Managerial risk taking incentives and corporate pension policy

We examine whether the compensation incentives of top management affect the extent of risk shifting versus risk management behavior in pension plans. We find that risk shifting through pension underfunding (and, to a lesser extent, through pension asset allocation to risky securities) is stronger with compensation structures that create high wealth-risk sensitivity (vega) and weaker with high wealth-price sensitivity (delta). These findings are stronger for chief financial officers (CFOs) than for chief executive officers (CEOs), suggesting that pension policy falls within the CFO’s domain. Risk shifting through pension underfunding is also lower when the CFO’s personal stake in the pension plan is larger. Overall, these findings show that top managers’ compensation structure is an important driver of corporate pension policy. They also highlight firms within which the moral hazard concerns fueled by Pension Benefit Guaranty Corporation insurance are most relevant.     

Tournament incentives, firm risk, and corporate policies

This paper tests the proposition that higher tournament incentives will result in greater risk-taking by senior managers in order to increase their chance of promotion to the rank of CEO. Measuring tournament incentives as the pay gap between the CEO and the next layer of senior managers, we find a significantly positive relation between firm risk and tournament incentives. Further, we find that greater tournament incentives lead to higher R&D intensity, firm focus, and leverage, but lower capital expenditures intensity. Our results support the hypothesis that option-like features of intra-organizational CEO promotion tournaments provide incentives to senior executives to increase firm risk by following riskier policies. Finally, the compensation levels and structures of executives of financial institutions have received a great deal of scrutiny after the financial crisis. In a separate examination of financial firms, we again find a significantly positive relation between firm risk and tournament incentives.     

Managerial incentives and risk-taking

We provide empirical evidence of a strong causal relation between managerial compensation and investment policy, debt policy, and firm risk. Controlling for CEO pay-performance sensitivity (delta) and the feedback effects of firm policy and risk on the managerial compensation scheme, we find that higher sensitivity of CEO wealth to stock volatility (vega) implements riskier policy choices, including relatively more investment in R&D, less investment in PPE, more focus, and higher leverage. We also find that riskier policy choices generally lead to compensation structures with higher vega and lower delta. Stock-return volatility has a positive effect on both vega and delta.     

Belief updating, debt pricing and financial decisions under asymmetric information

This paper studies debt holders’ belief updating, valuation of corporate debt, and equity owners’ financing decisions during financial distress under asymmetric information. This is done within a continuous-time framework, where the relevant state variable is assumed to follow an Arithmetic Brownian motion (ABM). ABM can take negative values and has very realistic feature compared with Geometric Brownian motion (GBM). Using Chapter 11 of U.S. Bankruptcy Code as a costly screening device, we can characterize which firm will choose private workouts (in the form of strategic debt service) and which will choose to file for the Chapter 11 Bankruptcy procedure (in the form of debt-equity swap) when the firm is in financial distress. Using arguments similar to equilibrium refinements, we give a clear picture of how debt holders’ beliefs about the firm’s types are updated according to the state variable and the firm’s default behavior, and describe optimal strategies of both parties under those beliefs. We also provide an approximate solution to the debt pricing problem under asymmetric information.     

Managerial ownership dynamics and firm value

From 1988 to 2003, the average change in managerial ownership is significantly negative every year for American firms. We find that managers are more likely to significantly decrease their ownership when their firms are performing well and more likely to increase their ownership when their firms become financially constrained. When controlling for past stock returns, we find that large increases in managerial ownership increase Tobin's q. This result is driven by increases in shares held by officers, while increases in shares held by directors appear unrelated to changes in firm value. There is no evidence that large decreases in ownership have an adverse impact on firm value. We rely on the dynamics of the managerial ownership/firm value relation to mitigate concerns in the literature about the endogeneity of managerial ownership.     

Managerial ownership and firm performance: Evidence from China's privatizations

We examine the relationship between managerial ownership and firm performance for a sample of Chinese State-owned enterprises (SOEs) privatized over the period 1992-2000. The results indicate that managerial ownership has a positive effect on firm performance. Although return on assets (ROA) and return on sales (ROS) decline post-privatization, firms with high managerial ownership and, specially, high CEO ownership, exhibit a smaller performance decline. The difference is highly significant, with or without controlling for residual state ownership and changes in the firm's operating environment. We also find that the influence on firm performance becomes less significant at higher levels of CEO ownership. In contrast, performance continues to increase with managerial ownership. This finding suggests that, beyond a certain point, the distribution of shares would be more effective if extended to the whole management team instead of being limited to the chief executive.     

