General Equilibrium and Finance
Capital Structure and Hedging Demand with Incomplete Markets,
with Gian Luca Clementi and Piero Gottardi, forthcoming, Economic Journal, 2025.
In this paper we study the role played by hedging demand in shaping firms’ capital structure. We develop and study a general equilibrium model with production and incomplete markets where households differ in their risk sharing needs. Value maximizing firms cater to these different needs when choosing their leverage, their size, and possibly the risk pro le of their production technology. We find that as the demand for hedging increases, firms issue more debt and destine only part of the greater proceeds to investment the remainder going to shareholders. How much more debt, depends on the availability of competing risk-sharing instruments, such as (government issued) risk free debt and derivatives. When the capital structure is jointly shaped by hedging demand and agency in the form of an asset substitution problem the greater risk induced by asymmetric information has countervailing effects on debt: On the one hand, debt is reduced to nudge shareholders into choosing lower risk. This is the standard asset substitution effect. On the other hand, however, the greater risk in production affects the state prices and calls for more debt.
Efficient Policy Interventions in an Epidemic,
with Piero Gottardi, forthcoming Journal of Public Economics, 2022
In the context of an epidemic, In the context of an epidemic, a society is forced to face a system of externalities in consumption and in production. Command economy interventions can support efficient allocations at the cost of severe information requirements. Competitive markets for infection rights (alternatively, Pigouvian taxes) can guarantee efficiency without requiring direct policy interventions on socio-economic activities. We demonstrate that this is the case also with moral hazard, when the infections cannot be associated to the specific activities which originated them. Finally, we extend the analysis to situations where governments have only incomplete information regarding the values of the parameters of the infection or of firms’ production.
Counterparty risk externality: Centralized versus Over-The-Counter Markets,
with Viral Acharya, Journal of Economic Theory, 49, 153-82, 2014.
We study financial markets where agents share risks, but have incentives to default and their financial positions might not be transparent, that is, might not be mutually observable. We show that a lack of position transparency results in a counterparty risk externality, that manifests itself in the form of excess “leverage,” in that parties take on short positions that lead to levels of default risk that are higher than Pareto efficient ones. This externality is absent when trading is organized via a centralized clearing mechanism that provides transparency of trade positions. Collateral requirements and especially subordination of nontransparent positions in bankruptcy can ameliorate the counterparty risk externality in market settings such as over-the-counter (OTC) markets which feature a lack of position transparency.
Other People’s Money: An Experimental Study of the Impact of the Competition for Funds
with Marina Agranov and Andy Schotter, Experimental Economics, 17:564–585, 2014.
In this paper we experimentally investigate the impact that competing for funds has on the risk-taking behavior of laboratory portfolio managers compensated through an option-like scheme according to which the manager receives (most of) the compensation only for returns in excess of pre-specified strike price. We find that such a competitive environment and contractual arrangement lead, both in theory and in the lab, to inefficient risk taking behavior on the part of portfolio managers. We then study various policy interventions, obtained by manipulating various aspects of the competitive environment and the contractual arrangement, e.g., the Transparency of the contracts offered, the Risk Sharing component in the contract linking portfolio managers to investors, etc. While all these interventions would induce portfolio managers, at equilibrium, to efficiently invest funds in safe assets, we find that, in the lab, Transparency is most effective in incentivising managers to do so. Finally, we document a behavioral “Other People’s Money” effect in the lab, where portfolio managers tend to invest the funds of their investors in a more risky manner than their Own Money, even when it is not in either the investors’ or the managers’ interest to do so.
Markets and Contracts,
with John Geanakoplos, Piero Gottardi, Enrico Minelli, Herakles Polemarchakis, Journal of Mathematical Economics, 47(3), 279–288, 2011.
Economies with asymmetric information are encompassed by an extension of the model of general competitive equilibrium that does not require an explicit modeling of private information. Sellers have discretion over deliveries on contracts; this is in common with economies with default, incomplete contracts or price rigidities. Competitive equilibria exist and anonymous markets are viable. But, for a generic economy, competitive equilibrium allocations are constrained suboptimal: there exist Pareto improving interventions via linear, anonymous taxes.
Managerial Hedging, Equity Ownership, and Firm Value,
with Viral Acharya, Rand Journal of Economics, 40(1), 47-77, Spring 2009.
Suppose risk-averse managers can hedge the aggregate component of their exposure to firm’s cash-flow risk by trading in financial markets but cannot hedge their firm-specific exposure. This gives them incentives to pass up firm-specific projects in favor of standard projects that contain greater aggregate risk. Such forms of moral hazard give rise to excessive aggregate risk in stock markets. In this context, optimal managerial contracts induce a relationship between managerial ownership and (i) aggregate risk in the firm’s cash flows, as well as (ii) firm value. We show that this can help explain the shape of the empirically documented relationship between ownership and firm performance.
