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Note: Electronic versions of published papers/working papers are provided as a professional courtesy to ensure timely dissemination of the research for individual non-commercial purposes. Copyright, and all other rights therein, reside with the respective copyright holders, as stated within each paper. These files may not be reposted without permission.
Distributed Ledger and Blockchain Technology: Framework and Use Cases,with Atulya Sarin, forthcoming in Journal of Investment Management
Since its first widespread implementation in 2009, distributed ledgers in general, and blockchain technology in particular, have rapidly become a part of the FinTech vernacular. In this paper, we provide an overview of the history of trade settlement and discuss this nascent technology that may now transform traditional methods of verifying and settling transactions. In so doing, we discuss current and potential use cases of this technology and provide a business-oriented framework for proper as well as improper implementations and applications of blockchains and distributed ledgers.
Crypto-Assets Unencrypted,with Atulya Sarin and Daljeet Virdi, 2018, Journal of Investment Management, Vol. 16 (2), p. 1-31
With the recent surge in crypto-activity, a natural question arises as to what exactly a “cryptocurrency” is and how to value and assess these digital assets. In this paper, we provide an overview of the history and technology underlying cryptocurrencies. We also present information on the volume, size, and volatility of this emerging asset class, which we compare to major fiat currencies and commodities. Finally, we provide a framework for valuing crypto-assets, discuss the still-evolving regulatory environment for this asset class, and discuss the mechanics of investing in cryptocurrencies.
Do Players Perform for Pay? An Empirical Examination via NFL Players' Compensation Contracts,with Atulya Sarin and Saagar Sarin, 2018, Journal of Banking and Finance, Vol. 88, p. 330-346
How to properly compensate and incentivize players is an important question in the realm of professional sports, and more broadly, is a central question in contract design. With the increasing use of performance-based compensation packages and tax law favoring such compensation design, a natural question arises as to whether workers do indeed perform for pay. We examine this question in a setting that is not fraught with the typical measurement and identification problems found in many pay-performance settings. Specifically, we examine changes in a NFL player’s Win Probability Added (WPA) and Expected Points Added (EPA) in response to his compensation-contract design. Overall, our paper provides evidence that players do indeed perform for (properly designed) pay, and has important implications for future work on compensation and incentive-based contract design.
Measuring Correlated Default Risk: A New Metric and Validity Tests, with Siamak Javadi, Tim Krehbiel, and Ali Nejadmalyeri, 2017, Journal of Fixed Income, lead article, Vol. 27 (2), p. 6-29
Extracting information from daily CDS spreads, we propose a measure of correlated default risk, which we show is a meaningful predictor of bankruptcy clusters. Focusing on U.S. corporate bonds, we also find that our measure of correlated default risk is more pronounced and commands a higher premium during periods of financial distress and for speculative issues. For instance, we find that after controlling for other known determinants of bond pricing, a 0.5 increase in aggregate correlated default risk is associated with a 13-bps increase in credit spreads, and elevates to a 22-bps premium for speculative issues and to a 17-bps premium during periods of financial distress. Overall, our paper provides compelling evidence as to the efficacy of our measure in capturing correlations in the likelihood of default over time, and has important implications for future work in asset allocation and fixed-income pricing.
Managing Rollover Risk with Capital Structure Covenants in Structured Finance Vehicles, with Sanjiv Das, 2017, Journal of Fixed Income, Vol. 26 (4), p. 99-112
The shadow banking system comprises special purpose vehicles (SPVs) characterized by high debt, illiquid long-maturity assets funded predominantly by short-maturity debt, and tranched liabilities also known as the capital structure of the SPV. These three features lead to an adversarial game among senior-note holders, who solve for an optimal rollover policy based on the other senior tranches with varying rollover dates. This rollover policy is, in turn, taken into account by capital-note holders (i.e., investors in the equity tranche) when choosing the capital structure (i.e., the assets-to-debt ratio) of the SPV. Rollover risk increases in the number of time tranches, resulting in a lower equilibrium level of debt and higher cost of debt. The expected life of the SPV may also be shortened. We propose a covenant-based capital structure that mitigates these problems and is Pareto-improving for equity and debt holders in the SPV.