Managing liquidity: Optimal degree of centralization

Large banking groups face the question of how to optimally allocate and generate liquidity: in a central liquidity hub or in many decentralized branches. We translate this question into a facility location problem under uncertainty. We show that volatility is the key driver behind (de-)centralization. We provide an analytical solution for the 2-branch model and show that a liquidity center can be interpreted as an option on immediate liquidity. Therefore, its value can be interpreted as the price of information, i.e., the price of knowing the exact demand. Furthermore, we derive the threshold above which it is advantageous to open a liquidity center and show that it is a function of the volatility and the characteristic of the bank network. Finally, we discuss the n-branch model for real-world banking groups (10-60 branches) and show that it can be solved with high granularity (100 scenarios) within less than 30 s.     

Asymmetric currency exposure and currency risk pricing

Whether stock returns are linked to currency movements and whether currency risk is priced in a domestic context are less conclusive and thus still subject to a great debate. Based on a different approach, this paper attempts to provide new empirical evidence on these two inter-related issues, which are critical to investors and corporate risk management. In particular, this paper not only explores the possibility of asymmetric currency exposure that may explain why prior studies, which focus exclusively on linear exposure, have difficulty in detecting it, but also tests whether this asymmetric currency exposure is priced. The results show strong evidence of asymmetric currency exposure and currency risk pricing, suggesting that both asymmetry and conditional heteroskedasticity play important roles in testing currency exposure and its price.     

Multivariate option pricing with time varying volatility and correlations

In this paper we consider option pricing using multivariate models for asset returns. Specifically, we demonstrate the existence of an equivalent martingale measure, we characterize the risk neutral dynamics, and we provide a feasible way for pricing options in this framework. Our application confirms the importance of allowing for dynamic correlation, and it shows that accommodating correlation risk and modeling non-Gaussian features with multivariate mixtures of normals substantially changes the estimated option prices.     

CEO risk incentives and firm performance following R&D increases

In this study we analyze how CEO risk incentives affect the efficiency of research and development (R&D) investments. We examine a sample of 843 cases in which firms increase their R&D investments by an economically significant amount over the period of 1995–2006. We find that firms with higher sensitivity of CEO compensation portfolio value to stock volatility (vega) are more likely to have large increases in R&D investments. More importantly, we find that high-vega firms experience lower abnormal stock returns and lower operating performance compared to their low-vega counterparts following the R&D increases. Our main results hold in a variety of robustness tests. The results are consistent with the conjecture that high-vega compensation portfolios may induce managers to overinvest in inefficient R&D projects and therefore hurt firm performance.     

Predictability of currency carry trades and asset pricing implications

This paper studies the time series predictability of currency carry trades, constructed by selecting currencies to be bought or sold against the US dollar, based on forward discounts. Changes in a commodity index, currency volatility and, to a lesser extent, a measure of liquidity predict in-sample the payoffs of dynamically re-balanced carry trades, as evidenced by individual and joint p-values in monthly predictive regressions at horizons up to six months. Predictability is further supported through out-of-sample metrics, and a predictability-based decision rule produces sizable improvements in the Sharpe ratios and skewness profile of carry trade payoffs. Our evidence also indicates that predictability can be traced to the long legs of the carry trades and their currency components. We test the theoretical restrictions that an asset pricing model, with average currency returns and the mimicking portfolio for the innovations in currency volatility as risk factors, imposes on the coefficients in predictive regressions.     

Managerial incentives,capital reallocation,and the business cycle

We argue that when managers have private information about the productivity of assets under their control and receive private benefits, substantial bonuses are required to induce less productive managers to declare that capital should be reallocated. The need to provide incentives for managers to relinquish control links executive compensation to capital reallocation and managerial turnover over the business cycle, rendering them procyclical if expected managerial compensation increases when more managers are hired. Moreover, capital is less productively deployed in downturns because agency costs make reallocation more costly. Empirically, we find that both CEO turnover and executive compensation are remarkably procyclical.     

Using Tucker’s theorem of the alternative to simplify,review and expand discrete arbitrage theory

For valuing derivatives and other assets in securities and commodities markets, arbitrage pricing theory has been a major approach for decades. This paper derives fundamental arbitrage pricing results in finite dimensions in a simple unified framework using Tucker’s theorem of the alternative. Frictionless results, that is perfect market results, plus imperfect market results such as those with dividends, periodic interest payments, transaction costs, different interest rates for lending and borrowing, shorting costs and constrained short selling are presented. While the results are mostly known and appear in various places, our contribution is to present them in a coherent and comprehensive fashion with very simple proofs. The analysis yields a simple procedure to prove new results and some are presented for cases with imperfect market frictions.     

Employee well-being,firm leverage,and bankruptcy risk

Employees of liquidating firms are likely to lose income and non-pecuniary benefits of working for the firm, which makes bankruptcy costly for employees. This paper examines whether firms take these costs into account when deciding on the optimal amount of leverage. We find that firms with leading track records in employee well-being significantly reduce the probability of bankruptcy by operating with lower debt ratios. Moreover, we observe that firms with better employee track records have better credit ratings, even when we control for differences in firm leverage.     