Managerial Hedging and Portfolio Monitoring,
with Piero Gottardi and Adriano Rampini, Journal of the European Economic Association, 6, 158–209, 2008
Incentive compensation induces correlation between the portfolio of managers and the cash flow of the firms they manage. This correlation exposes managers to risk and hence gives them an incentive to hedge against the poor performance of their firms. We study the agency problem between shareholders and a manager when the manager can hedge his compensation using financial markets and shareholders can monitor the manager’s portfolio in order to keep him from hedging, but monitoring is costly. We find that the optimal incentive compensation and governance provisions have the following properties: (i) the manager’s portfolio is monitored only when the firm performs poorly, (ii) the manager’s compensation is more sensitive to firm performance when the cost of monitoring is higher or when hedging markets are more developed, and (iii) conditional on the firm’s performance, the manager’s compensation is lower when his portfolio is monitored, even if no hedging is revealed by monitoring. Moreover, the model suggests that the optimal level of portfolio monitoring is higher for managers of firms whose performance can be hedged more easily, such as larger firms and firms in more developed financial markets.
Efficient Competitive Equilibria with Adverse Selection,
with Piero Gottardi, Journal of Political Economy, 114(3), 2006.
Do Walrasian markets function orderly in the presence of adverse selection? In particular, is their outcome efficient when exclusive contracts are enforceable? This paper addresses these questions in the context of a Rothschild-Stiglitz insurance economy. We identify an externality associated with the presence of adverse selection as a special form of consumption externality. Consequently, we show that competitive equilibria always exist but are not typically incentive efficient. However, as markets for pollution rights can internalize environmental externalities, markets for consumption rights can be designed to internalize the consumption externality due to adverse selection. With such markets competitive equilibria exist and incentive-constrained versions of the first and second welfare theorems hold.
Exclusive Contracts and the Institution of Bankruptcy,
with Adriano Rampini, Economic Theory, 27(2), 277-304, 2006.
The paper studies the institution of bankruptcy when exclusive contracts cannot be enforced ex ante, e.g., a bank cannot monitor whether the borrower enters into contracts with other creditors. The institution of bankruptcy enables the bank to enforce its claim to any funds that the borrower has above a fixed “bankruptcy protection” level. Bankruptcy improves on non-exclusive contractual relationships but is not a perfect substitute for exclusivity ex ante. We characterize the effect of bankruptcy provisions on the equilibrium contracts which borrowers use to raise financing.
Markets as Beneficial Constraints on the Government,
with Adriano Rampini, Journal of Public Economics, 90, 601-629, 2006.
We study the role of anonymous markets in which trades cannot be monitored by the government. We adopt a Mirrlees approach to analyze economies in which agents have private information and a benevolent government controls optimal redistributive tax policy. While unrestricted access to anonymous markets reduces the set of policy instruments available to the government, it also limits the scope of inefficient redistributive policies when the government lacks commitment. Indeed, the restrictions that anonymous markets impose on the optimal fiscal policy, especially on capital taxation and the history-dependence of income taxation, can have positive welfare effects in this case
Rational Expectations Equilibria of Economies with Local Interactions,
with Ulrich Horst and Onur Ozgur, Journal of Economic Theory, 127(1), 2006.
We consider general economies in which rational agents interact locally. The local aspect of the interactions is designed to represent in a simple abstract way social interactions, that is, socioeconomic environments in which markets do not mediate all of agents’ choices, which might be in part determined, for instance, by family, peer group, or ethnic group effects. We study static as well as dynamic infinite horizon economies; we allow for economies with incomplete information, and we consider jointly global and local interactions, to integrate e.g., global externalities and markets with peer and group effects. We provide conditions under which such economies have rational expectations equilibria. We illustrate the effects of local interactions when agents are rational by studying in detail the equilibrium properties of a simple economy with quadratic preferences which captures, in turn, local preferences for conformity, habit persistence, and preferences for status or adherence to aggregate norms of behavior.
Optimal Financial Integration and Security Design,
with Viral Acharya, Journal of Business, 78(6), 2397-433, 2005.
In this paper, we study financial innovations consisting of both the introduction of new assets and the integration of segmented markets. Our analysis proposes factors that determine the welfare gains from financial integration, in terms of the properties of the income processes of member agents. Moreover, we identify conditions under which a coordination of financial innovations (e.g., through a consolidation of local exchanges) is likely to be socially desirable.
