Payment choice in international trade: Theory and evidence from cross‐country firm‐level data

When trading across borders, firms choose between different payment contracts. Theoretically, this should allow firms to trade‐off differences in financing costs and enforcement across countries. This paper provides evidence for this hypothesis employing firm‐level data from a large number of developing countries. As predicted, international transactions are more likely paid after delivery when financing costs in the source country are high and when contract enforcement is low. We extend the theory and also show empirically that the more complex an industry is, the more important is contract enforcement and the less important are financing costs for the contract choice.     

Financial Intermediation with Risk Aversion

The paper extends Diamond's (1984) analysis of financial intermediation to allow for risk aversion of the intermediary. As in the case of risk neutrality, the agency costs of external funds provided to an intermediary are relatively small if the intermediary is financing many entrepreneurs with independent returns. Even though the intermediary is adding rather than subdividing risks, the underlying large-numbers argument is not invalidated by the presence of risk aversion.
With risk aversion of entrepreneurs as well as the intermediary, financial intermediation provides insurance as well as finance. In contrast to earlier results on optimal intermediation policies under risk neutrality, the paper shows that when an intermediary is financing many entrepreneurs with independent returns, optimal intermediation policies must shift return risks away from risk averse entrepreneurs and impose them on the intermediary or on final investors.     

The fog of fraud – Mitigating fraud by strategic ambiguity

Most insurance companies publish few data on the occurrence and detection of insurance fraud. This stands in contrast to the previous literature on costly state verification, which has shown that it is optimal to commit to an auditing strategy. The credible announcement of thoroughly auditing claim reports is a powerful deterrent. Yet, we show that uncertainty about fraud detection can be an effective strategy to deter ambiguity-averse agents from reporting false insurance claims. If, in addition, the auditing costs of the insurers are heterogeneous, it can be optimal not to commit, because committing to a fraud-detection strategy eliminates the ambiguity about auditing. Thus, strategic ambiguity can be an equilibrium outcome in the market. Even competition does not force firms to provide the relevant information. This finding is also relevant in other auditing settings, like tax enforcement.     

Optimal insurance design of ambiguous risks

We examine the characteristics of the optimal insurance contract under linear transaction costs and an ambiguous distribution of losses. Under the standard expected utility model, we know from Arrow (1965) that it contains a straight deductible. In this paper, we assume that the policyholder is ambiguity averse in the sense of Klibanoff et al. (Econometrica 73(6):1849–1892, 2005). The optimal contract depends upon the structure of the ambiguity. For example, if the set of possible priors can be ranked according to the monotone likelihood ratio order, the optimal contract contains a disappearing deductible. We also show that the policyholder’s ambiguity aversion may have the counterintuitive effect to reduce the optimal insurance coverage of an ambiguous risk.     

Efficient risk sharing,non-marketable labor income and fixed-wage contracts

This paper seeks to explain fixed-wage labor contracts. The traditional rationale that fixed wages represent an implicit sale of ‘wage insurance’ by risk-neutral firms to risk-averse workers is rejected as being incompatible with the fact that firms are owned by risk-averse investors. Instead, it is shown that fixed-wage contracts might arise from the non-marketability of labor income. When human capital is not marketable, it becomes optimal to shift all the risk in production onto the firm, since trading in equity markets enables efficient allocation of the uncertainty. The fixed-wage contract shifts the risk to equity owners and in fact replicates the first-best equilibrium that would emerge if individuals were paid their realized marginal product and allowed to trade shares in human capital.     

Aggregate fluctuations, financial constraints and risk sharing

Summary. Private information and costly state verification often result in credit rationing in models with smooth investment, affecting both loan size and total investment. The optimal contract is derived in a dynamic stochastic growth model with capital for two types of models: one with symmetric information and the other with asymmetric information and costly state verification. When all information is observed costlessly, the equilibrium optimal contract provides complete insurance to risk-averse savers against aggregate fluctuations. When information is asymmetric and there is costly state verification, the equilibrium optimal contract provides only partial insurance against aggregate shocks. The extent of insurance is measured by the marginal rate of transformation of consumption between borrowers and lenders which is closely linked to the user cost of capital. The deadweight monitoring costs create a wedge between a borrower's cost of capital and a lender's stochastic discount factor, with two results: (i) fluctuations in the user cost of capital provides a mechanism by which aggregate shocks can be␣propagated; (ii) the distribution of capital's share of output among borrowers, lenders, and monitoring costs varies even if capital's share is constant. Capital market frictions not only amplify aggregate fluctuations but also generate cross-sectional fluctuations that may not be observable in aggregate data. Received: November 17, 1997; revised version: April 20, 1998     

