Paper Abstracts
"Coalitions, Leadership, and Social Norms: The Power of Suggestion in Games," Games and Ecomomic Behavior, 1992, 4, 72-100.
Abstract: This paper examines the set of outcomes sustainable by a leader with the power to make suggestions in games. By acting as focal points, these suggestions are important even if players can communicate and form coalitions. For finite horizon games, I show that sustainable outcomes are supported by "scapegoat" strategies, which hold a single player accountable for the actions of a group. For infinite horizon, two player repeated games, I show that by using an appropriate sequence of punishments and rewards, a leader can induce sufficiently patient players to play any feasible, individually rational outcome. Finally, leadership power is shown to increase if coalitions must consider the credibility of deviations in a manner similar to Coalition Proof Nash Equilibrium.
Corprate Financial Hedging with Proprietary Information," with Darrell Duffie, Journal of Economic Theory, 1991, 53, 261-286.
Abstract: If a firm has information pertinent to its own dividend stream that is not made available to its shareholders, it may be in the interests of the firm and its shareholders to adopt a financial hedging policy. This is in contrast with the Modigliani-Miller Theorem, which implies that, with informational symmetry, such financial hedging is irrelevant. Even though markets are incomplete, it is possible, in certain cases, to identify hedging policies that are unanimously supported by shareholders. These results suggest that the firm act as though it were highly risk averse with regard to its financial hedging policy. This contrasts with the firm's production decisions, which generally would be made from a much more risk neutral perspective.
"Computing Equilibria when Asset Markets are Incomplete," with Donald Brown and Curtis Eaves, Econometrica, 1996, 64, 1-27.
Abstract: Existence of equilibrium with incomplete markets is problematic because demand functions are typically not continuous. Discontinuities occur at prices for which a marketed asset suddenly becomes redundant. We show that this discontinuity disappears if we allow an agent in the economy to introduce a new asset when such redundancies occur. This enables us to prove generic existence with incomplete markets using a standard path-following argument. Moreover, our approach suggests a simple algorithm for computing equilibria when markets are incomplete. We use this algorithm to compute equilibrium for a numerical example in which these discontinuities are problematic.
"An Extension of the Modigliani-Miller Theorem to Stochastic Economies with Incomplete Markets and Interdependent Securities," Journal of Economic Theory, 1988, 45, 353-369.
Abstract: The Modigliani-Miller Theorem is considered in a general model of a multi-period, stochastic economy with incomplete markets and perfect foresight. In the model, firms are allowed to trade all available securities; thus, share prices and dividends become fully interdependent. Also, unlike other models, the investment policy of the firm is endogenous, and thus the objective of the firm must be specified. With incomplete markets, value maximization is no longer unambiguous, and investors generally disagree regarding investment decisions. Thus, several mechanisms of corporate control are considered, including shareholder voting. The Modigliani-Miller Theorem can be shown to hold in this setting; i.e., firms have no incentive to trade securities in equilibrium, and any such trading does not alter the set of equilibrium allocations. However, this result critically depends on firms aggregating shareholder preferences in a proportional fashion.
"Computing Zeros of Sections of Vector Bundles using Homotopies and Relocalization," with Donald Brown and Curtis Eaves, Mathematics of Operations Research, 1996, 21, 26-43.
Abstract: An algorithm is described for computing fixed points on a Grassmannian manifold. The method can be applied in the more general setting of solving equations on abstract smooth manifolds into vector bundles. Applications include a computational proof of the Borsuk-Ulam Theorem and the computation of economic equilibria with incomplete markets.
"On the Uniqueness of Fully Informative Rational Expectations Equilibria," with Costis Skiadas, Economic Theory.
Abstract: This paper analyzes two equivalent equilibrium notions under asymmetric information: risk neutral rational expectations equilibria (rn-REE), and common knowledge equilibria. We show that the set of fully informative rn-REE is a singleton, and we provide necessary and sufficient conditions for the existence of partially informative rn-REE. In a companion paper (DeMarzo and Skiadas (1996)) we show that equilibrium prices for the larger class of quasi-complete economies can be characterized as rn-REE. Examples of quasi-complete economies include the type of economies for which demand aggregation in the sense of Gorman is possible (with or without asymmetric information), the setting of the Milgrom and Stokey no-trade theorem, an economy giving rise to the CAPM with asymmetric information but no normality assumptions, the simple exponential-normal model of Grossman (1976), and a case of no aggregate endowment risk. In the common-knowledge context, we provide necessary and sufficient conditions for a common knowledge posterior estimate, given common priors, to coincide with the full communication posterior estimate.
"Computing Equilibria of GEI by Relocalization on a Grassmann Manifold," with Curtis Eaves, Journal of Mathematical Economics, 1996, 26, 479-497.
