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Abstract:
We study the optimal portfolio choice of hedge fund managers who are compensated by high-water mark contracts. Surprisingly, we find that even risk-neutral managers will not place unboundedly large weights on the risky assets, despite the option-type features of the contract. Instead they will place a constant fraction of assets in a mean-variance efficient portfolio and the rest in the riskless asset, similar to investors with constant relative risk aversion. This result is a direct consequence of the indefinite horizon of the contract. We argue more generally that the risk-seeking incentives of option-type compensation contracts rely on the interaction of convex compensation and finite horizons, rather than on the convexity of the compensation scheme alone.

Performance evaluation, Hedge funds, Option-type compensation, High-water marks, Continuous time

Abstract:
We study the optimal portfolio choice of hedge fund managers who are compensated by high-water mark contracts. Surprisingly, we find that even risk-neutral managers will not place unboundedly large weights on the risky assets, despite the option-type features of the contract. Instead they will place a constant fraction of assets in a mean-variance efficient portfolio and the rest in the riskless asset, similar to investors with constant relative risk aversion. This result is a direct consequence of the in(de)finite horizon of the contract. We argue more generally that the risk-seeking incentives of option-type compensation contracts rely on the interaction of convex compensation and finite horizons, rather than on the convexity of the compensation scheme alone.

Performance Evaluation, Hedge funds, Option-Type Compensation, High-Water Marks, Continuous Time

Abstract:
In this paper I investigate whether firms' physical investments should react to the speculative overpricing of their securities. I introduce investment subject to quadratic adjustment costs (along the lines of Abel and Eberly [1994]) in an infinite horizon continuous time model with short sale constraints and heterogeneous beliefs (along the lines of Scheinkman and Xiong [2003]). Under standard assumptions, I show that the neoclassical q theory of investment will continue to hold despite the presence of (endogenous) speculative mispricing in the stock market. Strikingly, the welfare implications of the theory will also continue to hold, despite the presence of a speculative bubble. I show how the model provides a new formalization of the notions of short-termist and long-termist investment policies and also how the behavior of investment can be used to disentangle rational and behavioral approaches to so-called asset pricing anomalies.

Investment, q-theory, speculation, short sales constraints, heterogenous beliefs, bubbles, mispricing

Abstract:
We study optimal consumption and portfolio choice in a framework where investors save for early retirement and assume that agents can adjust their labor supply only through an irreversible choice of their retirement time. We obtain closed form solutions and analyze the joint behavior of retirement time, portfolio choice, and consumption. Investing for early retirement tends to increase savings and stock market exposure, and reduce the marginal propensity to consume out of accumulated personal wealth. Contrary to common intuition, prior to retirement an investor might find it optimal to increase the proportion of financial wealth held in stocks as she ages, even when she receives a constant income stream and the investment opportunity set is also constant. This is particularly true when the wealth of the investor increases rapidly due to strong stock market performance, as was the case in the late 1990's. We also show that the model can potentially provide a rational explanation for the paradoxical fact that some investors saving for retirement chose to increase their allocation to stocks as the market was booming and reduce it thereafter.

Retirement, Portfolio Choice, Marginal Propensity to Consume, Indivisible Labor

Abstract:
In this paper we investigate whether stock market overpricing leads to aggregate (real) inefficiencies. We first investigate a standard dynamic contracting model of investment subject to financing constraints. We show that stock market mispricing will have two robust effects on welfare: on the one hand it will distort investment decisions and lead to inefficiencies. On the other hand it will alleviate underinvestment problems and allow some efficient projects to be undertaken. We then turn to the data and investigate which of the two effects dominates at the aggregate. By using proxies for investor sentiment within a vector autoregression (VAR) we find that positive shocks to sentiment boost (real) investment while reducing aggregate profits over the long run, all else equal. We interpret this as evidence that mispricing causes more inefficiencies than it corrects.

