Research Interests: Financial Economics, Liquidity, Asset Pricing & Corporate Finance under Frictions
Endogenous Liquidity and Defaultable Debt (with Zhiguo He, Chicago-Booth)
Revise & Resubmit Econometrica
Winner Best Paper Award, Utah Winter Finance Conference 2013
Abstract: This paper studies the interaction between fundamental and liquidity for defaultable corporate bonds that are traded in an over-the-counter secondary market with search frictions. Bargaining with dealers determines a bond’s endogenous liquidity, which depends on both the ﬁrm fundamental and the time-to-maturity of the bond. Corporate default decisions interact with the endogenous secondary market liquidity via the rollover channel. A default-liquidity loop arises: Earlier endogenous default worsens a bond’s secondary market liquidity, which ampliﬁes equity holders’ rollover losses, which in turn leads to earlier endogenous default. Besides characterizing in closed form the full inter-dependence between liquidity premium and default premium for credit spreads, we also study the optimal maturity implied by the model based on the tradeoﬀ between liquidity provision and ineﬃcient default.
Maturity Rationing and Collective Short-Termism (with Martin Oehmke, Columbia-GSB)
Abstract: Financing terms and investment decisions are jointly determined. This interdependence links ﬁrms’ asset and liability sides and can lead to short-termism in investment. In our model, asymmetric information frictions increase with the investment horizon, such that ﬁnancing for long-term projects is relatively expensive or even rationed. In response, ﬁrms whose ﬁrst-best investment opportunities are long-term may distort their investment towards second-best projects of shorter maturities. This worsens ﬁnancing terms for ﬁrms with shorter maturity projects, inducing them to distort their investment as well. In equilibrium, investment is ineﬃciently short-term. Moreover,equilibrium asset-side adjustments by ﬁrms amplify shocks and, while privately optimal, may be socially undesirable.
Quantifying Liquidity and Default Risks of Corporate Bonds over the Business Cycle
(with Hui Chen, MIT-Sloan, Rui Cui, Chicago-Booth, Zhiguo He, Chicago-Booth)
Abstract: This paper builds over-the-counter search frictions into a structural model of cor- porate bonds with time varying macroeconomic and secondary market liquidity con- ditions. We explain both non-default and default components of corporate bonds by quantitatively studying endogenous liquidity and default risks jointly. Procyclical liq- uidity and countercyclical risk premium allows the model to match the total credit spread of corporate bonds of different rating classes, as well as their default probabili- ties and corresponding CDS spreads. We proposed a novel model-based decomposition scheme that captures the interaction between liquidity frictions and corporate default decisions via the rollover channel, and these interactions represent quantitatively im- portant economic forces that were previously overlooked by empirical researchers.
The Hazards of Debt: Rollover Freezes, Incentives, and Bailouts (with Ing-Haw Cheng, UMichigan-Ross)
Review of Financial Studies (2012), 25(4): 1070-1110
Abstract: We investigate the trade-off between incentive provision and inefficient rollover freezes for a firm financed with short-term debt. First, debt maturity that is too short-term is inefficient, even with incentive provision. The optimal maturity is an interior solution that avoids excessive rollover risk while providing sufficient incentives for the manager to avoid risk-shifting when the firm is in good health. Second, allowing the manager to risk-shift during a freeze actually increases creditor confidence. Debt policy should not prevent the manager from holding what may appear to be otherwise low-mean strategies that have option value during a freeze. Third, a limited but not perfectly reliable form of emergency financing during a freeze - a “bailout” - may improve the terms of the trade-off and increase total ex-ante value by instilling confidence in the creditor markets. Our conclusions highlight the endogenous interaction between risk from the asset and liability sides of the balance sheet.
Level 3 Assets: Booking Profits, Concealing Losses
Review of Financial Studies (2012), 25(1): 55-95
Abstract: Fair value accounting forces institutions to revalue their inventory whenever a new transaction price is observed. An institution facing a balance sheet constraint can have incentives to suspend trading in Level 3 assets (traded on opaque over-the-counter markets) to avoid marking-to-market. This way the asset's book valuation can be kept artificially high, thereby relaxing the institution's balance sheet constraint. But, the institution loses direct control of its asset holdings, leading to possible excessive risk exposure. A regulator trying to reign in risk-taking faces ambiguous tools of increasing fines for mismarking and tightening capital requirements: although both make no-trading less like, conditional on no-trading they increase risk-taking. Random audits in general decrease risk-taking. Outside investors, who do not know at what price the asset would trade, reduce their valuation of the bank's balance sheet the longer the asset has not traded. Their expected discount from reported book value is convex in time since last trade.
Work in progress:
Dynamic Debt Maturity (with Zhiguo He, Chicago-Booth)
Multiple Equilibria in Models of Debt Rollover