use its control over the price of the offering. For the median class to choose to acquire enough shares to shift its political allegiance, the government needs to underprice the shares. As this leads to rationing, the government can then devises a self-selecting rationing scheme. We find that since income inequality makes the middle class more interested in redistribution, underpricing and rationing are increasing in social inequality.

This general result has already found strong empirical evidence in the literature (Jones et al, 1998) . In certain extreme situations firms shares may be sold at zero price, as in voucher privatizations; more generally zero-price share distributions may break self-fulfilling equilibria. Intuitively, there is an equilibrium in which investors do not believe other median class investors will buy shares at the sale, anticipating a victory by the opposition; such a belief can become self-fulfilling. A share distribution (directly to citizen or via investment or pension funds) rules out this possibility. In the case when only a fraction of shares needs to be sold before an election, the rest may be optimally sold later at an auction designed for richer investors.

Shifting the preferences of the middle class may be impossible when strong ex ante political constraints require large upfront transfers to insiders, reducing the value which may be distributed through the privatization program, or when social inequality is extreme.

Abstract:
Economic growth occurs as resources are reallocated from the traditional sector to the more productive modern sector. Yet, the latter is more vulnerable to political predation. Hence, political risk hinders development. We analyze a politico-economic game between citizens and governments, whose type (benevolent or predatory) is unknown to the citizens. In equilibrium, opportunistic governments mix between predation and restraint. As long as restraint is observed, political expectations improve and the economy grows. Once there is predation, the reputation of the current government is ruined and the economy collapses. If citizens are unable to overthrow this government, the collapse is durable. Otherwise, a new government is drawn and the economy can rebound. Equilibrium dynamics are characterized as a Markov chain. Consistent with stylized facts, equilibrium political and economic histories are random, unstable and exhibit long-term divergence. Our theoretical model also generates new empirical implications on the joint dynamics of income inequality, output and political variables.

Political economy, political predation, reputation, economic development

Abstract:
Economic growth occurs as resources are reallocated from the traditional sector to the more productive modern sector. Yet, the latter is more vulnerable to political predation. Hence, political risk hinders development. We analyze a politico-economic game between citizens and governments, whose type (benevolent or predatory) is unknown to the citizens. In equilibrium, opportunistic governments mix between predation and restraint. As long as restraint is observed, political expectations improve and the economy grows. Once there is predation, the reputation of the current government is ruined and the economy collapses. If citizens are unable to overthrow this government, the collapse is durable. Otherwise, a new government is drawn and the economy can rebound. Equilibrium dynamics are characterized as a Markov chain. Consistent with stylized facts, equilibrium political and economic histories are random, unstable and exhibit long-term divergence. Our theoretical model also generates new empirical implications on the joint dynamics of income inequality, output and political variables.

political risk, economic development, two-sector economy, growth paths, markov chain, reputation

Abstract:
We propose a dynamic competitive equilibrium model of limit order trading, based on the premise that investors cannot monitor markets continuously. We study how limit order markets absorb transient liquidity shocks, which occur when a significant fraction of investors lose their willingness and ability to hold assets. We characterize the equilibrium dynamics of market prices, bid-ask spreads, order submissions and cancelations, as well as the volume and limit order book depth they generate.

Abstract:
We analyze empirically the determinants of Eurozone Treasury bills yields. Market microstructure as well as macroeconomic variables are found to significantly impact yields. Secondary trading in a centralized transparent electronic limit order book enhances liquidity and thus reduce yields. Irregularly issuing securities raises the yields government must pay. Consistent with the flight to quality hypothesis, yields are lower when the stock market is volatile. In such periods, the value of liquidity is found to be particularly high. Finally, yields are found to be greater when governments are more indebted.

Liquidity, market microstructure, volatility, treasury bills, treasury auctions, yield spread, flight to quality, eurozone

Abstract:
We survey the literature analysing the price formation and trading process, and the consequences of market organization for price discovery and welfare. We develop a united perspective on theoretical, empirical and experimental approaches. We discuss the evidence on transaction costs and the price impact of trades and its analyses in terms of adverse selection, inventory costs and market power. We review the extent to which the associated frictions can be mitigated by such features of market design as the degree of transparency, the use of call auctions, the discreteness of the pricing grid and the regulation of competition between liquidity suppliers or exchanges.