Mispricing, Efficiency, Real Effects of Stock market bubbles, Investment, Investor Sentiment

Abstract:
A firm's termination leads to bankruptcy costs. This may create an incentive for outside stakeholders or the firm's debtholders to bail out the firm as bankruptcy looms. Because of this implicit guarantee, firm shareholders have an incentive to increase volatility in order to exploit the implicit protection. However, if they increase volatility too much they may induce the guarantee-extending parties to walk away. I derive the optimal risk management rule in such a framework and show that it allows high volatility choices, while net worth is high. However, risk limits tighten abruptly when the firm's net worth declines below an endogenously determined threshold. Hence, the model reproduces the qualitative features of existing risk management rules, and can account for phenomena such as flight to quality.

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:
A firm's termination leads to bankruptcy costs. This may create an incentive for outside stakeholders or the firm's debtholders to bail out the firm as bankruptcy looms. Because of this implicit guarantee, firm shareholders have an incentive to increase volatility in order to exploit the implicit protection. However, if they increase volatility too much they may induce the guarantee-extending parties to "walk away". I derive the optimal risk management rule in such a framework and show that it allows high volatility choices, while net worth is high. However, risk limits tighten abruptly when the firm's net worth declines below an endogenously determined threshold. Hence, the model reproduces the qualitative features of existing risk management rules, and can account for phenomena such as "flight to quality".

Option Pricing, Continuous time stochastic optimization, Implicit Guarantees, Default, Bailouts, Financial Crises

Abstract:
Emerging market economies, which have much of their growth ahead of them, run persistent current account deficits in order to smooth consumption intertemporally. The counterpart of these deficits is their dependence on capital inflows, which can suddenly stop. In this paper we develop and estimate a quantifiable model of sudden stops and use it to study practical mechanisms to insure emerging markets against them. We first assess the standard practice of protecting the current account through the accumulation of international reserves and conclude that, even when optimally managed, this mechanism is expensive and incomplete. External insurance, on the other hand, is hard to obtain because sudden stops often come together with distress in emerging market investors themselves (the most natural insurers). Thus, one needs to find global (non-emerging-market-specific) assets that are correlated to sudden stops. We show an example of such an asset based on the S&P 500's implied volatility index. If added to these countries portfolios, it would significantly enhance their sudden stop risk-management strategies. In our simulations, the median gain in terms of reserves available at the time of sudden stop is around 30 percent. Moreover, in instances where the level of non-contingent reserves is low, the median gain is close to 300 percent. We also find that as countries manage to reduce the size of the sudden stops that afflict them, they should reduce their stock of reserves and significantly increase their share of contingent reserves. The main insights of the paper extend to external liquidity and liability management more generally.

Abstract:
Emerging market economies, which have much of their growth ahead of them, run persistent current account deficits in order to smooth consumption intertemporally. The counterpart of these deficits is their dependence on capital inflows, which can suddenly stop. In this paper we develop and estimate a quantifiable model of sudden stops and use it to study practical mechanisms to insure emerging markets against them. We first assess the standard practice of protecting the current account through the accumulation of international reserves and conclude that, even when optimally managed, this mechanism is expensive and incomplete. External insurance, on the other hand, is hard to obtain because sudden stops often come together with distress in emerging market investors themselves (the most natural insurers). Thus, one needs to find global (non-emerging-market-specific) assets that are correlated to sudden stops. We show an example of such an asset based on the S&P 500's implied volatility index. If added to these countries portfolios, it would significantly enhance their sudden stop risk-management strategies. In our simulations, the median gain in terms of reserves available at the time of sudden stop is around 30 percent. Moreover, in instances where the level of non-contingent reserves is low, the median gain is close to 300 percent. We also find that as countries manage to reduce the size of the sudden stops that afflict them, they should reduce their stock of reserves and significantly increase their share of contingent reserves. The main insights of the paper extend to external liquidity and liability management more generally.

Capital flows, sudden stops, reserves, international liquidity and liability management, specialists, world capital markets, swaps, insurance, hedging, options, hidden states, Bayesian methods

Abstract:
One of the most serious problems that a central bank in an emerging market economy can face, is the sudden reversal of capital inflows. Hoarding international reserves can be used to smooth the impact of such reversals, but these reserves are seldom sufficient and always expensive to hold. In this paper we argue that adding richer hedging instruments to the portfolios held by central banks can significantly improve the efficiency of the anti-sudden stop mechanism. We illustrate this point with a simple quantitative hedging model, where optimally used options and futures on the S&P100's implied volatility index (VIX), increases the expected reserves available during sudden stops by as much as 40 percent.