Staged financing: a trade-off theory of holdup and option value

This paper investigates financial contract design in venture capital investments and shows that staged financing is the implementation of optimal contracts. In designing contracts, venture capitalists consider the value of real options and the costs of holdup. This consideration boils down to contract rigidity and flexibility: rigid contracts mitigate the holdup problem of entrepreneurs, but have little option values, whereas flexible contracts create real options for venture capitalists in corporate decision-making, but yield weak bargaining power when ventures appear promising. In optimal contracts, venture capitalists choose flexibility by separating capital into stages and then strategically allocating control rights at each stage. This strategy creates option value in corporate governance, and can protect sunk investments in distress while capturing the potential benefits of good outcomes.     

DEGREASING THE WHEELS OF FINANCE

Can there be too much trading in financial markets? We construct a dynamic general equilibrium model, where agents face idiosyncratic liquidity shocks. A financial market allows agents to adjust their portfolio of liquid and illiquid assets in response to these shocks. The optimal policy is to restrict access to this market because portfolio choices exhibit a pecuniary externality: Agents do not take into account that by holding more of the liquid asset, they not only acquire additional insurance against these liquidity shocks, but also marginally increase the value of the liquid asset, which improves insurance for other market participants.     

Regulation of a Risk Averse Firm

We extend the Laffont–Tirole regulation model to the case of risk-averse firms. Our main results are:

• The impact of risk aversion is to shift the optimal contract toward a cost-plus contract.

• As compared with the risk-neutral case, distortions are greater and informational rents are smaller.

• For high levels of risk aversion, the optimal contract involves cost ceilings and the less efficient firms are bunched together.

Journal of Economic LiteratureClassification Numbers: D8, L5.     

Dynamic Incentive Contracts under No-Commitment to Periodic Auditing and a Non-retrospective Penalty System

This paper generalizes Khalil’s (1997) static model to a multiperiod one. The associated optimal dynamic contracts are derived and analyzed. At every-period’s equilibrium, the principal conducts no sure auditing. While duplication of the Baron-Myerson-type (1982) contract cannot be optimal, duplication of the Khalil-type (1997) contract can be optimal when the cheating penalty is large or discount factors are small. This implies that static contracts with no-commitment to auditing can describe players’ long-run behavior only under specific conditions. Moreover, our separating and pooling equilibria are compared with Baron and Besanko’s (1984a) and Laffont and Tirole’s (1987) equilibria, respectively.     

Imagery and Financial Judgment

Many studies have indicated that a buy-and-hold investment strategy is superior to a trading strategy. This is thought to be true because trading incurs transaction costs that lower net returns compared to a buy-and-hold strategy. We propose a behavioral finance argument to illustrate that merely switching between positive expected return assets can lead to a long-run negative expected return, even when transaction costs are ignored. This counterintuitive result may obtain because of Parrondo's Paradox. We provide a stylized theoretical example that demonstrates how a trader can lose money by trading between assets with positive long-run expected returns. We also present simulation results to support our example. Thus, long-run negative results from trading may not be due entirely to transaction costs. A trading strategy may prove inferior to buy-and-hold for agents simply because of their singular trading patterns, as we outline in the paper.     

Market Architecture and Nonlinear Dynamics of Australian Stock and Futures Indices

This paper studies the All Ordinaries Index in Australia, and its futures contract known as the Share Price Index. We use a new form of smooth transition model to account for a variety of nonlinearities caused by transaction costs and other market/data imperfections, and given the recent interest in the effects of market automation on price discovery, we focus on how the nonlinear properties of the basis and returns have changed, now that floor trading in the futures contract has been replaced by electronic trading.     

A Pure Theory of Job Security and Labour Income Risk

Models of labour market equilibrium where forward-looking decisions maximize both profits and labour income on a risk-neutral basis offer valuable insights into the effects of employment protection legislation. Since risk-neutral behaviour in the labour market presumes perfect insurance, however, job security provisions plays no useful role in such models. This paper studies a stylized model of dynamic labour market interactions where labour reallocation costs are partly financed by uninsured workers' consumption flows. In the resulting second-best equilibrium, provisions that shift labour reallocation costs to risk-neutral employers can increase productive efficiency if their administrative dead-weight costs are not too large, and increase workers' welfare as long as employers' firing costs at least partly finance workers' mobility.     

