Colluding through suppliers

This article investigates downstream firms’ ability to collude in a repeated game of competition between supply chains. We show that downstream firms with buyer power can collude more easily in the output market if they also collude on their input supply contracts. More specifically, an implicit agreement on input supply contracts with above‐cost wholesale prices and negative fixed fees (that is, slotting fees) facilitates collusion on downstream prices. Banning information exchange about wholesale prices decreases the scope for collusion. Moreover, high downstream prices are more difficult to sustain if upstream rather than downstream firms make contract offers.     

Do Banks Price Litigation Risk in Debt Contracting? Evidence from Class Action Lawsuits

Class action lawsuits can be detrimental to debtholders because they deteriorate defendant firms’ financial position and lower these firms’ value. This study examines whether banks price their borrowers’ litigation risk in debt contracting. We find that banks charge 19% higher interest spreads on loans to lawsuit firms after litigation. In addition, banks monitor lawsuit firms more closely by using tighter non‐price terms. The results are robust after correcting for possible endogeneity issues using the propensity score matching approach. We further find that the effects of lawsuit filing are more pronounced for firms with weaker corporate governance. Following a lawsuit in the industry, banks also perceive an increased likelihood of litigation for industry peer firms and adjust price and non‐price terms accordingly. Finally, we find that the magnitude of the lawsuit filing effect is greater for firms with lower ex‐ante litigation risk. Taken as a whole, our findings suggest that banks, as informed stakeholders, perceive litigation risk to be detrimental and price this risk in debt contracting.     

Risk aversion,prudence, and compensation

In a standard principal-agent setting, we use a comparative approach to study the incentives provided by different types of compensation contracts, and their valuation by managers with utility function u who are risk averse (u″<0) and prudent (u″′>0). We show that concave contracts tend to provide more incentives to risk averse managers, while convex contracts tend to be more valued by prudent managers. This is because concave contracts concentrate incentives where the marginal utility of risk averse managers is highest, while convex contracts protect against downside risk. Thus, managerial prudence can contribute to explain the prevalence of stock-options in executive compensation. However, convex contracts are not optimal when the principal is sufficiently prudent relative to the manager.     

Work Ethic, Employment Contracts, and Firm Value

We analyze how the work ethic of managers impacts a firm's employment contracts, riskiness, growth potential, and organizational structure. Flat contracts are optimal for diligent managers because they reduce risk-sharing costs, but they attract egoistic agents who shirk and unskilled agents who add no value. Stable, bureaucratic firms with low growth potential are more likely to gain value from managerial diligence. Firms that hire from a virtuous pool of agents are more conservative in their investments and have a horizontal corporate structure. Our theory also yields several testable implications that distinguish it from standard agency models.     

Prospect theory and the effectiveness of price limits

Assuming that traders are risk-neutral, Brennan (1986) shows that price limits are effective in improving the efficiency of futures contracts with limited accessibility to information because they obscure the exact loss when they are triggered. However, Brennan's (1986) model fails to explain why price limits also exist in contracts with abundant information like those of financial futures. We show that when traders are loss-averse, the effectiveness of price limits is strengthened even in the presence of precise information. Thus, our analysis provides a theoretical foundation explaining why price limits can be useful when market participants are not fully rational.     

Does Risk Management Add Value? A Survey of the Evidence

The fact that 92% of the world's 500 largest companies recently reported using derivatives suggests that corporate managers believe financial risk management can increase shareholder value. Surveys of finance academics indicate that they too believe that corporate risk management is, on the whole, a valueadding activity. This article provides an overview of almost 30 years of broadbased, stock‐market‐oriented academic studies that address one or more of the following questions:

• ? Are interest rate, exchange rate, and commodity price risks reflected in stock price movements?
• ? Is volatility in corporate earnings and cash flows related in a systematic way to corporate market values?
• ? Is the corporate use of derivatives associated with reduced risk and higher market values?

The answer to the first question, at least in the case of financial institutions and interest rate risk, is a definite yes; all studies with this focus find that the stock returns of financial firms are clearly sensitive to interest rate changes. The stock returns of industrial companies exhibit no pronounced interest rate exposure (at least as a group), but industrial firms with significant cross‐border revenues and costs show considerable sensitivity to exchange rates (although such sensitivity actually appears to be reduced by the size and geographical diversity of the largest multinationals). What's more, the corporate use of derivatives to hedge interest rate and currency exposures appears to be associated with lower sensitivity of stock returns to interest rate and FX changes. But does the resulting reduction in price sensitivity affect value—and, if so, how? Consistent with a widely cited theory that risk management increases value by limiting the corporate “underinvestment problem,” a number of studies show a correlation between lower cash flow volatility and higher corporate investment and market values. The article also cites a small but growing group of studies that show a strong positive association between derivatives use and stock price performance (typically measured using price‐to‐book ratios). But perhaps the nearest the research comes to establishing causality are two studies—one of companies that hedge FX exposures and another of airlines' hedging of fuel costs—that show that, in industries where hedging with derivatives is common, companies that hedge outperform companies that don't.     