Sudden stops, reserves, portfolio, VIX, hedging, options, futures.

Abstract:
One of the most serious problems that a central bank in an emerging market economy can face, is the sudden reversal of capital inflows. Hoarding international reserves can be used to smooth the impact of such reversals, but these reserves are seldom sufficient and always expensive to hold. In this paper we argue that adding richer hedging instruments to the portfolios held by central banks can significantly improve the efficiency of the anti-sudden stop mechanism. We illustrate this point with a simple quantitative hedging model, where optimally used options and futures on the S&P100's implied volatility index (VIX), increases the expected reserves available during sudden stops by as much as 40 percent.

Abstract:
In this paper we study the implications of general-purpose technological growth for asset prices. The model features two types of shocks: ``small", frequent, and disembodied shocks to productivity and ``large" technological innovations, which are embodied into new vintages of the capital stock. While the former affect the economy on impact, the latter affect the economy with lags, since firms need to first adopt the new technologies through investment. The process of adoption leads to cycles in asset valuations and risk premia as firms convert the growth options associated with the new technologies into assets in place. This process can help provide a unified, investment-based view of some well documented phenomena such as the asset-valuation patterns around major technological innovations, the countercyclical behavior of returns, the lead-lag relationship between the stock market and output, and the increasing patterns of consumption-return correlations over longer horizons.

Production-based asset pricing, continuous-time methods, macro-finance, growth options, irreversible investment, technology adoption, vintage models

Abstract:
Even well managed emerging market economies are exposed to significant external risk, the bulk of which is financial. At a moment's notice, these economies may be required to reverse the capital inflows that have supported the preceding boom. While capital flows crises are sudden nonlinear events (sudden stops), their likelihood fluctuates over time. The question we address in the paper is: how should a country react to these fluctuations. Depending on the hedging possibilities the country faces, the options range from pure self-insurance to hedging the sudden stop jump itself. In between, there is the more likely possibility to hedge the smoother fluctuations in the likelihood of sudden stops. The main contribution of the paper is to provide an analytically and empirically tractable model that allows us to characterize and quantify optimal contingent liability management in a variety of scenarios. We show, with a concrete example, that the gains from contingent liability management can easily exceed the equivalent of cutting a country's external liabilities by 10 percent of GDP.

Capital flows, sudden stops, financial constraints, contractions, hedging, insurance, signals

Abstract:
Emerging market economies, which have much of their growth ahead of them, either run or should run persistent current account deficits in order to smooth consumption intertemporally. The counterpart of these deficits is their dependence on capital inflows, which can suddenly stop. We make two contributions in this paper: First, we develop a quantitative global-equilibrium model of sudden stops. Second, we use this structure to discuss practical mechanisms to insure emerging markets against sudden stops, ranging from conventional non-contingent reserves accumulation to more sophisticated contingent instrument strategies. Depending on the source of sudden stops, their correlation with world events, and the quality of the hedging instrument available, the gains from these strategies can represent a substantial improvement over existing practices.

Capital flows, sudden stops, reserves, international liquidity management, world, capital markets, swaps, insurance, hedging, options, hidden states, Bayesian methods

Abstract:
We study asset-pricing implications of innovation in a general-equilibrium overlapping-generations economy. Innovation increases the competitive pressure on existing firms and workers, reducing the profits of existing firms and eroding the human capital of older workers. Due to the lack of inter-generational risk sharing, innovation creates a systematic risk factor, which we call ``displacement risk.'' This risk helps explain several empirical patterns, including the existence of the growth-value factor in returns, the value premium, and the high equity premium. We assess the magnitude of displacement risk using estimates of inter-cohort consumption differences across households and find support for the model.

