do firms engage in risk shifting empirical evidence i empirically test whether firms engage in risk shifting contrary to what risk shifting theory predicts i find that firms reduce investment risk when they approach financial distress to identify the effect of distress on risk taking i use a natural experiment with exogenous changes to leverage risk reduction is most prevalent among firms that have shorter maturity debt bank debt and tighter bank loan financial covenants these findings suggest that debt composition and financial covenants serve as important mechanisms to mitigate debt equity agency conflicts such as risk shifting that are not explicitly contracted on received january 8 2015 accepted may 27 2016 by editor david denis

a multiplicative model of optimal ceo incentives in market equilibrium this paper presents a unified theory of both the level and sensitivity of pay in competitive market equilibrium by embedding a moral hazard problem into a talent assignment model by considering multiplicative specifications for the ceo s utility and production functions we generate a number of different results from traditional additive models first both the ceo s low fractional ownership the jensen murphy incentives measure and its negative relationship with firm size can be quantitatively reconciled with optimal contracting and thus need not reflect rent extraction second the dollar change in wealth for a percentage change in firm value divided by annual pay is independent of firm size and therefore a desirable empirical measure of incentives third incentive pay is effective at solving agency problems with multiplicative impacts on firm value such as strategy choice however additive issues such as perk consumption are best addressed through direct monitoring jel d2 d3 g34 j3

the correlation of productivity growth across regions and industries in the united states abstract this paper shows that productivity growth is more strongly correlated across u s regions than across the g7 countries cross region correlations of productivity growth within a given industry are typically stronger than cross sector correlations of productivity growth within the same region

status intertemporal choice and risk taking this paper takes the position that an individual s concern for relative status is expressed in her preferences we embed this hypothesis in an otherwise conventional model of economic growth and examine its consequences the model generates two kinds of equilibrium in the first all individuals always follow a deterministic consumption and investment strategy such a strategy must be linear in output is independent of payo s and technology and only depends on the discount factor this sort of equilibrium exists when the individual cares only about status and the individual production function is convex in investment in contrast the other kind of equilibrium involves convergence to a steady state in which there is persistent and endogenously generated gambling this kind of equilibrium exists in more plausible circumstances the individual has a utility function that may depend on consumption per se as well as implied status and individual production functions are concave we characterize the unique steady state in such a situation and prove that any dynamic equilibrium path must converge to it risk taking arises not from the presumption of a utility function with strictly convex segments as in friedman savage but naturally from a view of utility as depending on relative status our steady state is broadly consistent with the stylized facts that individuals both insure downside risk and to gamble over upside risk and generates similar patterns of risk taking and avoidance across environments with quite di erent overall wealth levels finally in contrast to friedman 1953 endogenous risk taking here is generally pareto ine cient

empowering change the effects of energy provision on individual aspirations in slum communities this paper discusses the role of energy provision in influencing the social aspirations of people living in slums we examine factors that influence the shift in aspirations in five slum settlements using data from 500 interviews conducted in serviced and non serviced slums from the state of gujarat in india the non serviced slums did not have access to basic services namely water sanitation energy roads solid waste and rainwater management we find empirical evidence which suggests that when basic infrastructure provisions are met slum dwellers shift their focus from lower order aspirations to the higher order aspirations like health education housing and land ownership we argue that energy provision enhances productivity and enables slum dwellers to shift their aspirations upwards furthermore we test the effect of work days lost due to illness on the relationship between higher order aspirations and aspirations for energy provision when provision of energy is low higher work day loss dampens higher order aspirations for policy makers this study highlights the critical link between the infrastructure services preferred by slum dwellers and their social aspirations for growth

human capital bankruptcy and capital structure we derive a firm s optimal capital structure and managerial compensation contract when employees are averse to bearing their own human capital risk while equity holders can diversify this risk away in the presence of corporate taxes our model delivers optimal debt levels consistent with those observed in practice it also makes a number of predictions for the cross sectional distribution of firm leverage consistent with existing empirical evidence it implies persistent idiosyncratic dierences in leverage across firms an important new empirical prediction of the model is that ceteris paribus firms with more leverage should pay higher wages

managerial incentives on the near linearity of optimal compensation contracts are examined when outcomes depend on managers choices as well as efforts as the cost of effort shrinks relative to payoffs the optimal contract converges to a linear payoff if the control space of the agent has full dimensionality but not otherwise thus when the agent can trade expected return for greater correlation with other returns it is better to ignore relative performance when the cost of effort is small when the choices include all fair gambles and hedges the linear schedule is no more expensive than any other schedule that induces effort unfair gambles are examined as well

