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Abstract:
In the standard real options approach to investment, the owner of the option decides when to exercise the investment option. However, in many real-world settings, investment decisions are delegated to managers. This article provides a model of optimal contracting in a continuous-time principal-agent setting in which there is both moral hazard and adverse selection. We show that the underlying option can be decomposed into two components: A manager's option and an owner's option. The specification of the manager's option is determined by a compensation contract, and must provide an incentive for the manager to both extend effort and to exercise as close to the value-maximizing stopping time as possible. The residual option payout goes to the owner. The implied investment behavior differs significantly from that of the first-best no-agency solution. In particular, there will be greater inertia in investment, in that the model leads to the manager having an even greater "option to wait" than the owner. The interplay between the twin forces of hidden information and hidden action leads to markedly different investment outcomes than when only one of the two forces is at work.

Real Options, Agency Costs, Hidden Information, Hidden Action, Investment Timing

Abstract:
The separation of ownership and control allows controlling shareholders to pursue private benefits.

We develop an analytically tractable dynamic stochastic general equilibrium model to study asset pricing and welfare implications of imperfect investor protection. Consistent with empirical evidence, the model predicts that countries with weaker investor protection have more incentives to overinvest, lower Tobin's q, higher return volatility, larger risk premium, and higher interest rate. Calibrating the model to the Korean economy reveals that perfecting investor protection increases the stock market's value by 22 percent, a gain for which outside shareholders are willing to pay 11 percent of their capital stock.

Abstract:
The separation of ownership and control allows controlling shareholders to pursue private benefits. We develop an analytically tractable dynamic stochastic general equilibrium model to study asset pricing and welfare implications of imperfect investor protection. Consistent with empirical evidence, the model predicts that countries with weaker investor protection have more incentives to overinvest, lower Tobin's q, higher return volatility, larger risk premium, and higher interest rate. Calibrating the model to the Korean economy reveals that perfecting investor protection increases the stock market's value by 22 percent, a gain for which outside shareholders are willing to pay 11 percent of their capital stock.

Abstract:
The separation of ownership and control allows controlling shareholders to pursue private benefits. We develop an analytically tractable dynamic stochastic general equilibrium model to study asset pricing and welfare implications of imperfect investor protection. The model predicts that countries with weaker investor protection have more incentives to overinvest, lower Tobin's q, higher return volatility, larger risk premium, and higher interest rate, consistent with empirical evidence. Calibrating the model to the Korean economy reveals that making investor protection perfect increases the stock market value by 22%, a gain for which outside shareholders are willing to pay 11% of their capital stocks.

Asset prices, heterogeneous agents, agency, corporate governance, investor protection, volatility, overinvestment

Abstract:
The recent law and finance literature following Shleifer and Vishny (1997) and La Porta, Lopez-de Silanes, and Shleifer (1998) argues that the expropriation of minority shareholders by controlling shareholders is at the core of agency conflicts in most countries. While much empirical evidence has been accumulated regarding the importance and effects of this particular type of conflict, theoretical work in this area has largely been qualitative, focusing only on directional effects. This paper builds a contingent claims model in which a controlling shareholder can divert part of the firm's cash flows as private benefits at the expense of minority shareholders. In this environment, we examine the impact of the opportunistic behavior of the controlling shareholder on investment and financing decisions. The model shows that conflicts of interests among shareholders can explain the low debt levels observed in practice. It also examines the impact of agency conflicts on firms' investment decisions and the cross-sectional variation in capital structures.

private benefits of control, investment policy, financing policy

Abstract:
This paper provides a model of optimal investment timing in a decentralized firm under conditions of agency and asymmetric information. Using a real options approach, we show that an underlying option to invest can be decomposed into two components: a manager's option and an owner's option. The terms of the manager's option are determined by an optimal contracting model, and provide an incentive for the manager to both extend effort and truthfully reveal his private information. The implied investment behavior differs significantly from that of standard real options models. In particular, there will be greater inertia in investment, in that the model leads to the manager having an even greater "option to wait" than the owner. The interplay between the twin forces of hidden information and hidden action leads to markedly different investment outcomes than when only one of the two forces is at work.