Abstract: An algorithm is described for computing equilibria of economies with incomplete markets. The algorithm is based on existence of a route of zeros of a homotopy whose domain includes the price simplex and a Grassmann manifold. This route is followed, in effect, by localizing and following diffeomorphic pieces in euclidean space, and by relocalizing as necessary.
"Sequential Trade and the Coase Conjecture: A General Model of Durable Goods Monopoly with Applications to Finance," with David Bizer.
Abstract: When buyers and sellers cannot commit to a single round of trade, market participants must anticipate future trading opportunities when considering whether to make or accept offers in the present. We construct a general model of this environment and characterize the time consistent (i.e., subgame perfect) equilibrium trade. We establish conditions under which the Coase conjecture holds and the competitive outcome is achieved in the unique subgame perfect equilibrium. We also demonstrate conditions under which a monopolist earns super-competitive profits in the unique equilibrium. Finally, we show cases in which there exists a unique, but "unpredictable," equilibrium. Our analysis provides a unified theory of market environments for a variety of applications, including the durable goods monopoly problem, the large shareholder takeover problem, and the debt overhang problem.
"A Liquidity-Based Model of Security Design," with Darrell Duffie, Econometrica, 1999, 67, 65-99.
Abstract: We consider the problem faced by an issuer who wishes to design and issue a security backed by some exogenously given assets. The issuer has access to higher return investments and so has an incentive to raise capital by securitizing these assets. Because the issuer has private information regarding the value of the assets at the time the security is issued, the security may be "illiquid"; that is, the issuer experiences a downward sloping demand curve for the security. The severity of this liquidity or "lemons" problem depends upon the informational sensitivity of the issued security. Thus, the security design problem involves a tradeoff between the retention cost of holding any cash flows not included in the security design, and the liquidity cost of including the cash flows and making the security design more sensitive to the issuer's private information. We characterize the optimal security design in several cases. We show, for example, that indexing the security to market observables may be optimal. We also demonstrate circumstances in which standard debt is the optimal security. For this case, the debt is risky (i.e., has a positive probability of default). If the opportunity cost of the issuer is high enough, an equity claim on the underlying assets is optimal.
"The Optimal Enforcement of Insider Trading Regulations," with Michael Fishman and Kathleen Hagerty, Journal of Political Economy, 1998, 106, 602-632.
Abstract: We consider the problem of enforcing insider trading regulations. Regulating insider trading lessens the adverse selection problem faced by market makers, enabling them to quote more favorable prices for traders. These benefits of regulation, however, must be balanced against the costs of enforcement. In designing the optimal enforcement policy the objective is to maximize the expected utility of the traders who are not insiders. Specifically, the problem is to design an enforcement policy consisting of (i) the circumstances under which the regulator undertakes a costly investigation to detect the presence of insider trading; (ii) the penalty schedule for insider trading; and (iii) a transaction tax to be levied and used for the regulator’s budget. Among the results, we show that the optimal policy has the following features. Investigations are triggered by large trading volume and/or large price movements. Insiders caught making large trades are assessed the maximum legal penalty, while small trades are not penalized. Given this optimal enforcement policy, we find that an insider would not trade aggressively on very modest or very extreme news, but would trade most aggressively on news leading to an "intermediate" price change.
"Optimal Incentive Contracts when Agents Can Save, Borrow, and Default," with David Bizer, Journal of Financial Intermediation, forthcoming.
Abstract: The standard Principal-Agent (PA) model assumes that the principal can control the agent's consumption profile. In an intertemporal setting, however, Rogerson [1985] shows that given the optimal PA contract, the agent has an unmet precautionary demand for savings. Thus the standard PA model is invalid if the agent has access to credit markets. In this paper we generalize the standard PA model to allow for saving and borrowing by the agent. We show that the impact of such access critically depends upon the treatment of default. If default is not permitted, efficiency is strictly reduced by the introduction of credit markets, and the equilibrium level of borrowing or saving is indeterminate in the model. If default is allowed, however, the optimal contract depends upon the level of bankruptcy protection in the economy, which is described by a minimum level of wage income. We show that there is an optimal intermediate range of bankruptcy protection. Within this range, allowing default increases efficiency in the economy relative to the case of no default. Also, the model predicts specific levels of consumer debt, interest and default rates as function of the level of bankruptcy protection level.
"A Near-Rational Model of Persuasion—With Implications for Financial Markets," with Dimitri Vayanos and Jeff Zwiebel.
Abstract: We analyze a model of persuasion whereby agents overweight the information of individuals who they "listen to" relative to other individuals. Such agents can be understood to be acting rationally, subject to a misspecified model of the world. We analyze dynamics and convergence of beliefs, characterizing when agents' initial beliefs converge over time to the same beliefs, and when they instead diverge. Convergent beliefs can be characterized as a weighted average of agent's initial beliefs, with weights corresponding to "influence." We then explore implications in an asset trading setting. Here we demonstrate that agents profit from being influential as well as being accurate. We further endogenize the choice of which agents to listen to in this setting, and obtain preliminary results on the persistence of influence.