Market microstructure, liquidity, bid-ask spread, market design, transactions costs

Abstract:
We study how securities and trading mechanisms can be designed to optimally mitigate the adverse impact of market imperfections on liquidity. Asset owners seek to obtain liquidity by selling their claims on future cash-flows, on which they have private information. Our analysis encompasses both the cases of competitive and monopolistic liquidity supply. In the optimal trading mechanism associated to an arbitrary given security, issuers with low cash-flows sell their entire holdings of the security, while issuers with larger cash-flows are typically excluded from trade. By designing the security optimally, issuers can eshew exclusion altogether. The optimal security is debt. Because of its low informational sensitivity, debt mitigates the adverse selection problem. Furthermore, by pooling all issuers with high cash-flows, debt also reduces the ability of a monopolistic liquidity supplier to exclude them from trade in order to better extract rents from issuers with low cash-flows.

Abstract:
We study how securities and issuance mechanisms can be designed to mitigate the adverse impact of market imperfections on liquidity. In our model, asset owners seek to obtain liquidity by selling claims contingent on privately observed future cash-flows. Liquidity suppliers can be competitive or strategic. In the optimal trading mechanism associated with an arbitrary given security, issuers with low cash-flows sell their entire holdings of the security, while issuers with high cash-flows are typically excluded from trade. By designing the security optimally, issuers can avoid exclusion altogether. We show that the optimal security is debt. Because of its low informational sensitivity, debt mitigates the adverse selection problem. Furthermore, by pooling all issuers with high cash-flows, debt also reduces the ability of a monopolistic liquidity supplier to exclude them from trade in order to better extract rents from issuers with lower cash-flows.

Abstract:
We study how securities and trading mechanisms can be designed to mitigate the adverse impact of market imperfections on liquidity. Following De Marzo and Duffie (1999), we consider asset owners who seek to obtain liquidity by selling their claims on future cash-flows, on which they have private information. We allow for strategic liquidity supply and take a mechanism design approach to characterize both the optimal security and the optimal trading mechanism. For a given arbitrary security, issuers with cash-flows below a threshold entirely sell their holdings of the securities, while issuers with larger cash-flows are excluded from trading. The optimal security design entirely avoids this partial market breakdown phenomenon. We find that the optimal security is debt. Because of its low informational sensitivity, debt mitigates the adverse selection problem. Furthermore, by pooling all issuers with high cash-flows, it reduces the ability of strategic liquidity suppliers to exclude them from trade to better extract rents from agents with lower cash-flows. We also show that competition in non-exclusive schedules between finitely many oligopolistic liquidity suppliers implements the competitive trading mechanism.

Security design, liquidity, mechanism design, adverse selection

Abstract:
In this Paper we measure psychological traits and show that they significantly affect behaviour and performance in a financial context. Based on the answers of 184 subjects to a psychological questionnaire we measured their degree of overconfidence, ie. the extent to which they overestimate the precision of their information, and self-monitoring, which is a form of social intelligence. The subjects also participated in an experimental financial market under asymmetric information in the spirit of Plott and Sunder (1988). In line with the hypothesis that they suffer from the winner's curse, overconfident subjects are found to earn relatively low trading profits. In contrast, our finding that high self-monitors earn relatively large trading profits is consistent with the hypothesis that they are relatively good at anticipating the trading motivations of the other traders.

Social intelligence, self-monitors, trading strategies

Abstract:
We analyze dynamic financial contracting under moral hazard. The ability to rely on future rewards relaxes the tension between incentive and participation constraints, relative to the static case. Managers are incited by the promise of future payments after several successes and the threat of liquidation after several failures. The more severe the moral hazard problem, the greater the liquidation risk. The optimal contract can be implemented by holding cash reserves and by issuing debt and equity. The firm is liquidated when it runs out of cash. Dividends are paid only when accumulated earnings reach a certain threshold. In the continuous time limit of the model, stocks follow a diffusion process, with a stochastic volatility that increases after price drops. In line with empirical findings, performance shocks induce long lasting changes in leverage.

Security design, moral hazard, asset pricing, dynamic financial contracting

Abstract:
We analyze dynamic financial contracting under moral hazard. The ability to rely on future rewards relaxes the tension between incentive and participation constraints relative to the static case. Entrepreneurs are incited to effort by the promise of future payments after several successes and the threat of liquidation after several failures. The more severe the moral hazard problem, the greater the liquidation risk. The optimal contract can be implemented by holding cash reserves and issuing debt and equity. The firm is liquidated when it runs out of cash. Dividends are paid only when accumulated earnings reach a certain threshold. In the continuous-time limit of the model, stock prices follow a diffusion process, with a stochastic volatility that increases after price drops. In line with empirical findings, performance shocks induce long lasting changes in leverage.