Moral Hazard and Non-exclusive Contracts,
with Danilo Guaitoli, Rand Journal of Economics, 35(2), 306-28, Summer 2004.
We study equilibria for economies with hidden action in environments in which the agents’ contractual relationships with competing financial intermediaries cannot be monitored (or are not contractible upon). We fully characterize equilibrium allocations and contracts for such economies, as well as discuss their welfare properties. Depending on the parameters of the economy, either the optimal action choice is not sustained in equilibrium or, if it is, agents necessarily enter into multiple contractual relationships and intermediaries make positive profits, even under free-entry conditions. The main features and implications of these environments are consistent with several stylized facts of markets for unsecured.
Competitive Markets for Non-exclusive Contracts with Adverse Selection: The Role of Entry-Fees,
with Piero Gottardi, Review of Economics Dynamics, 6, 313-38, 2003.
This paper studies competitive equilibria in economies characterized by the presence of asymmetric information, where non-exclusive contracts are traded in competitive markets and agents may be privately informed over contracts’ payoffs. For such economies competitive equilibria may not exist when contracts trade at linear prices. We show that (non-trivial) competitive equilibria exist, under general conditions, when prices exhibit a minimal form of non-linearity (or, equivalently, a minimal requirement on the observability of agents’ trades): the presence of two-part tariffs suffices, where the cost of trading each contract consists of an entry fee and a linear component in the quantity traded. The entry fee is determined at equilibrium and represents a measure of adverse selection in the economy.
Competitive Equilibria with Asymmetric Information,
with Piero Gottardi, Journal of Economic Theory, 87(1), 1-48, 1999
This paper studies competitive equilibria in economies where agents trade in markets for standardized, non-exclusive financial contracts, under conditions of asymmetric information (both of the moral hazard and the adverse selection type). The problems for the existence of competitive equilibria in this framework are identified, and shown to be essentially the same under different forms of asymmetric information. We then show that a “minimal” form of non-linearity of prices (a bid-ask spread, requiring only the possibility to separate buyers and sellers), and the condition that the aggregate return on the individual positions in each contract can be perfectly hedged in the existing markets, ensure the existence of competitive equilibria in the case of both adverse selection and moral hazard.
At the Roots of Indeterminacy,
Markets and Games, Pierpaolo Battigalli, Aldo Montesano, and Fausto Panunzi, Eds., , Basil Blackwell, 1998.
This paper analyzes some focal example economies which have been shown in the literature to be characterized by Indeterminacy of Competitive Equilibria. It argues that Indeterminacy can be eliminated by excluding forms of “money illusion” from agents’ objectives, by adding equations or by restricting the partition of exogenous/endogenous variables, in an economically meaningful way.
A Note on Convergence to Competitive Equilibria in Economies with Moral Hazard,
with Piero Gottardi and Danilo Guaitoli, The Theory of Markets, Jean-Jacques Herings, G. van der Laan, and A.J.J. Talman, Eds., North Holland, 1998.
We examine the conditions under which competitive equilibria can be obtained as the limit, when the number of strategic traders gets large, of Nash equilibria in economies with asymmetric information on agents’ effort and possibly imperfect observability of agents’ trades. Convergence always occur when either effort is publicly observed (no matter what is the information available to intermediaries on agents’ trades); or effort is private information but agents’ trades are perfectly observed; or no information at all is available on agents’ trades. On the other hand, when each intermediary can observe its trades with an agent, but not the agent’s trades with other intermediaries, the (Nash) equilibria with strategic intermediaries do not converge to any of the competitive equilibria, for an open set of economies. The source of the difficulties for convergence is the combination of asymmetric information and the restrictions on the observability of trades which prevent the formation of exclusive contractual relationships and generate barriers to entry in the markets for contracts.
General Equilibrium with Endogenously Incomplete Financial Markets,
Journal of Economic Theory, 82(1), 19-45, 1996.
The present paper studies a class of general equilibrium economies with
imperfectly competitive financial intermediaries and price-taking consumers. Intermediaries optimally choose the securities they issue and the bid-ask spread they charge. Financial intermediation is costly, and hence markets are endogenously
incomplete. An appropriate equilibrium concept is developed, and existence is proved. Competitive equilibria for this class of economies display full indexation of securities payoffs and monetary neutrality even if intermediaries are restricted to
issue “nominal” securities and financial markets turn out to be incomplete. This is in sharp contrast with the indeterminacy and non-neutrality results established in
the literature for incomplete markets economies with exogenously given “nominal” securities.