"Aggregation, Determinacy, and Informational Efficiency for a Class of Economies with Asymmetric Information," with Costis Skiadas, Journal of Economic Theory, 1998, 80, 123-152.
Abstract: In this paper we identify and analyze a class of economies with asymmetric information that we call quasi-complete. Quasi-complete economies have many of the properties commonly associated with complete markets, but unlike the latter they may support equilibria that do not perfectly aggregate agents' private information. Special cases include a class of economies with traded endowments and linear risk tolerance, Grossman's (1976) exponential-normal model, the setting of the no-trade theorem of Milgrom and Stokey (1982), and an economy with no aggregate endowment risk. For quasi-complete economies we determine equilibrium trades, we show that the set of fully informative equilibria is a singleton, and we give necessary and sufficient conditions for the existence of partially informative equilibria. Besides unifying some familiar settings, the following new results are proved: (a) The same restrictions that deliver Gorman aggregation under symmetric information, are sufficient for Gorman aggregation under asymmetric information, even under partially informative prices. (b) The traditional assumptions of quadratic utilities and endowment spanning that result in the CAPM under symmetric information (without distributional assumptions) deliver a conditional CAPM under asymmetric information with prices that need not be fully informative. (c) The linear equilibrium in Grossman's (1976) model is the only equilibrium (linear or not), while minor changes in the normality assumptions result in indeterminacy and partially informative equilibria. (d) If there is no aggregate endowment risk, agents with common priors will always sell the risky part of their endowment, no matter what private information they receive.
"The Pooling and Tranching of Securities."
Abstract: This paper considers the problem faced by a financial intermediary with n assets to sell in the presence of asymmetric information. I show that when the intermediary has superior information about the value of each asset, the intermediary is better off selling shares in the assets individually rather than as a pool. In particular, pooling has an information destruction effect that operates to the disadvantage of the intermediary by preventing the intermediary from fully exploiting its information regarding each individual asset. If, however, the intermediary can create a derivative security that is collateralized by the assets, pooling and “tranching” may be optimal. Tranching allows the intermediary to take advantage of the risk diversification effect of pooling to create a low risk and highly liquid security. I show that if the residual risk of each asset is not too highly correlated, then for large enough n, the risk diversification effect dominates and pooling and tranching is optimal for the informed intermediary. I then contrast this with the case of an uninformed originator, selling to both informed intermediaries and uninformed investors. I show that for an uninformed seller, pooling is is preferred to separate asset sales. Finally, I combine these results in a dynamic model of financial intermediation: uninformed originators sell pools of assets, some of which are purchased by informed intermediaries. These intermediaries then further pool the assets and sell senior tranches to investors in order to raise cash to buy new securities in the origination market. These results are consistent with several qualitative features of the asset-backed securities market.
"The Enforcement Policy of a Self-Regulatory Organization," with Michael Fishman and Kathleen Hagerty.
Abstract: The federal government delegates various aspects of financial market regulation to self-regulatory organizations (SROs) such as the New York Stock Exchange and the National Association of Securities Dealers. We model one regulatory task of an SRO, the enforcement of rules designed to prevent the SRO’s members from cheating customers. Specifically, we focus on the determination of an SRO’s optimal policy for investigating agents who may have defrauded customers and the penalties associated with fraud. We model contracting/enforcement as a two-tier problem. First, an SRO chooses its enforcement policy, consisting of a specification of the likelihood that an agent is investigated for fraud and a penalty schedule. We assume that the SRO’s objective is to maximize the welfare of its members, the agents. Taking the SRO’s enforcement policy as given, agents compete with one another to handle customer transactions. They compete by offering contracts promising (outcome-contingent) payoffs that maximize customers’ expected utility. When choosing an enforcement policy, the SRO anticipates the competition among its members. Indeed, we show that the SRO’s optimal enforcement policy is designed to mute this competition. In doing so, an SRO chooses a more lax enforcement policy than would be preferred by customers. Investigations for cheating are less frequent and penalties are lower than what a customer would choose. Moreover, a decrease in investigation cost might lead an SRO to actually investigate less. Enforcement will become more vigorous, however, as a customer’s alternatives to dealing with an agent of the SRO improve. A general conclusion of the analysis is that control of the enforcement policy governing contracts confers substantial market power to a group of otherwise competitive agents. In fact, we show that if agents are risk neutral, control of the enforcement policy is equivalent to agents behaving as monopolists. We also investigate the effect of government oversight on the self-regulatory process. We show that in equilibrium the threat of governmental enforcement will lead to more rigorous enforcement by the SRO, to the benefit of customers. Moreover, this benefit is achieved even without actual governmental enforcement taking place.
