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Abstract:
We study a hedge fund style contract in which management fees, incentive fees and a high water mark provision drive a fund manager's effort and risk choices as well as walkaway decisions by both the fund manager and the investor. We model this relationship and calibrate the model to observed data. Using the calibrated model, we consider welfare implications of changes to the standard 2/20 contract. Welfare results highlight the critical role higher management fees play in such contracts in terms of improving the manager's risk taking and effort expenditure decisions. In particular, a higher management fee and lower incentive fee (e.g. a 2.5/10 contract) leads to Pareto improvement in the calibrated model.

Hedge Funds, Corporate Finance, Contracts

Abstract:
I show that banks place investment and borrowing restrictions on firms that are in lending relationships so that the banks can continue extracting surplus from the firms over multiple periods. This agency problem is more pronounced for firms that have larger information asymmetries with the credit market. I use the term Reverse Asset Substitution (RAS) to express this partial transfer of control that benefits debt holders at the expense of equity holders when firm is not in danger of bankruptcy. Equity holders take this agency problem along with potential bankruptcy costs of debt into account when choosing firm leverage. I find that firms enjoying perfect competition in credit supply invest 2% more in PP&E than firms facing a monopoly in credit supply by banks. RAS reduces firm growth (11% lower PP&E) and leverage (24% lower). Also, RAS reduces firm value by 23% compared to the case where bankruptcy cost is the only concern in choosing the amount of bank loan.

Financing, Investment, Asset Substitution, Reverse Asset Substitution, Leverage, Under Leverage, Agency Cost, Bank Loan

Abstract:
Optimal contracts under information asymmetry require an amount of ownership that management needs to have for incentive compatibility, that is often not practical for large firms. I argue that corporate governance mechanisms help achieve second best control for the investor under such conditions. I propose that the amount of management autonomy in a firm is chosen as a best response to exogenous firm characteristics, such as output variance. Shareholders face a trade-off regarding autonomy as higher autonomy increases firm productivity but also leads to increased private benefits. Shareholders in firms with higher exogenous variance attempt to reduce the information disadvantage they face by reducing autonomy of management. Thus, in practice, I observe a range of governance control that is negatively correlated to the variance of firm output. In addition, I find that over time, this information gap has decreased in US capital markets, and since Sarbanes-Oxley the information asymmetry does not play a role in the choice of corporate governance mechanisms.

Corporate Governance, Shareholder Response, Sarbanes-Oxley

Abstract:
Trading firms, whom we entrust the job of providing liquidity, may exacerbate liquidity shocks to the economy and furthermore, reduce efficacy of liquidity injections by the state. Unlike traditional banks, trading firms observe their losses privately and have incentives to avoid revealing losses due to the fear of a bank run by investors and counter-parties. Hence, even if central banks stand ready to guarantee liquidity, due to the pooling behavior of trading firms, liquidity allocation will be inefficient. This prolongs the liquidity crisis, as firms in red use injected liquidity to stave off bank runs, while other firms may use new liquidity to take predatory positions. The moral hazard problem is also exacerbated as firms taking excessive risk are provided cheap money. Hence, we suggest a different approach in this paper: to avoid the pooling equilibrium between firms in black and in red, a separating equilibrium is encouraged where all the liquidity is provided to firms with stronger balance sheets, allowing them to absorb the assets of the firms facing losses. As the firms with better books compete against each other with new found liquidity, and the firms in red exit, the liquidity in capital markets also improves quickly.

Liquidity, Systemic Risk, Leverage, Margins, Haircuts, Value-at-Risk, Credit Crunch, Counterparty Credit Risk, Financial crises, Incomplete markets, Insurance

Abstract:
I show that if more than one assets are correlated with a traded factor, then under certain conditions, an informed trader can make superior profits or reveal less information if she trades a combination of these correlated assets to gain exposure to the factor. Information sharing by market makers in correlated assets is thus necessary to level the playing field. The result holds for both risk neutral and risk averse investors.

Correlated Assets, Market Making, Asymmetric Information, Private Information