real options, capital budgeting, agency cost, hidden information, hidden action, investment timing

Abstract:
We model dynamic investment, financing and default decisions of a firm, which begins its life with a collection of growth options. The firm exercises them optimally over time, and finances the costs of investment by trading off tax benefits of debt with both distress costs and agency costs of debt. Conflicts of interests between equityholders and various classes of debtholders are managed through optimal choice of investment triggers, capital structure, and default triggers. We show that (i) existing debt may significantly distort investment decisions (debt overhang and risk shifting); (ii) anticipating distortions induced by debt, firms with more growth options on average have lower leverages, consistent with empirical evidence; (iii) the seniority structure of debt has significant effects on the firm's default, leverage, and investment decisions, when existing debt is exogenously given; (iv) when future growth options are anticipated, the firm optimally chooses its initial investment and leverage decisions, which substantially mitigate the anticipated endogenous debt overhang, and make debt seniority structure much less relevant.

Endogenous default, leverage, real options, debt overhang, debt seniority

Abstract:
The real options framework has been used extensively to analyze the timing of investment under uncertainty. While standard real options models assume that agents possess a constant rate of time preference, there is substantial evidence that agents are very impatient about choices in the short-term, but are quite patient when choosing between long-term alternatives. We extend the real options framework to model the investment timing decisions of entrepreneurs with such time-inconsistent preferences. Two opposing forces determine investment timing: while evolving uncertainty induces entrepreneurs to defer investment in order to take advantage of the option to wait, their time-inconsistent preferences motivate them to invest earlier in order to avoid the time-inconsistent behavior they will display in the future. We find that the precise trade-off between these two forces depends on such factors as whether entrepreneurs are sophisticated or naive in their expectations regarding their future time-inconsistent behavior, as well as whether the payoff from investment occurs all at once or over time. We extend the model to consider equilibrium investment behavior for an industry comprised of time-inconsistent entrepreneurs. Such an equilibrium involves the dual problem of entrepreneurs playing dynamic games against competitors as well as against their own future selves.

irreversible investment, hyperbolic discounting, time inconsistency, real options

Abstract:
Many economic decisions can be described as an option exercise or optimal stopping problem under uncertainty. Motivated by experimental evidence such as the Ellsberg Paradox, we follow Knight (1921) and distinguish risk from uncertainty. To afford this distinction, we adopt the multiple-priors utility model. We show that the impact of ambiguity on the option exercise decision depends on the relative degrees of ambiguity about continuation payoffs and termination payoffs. Consequently, ambiguity may accelerate or delay option exercise. We apply our results to firm investment and exit problems, and show that the myopic NPV rule can be optimal for an agent having an extremely high degree of ambiguity aversion.

Ambiguity, multiple-priors utility, real options, optimal stopping problem

Abstract:
Empirical evidence shows that entrepreneurs on average do not earn more than paid employees in terms of the net present value (NPV). One natural question is what makes the entrepreneurs to stay in business. To address this question, we propose a continuous time real options model in which an entrepreneur does not know his investment quality and learn about it over time. We show that due to the option value of learning, an entrepreneur may stay in business even though the NPV is negative. We also show that risk aversion erodes option value and lowers private firm value so that a highly risk averse entrepreneur may exit even when the NPV is positive. In addition, a more risk averse or a more pessimistic entrepreneur exits earlier. Finally, the model can generate the positive relation between wealth and survival duration without liquidity constraints.

real options, learning, private firm value, survival, precautionary savings, incomplete markets

