Fund managers, career concerns, and asset price volatility

We propose a model of delegated portfolio management with career concerns. Investors hire fund managers to invest their capital either in risky bonds or in riskless assets. Some managers have superior information on the default probability. Looking at the past performance, investors update beliefs on their managers and make firing decisions. This leads to career concerns which affect investment decisions, generating a positive or negative “reputational premium.” For example, when the default probability is high, the return on the risky bond has to be high to compensate the uninformed managers for the high risk of being fired. As the default probability changes over time, the reputational premium amplifies price volatility.Asset pricing

Inefficient investment waves

We show that firms' individually optimal liquidity management results in socially inefficient boom-and-bust patterns. Financially constrained firms decide on the level of their liquid resources facing cash-flow shocks and time-varying investment opportunities. Firms' liquidity management decisions generate simultaneous waves in aggregate cash holdings and investment, even if technology remains constant. These investment waves are not constrained efficient in general, because the social and private value of liquidity differs. The resulting pecuniary externality affects incentives differentially depending on the state of the economy, and often overinvestment occurs during booms and underinvestment occurs during recessions. In general, policies intended to mitigate underinvestment raise prices during recessions, making overinvestment during booms worse. However, a well-designed price-support policy will increase welfare in both booms and recessions

Trading and information diffusion in OTC markets

We propose a model of trade in over-the-counter (OTC) markets in which each dealer with private information can engage in bilateral transactions with other dealers, as determined by her links in a network. Each dealer's strategy is represented as a quantity-price schedule. We analyze the effect of trade decentralization and adverse selection on information diffusion, expected profits, trading costs and welfare. Information diffusion through prices is not affected by dealers' strategic trading motives, and there is an informational externality that constrains the informativeness of prices. Trade decentralization can both increase or decrease welfare. A dealer's trading cost is driven by both her own and her counterparties' centrality. Central dealers tend to learn more, trade more at lower costs and earn higher expected profi

Trading and information diffusion in over-the-counter markets

We propose a model of trade in over-the-counter (OTC) markets in which each dealer with private information can engage in bilateral transactions with other dealers, as determined by her links in a network. Each dealer's strategy is represented as a quantity-price schedule. We analyze the effect of trade decentralization and adverse selection on information diffusion, expected profits, trading costs and welfare. Information diffusion through prices is not affected by dealers' strategic trading motives, and there is an informational externality that constrains the informativeness of prices. Trade decentralization can both increase or decrease welfare. A dealer's trading cost is driven by both her own and her counterparties' centrality. Central dealers tend to learn more, trade more at lower costs and earn higher expected profit

Heterogeneous global cycles

Why do countries differ in terms of their exposure to fluctuations in the global supply of credit? We argue that frictions in global intermediation lead to an endogenous partitioning of economies into groups with low and high exposure to the global credit cycle. We show that investors with varying degree of information hold dissimilar portfolios, with low skilled investors sharply rebalancing their cross-country asset holdings across different aggregate states. The differential response of investors invites differential strategies of firms, jointly shaping heterogeneous global cycles. We connect the implications of our model to stylized facts on credit spreads, investment, safe asset supply, concentration of debt ownership, and the return on debt during various boom-bust episodes, both in the time series and in the cross-section. We demonstrate that a global savings glut not only exacerbates both booms and busts in high exposure countries, but also increases the exposure of some countries to credit cycles

Learning in crowded markets

We present a novel entry-game with endogenous information acquisition to study the welfare effects of opacity and competition. Potential entrants to an opaque market are uncertain about their competitive advantage relative to other investors, i.e. their type. They construct optimal costly signals to learn about their types, where the marginal cost of learning captures the opacity of the market. In general, the individually optimal entry and learning decisions are socially suboptimal. Players over-invest in learning and more opaque markets are associated with more crowding. Nevertheless, more opaque markets might still lead to higher welfare by implying a better trade-off between the degree of crowding and the total cost of learning. Similarly, decreasing the share of smart investors in the market might also improve welfare. However, fierce competition is always detrimental to welfare as it leads to more wasteful learning without changing the level of crowding

Clients' connections

We propose a new measure of private information in decentralised markets - connections - defined as the number of dealers with whom a client trades in a time period. Using proprietary data for the UK government bond market, we show that clients have systematically better performance when having more connections, and this effect is stronger during macroeconomic announcements. Time-variation in market-wide connections also helps explain yield dynamics. Given our novel measure, we present two applications suggesting that (i) dealers pass on information, acquired from their informed clients, to their subsidiaries, and (ii) informed clients better predict the order-flow intermediated by their dealers

Learning in crowded markets

We study how competition among investors affects the efficiency of capital allocation, the speed of capital, and welfare. In our model, investors learn about other entrants in a fully flexible way. We find that competition increases the speed of capital, but does not necessarily improve the efficiency of capital allocation: there is persistent over- or underinvestment. As speed is a by-product of costly over-learning, increasing competition decreases welfare. We describe how the speed of capital and the level of over- or underinvestment depend on market and investor characteristics. With investors of heterogeneous skills, more sophisticated investors might harm welfare

Liquidity risk and the dynamics of arbitrage capital

We develop a continuous-time model of liquidity provision in which hedgers can trade multiple risky assets with arbitrageurs. Arbitrageurs have constant relative risk-aversion (CRRA) utility, while hedgers' asset demand is independent of wealth. An increase in hedgers' risk aversion can make arbitrageurs endogenously more risk-averse. Because arbitrageurs generate endogenous risk, an increase in their wealth or a reduction in their CRRA coefficient can raise risk premia despite Sharpe ratios declining. Arbitrageur wealth is a priced risk factor because assets held by arbitrageurs offer high expected returns but suffer the most when wealth drops. Aggregate illiquidity, which declines in wealth, captures that factor

Cleansing by tight credit: rational cycles and endogenous lending standards

Endogenous cycles are generated by the two-way interaction between lenders' behavior in the credit market and production fundamentals. When lenders choose credit quantity over quality, the resulting lax lending standards lead to low interest rates and high output growth but the deterioration of future loan quality. When the quality is sufficiently low, lenders change their behavior and switch to tight standards, causing high credit spreads and low growth but a gradual improvement in the quality of loans. This eventually triggers a shift back to a boom with lax lending, and the cycle continues. Lenders fail to internalize that tight lending standards cleanse the economy of low quality borrowers and lead to healthier subsequent booms. Therefore, carefully chosen macro-prudential or counter-cyclical monetary policy often improves the decentralized equilibrium cycle