Security design, dynamic financial contracting, moral hazard, asset pricing

Abstract:
We study the impact of different bankruptcy laws in general equilibrium, taking into account the interactions between the credit and labour markets, as well as wealth heterogeneity. Soft bankruptcy laws often preclude liquidation, to avoid ex-post inefficiencies. This worsens credit rationing, depresses investment and reduces aggregate leverage. Yet, tough laws do not necessarily maximize social welfare or emerge from the legislative process. Relatively rich agents can invest irrespective of the law. They favour soft laws that exclude poorer entrepreneurs from the market and thus reduce labour demand and wages. This raises the pledgeable income of the entrepreneurs who still can raise funds, and thus lowers their liquidation rates and the associated inefficiencies. Hence, a soft law can maximize social welfare.

Financial constraints, credit rationing, bankruptcy law

Abstract:
This Paper studies the formation of opening prices for German and French stocks, simultaneously traded in Frankfurt and Paris. We analyse theoretically the case where investors and traders based in the same country as the firm have better information on its value than foreign traders. Our model implies that prices set on the domestic market should be informationally more efficient than prices set on the foreign market. For German stocks, our empirical results are consistent with theory. The informational efficiency of French stock prices is comparable in the two markets when the Frankfurt specialist can observe Paris preopening prices before opening the market.

International financial markets integration, information assymeteries, market microstructure

Abstract:
An entrepreneur with limited liability needs to finance an infinite horizon investment project. An agency problem arises because she can divert operating cash flows before reporting them to the financiers. We first study the optimal contract in discrete time. This contract can be implemented by cash reserves, debt, and equity. The latter is split between the financiers and the entrepreneur and pays dividends when retained earnings reach a threshold. To provide appropriate incentives to the entrepreneur, the firm is downsized when it runs short of cash. We then study the continuous-time limit of the model. We prove the convergence of the discrete-time value functions and optimal contracts. Our analysis yields rich implications for the dynamics of security prices. Stock prices follow a diffusion reflected at the dividend barrier and absorbed at 0. Their volatility, as well as the leverage ratio of the firm, increase after bad performance. Stock prices and book-to-market ratios are in a non-monotonic relationship. A more severe agency problem entails lower price-earning ratios and firm liquidity and higher default risk.

Abstract:
We measure the degree of overconfidence in judgement (in the form of miscalibration, i.e. the tendency to overestimate the precision of one's information) and self-monitoring (a form of attentiveness to social cues) of 245 participants and also observe their behaviour in an experimental financial market under asymmetric information. Miscalibrated traders, underestimating the conditional uncertainty about the asset value, are expected to be especially vulnerable to the winner's curse. High self-monitors are expected to behave strategically and achieve superior results. Our empirical results show that miscalibration reduces and self-monitoring enhances trading performance. The effect of the psychological variables is strong for men but non-existent for women.

Abstract:
We propose a dynamic competitive equilibrium model of limit order trading, based on the premise that investors cannot monitor markets continuously. We study how limit order markets absorb transient liquidity shocks, which occur when a significant fraction of investors lose their willingness and ability to hold assets. We characterize the equilibrium dynamics of market prices, bid-ask spreads, order submissions and cancelations, as well as the volume and limit order book depth they generate.

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 analyze a game between citizens and governments, whose type (benevolent or predatory) is unknown to the public. Opportunistic governments mix between predation and restraint. As long as restraint is observed, political expectations improve, people enter the modern sector, and the economy grows. Once there is predation, the reputation of the government is ruined and the economy collapses. If citizens are unable to overthrow this government, the collapse is durable. Otherwise, a new government is drawn and the economy can rebound. Consistent with stylized facts, equilibrium political and economic histories are random, unstable, and exhibit long-term divergence.

Abstract:
Once they have observed information, hindsight biased agents fail to remember how ignorant they were initially, they knew it all along. We formulate a theoretical model of this bias, providing a foundation for empirical measures, and implying that hindsight biased agents learning about volatility will underestimate it. In an experiment involving 67 students from Mannheim University, we find that hindsight bias reduces volatility estimates. In another experiment, involving 85 investment bankers in London and Frankfurt, we find that more biased agents have lower performance. These findings are robust to differences in location, information, overconfidence and experience.

