Fear and loathing in executive pay

A look at how U.S. corporations choose to motivate their top officers and a presentation of evidence showing that linking executive compensation too closely to firm performance may be a mistake.Executives - Salaries

Sharing with a risk-neutral agent

A study that demonstrates multiple equilibria in a class of principal-agent models and that examines the convergence properties of contracts as risk aversion approaches zero.Risk

Bank diversification: laws and fallacies of large numbers

A clarification of the distinction between risk and failure in assessing bank diversification, showing how increasing bank size may increase bank risk even though it lessens the probability of failure and lowers the expected loss.Bank failures ; Nonbank activities

Productivity and the term structure

The recent record-setting economic expansion and the accompanying record-setting bull market in stocks are often attributed to Federal Reserve interest rate policy and increased productivity. But if interest rates behave differently when productivity changes, interest rate policy may need to change as well. This article examines how productivity changes affect the entire term structure-from short-term interest rates like the federal funds rate, to long-term rates like mortgages, car loans, and corporate bonds.Productivity ; Interest rates

Expensing stock options

Many market commentators argue that companies should expense the stock options they give their employees. Will expensing give investors better information about what companies earn and spend?Stock options ; Corporations - Finance ; Accounting

Bank diversification: laws and fallacies of large numbers

Conventional wisdom on bank diversification confuses risk with failure. This article clarifies the distinction and shows how increasing bank size may increase bank risk, even though it lessens the probability of failure and lowers the expected loss. The key result is an application of Samuelson's "fallacy of large numbers."Bank size ; Bank failures ; Risk

Term structure economics from A to B

The interest rates for bonds of different maturities are related, but the interplay of factors that influence these rates is not easy to tease apart. The author leads the reader through the development of a model of the term structure of interest rates, then works with the model to provide some insights into the interplay of factors, especially the effect of uncertainty on interest rates. His analysis shows how a common simplification known as the expectations hypothesis obscures the significant contribution that uncertainty can make to the determination of interest rates.Interest rates

Sharing with a risk-neutral agent

In the standard solution to the principal–agent problem, a risk-neutral agent bears all the risk. The author shows that, in fact, multiple solutions exist, and often the risk-neutral agent is not the sole bearer of risk. As risk aversion approaches zero, the unique risk-averse solution converges to the risk-neutral solution, wherein the agent bears the least amount of risk. Even a small degree of risk aversion can result in agents bearing significantly less risk than the standard solution suggests.Risk

Derivative mechanics: the CMO

A primer on how collateralized mortgage obligations (CMOs) work, looking at both their advantages and disadvantages and explaining how some seasoned market participants got into trouble by investing in these interest-rate-sensitive financial instruments.Derivative securities ; Mortgages

Imperfect state verification and financial contracting

An argument that in a costly state verification model of financial contracting, relaxing the assumption of perfect verification makes the measurement of information difficult.Contracts ; Information theory