Abstract:
Entrepreneurs often face undiversifiable idiosyncratic risks from their business investments. Motivated by this observation, we extend the standard real options approach to investment to an incomplete markets environment and analyze the joint decisions of business investments, consumption-saving and portfolio selection. We show that precautionary saving motive affects the investment timing decision in an important way. When the investment payoffs are given in lump sum, risk aversion accelerates investment. For an agent with sufficiently strong precautionary motive, an increase in volatility may accelerate investment, opposite to the standard real options analysis. When the agent can trade the market portfolio to partially hedge against the investment risk, the systematic volatility is compensated via the standard CAPM argument, and the idiosyncratic volatility generates a private equity premium. Finally, for the flow payoff case, the agent's idiosyncratic risk exposure alters both the implied option value and the implied project value, causing the reversal of the results in the lump sum payoff case.

real options, idiosyncratic risk, hedging, risk aversion, precautionary saving, incomplete markets

Abstract:
Across U.S. households, the distribution of wealth is more skewed and fat-tailed than that of earnings. Benchmark models such as Aiyagari (1994), however, imply a less skewed and
fat-tailed distribution for wealth than for earnings, because of their assumptions of (i) stationary earnings processes and (ii) infinite horizon. This paper provides a model based on (i) highly-persistent conditionally-heteroskedastic earnings processes, motivated by empirical evidence, and (ii) realistic, stochastic, and finite life horizons. These two features together generate an endogenous wealth distribution that is more skewed and fat-tailed than earnings. Preferences and earnings processes are specified so as to allow a closed-form solution, which facilitates analysis and calibration.

Wealth Distribution, Stochastic Life Horizon, Conditional Heteroskedasticity

Abstract:
This paper analyzes a risk averse entrepreneur's real investment decision under incomplete markets. The entrepreneur smoothes his intertemporal consumption by investing in both a risk-free asset and a risky asset, which allows him to partially hedge against the project cash flow risk. We show that risk aversion lowers both the project value upon investment and the option value of waiting to invest through the precautionary saving effect. Furthermore, risk aversion delays investment since the project value is reduced more than the option value to invest. It is also shown that although hedging can reduce the cash flow risk, it may have a positive or negative return effect, depending on the correlation between the cash flow risk and the market. Consequently, investment timing is not monotonic with the extent of hedging opportunity. Finally, welfare implications of hedging are analyzed.

Real options, risk aversion, incomplete markets, hedging, precautionary saving

Abstract:
I propose an intertemporal precautionary-saving model in which the agent's labor income is subject to both permanent and transitory shocks. However, he only observes his total income, not individual components. I show that partial observability of individual components of income gives rise to additional precautionary saving because of uncertainty in estimating individual components of income. This additional precautionary saving is higher, when there is greater uncertainty associated with estimating the individual components of income.
Incomplete Information, Kalman Filter

Precautionary Savings, Separation Principle,

Abstract:
This paper presents a model for an explicitly-solved optimal consumption in which there is a lower marginal propensity to consume out of "human wealth" than out of financial wealth. I deliver this widely-noted consumption property (Friedman (1957) and Zeldes (1989)) by specifying that the conditional variance of income increases in its level. A larger realization of income not only implies that a higher level of human walth, but also signals a riskier stream of future labor income, inducing a higher propensity to save. A natural decomposition of saving is proposed to formulate Friedman's insights on motives for holding wealth.

Precautionary Savings, Permanent Income, Conditional Heteroskedasticity

Abstract:
I present an explicitly solved model for the distribution of wealth and income in an incomplete-markets economy. I first propose a consumption model with an inter-temporally dependent preference (Uzawa (1968) and Obstfeld (1990)). I then derive an analytical consumption rule which captures stochastic precautionary saving motive and generates stationary wealth accumlation. Finally, I provide a complete characterization for the equilibrium cross-selectional distribution of wealth and income in closed form by developing a recursive formulation for the moments of the distribution of wealth and income. Using this recursive formulation, I show that income persistence and the degree of wealth mean reversion are the main determinants of wealth-income correlation and relative dispersions of wealth to income, such as skewness and kurtosis ratios between wealth and income.