optimal contracts with shirking i explicitly derive the optimal dynamic incentive contract in a standard continuoustime agency setting where the agent has a shirking action my solution generates two dynamic contracts new to the literature both contracts include phases when the agent frequently shirks in one contract the shirking phases are relaxation periods rewarding the agent for good performance in the other the shirking phases are suspension type arrangements punishing the agent for poor performance in addition i also explore the relationships between optimal contracting and taxes bargaining and renegotiation

empirical evidence of risk shifting in financially distressed firms this paper provides evidence of risk shifting behavior in the investment decisions of financially distressed firms using a real options framework i show that shareholders risk shifting incentives can reverse the expected negative relation between volatility and investment i test two hypotheses that are consistent with risk shifting behavior i volatility has a positive effect on distressed firms investment ii investments of distressed firms generate less value during times of high uncertainty empirical evidence using 40 years of data supports both hypotheses i further evaluate the effect of various firm characteristics on risk shifting and estimate the costs of the investment distortion

relational incentive contracts standard incentive theory models provide a rich framework for studying informational problems but assume that contracts can be perfectly enforced this paper studies the design of self enforced relational contracts i show that optimal contracts often can take a simple stationary form but that self enforcement restricts promised compensation and affects incentive provision with hidden information it may be optimal for an agent to supply the same inefficient effort regardless of cost conditions with moral hazard optimal contracts involve just two levels of compensation this is true even if performance measures are subjective in which case optimal contracts terminate following poor performance jel c73 d82 l14

dynamic security design convergence to continuous time and asset pricing implications an entrepreneur with limited liability needs to finance an infinite horizon investment project an agency problem arises because she can divert operating cash flows before reporting them to the financiers we first study the optimal contract in discrete time this contract can be implemented by cash reserves debt and equity the latter is split between the financiers and the entrepreneur and pays dividends when retained earnings reach a threshold to provide appropriate incentives to the entrepreneur the firm is downsized when it runs short of cash we then study the continuous time limit of the model we prove the convergence of the discrete time value functions and optimal contracts our analysis yields rich implications for the dynamics of security prices stock prices follow a diusion reflected at the dividend barrier and absorbed at zero their volatility as well as the leverage ratio of the firm increase after bad performance stock prices and book tomarket ratios are in a non monotonic relationship a more severe agency problem entails lower price earning ratios and firm liquidity and higher default risk

international real business cycles we ask whether a two country real business cycle model can account simultaneously for domestic and international aspects of business cycles with this question in mind we document a number of discrepancies between theory and data the most striking discrepancy concerns the correlations of consumption and output across countries in the data outputs are generally more highly correlated across countries than consumptions in the model we see the opposite

optimal security design and dynamic capital structure in a continuous time agency model we derive the optimal dynamic contract in a continuous time principal agent setting and implement it with a capital structure credit line long term debt and equity over which the agent controls the payout policy while the project s volatility and liquidation cost have little impact on the firm s total debt capacity they increase the use of credit versus debt leverage is nonstationary and declines with past profitability the firm may hold a compensating cash balance while borrowing at a higher rate through the credit line surprisingly the usual conflicts between debt and equity asset substitution strategic default need not arise in this paper we consider a dynamic contracting environment in which a riskneutral agent or entrepreneur with limited resources manages an investment activity while the investment is profitable it is also risky and in the short run it can generate arbitrarily large operating losses the agent will need outside financial support to cover such losses and continue the project the difficulty is that while the probability distribution of the cash flows is publicly known the agent may distort these cash flows by taking a hidden action that leads to a private benefit specifically the agent may i conceal and divert cash flows for his own consumption and or ii stop providing costly effort which would reduce the mean of the cash flows therefore from the perspective of the principal or investors that fund the project there is the concern that a low cash flow realization may be a result of the agent s actions rather than the project s fundamentals to provide the agent with appropriate incentives investors control the agent s wage and may also withdraw their financial support for the project and force its early termination we seek to characterize an optimal contract in this framework and relate it to the firm s choice of capital structure we develop a method to solve for the optimal contract given the incentive constraints in a continuous time setting and study the properties of the credit line debt and equity that implement the contract as in the discrete time model of demarzo and fishman 2003 the continuous time setting offers several peter m demarzo is from stanford university and yuliy sannikov is from u c berkeley we