The Design and Risk Management of Structured Finance Vehicles, with Sanjiv Das, 2016, Journal of Risk and Financial Management, Vol. 9, Special Issue "Credit Risk"
Special purpose vehicles (SPVs), extremely popular financial structures for the creation of highly-rated tranched securities, experienced spectacular demise in the 2007--08 financial crisis. These financial vehicles epitomize the shadow banking sector, characterized by high leverage, undiversified asset pools, and long-dated assets supported by short-term debt, thus bearing material rollover risk on their liabilities which led to defeasance. This paper models these vehicles, and shows that imposing leverage risk control triggers can be optimal for all capital providers. The efficacy of these risk controls vary depending on anticipated asset volatility and fire-sale discounts on defeasance. Despite risk management controls, we show that a high failure rate is inherent in the design of these vehicles, and may be mitigated to some extent by including contingent capital provisions in the ex-ante covenants. Post the recent subprime financial crisis, we inform the creation of safer SPVs in structured finance, and propose avenues of mitigating risks faced by senior debt through deleveraging policies in the form of leverage risk controls and contingent capital.
Credit Spreads with Dynamic Debt, with Sanjiv Das, 2015, Journal of Banking and Finance, Vol. 50, p.121-140
This paper extends the baseline Merton (1974) structural default model, which is intended for static debt spreads, to a setting with dynamic debt, where leverage can be ratcheted up as well as written down through pre-specified exogenous policies. We provide a different and novel solution approach to dynamic debt than in the extant literature. For many dynamic debt covenants, ex-ante credit spread term structures can be derived in closed-form using modified barrier option mathematics, whereby debt spreads can be expressed using combinations of single barrier options (both knock-in and knock-out), double barrier options, double-touch barrier options, in-out barrier options, and one-touch double barrier binary options. We observe that debt principal swap down covenants decrease the magnitude of credit spreads but increase the slope of the credit curve, transforming downward sloping curves into upward sloping ones. On the other hand, ratchet covenants increase the magnitude of ex-ante spreads without dramatically altering the slope of the credit curve. These covenants may be optimized by appropriately setting restructuring boundaries, which entails a trade-off between the reduction in spreads against restructuring costs. Overall, explicitly modeling this latent option to alter debt leads to term structures of credit spreads that are more consistent with observed empirics.
Coming Up Short: Managing Underfunded Portfolios in a LDI-BPT Framework, with Sanjiv Das and Meir Statman, 2014, Journal of Portfolio Management, Vol. 41 (1), p.95-108
We employ a liability directed investment (LDI) framework built on behavioral portfolio theory (BPT), which we refer to as LDI-BPT, to prescribe remedies for an underfunded portfolio. Investors in the LDI-BPT framework face a risky asset, such as a stock index, and a risk-free bond. They begin with some level of current wealth and set their target wealth at the end of N periods, and their tolerance for shortfalls from that target wealth. Portfolio rebalancing in the LDI-BPT framework is quite different from the common fixed-proportions rebalancing, where portfolio allocations are rebalanced to ratios, such as 60:40, at the beginning of each of N periods. We consider critical issues of underfunding, where there is no portfolio that can meet the shortfall constraint, and we explore the effectiveness of portfolio infusions in resolving underfunded situations, relative to other measures such as increasing risk, cutting back on target liabilities/goals, and extending the portfolio horizon.