Sustaining implicit contracts when agents have career concerns: the role of information disclosure

Firms often augment career concerns incentives with implicit incentive contracts. I formalize the interaction between these two incentives, and highlight its implications on a firm's decision to disclose its workers' productivity information. Disclosure enhances career concerns but inhibits implicit contracts. I show two main results. First, implicit contracts weaken (i.e., substitute) career concerns if the prior belief about the worker's ability is low, and vice versa. Second, when these incentives are substitutes, the optimal disclosure policy follows a cutoff rule: patient firms are opaque, and transparent firms never offer implicit contracts. These results need not hold if the incentives are complements.     

Government contracts and trade credit

This study examines the association between government contracts and firms' use of trade credit. Firms with government contracts may demand less trade credit because of their lower operational risk, higher firm performance, stronger capacity to generate internal funds, and better access to other sources of financing. On the other hand, government contractors could receive more trade credit extensions from suppliers. We examine a sample of U.S. listed firms from 2000 to 2016 and find that firms with government contracts have a lower level of trade credit. We also find that government contractors make quicker payments for trade credit contracts than other firms. Moreover, we provide empirical evidence of government contractors' lower levels of operational risk and higher firm performance, which may enable government contractors to generate adequate internal funds for their operations or to obtain other forms of financing at a lower cost and thus lower their demand for trade credit. Incremental to prior research, our study suggests that having government contracts is one of the factors determining trade credit and firms' financing decisions.     

Credit Contagion Channels: Market Microstructure Evidence from Lehman Brothers’ Bankruptcy

Immediately after Lehman Brothers’ bankruptcy, many firms disclosed their financial exposure (or lack thereof) to Lehman. This offers a clean setting to test two credit contagion channels through which a financial firm's bankruptcy can affect other firms—“counterparty risk” and “information transmission” channels. Using market microstructure variables to measure the various dimensions of contagion effects, we provide robust evidence supporting the significance of counterparty risk. Firms with exposure to Lehman suffered more severe negative effects—wider bid‐ask spread, higher price impact, greater information asymmetry, and greater selling pressure—than unexposed firms. We find mixed evidence regarding the information transmission hypothesis.     

Vertical collusion

We characterize collusion involving secret vertical contracts between retailers and their supplier—who are all equally patient (“vertical collusion”). We show such collusion is easier to sustain than collusion among retailers. Furthermore, vertical collusion can solve the supplier's inability to commit to charging the monopoly wholesale price when retailers are differentiated. The supplier pays retailers slotting allowances as a prize for adhering to the collusive scheme and rejects contract deviations. In the presence of competing suppliers, vertical collusion can be sustained using short-term exclusive dealing.     

Investing in a relationship

A principal can make an investment anticipating a repeated relationship with an agent, but the agent may appropriate the returns through ex post bargaining. I study how this holdup problem and efficiency depend on the contracting environment. When investment returns are observable, informal contracts ex post can be more efficient than formal contracts, as they induce higher investment ex ante: the principal invests not only to generate direct returns, but also to improve relational incentives. Unobservability of returns increases the principal's ability to appropriate the returns but reduces her ability to improve incentives. The optimal information structure depends on bargaining power.     

The Beta Dilemma in Emerging Markets

In principle, emerging markets analysts employ the same analytical framework when estimating the value of businesses as their counterparts in developed economies: they forecast future cash flows and discount those to the present with appropriate costs of capital that are estimated using the Capital Asset Pricing Model (CAPM) framework. But in practice, emerging market analysts have a more complicated job because the task of estimating costs of equity in emerging markets is more difficult. Whereas developed economies have an abundance of historical data on overall stock market movements, industry share price behavior, and many individual share price histories, emerging market economies often do not. There may be no comparable local firms that are publicly traded—or if there are, their CAPM betas may be unreliable. And if analysts instead use the beta of a U.S. competitor as a surrogate for the emerging market beta, they face the question of whether domestic betas are equivalent across borders. As a consequence, appraisers of emerging market companies confront a “beta dilemma.” Part of this is a data problem stemming from shorter share price histories in emerging markets and the absence of publicly traded companies in some industries. In such cases, analysts may be inclined to use industry betas calculated with U.S. share prices as a substitute. But this creates an equivalence problem—the possibility, as confirmed by the author's research, that domestic U.S. and emerging market betas are not statistically equivalent for most industries. The author proposes a solution to this problem that involves grouping emerging markets into a single, distinctive asset class that allows for reliable calculations of industry betas. He also suggests ways of testing emerging market industry betas to determine whether they are statistically comparable.     