explaining saving investment correlations national saving and investment rates are highly positively correlated in virtually all countries this is puzzling as it apparently implies a low degree of international capital mobility this paper shows that the observed positive correlation between national saving and investment rates arises naturally within a quantitatively restricted equilibrium model with perfect mobility of financial and physical capital the model is consistent with the fact that saving investment correlations are larger for larger countries but are still substantial for small countries further the model is consistent with the finding that current account deficits tend to be associated with investment booms copyright 1993 by american economic association

optimal risk sharing and borrowing constraints in a continuous time model with limited commitment abstract we study a continuous time version of the optimal risk sharing problem with one sided commitment in the optimal contract the agent s consumption is a time invariant strictly increasing function of a single state variable the maximal level of the agent s income realized to date we characterize this function in terms of the agent s outside option value function and the discounted amount of time in which the agent s income process is expected to reach a new to date maximum under constant relative risk aversion we solve the model in closed form optimal consumption of the agent equals a constant fraction of his maximal income realized to date in the complete markets implementation of the optimal contract the alvarez jermann solvency constraints take the form of a simple borrowing constraint familiar from the bewley aiyagari incomplete markets models

dynamic resource allocation with hidden volatility abstract we study a firm s internal resource allocation using a dynamic principal agent model with endogenous cash flow volatility the principal supplies the agent with resources for productive use but the agent has private control over both project volatility and resource intensity and may misallocate resources to obtain private benefits the optimal contract can yield either overly risky or overly prudent project selection it can be implemented with a constant pricing schedule i e a static decentralized linear mechanism giving the agent control over the resource quantities project risk and agent s equity share the implementation rationalizes the use of hurdle rates above a firm s cost of capital and transfer prices above marginal cost while showing that hurdle rates or transfer prices may not vary with the agent s risk choice

optimal mortgage design this article studies optimal mortgage design in a continuous time setting with volatile and privately observable income costly foreclosure and a stochastic market interest rate we show that the features of the optimal mortgage are consistent with an option adjustable rate mortgage option arm under the optimal contract the borrower is given discretion of how much to repay until his balance reaches a certain limit the default rates and interest rate payment on the mortgage correlate positively with the market interest rate gains from using the optimal contract relative to simpler mortgages are the biggest for those who face more income variability buy pricey houses given their income level or make little or no down payment our model thus may help to explain a high concentration of option arms among riskier borrowers jel g20 g21 g33

impatience versus incentives this paper studies the dynamics of long term contracts in repeated principal agent relationships with an impatient agent despite the absence of exogenous uncertainty pareto optimal dynamic contracts generically oscillate between favoring the principal and favoring the agent

intermediary asset pricing abstract we model the dynamics of risk premia during crises in asset markets where the marginal investor is a financial intermediary intermediaries face an equity capital constraint risk premia r

rewarding trading skills without inducing gambling this paper develops a model of active portfolio management in which fund managers may secretly gamble in order to manipulate their reputation and attract more funds we show that such trading strategies may expose investors to severe losses and are more likely to occur when fund managers are impatient their trading skills are scalable and generate higher prot per unit of risk we study investment management contracts that deter this behavior if investors are short lived then the manager must leave rents to investors in order to credibly commit not to gamble if investors are long lived contracts that increase but defer expected bonuses after an outstanding performance implement the rstbest our model can explain a number of observed dierences

optimal leverage and aggregate investment we analyze the optimal financing of investment projects when managers must exert unobservable effort and can also switch to less profitable riskier ventures optimal financial contracts can be implemented by a combination of debt and equity when the risk shifting problem is the most severe while stock options are also needed when the effort problem is the most severe worsening of the moral hazard problems leads to decreases in investment and output at the macroeconomic level moreover aggregate leverage decreases with the risk shifting problem and increases with the effort problem

corporate policies with permanent and transitory shocks we model the financing cash holdings and hedging policies of a firm facing financing frictions and subject to permanent and transitory cash flow shocks the permanent and transitory shocks generate distinct sometimes opposite effects on corporate policies we use the model to develop a rich set of empirical predictions in our model correlated permanent and transitory shocks imply less risk lower cash savings and a drop in the value of credit lines the composition of cash flow shocks affects the cash flow sensitivity of cash which can be positive or negative optimal hedging of permanent and transitory shocks may involve opposite positions