precautionary savings, wealth distribution, Bewley models, affine process, recursive utility, stochastic discounting

Abstract:
Entrepreneurs face significant non-diversifiable business risks. We build a dynamic incomplete markets model of entrepreneurial finance to demonstrate the important implications of nondiversifiable risks for entrepreneurs' interdependent consumption, portfolio allocation, financing, investment, and business exit decisions. The optimal capital structure is determined by a generalized tradeoff model where leverage via risky non-recourse debt provides significant diversification benefits. More risk-averse entrepreneurs default earlier, but also choose higher leverage, even though leverage makes his equity more risky. Non-diversified entrepreneurs demand both systematic and idiosyncratic risk premium. Cash-out option and external equity further improve diversification and raise the entrepreneur's valuation of the firm. Finally, entrepreneurial risk aversion can overturn the risk-shifting incentives induced by risky debt.

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:
Entrepreneurs face significant non-diversifiable business risks. We build a dynamic incomplete-markets model of entrepreneurial finance to demonstrate the important implications of non-diversifiable risks for entrepreneurs' interdependent consumption, portfolio allocation, financing, investment, and business exit decisions. The optimal capital structure is determined by a generalized tradeoff model where leverage via risky non-recourse debt provides significant diversification benefits. More risk-averse entrepreneurs default earlier, but also choose higher leverage, even though leverage makes his equity more risky. Non-diversified entrepreneurs demand both systematic and idiosyncratic risk premium. Cash-out option and external equity further improve diversification and raise the entrepreneur's valuation of the firm. Finally, entrepreneurial risk aversion can overturn the risk-shifting incentives induced by risky debt.

Default, diversification benefits, entrepreneurial risk aversion, incomplete markets, private equity premium, hedging, capital structure, cash-out option, precautionary saving

Abstract:
What is the likelihood that the U.S. will experience a devastating catastrophic event over the next few decades -- something that would substantially reduce the capital stock, GDP and wealth? What does the possibility of such an event imply for the behavior of economic variables such as investment, interest rates, and equity prices? And how much should society be willing to pay to reduce the probability or likely impact of such an event? We address these questions using a general equilibrium model that describes production, capital accumulation, and household preferences, and includes as an integral part the possible arrival of catastrophic shocks. Calibrating the model to average values of economic and financial variables yields estimates of the implied expected mean arrival rate and impact distribution of catastrophic shocks. We also use the model to calculate the tax on consumption society would accept to reduce the probability or impact of a shock.

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:
What is the likelihood that the U.S. will experience a devastating catastrophic event over the next few decades – something that would substantially reduce the capital stock, GDP and wealth? What does the possibility of such an event imply for the behavior of economic variables such as investment, interest rates, and equity prices? And how much should society be willing to pay to reduce the probability or likely impact of such an event? We address these questions using a general equilibrium model that describes production, capital accumulation, and household preferences, and includes as an integral part the possible arrival of catastrophic shocks. Calibrating the model to average values of economic and financial variables yields estimates of the implied expected mean arrival rate and impact distribution of catastrophic shocks. We also use the model to calculate the tax on consumption society would accept to reduce the probability or impact of a shock.

Catastrophes, disasters, rare events, economic uncertainty, consumption tax, national security