Estate recovery and long‐term care insurance

Estate recovery is a policy under which the state recovers part of long‐term care (LTC) subsidies from the estates of deceased beneficiaries. This paper studies the effect of estate recovery on LTC insurance demand. This effect strongly relies on the bequest motive since the main purpose behind purchasing LTC insurance is to protect bequests from the financial costs of LTC. We find that the impact of estate recovery on LTC insurance depends on the level of parental bequests and on whether and how the parent anticipates the child's preferences with respect to informal care. More specifically, we show that estate recovery encourages the parent to purchase LTC insurance when his child is considered selfish or to like providing care. However, this policy could provide disincentives to LTC insurance purchase by the parent if his child is considered to dislike providing informal care. Our results also show that estate recovery reduces and may even eliminate public support crowding out of private LTC insurance demand. Finally, we characterize the welfare implications of financing LTC public support by estate recovery.     

Start up costs, limited enforcement, and the hidden economy

This paper examines how much of the difference in the size of the informal sector and in per capita income across countries can be accounted by regulation costs and enforcement of financial contracts. It constructs and solves numerically a general equilibrium model with credit constrained heterogenous agents, occupational choices over formal and informal businesses, financial frictions and a government sector which imposes taxes and regulations on formal firms. The benefit from formalization is better access to outside finance. The quantitative exercises suggest that: (i) regulation costs and not the level of enforcement account for differences in the size of the informal sector between United States and Mediterranean Europe; (ii) for a developing country like Peru, however, contract enforcement and regulation costs are equally important in accounting for the size of the informal sector; and (iii) regulation costs and contract enforcement do not account for most of the income differences observed among countries.     

Optimal Policy with Tradable and Bankable Pollution Permits: Taking the Market Microstructure into Account

This paper analyzes how the way emission permits are traded—their market microstructure—affects the optimal policy to be adopted by the environmental agency. The microstructure used is one of a quote driven market type, which characterizes many financial markets. Market makers act as intermediaries for trading the permits by setting an ask price and a bid price. The possibility of bank permits is also introduced in our dynamic two‐period model. We consider two models whether the market makers are perfectly informed about the technology of the producers or not. When the market makers have complete information, the equilibrium price of permits is the same as if the market is walrasian. When they are imperfectly informed, they may set a positive spread between bid and ask permit prices, which creates some inefficiency as the marginal abatement costs of polluters do not equalize. By allowing more flexibility in the use of the permits, banking may reduce the spread. Moreover, it may introduce price rigidities due to intertemporal arbitrage. In this framework, the circumstances under which banking should be allowed or not depend crucially on the evolution of the marginal willingness to pay for the environment.     

Two Remarks on the Property-Rights Literature

We first point out that the recent property-rights literature is based on three assumptions: (1) that contracts are always subject to renegotiation; (2) that the exercise of a property right confers a private benefit and (3) that parties are risk-neutral. Building on Hart–Moore (1999), we provide conditions under which an optimal contract consists of nothing more than an assignment of property rights.
We also examine the robustness of some of the literature's standard predictions about asset ownership to the introduction of mechanisms for eliciting parties' ex post willingness to pay for the assets (such as options or financial markets). To illustrate the issue, we revisit the Hart–Moore (1990) proposition that joint ownership is suboptimal, and argue that ownership by a single party is dominated by joint ownership with put options.     

Endogenous market structures and the optimal financial structure

Abstract We characterize the optimal financial structure as a strategic device to optimize the value of a firm competing in a market where entry is endogenous. Debt financing is always optimal under quantity competition, and, contrary to the Brander‐Lewis‐Showalter results based on duopolies, we show the optimality of moderate debt financing also under price competition with cost uncertainty (but not with demand uncertainty). We derive the formulas for the optimal financial structure, which does not affect the strategies of the other firms but reduces their number.     

Insider ownership and financial flexibility

This study examines the cash flow sensitivity of external financing (financial flexibility (FF)) of firms from the perspective of the agency by focusing on whether and how insider ownership has a modifying effect on the FF of firms. Given the documented relationship between corporate governance and cost of external financing, insider ownership, an important proxy of corporate governance, should affect FF via the agency cost channel. A review of the US nonfinancial firms from 1992 to 2009 indicates that insider ownership aids in determining the FF of firms. More specifically, results indicate the existence of optimal insider ownership, and any deviation from it causes FF to decrease. In addition, FF is higher when CEO ownership is lower (<0.08%) and this phenomenon is more pronounced for financially unconstrained firms. Furthermore, FF is higher when non-CEO insider ownership is in the middle range (0.12–0.43%) for financially constrained firms, whereas non-CEO insider ownership has minimal impact on FF for unconstrained firms.