Abstract:
We measure the degree of overconfidence in judgment (in the form of miscalibration, i.e., the tendency to overestimate the precision of one's information) and self-monitoring (a form of attentiveness to social cues) of 245 participants and also observe their behaviour in an experimental financial market under asymmetric information. Miscalibrated traders, underestimating the conditional uncertainty about the asset value, are expected to be especially vulnerable to the winner's curse. High self-monitors are expected to behave strategically and achieve superior results. Our empirical results show that miscalibration reduces and self-monitoring enhances trading performance. The effect of the psychological variables is strong for men but non-existent for women.

Psychology and finance, overconfidence, miscalibration, self-monitoring, experimental finance, trading game, asymmetric information, winner's curse

Abstract:
This paper endeavours to shed light on the respective roles of the formal and the informal credit markets in developing countries. We use survey data for manufacturing firms in Cote de Ivoire, documenting their access to informal credit markets, their investments, and their financing. We confront these data with a simple moral-hazard model of credit rationing. Because of socio-cultural effects, the magnitude of moral-hazard problems and the cost of credit can be different in the informal credit market. We offer a structural econometric estimation of this model. Our empirical results point at severe moral-hazard problems for all firms, and reduced cost of credit in the informal market. Our point estimate suggests that moral-hazard problems can be alleviated in the informal credit market. Policy implications of our results are sketched.

Abstract:
Unseasoned shares are sold through the Book Building process in the US and the UK, fixed price offerings in several countries, uniform price auctions in Israel or the new internet-based Open IPO mechanism, and an auction-like mechanism called the Mise en Vente in France. We analyze and compare the performance of these various IPO mechanisms within the context of a unified theoretical model. Fixed price offerings lead to inefficient pricing and winner's curse. Dutch auctions can also lead to inefficiencies, to the extent that they are conducive to tacit collusion by investors. The Book Building and Mise en Vente can lead to optimal information elicitation and price discovery. We document empirically the similarity between the Book Building and the Mise en Vente. We discuss the implications of our analysis for the design of optimal Internet IPO auctions.

Abstract:
Recent empirical findings suggest that spreads quoted in dealership markets might be uncompetitive. This paper analyzes theoretically if price competition between risk-averse market-makers leaves room for implicit collusive behavior. We compare the spread and risk-sharing efficiency arising in several market structures differing in terms of i) the priority rule followed in case of ties, and ii) the type of schedules market-makers may use, namely: general schedules, linear schedules, or limit orders. In general, competitive pricing does not arise in equilibrium, and there is a conflict between risk-sharing efficiency and the tightness of the spread. This conflict can be mitigated by an appropriate market structure design. The limit order market is the only market structure in which the competitive equilibrium is the unique equilibrium.

Abstract:
As a centralized, computerized, limit order market, the Paris Bourse is particularly appropriate for studying the interaction between the order book and order flow. Descriptive methods capture the richness of the data and distinctive aspects of the market structure. Order flow is concentrated near the quote, while the book is somewhat larger at nearby valuations. We analyze the supply and demand of liquidity. For example, thin books elicit orders and thick books result in trades. To gain price and time priority, investors quickly place orders within the quotes when the depth at the quotes or the spread is large. Consistent with information effects, downward (upward) shifts in both bid and ask quotes occur after large sales (purchases).

Abstract:
Because the Paris Bourse is a centralized, computerized, limit order market, the dataset it generates is particularly appropriate for studying the interaction between the order book and order flow dynamics. We use descriptive methods to capture the richness of the data and the distinctive aspects of the market structure. We characterize the average order book and order flow. Order flow is concentrated near the quote, while the book is somewhat thinner at the quote than at nearby valuations. We analyze how the order flow is affected by the state of the book and the previous order flow documenting the supply and demand of liquidity in the market. For example, we find that thin books elicit orders and thick books result in trades. We also find evidence of priority effects. For example, investors quickly place orders within the quotes when the depth at the quotes is large or when the spread is large in order to gain price and time priority. Some of our results are also consistent with information effects. For example, a downward (upward) shift in the bid and ask quotes is observed after large sales (purchases).