Abstract:
This paper proposes a simple homogeneous dynamic model of investment and corporate risk management for a financially constrained firm. Following Froot, Scharfstein, and Stein (1993), we define a corporation's risk management as the coordination of investment and financing decisions. In our model, corporate risk management involves internal liquidity management, financial hedging, and investment. We determine a firm's optimal cash, investment, asset sales, credit line, external equity finance, and payout policies as functions of the following key parameters: 1) the firm's earnings growth and cash-flow risk; 2) the external cost of financing; 3) the firm's liquidation value; 4) the opportunity cost of holding cash; 5) investment adjustment and asset sales costs; and 6) the return and covariance characteristics of hedging assets the firm can invest in. The optimal cash inventory policy takes the form of a double-barrier policy where i) cash is paid out to shareholders only when the cash-capital ratio hits an endogenous upper barrier, and ii) external funds are raised only when the firm has depleted its cash. In between the two barriers, the firm adjusts its capital expenditures, asset sales, and hedging policies. Several new insights emerge from our analysis. For example, we find an inverse relation between marginal Tobin's q and investment when the firm draws on its credit line. We also find that financially constrained firms may have a lower equity beta in equilibrium because these firms tend to hold higher precautionary cash inventories.

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:
Corporations in most countries are run by controlling shareholders whose cash flow rights are substantially smaller than their control rights in the firm. This separation of ownership and control allows the controlling shareholders to pursue private benefits at the cost of outside minority investors by diverting resources away from the firm and distorting corporate investment and payout policies. We develop a dynamic stochastic general equilibrium asset-pricing model that acknowledges the implications of agency conflicts through imperfect investor protection on security prices. We show that countries with weaker investor protection have more overinvestment, lower market-to-book equity values, larger expected equity returns and return volatility, higher dividend yields, and higher interest rates. These predictions are consistent with empirical findings. We develop new predictions: countries with high investment-capital ratios have both higher variance of GDP growth and higher variance of stock returns. We provide evidence consistent with these hypotheses. Finally, we show that weak investor protection causes significant wealth redistribution from outside shareholders to controlling shareholders.

Asset prices, heterogeneous agents, agency, corporate governance, investor protection, volatility, overinvestment

Abstract:
This paper provides a model of investment timing by managers in a decentralized firm in the presence of agency conflicts and information asymmetries. When investment decisions are delegated to managers, contracts must be designed to provide incentives for managers to both extend effort and truthfully reveal private information. Using a real options approach, we show that an underlying option to invest can be decomposed into two components: a manager's option and an owner's option. The implied investment behavior differs significantly from that of the first-best no-agency solution. In particular, greater inertia occurs in investment, as the model predicts that the manager will have a more valuable option to wait than the owner.

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 real options framework has been used extensively to analyze the timing of investment under uncertainty. While standard real options models assume that agents possess a constant rate of time preference, there is substantial evidence that agents are very impatient about choices in the short-term, but are quite patient when choosing between long-term alternatives. We extend the real options framework to model the investment timing decisions of entrepreneurs with such time-inconsistent preferences. Two opposing forces determine investment timing: while evolving uncertainty induces entrepreneurs to defer investment in order to take advantage of the option to wait, their time-inconsistent preferences motivate them to invest earlier in order to avoid the time-inconsistent behavior they will display in the future. We find that the precise trade-off between these two forces depends on such factors as whether entrepreneurs are sophisticated or naive in their expectations regarding their future time-inconsistent behavior, as well as whether the payoff from investment occurs all at once or over time. We extend the model to consider equilibrium investment behavior for an industry comprised of time-inconsistent entrepreneurs. Such an equilibrium involves the dual problem of entrepreneurs playing dynamic games against competitors as well as against their own future selves.

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:
Entrepreneurs often face undiversifiable idiosyncratic risks from their business investments. We extend the standard real options approach to an incomplete markets environment and analyze the joint decisions of business investments, consumption/savings, and portfolio selection. For a lump-sum investment payoff and an agent with a sufficiently strong precautionary savings motive, an increase in volatility can accelerate investment, contrary to the standard real options analysis. When the agent can trade the market portfolio to partially hedge against investment risk, the systematic volatility is compensated via the standard CAPM argument, and the idiosyncratic volatility generates a private equity premium. Finally, when the investment payoff is a series of flows, the agent's idiosyncratic risk exposure alters both the implied option value and the implied project value, causing a reversal of the results in the lump-sum payoff case.