a continuous time version of the principal agent problem this paper describes a new continuous time principal agent model in which the output is a diffusion process with drift determined by the agent s unobserved effort the risk averse agent receives consumption continuously the optimal contract based on the agent s continuation value as a state variable is computed by a new method using a differential equation during employment the output path stochastically drives the agent s continuation value until it reaches a point that triggers retirement quitting replacement or promotion the paper explores how the dynamics of the agent s wages and effort as well as the optimal mix of short term and long term incentives depend on the contractual environment the understanding of dynamic incentives is central in economics how do companies motivate their workers through piece rates bonuses and promotions how is income inequality connected with productivity investment and economic growth how do financial contracts and capital structure give incentives to the managers of a corporation the methods and results of this paper provide important insights to many such questions this paper introduces a continuous time principal agent model that focuses on the dynamic properties of optimal incentive provision we identify factors that make the agent s wages increase or decrease over time we examine the degree to which current and future outcomes motivate the agent we provide conditions under which the agent eventually reaches retirement in the optimal contract we also investigate how the costs of creating incentives and the dynamic properties of the optimal contract depend on the contractual environment the agent s outside options the difficulty of replacing the agent and the opportunities for promotion our new dynamic insights are possible due to the technical advantages of continuous time methods over the traditional discrete time ones continuous time leads to a much simpler computational procedure to find the optimal contract by solving an ordinary differential equation this equation highlights the factors that determine optimal consumption and effort the dynamics of the agent s career path are naturally described by the drift and volatility of the agent s pay offs the geometry of solutions to the differential equation allows for easy comparisons to see how the agent s wages effort and incentives depend on the contractual environment finally continuous time highlights many essential features of the optimal contract including the agent s eventual retirement in our benchmark model a risk averse agent is tied to a risk neutral principal forever after employment starts the agent influences output by his continuous unobservable effort input the principal sees only the output a brownian motion with a drift that depends on the agent s effort the agent dislikes effort and enjoys consumption we assume that the agent s utility function has the income effect that is as the agent s income increases it becomes costlier to compensate him for the effort also we assume that the agent s utility of consumption is bounded from below

uncertainty shocks and balance sheet recessions this paper investigates the origin and propagation of balance sheet recessions i first show that in standard models driven by tfp shocks the balance sheet channel disappears when agents can write contracts on the aggregate state of the economy optimal contracts sever the link between leverage and aggregate risk sharing eliminating the concentration of aggregate risk that drives balance sheet recessions i then show that uncertainty shocks can help explain this concentration of aggregate risk and drive balance sheet recessions even with contracts on aggregate shocks the mechanism is quantitatively important and i explore implications for financial regulation

reward for luck in a dynamic agency model this paper studies a continuous time principal agent problem of a rm whose cash ows are determined by the manager s unobserved eort the rm s cash ows are further subject to persistent and publicly observable shocks that are beyond the manager s control while standard contracting models predict that compensation should optimally lter out these shocks empirical evidence suggests otherwise in line with this evidence our model predicts that the manager is rewarded for luck

international lending with moral hazard and risk of repudiation in this paper i examine the constrained optimal pattern of capital flows between a lender and a borrower in an environment in which there are two impediments to forming contracts the first impediment to contracting arises from the assumption that lenders cannot observe whether borrowers invest or consume borrowed funds this assumption leads to a moral hazard problem in investment the second impediment arises from the assumption that the borrower as a sovereign nation may choose to repudiate his debts the optimal contract is shown to specify that the borrowing country experience a capital outflow when the worst realizations of national output occur this seemingly perverse capital outflow forms a necessary part of the optimal solution to the moral hazard problem in investment

self enforcing wage contracts we examine long term wage contracts between a risk neutral firm and a risk averse worker when both can costlessly renege and buy or sell labour at a random spot market wage a self enforcing contract is one in which neither party ever has an incentive to renege in the optimum self enforcing contract wages are sticky they are less variable than spot market wages and positively serially correlated they are updated by a simple rule around each spot wage is a time invariant interval and the contract wage changes each period by the smallest amount necessary to bring it into the current interval

executive compensation a modern primer this article studies traditional and modern theories of executive compensation bringing them together under a simple unifying framework accessible to the general interest reader we analyze assignment models of the level of pay and static and dynamic moral hazard models of incentives and compare their predictions to empirical findings we make two broad points first traditional theories find it difficult to explain the data suggesting that compensation results from rent extraction by ceos however more modern shareholder value theories that arguably better capture the ceo setting do deliver predictions consistent with observed practices suggesting that these practices need not be inefficient second seemingly innocuous features of the modeling setup often made for tractability or convenience can lead to significant differences in the model s implications and conclusions on the efficiency of observed practices we close by highlighting apparent inefficiencies in executive compensation and additional directions for future research