Hysteresis in price efficiency and the economics of slow moving capital.
Review of Financial Studies, 34, 2857–2909 (2021)
Will arbitrage capital flow into markets experiencing shocks, mitigating adverse effects on price efficiency? Not necessarily. In a dynamic model with privately informed capital-constrained arbitrageurs, price efficiency plays a dual role, determining both the profitability of new arbitrage and the ability to close existing positions profitably. An adverse shock to efficiency lengthens arbitrage duration, effectively reducing the amount of arbitrage capital available for new positions. If this falls below a critical mass, arbitrage capital flows out, amplifying the impact on price efficiency. This creates endogenous regimes: temporary shocks can trigger “hysteresis,” a persistent shift in price efficiency.
Searching for Information.
Journal of Economic Theory, 175, 342-373 (2018)
This paper provides a search-based information acquisition framework using an urn model with an asymptotic approach. The underlying intuition of the model is simple: when the scope of information search is more limited, marginal search efforts produce less useful information due to redundancy, but commonality of information among different agents increases. Consequently, limited information searchability induces a trade-off between an information source’s precision and its commonality. In a beauty contest game with endogenous information acquisition, this precision-commonality trade-off generates non-fundamental volatility through the channel of information acquisition.
The Economics of Credit Rating Agencies.
Foundations and Trends in Finance, 12, 1-116 (2017)
We explore through both an economics and regulatory lens the frictions associated with credit rating agencies in the aftermath of the financial crisis. While ratings and other public signals are an efficient response to scale economies in information production, these also can discourage independent due diligence and be a source of systemic risk. Though Dodd-Frank pulls back on the regulatory use of ratings, it also promotes greater regulation of the rating agencies. We highlight the diverse underlying views towards these competing approaches to reducing systemic risk. Our monograph also discusses the subtle contrasts between credit rating agencies and other types of due diligence providers, such as auditors, analysts and proxy-voting advisors. We discuss the frictions associated with paying for information in the context of credit ratings; while the issuer-pay model has been identified as a major issue because of potential conflict of interests, we argue that it has several advantages over the investor-pay model in promoting market transparency.
We develop a formal reputation model to explore the underlying nature of rating inflation and how the reputational trade-off is affected by various aspects of the rating process such as regulatory constraints, the fee structure, asymmetric information between issuers and investors and the extent of competition among rating agencies. The monograph also uses our illustrative framework to highlight tension between rating accuracy and economic efficiency when ratings influence project value in the presence of feedback effects. We discuss how selective disclosure of ratings by the issuer distorts the distribution of observed ratings. Selection also provides an alternative explanation for why solicited (purchased) ratings exceed unsolicited (complimentary) ratings and helps interpret the greater SEC support for unsolicited ratings in recent years as illustrating the theory of the second best. We explore the impact of greater competition on welfare, building upon a variety of frameworks. Our analysis points to several ways in which ratings matter as well as techniques for documenting such effects.
Opacity, Credit Rating Shopping and Bias.
Management Science, 63, 4016-4036 (2017)
We develop a rational expectations model in which an issuer purchases credit ratings sequentially, deciding which to disclose to investors. Opacity about contacts between the issuer and rating agencies induces potential asymmetric information about which ratings the issuer obtained. While the equilibrium forces disclosure of ratings when the market knows these have been generated, endogenous uncertainty about whether there are undisclosed ratings can arise and lead to selective disclosure and rating bias. Although investors account for this bias in pricing, selective disclosure makes ratings noisier signals of project value, leading to inefficient investment decisions. Our paper suggests that regulatory disclosure requirements are welfare-enhancing.
Uncertainty, Information Acquisition and Price Swings in Asset Markets.
Review of Economic Studies, 82, 1533-1567 (2015)
This paper analyzes costly information acquisition in asset markets with Knightian uncertainty about the asset fundamentals. In these markets, acquiring information not only reduces the expected variability of the fundamentals for a given distribution (i.e., risk). It also mitigates the uncertainty about the true distribution of the fundamentals. Agents who lack knowledge of this distribution cannot correctly interpret the information other investors impound into the price. We show that, due to uncertainty aversion, the incentives to reduce uncertainty by acquiring information increase as more investors acquire information. When uncertainty is high enough, information acquisition decisions become strategic complements and lead to multiple equilibria. Swift changes in information demand can drive large price swings even after small changes in Knightian uncertainty.
Models of Credit Ratings Failure.
Rivista di Politica Economica, January-March 2014 (invited paper)
Drawing on the recent theoretical literature on credit rating agencies (CRAs), we provide a simple model that nests the following frictions: conflicts of interest between CRAs and investors, regulatory reliance on ratings, investor naiveté and opacity in the rating process. These frictions cause ratings inflation and selective disclosure that distort the transmission of information from CRAs to investors, resulting in inefficient financing decisions. Rating-contingent regulation and investor naiveté exacerbate the conflicts of interest, but are neither necessary nor sufficient for the occurrence of inefficiencies. The model is used to discuss some of the regulatory response to the 2007-2009 financial crisis.