Going for Broke: Restructuring Distressed Debt, with Sanjiv Das, 2014, Journal of Fixed Income, lead article, Vol. 24 (1), p.5-27
This paper discusses how to restructure a portfolio of distressed debt, what the gains are from doing so, and attributes these gains to restructuring and portfolio effects. This is an interesting and novel problem in fixed-income portfolio management that has received scant modeling attention. We show that debt restructuring is Pareto improving and lucrative for borrowers, lenders, and investors in distressed debt. First, the methodological contribution of the paper is a parsimonious model for the pricing and optimal restructuring of distressed debt, i.e., loans that are under-collateralized and are at risk of borrower default, where willingness to pay and ability to pay are at issue. Distressed-debt investing is a unique portfolio problem in that (a) it requires optimization over all moments, not just mean and variance, and (b) with debt restructuring, the investor can endogenously alter the return distribution of the candidate securities before subjecting them to portfolio construction. Second, economically, we show that post-restructuring return distributions of distressed debt portfolios are attractive to fixed-income investors, with risk-adjusted certainty equivalent yield pick-ups in the hundreds of basis points, suggesting the need for more efficient markets for distressed debt, and shedding light on the current policy debate regarding the use of eminent domain in mitigating real estate foreclosures.
Structured Finance Deals: A Review of the Rating Process and Recent Evidence Thereof, 2012, Journal of Investment Management, Vol. 10 (4), p.103-115
The pooling and tranching of assets into prioritized cash-flow claims has become a substantial source of revenue for issuers as well as rating agencies in the last decade. With the recent demise of vehicles used to operationalize these structured deals, a natural question arises as to the quality of standards applied in structuring, managing, and ultimately rating these products. The purpose of this paper is to review rating practices in the area of structured finance, and to summarize the research and empirical evidence pertaining to these questions.
It Pays to Have Friends, with Byoung-Hyoun Hwang, 2009, Journal of Financial Economics, Vol. 93 (1), p.138-158
Currently, a director is classified as independent if he/she has neither financial nor familial ties to the CEO or to the firm. We add another dimension: social ties. Using a unique data set, we find that 87% of boards are conventionally independent, but that only 62% are conventionally and socially independent. Furthermore, firms whose boards are conventionally and socially independent award a significantly lower level of compensation, exhibit stronger pay performance sensitivity, and exhibit stronger turnover-performance sensitivity than firms whose boards are only conventionally independent. Our results suggest that social ties do matter, and that consequently, a considerable percentage of the conventionally independent boards are substantively not.
Return Performance Surrounding Reverse Stock Splits, with April Klein and James Rosenfeld, 2008, Financial Management, lead article, Vol. 37 (2), p.173-192
We examine the long-run return performance of over 1,600 firms with reverse stock splits. These stocks record statistically significant negative abnormal returns over the three-year period following the month of the reverse split. The sample firms experience poor operating performances over the four years that include and follow the year of the reverse split, which suggests informational inefficiencies. Because these stocks have unique financial characteristics, we also show that they would be very difficult to sell short. Thus, arbitrageurs would be restricted in their ability to earn abnormal profits, even if they correctly anticipated a price decline.
Working Papers / Works in Progress
Violations of Price-Time Priority and Implications for Market Quality,with Daniel Trepanier, 2017 **coming soon**
Using a proprietary dataset of a market maker’s limit orders and order acknowledgments timestamped to the nanosecond (i.e., one-billionth of a second), we explore the timely and important question regarding the consistency and reliability of an exchange’s price/time priority in practice. We find a high degree of variability (i.e., jitter) in the time it takes to receive official exchange acknowledgement once an order is placed, and we find that the proportion of times in which the first order entered is also first to be acknowledged by the exchange’s matching engine is surprisingly low when consecutive orders are placed at very high frequencies. Furthermore, we provide suggestive evidence of impaired market quality in the form of: (i) excess messaging, and (ii) unabsorbed end-of-day order imbalance as a result. Overall, the queuing uncertainty that arises at high frequencies presents issues in high-frequency market structure that remain irrespective of the higher-level market design in place (e.g., continuous-time versus discrete-time markets).
Dynamic Systemic Risk Networks, with Sanjiv Das and Daniel Ostrov, 2017
We propose a theory-driven framework for monitoring system-wide risk. Our approach extends the one-firm Merton (1974) credit risk model to a generalized stochastic network-based framework across all financial institutions, comprising a novel approach to measuring systemic risk over time. We develop four desired properties for any systemic risk measure. We also develop measures for the risks created by each individual institution and a measure for risk created by each pairwise connection between institutions. Four specific implementation models are then explored, and brief empirical examples illustrate the ease of implementation of these four models and show general consistency between their results.