Forum Selection in International Business Contracts: Home Bias Portfolio Puzzle and Managerial Moral Hazard

We provide an economic analysis of forum selection in international business contracts. International business contracts or multi-state transactions within federally structured countries might be subject to more than one sovereign adjudication system. In case of conflict between the transacting parties, the appropriate tribunal must be identified. We examine the question of business firms' optimal choice of the forums to adjudicate future business disputes. We extend the investment model approach to litigation by applying a portfolio theory type analysis. We show that firms that prefer higher expected income and lower income volatility are better off diversifying the forums under which they litigate business disputes. This stands in contrast to real-world business practice that consistently shows a clear preference to selecting the home court and legal system to settle international business disputes. In a fraction of the cases, both parties gain by selecting a certain forum, because of specialization for example, and it becomes optimal to ignore diversification. In most cases, however, the relevant factors that affect forum selection are zero sum and priced ex ante, court bias, for example. Once priced, there is no incentive to disregard diversification. We hypothesize that, in addition to specialization, factors such as managerial moral hazard explain the real-world behavior of firms: managers are less likely to be blamed, ex post, for choosing the home court. We suggest that, as international barriers decline and international trade grows, firms will diversify the forums in which they adjudicate international business disputes.     

Allocative efficiency of internal capital markets: Evidence from equity carve-outs by diversified firms

We examine whether equity carve-outs (ECOs) lead to improvements in the functioning of the internal capital markets (ICM) of diversified firms. Divestitures, including spin-offs, sell-offs, and equity carve-outs, can be employed by firms to improve allocative efficiency. Equity carve-outs, unlike other forms of divestiture, leave the parent's ICM largely intact but provide the opportunity to enhance internal and external corporate governance mechanisms that can improve the parent's ICM. Using a US sample of 354 equity carve-outs completed between 1980 and 2013, we find that the allocative efficiency of parents is augmented significantly following transaction completion. This increase in allocative efficiency is driven by improvements in both the external and internal governance characteristics of parent companies, consistent with the expectation that motivates equity carve-outs.     

Efficiency out of disorder: Contested ownership in incomplete contracts

In many situations, irreconcilable disagreements between players lead to costly ownership disputes over assets—for example, in case of joint ownership. This article studies the role of such disputes in a situation where two players have to make a transaction‐specific investment and when contracts are incomplete. I show that potentially contested ownership may mitigate the inefficiency of investments due to the incompleteness of contracts generating an exchange surplus that comes closer to the first‐best surplus as compared to any other ex ante distribution of ownership typically discussed in the literature following the influential work by Grossman, Hart, and Moore. If the contest is an all‐pay auction, each player makes a transaction‐specific investment as if he or she owns the asset. This article can explain why shared ownership—as for example in equity joint ventures, family firms, start‐up partnerships, and so on—is an important part of today's corporate landscape.     

Optimal job design in the presence of implicit contracts

We characterize the optimal job design in a multitasking environment when the firms use implicit contracts (i.e., bonus payments). Two natural forms of job design are compared: (i) individual assignment, where each agent is assigned to a particular job and (ii) team assignment, where a group of agents share responsibility for a job and are jointly accountable for its outcome. Team assignment mitigates the multitasking problem but may weaken the implicit contracts. The optimal job design follows a cutoff rule where only the firms with high reputation concerns opt for team assignment. However, the cutoff rule need not hold if the firm can combine implicit incentives with explicit pay‐per‐performance contracts.     

Vertical integration,foreclosure, and productive efficiency

We analyze the consequences of vertical integration by a monopoly producer dealing with two retailers (downstream firms) of varying efficiency via secret two‐part tariffs. When integrated with the inefficient retailer, the monopoly producer does not foreclose the rival retailer due to an output‐shifting effect. This effect can induce the integrated firm to engage in below‐cost pricing at the wholesale level, thereby rendering integration procompetitive. Output shifting arises with homogeneous and differentiated products. Moreover, we show that integration with an inefficient retailer emerges in a model with uncertainty over retailers' costs, and this merger can be procompetitive in expectation.     

An empirical investigation of the welfare effects of banning wholesale price discrimination

Economic theory does not provide sharp predictions on the welfare effects of banning wholesale price discrimination: if downstream cost differences exist, then discrimination shifts production inefficiently, toward high‐cost retailers, so a ban increases welfare; if differences in price elasticity of demand across retailers exist, discrimination may increase welfare if quantity sold increases, so a ban reduces welfare. Using retail prices and quantities of coffee brands sold by German retailers, I estimate a model of demand and supply and separate cost and demand differences. Simulating a ban on wholesale price discrimination has positive welfare effects in this market, and less if downstream cost differences shrink, or with less competition.     

Political Connections and the Cost of Bank Loans

This paper analyzes whether the political connections of listed firms in the United States affect the cost and terms of loan contracts. Using a hand‐collected data set of the political connections of S&P 500 companies over the 2003–2008 time period, we find that the cost of bank loans is significantly lower for companies that have board members with political ties. We consider two possible explanations for these findings: a Borrower Channel in which lenders charge lower rates because they recognize that connections enhance the borrower's credit worthiness and a Bank Channel in which banks assign greater value to connected loans to enhance their own relationships with key politicians. After employing a series of tests to distinguish between these two channels, we find strong support for the Borrower Channel but no direct evidence supporting the Bank Channel. Finally, we demonstrate that political connections reduce the likelihood of a capital expenditure restriction or liquidity requirement commanded by banks at the origination of the loan. Taken together, our results suggest that political connections increase the value of U.S. companies and reduce monitoring costs and credit risk faced by banks, which, in turn, reduces the borrower's cost of debt.