Information Sales and Strategic Trading.
Review of Financial Studies, 24, 3069-3104 (2011)
We study information sales in financial markets with strategic risk-averse traders. The optimal selling mechanism is one of the following two: (i) sell to as many agents as possible very imprecise information; (ii) sell to a small number of agents information as precise as possible. As risk sharing considerations prevail over the negative effects of competition, the newsletters or rumors associated with (i) dominate the exclusivity contract in (ii). These allocations of information have distinct implications for price informativeness and trading volume, and thus our paper provides a direct link between properties of asset prices and financial intermediation. Moreover, as more information is sold when the externality in its valuation is relatively less intense, we find a ranking reversal of the informational content of prices between (a) market structures (market-orders vs. limit-orders), and (b) models of traders’ behavior (imperfect vs. perfect competition).
Overconfidence and Market Efficiency with Heterogeneous Agents.
Economic Theory, 30, 313-336 (2007)
We study financial markets in which both rational and overconfident agents coexist and make endogenous information acquisition decisions. We demonstrate the following irrelevance result: when a positive fraction of rational agents (endogenously) decides to become informed in equilibrium, prices are set as if all investors were rational, and as a consequence the overconfidence bias does not affect informational efficiency, price volatility, rational traders’ expected profits or their welfare. Intuitively, as overconfidence goes up, so does price informativeness, which makes rational agents cut their information acquisition activities, effectively undoing the standard effect of more aggressive trading by the overconfident. The main intuition of the paper, if not the irrelevance result, is shown to be robust to different model specifications.
Asset Pricing in New Keynesian Monetary Models.
Monetary Policy and Institutions, Luiss University Press (2006)
The aim of this paper is to inspect the asset pricing properties of basic New Keynesian monetary models. Because of monetary nonneutrality, expected returns on assets must pay a risk premium not only on technology shocks, as in RBC models, but also on monetary shocks. We provide closed form solutions for risk premia and show how the equity premium depends on the type of nominal rigidity considered. In particular, a model with staggered wages is shown to perform better than a model with staggered prices in the sense of generating a higher equity premium than in the benchmark flexible equilibrium. The model also produces unconditional pricing implications to be tested empirically.
Factor Investing, Learning from Prices, and Endogenous Uncertainty in Asset Markets.
We use an endogenous information model with correlated assets to study learning and uncertainty under the factor investing paradigm. As investors shift attention away from firms toward a systematic risk factor, firms’ stock prices become less informative about it. This loss of price information raises systematic uncertainty, increasing incentives to learn about systematic risk. Such a learning complementarity leads to multiple regimes in systematic uncertainty and attention allocation. Empirically, we specify and estimate a model-based, forward-looking measure for investor attention to systematic versus firm-level information. Consistent with the model, the measure follows a regime-switching process. The high-level regime is linked to lower stock price sensitivity to firm-specific information and higher systematic risk concentration.
Insider Trading Regulation and Market Quality Tradeoffs.
Insider trading should not be left unregulated: it should be either subject to mandatory disclosure or banned altogether. As the costs to collect and process information drop, investors render markets increasingly efficient. Insider trading would hinder this process by discouraging such activities: prohibiting it would avoid information crowding-out and make markets more efficient. When information costs are large, or uncertainty is small, such that information activities are limited to start with, these effects are small and regulating insider trading through mandatory disclosure leads to the informationally most efficient market. In times of elevated uncertainty, post-trade regulation of insider trading also acts as policy complement to ex ante corporate disclosure for the purpose of increasing market efficiency. Finally, markets are always the most liquid with a complete ban on insider trading.
The Short-Termism Trap: Catering to Informed Investors Under Stock-Based CEO Compensation.
The combination of stock-based CEO compensation and limited informed trading capital creates a ”race to the bottom among firms resulting in myopic project choice. More informative stock prices reduce the agency cost of incentivizing managers. Also, shortening project maturity improves stock price informativeness by catering to informed investors, who prefer short-term assets. However, since informed trading capital is a scarce resource, attracting informed investors cannot increase an individual firm’s price informativeness in equilibrium: it simply destroys shareholder value. The ”short-termism trap” can destroy large amounts of shareholder value, potentially up to 100% of the benefits of stock market listing.
Media Narratives and Price Informativeness.
We show that an increase in stock return exposure to media attention to narratives, measured with standard methods for extracting topic attention from news text, leads to a lower stock price informativeness about future fundamentals. Empirically, narrative exposure explains over 86% of idiosyncratic variance in the cross-section, and both narrative exposure and non-systematic information channels—idiosyncratic variance and variance related to public information—decrease stock price informativeness. Moreover, stocks with high narrative exposure demonstrate elevated trading volume. To rationalize these results, we develop a theoretical model based on investor disagreement stemming from differential interpretations of media narratives.