What Makes a Winner? Toward Resolving the Role of Luck and Skill in Sustained CEO Performance, with Robert Eberhart and Daniel Armanios 2017
(link to online appendix)
This study is an empirical examination of the extent to which luck can explain sustained performance. Using a unique empirical strategy of bootstrap simulations that we compare to actual performances of public companies, we observe that over 95% of the substantial differences in performance outcomes can be attributed to luck, even if all CEOs in a given sample were equally skilled. Through this novel empirical approach, we can better incorporate the role of luck into studies of sustained performance, and our findings suggest more attention should be placed on the role of unanticipated and even uncontrollable changes on performance.
Zero-Revelation RegTech: Detecting Risk through Corporate Emails and News, with Sanjiv Das and Bhushan Kothari, 2017
In this paper, we demonstrate how an applied linguistics platform may be used to parse corporate email content and news to assess factors predicting escalating risk or the gradual shifting of other critical characteristics within the firm before they are eventually manifested in observable data and financial outcomes. We find that email content and news articles meaningfully predict increased risk and potential malaise. We also find that other structural characteristics, such as the average email length, are strong predictors of risk and subsequent performance. We present implementations of three spatial analyses of internal corporate communication, i.e., email networks, vocabulary trends, and topic analysis. Overall, we propose a RegTech solution by which to systematically and effectively detect escalating risk or potential malaise without the need to manually read individual employee emails.
Directors' Decision-Making Involvement on Corporate Boards, 2017
Using the full set of committee memberships for the directors of Fortune 100 firms (which I collect from annual proxy statements), I introduce a measure to capture the extent of a director's involvement in discussion and decisions that affect corporate strategy. I document substantial variation in directors' decision-making power both within and across boards, and I provide evidence that this more nuanced yet systematically available measure yields more powerful and better specified tests in examining the link between board composition, accounting performance metrics, and shareholder value. Overall, I argue that incorporating these differences in decision-making power has important implications for studies in corporate governance.
Social Ties and Earnings Management, with Byoung-Hyoun Hwang, 2012
We detect a significant presence of social ties between the CEO and audit committee members and our results suggest that these informal ties play a material role in audit-committee oversight. In particular, we find a substantially stronger, positive relation between abnormal (i.e., discretionary) accruals and the extent of an audit committee's connection to the CEO when we consider social ties in addition to the conventional ties. Moreover, we find that an audit committee's social affiliation is associated with an increased discontinuity in the earnings distribution surrounding earnings targets. Together, our findings suggest that informal ties play a material role in facilitating creative accounting practices.
Distressed Debt (Ch. 32), forthcoming in Debt Market and Investments, Oxford University Press **coming soon**
This chapter provides an introduction to distressed debt, primarily from the vantage point of debtholders in financially distressed corporations. In doing so, it provides a description of this sub-asset class and the basic intuition along with stylized examples to explain the motivating factors behind the strategic behavior of other stakeholders that may devalue a distressed-debt investor’s financial claim if left unattended. This chapter also discusses the considerations in distressed debt exchanges of public bond issuances or in the restructuring of private loan agreements, with the view to minimizing the likelihood of strategic default and other inefficient outcomes to investors of distressed debt. Overall, this chapter offers exposure to the basic features and terminology in distressed debt and debt restructuring.
Detecting Risk through Firms’ Emails, with Sanjiv Das and Bhushan Kothari, February 2017
Article for the CLS Blue Sky Blog (Columbia Law School's blog on corporations and the capital markets). This article was based on "Zero-Revelation RegTech: Detecting Risk through Corporate Emails and News", a working paper listed above.
Practical Applications of... Coming up Short: Managing Undergunded Portfolios in an LDI-ES Framework, with Sanjiv Das and Meir Statman, 2015
Article for the Practical Applications series of the Institutional Investor Journals. This article was based on "Coming up Short: Management Underfunded Portfolios in an LDI-ES Framework", a published paper listed above.