Asset Pricing, Equity Premium, Value Premium, Intergenerational Risk, Innovation, Displacement Risk

Abstract:
Even well managed emerging market economies are exposed to significant external risk, the bulk of which is financial. At a moment's notice, these economies may be required to reverse the capital inflows that have supported the preceding boom. While capital flows crises are sudden nonlinear events (sudden stops), their likelihood fluctuates over time. The question we address in the paper is how should a country react to these fluctuations. Depending on the hedging possibilities the country faces, the options range from pure self-insurance to hedging the sudden stop jump itself. In between, there is the more likely possibility to hedge the smoother fluctuations in the likelihood of sudden stops. The main contribution of the paper is to provide an analytically and empirically tractable model that allows us to characterize and quantify optimal contingent liability management in a variety of scenarios. We show, with a concrete example, that the gains from contingent liability management can easily exceed the equivalent of cutting a country's external liabilities by 10 percent of GDP.

*This is a revision of the June 2003 version.

Abstract:
Recurrent intervals of inattention to the stock market are optimal if consumers incur a utility cost to observe asset values. When consumers observe the value of their wealth, they decide whether to transfer funds between a transactions account from which consumption must be financed and an investment portfolio of equity and riskless bonds. Transfers of funds are subject to a transactions cost that reduces wealth and consists of two components: one is proportional to the amount of assets transferred, and the other is a fixed resource cost. Because it is costly to transfer funds, the consumer may choose not to transfer any funds on a particular observation date. In general, the optimal adjustment rule - including the size and direction of transfers, and the time of the next observation - is state-dependent. Surprisingly, unless the fixed resource cost of transferring funds is large, the consumer's optimal behavior eventually evolves to a situation with a purely time-dependent rule with a constant interval of time between observations. This interval of time can be substantial even for tiny observation costs. When this situation is attained, the standard consumption Euler equation holds between observation dates if the consumer is sufficiently risk averse.

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 study asset-pricing implications of innovation in a general-equilibrium overlapping-generations economy. Innovation increases the competitive pressure on existing firms and workers, reducing the profits of existing firms and eroding the human capital of older workers. Due to the lack of inter-generational risk sharing, innovation creates a systematic risk factor, which we call "displacement risk." This risk helps explain several empirical patterns, including the existence of the growth-value factor in returns, the value premium, and the high equity premium. We assess the magnitude of displacement risk using estimates of inter-cohort consumption differences across households and find support for the model.

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:
In this paper we study the implications of general-purpose technological growth for asset prices. The model features two types of shocks: "small", frequent, and disembodied shocks to productivity and large technological innovations, which are embodied into new vintages of the capital stock. While the former affect the economy on impact, the latter affect the economy with lags, since firms need to first adopt the new technologies through investment. The process of adoption leads to cycles in asset valuations and risk premia as firms convert the growth options associated with the new technologies into assets in place. This process can help provide a unified, investment-based view of some well documented phenomena such as the asset-valuation patterns around major technological innovations, the countercyclical behavior of returns, the lead-lag relationship between the stock market and output, and the increasing patterns of consumption-return correlations over longer horizons.

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 termination of a representative financial firm due to excessive leverage may lead to substantial bankruptcy costs. A government in the tradition of Ramsey (1927) may be inclined to provide transfers to the firm so as to prevent its liquidation and the associated deadweight costs. It is shown that the optimal taxation policy to finance such transfers exhibits countercyclicality and history dependence, even in a complete market. These results are in contrast with pre-existing literature on optimal fiscal policy, and are driven by the endogeneity of the transfer payments that are required to salvage the financial firm.

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 propose a study of an important source of stock market risk, the displacement risk. We focus on the fundamental inequality among firms and consumers with respect to technological innovation. New firms are the primary innovators who increase the overall productivity, but also steal business from older firms. Likewise, skills of younger households are better aligned with new technologies, while the human capital of older agents does not quite keep up with technological progress. Innovation activity increases total output while reducing the share of existing firms' profits in aggregate output. This displacement risk makes households reluctant to own stocks, particularly those of value firms, whose output is relatively exposed to the risk of increased innovation and competition by new firms, while assigning hedging value to growth firms, which profit from innovation. We propose a quantitative general-equilibrium model of displacement risk and offer an intuitive fundamental explanation of several basic empirical asset-pricing facts, including the high value premium, the high equity premium, and the low and stable risk-free rate. Our preliminary calibration results suggest that our model performs well quantitatively. Moreover, our model has unique empirical implications connecting historical returns on value and growth stocks to cross-sectional differences in consumption among households. Preliminary empirical analysis supports these implications of our theory.