Option-implied volatility factors and the cross-section of market risk premia

The main goal of this paper is to study the cross-sectional pricing of market volatility. The paper proposes that the market return, diffusion volatility, and jump volatility are fundamental factors that change the investors’ investment opportunity set. Based on estimates of diffusion and jump volatility factors using an enriched dataset including S&P 500 index returns, index options, and VIX, the paper finds negative market prices for volatility factors in the cross-section of stock returns. The findings are consistent with risk-based interpretations of value and size premia and indicate that the value effect is mainly related to the persistent diffusion volatility factor, whereas the size effect is associated with both the diffusion volatility factor and the jump volatility factor. The paper also finds that the use of market index data alone may yield counter-intuitive results.     

Executive stock options,differential risk-taking incentives,and firm value

The sensitivity of stock options' payoff to return volatility, or vega, provides risk-averse CEOs with an incentive to increase their firms' risk more by increasing systematic rather than idiosyncratic risk. This effect manifests because any increase in the firm's systematic risk can be hedged by a CEO who can trade the market portfolio. Consistent with this prediction, we find that vega gives CEOs incentives to increase their firms' total risk by increasing systematic risk but not idiosyncratic risk. Collectively, our results suggest that stock options might not always encourage managers to pursue projects that are primarily characterized by idiosyncratic risk when projects with systematic risk are available as an alternative.     

Credit risk drivers: Evaluating the contribution of firm level information and of macroeconomic dynamics

Understanding if credit risk is driven mostly by idiosyncratic firm characteristics or by systematic factors is an important issue for the assessment of financial stability. By exploring the links between credit risk and macroeconomic developments, we observe that in periods of economic growth there may be some tendency towards excessive risk-taking. Using an extensive dataset with detailed information for more than 30 000 firms, we show that default probabilities are influenced by several firm-specific characteristics. When time-effect controls or macroeconomic variables are also taken into account, the results improve substantially. Hence, though the firms’ financial situation has a central role in explaining default probabilities, macroeconomic conditions are also very important when assessing default probabilities over time.     

Nonlinearly weighted convex risk measure and its application

We propose a new class of risk measures which satisfy convexity and monotonicity, two well-accepted axioms a reasonable and realistic risk measure should satisfy. Through a nonlinear weight function, the new measure can flexibly reflect the investor’s degree of risk aversion, and can control the fat-tail phenomenon of the loss distribution. A realistic portfolio selection model with typical market frictions taken into account is established based on the new measure. Real data from the Chinese stock markets and American stock markets are used for empirical comparison of the new risk measure with the expected shortfall risk measure. The in-sample and out-of-sample empirical results show that the new risk measure and the corresponding portfolio selection model can not only reflect the investor’s risk-averse attitude and the impact of different trading constraints, but can find robust optimal portfolios, which are superior to the corresponding optimal portfolios obtained under the expected shortfall risk measure.     

How do family ownership,control and management affect firm value?

Using proxy data on all Fortune-500 firms during 1994–2000, we find that family ownership creates value only when the founder serves as CEO of the family firm or as Chairman with a hired CEO. Dual share classes, pyramids, and voting agreements reduce the founder's premium. When descendants serve as CEOs, firm value is destroyed. Our findings suggest that the classic owner-manager conflict in nonfamily firms is more costly than the conflict between family and nonfamily shareholders in founder-CEO firms. However, the conflict between family and nonfamily shareholders in descendant-CEO firms is more costly than the owner-manager conflict in nonfamily firms.     

Noise sensitivity of portfolio selection under various risk measures

We study the sensitivity to estimation error of portfolios optimized under various risk measures, including variance, absolute deviation, expected shortfall and maximal loss. We introduce a measure of portfolio sensitivity and test the various risk measures by considering simulated portfolios of varying sizes N and for different lengths T of the time series. We find that the effect of noise is very strong in all the investigated cases, asymptotically it only depends on the ratio N/T, and diverges (goes to infinity) at a critical value of N/T, that depends on the risk measure in question. This divergence is the manifestation of a phase transition, analogous to the algorithmic phase transitions recently discovered in a number of hard computational problems. The transition is accompanied by a number of critical phenomena, including the divergent sample to sample fluctuations of portfolio weights. While the optimization under variance and mean absolute deviation is always feasible below the critical value of N/T, expected shortfall and maximal loss display a probabilistic feasibility problem, in that they can become unbounded from below already for small values of the ratio N/T, and then no solution exists to the optimization problem under these risk measures. Although powerful filtering techniques exist for the mitigation of the above instability in the case of variance, our findings point to the necessity of developing similar filtering procedures adapted to the other risk measures where they are much less developed or non-existent. Another important message of this study is that the requirement of robustness (noise-tolerance) should be given special attention when considering the theoretical and practical criteria to be imposed on a risk measure.