Abstract:
I study the agent's optimal consumption-saving and portfolio choice decisions when he cannot fully insure his income shocks and does not know his income growth rate. I show that the agent rationally saves for precaution against the risk of estimating his income growth, in addition to his standard precautionary saving demand induced by income volatility. I then extend the analysis to allow for the agent's unknown growth rate to be stochastic. Finally, I generalize the model to allow the agent to trade risky assets to hedge against both his income risk and estimation risk. A more volatile and nosier underlying income process gives rise to a less volatile belief updating process. Hence, estimation risk (due to stochastic belief updating) is lower, and the implied hedging demand against estimation risk is smaller. The agent's total hedging demand is thus non-monotonic in his income volatility because estimation risk decreases with income volatility, ceteris paribus.

Incomplete markets, precautionary saving, Kalman filter, learning, regime switching, portfolio choice, hedging, estimation risk

Abstract:
The permanent-income hypothesis (PIH) of Milton Friedman (1957) states that the agent saves in anticipation of possible future declines in labor income (John Y. Campbell, 1987). He also saves for precautionary reasons, and dissaves because of impatience. To justify the PIH in an intertemporal optimization framework, it has been conventional to assume both (i) quadratic utility, to turn off precautionary motives (Hall, 1978), and (ii) equality between the subjective discount rate and the interest rate, in order to rule out dissavings for lack of patience. Neither assumption is plausible. Much work on consumption in the past decade has focused on individual's precautionary savings motives and liquidity constraints. Impatience is a standard result in heterogeneous agents general-equilibrium incomplete-markets models, generally known as Bewley models. This paper shows that the PIH is in any case the optimal rule, in a Bewley model, in which each agent solves the precautionary-savings model of Caballero (1990, 1991). In addition to the demand for savings for a rainy day, Caballero's model also predicts a constant precautionary - savings demand and constant dissavings due to impatience. In equilibrium, I show that these two forces must cancel each other. As a result, the agent behaves in accordance with the PIH.

Precautionary saving, Permanent Income, Consumption, Income fluctuation

Abstract:
A planner and agent in a permanent-income economy cannot observe part of the state, regard their model as an approximation, and value decision rules that are robust across a set of models. They use robust decision theory to choose allocations. Equilibrium prices reflect the preference for robustness and so embody a "market price of Knightian uncertainty." We compute market prices of risk and compare them with a model that assumes that the state is fully observed. We use detection error probabilities to constrain a single parameter that governs the taste for robustness.

Kalman filter, approximating model, Knightian uncertainty, robustness, equity premium, market price of uncertainty, permanent income

Abstract:
This paper provides a model of investment timing by managers in a decentralized firm in the presence of agency conflicts and information asymmetries. When investment decisions are delegated to managers, contracts must be designed to provide incentives for managers to both extend effort and truthfully reveal private information. Using a real options approach, we show that an underlying option to invest can be decomposed into two components: a manager's option and an owner's option. The implied investment behavior differs significantly from that of the first-best no-agency solution. In particular, greater inertia occurs in investment, as the model predicts that the manager will have a more valuable option to wait than the owner.

Real options, investment timing, contracting, agency

Abstract:
I propose an intertemporal precautionary saving model in which the agent's labor income is subject to (possibly correlated) shocks with different degrees of persistence and volatility. However, he only observes his total income, not individual components. I show that partial observability of individual components of income gives rise to additional precautionary saving due to estimation risk, the error associated with estimating individual components of income. This additional precautionary saving is higher, when estimation risk is greater. Compared with a precautionary agent who is otherwise identical, but ignores estimation risk, the rational agent consumes less at the beginning of his life, but consumes more later, because of larger wealth accumulated from savings for estimation risk. The utility cost of ignoring estimation risk is also quantified in closed form.

Precautionary saving, separation principle, incomplete information, Kalman filter