Bhagwan Chowdhry

Stabilization, Syndication, and Pricing of IPOs

We argue that in the after-market trading of an IPO, the underwriting syndicate, by standing ready to buy back shares at the offer price (“price stabilization”), compensates uninformed investors ex post for the adverse selection cost they face in bidding for IPOs. This dominates ex ante compensation by underpricing. The reason is that stabilization exploits ex post information about investor demand whereas underpricing must be based on ex ante information. However, liquidity and syndication costs constrain the use of stabilization which, in equilibrium, generates some underpricing as well. We develop a model that formalizes this intuition and generates several empirical implications.

Corporate Risk Management for Multinational Corporations: Financial and Operational Hedging Policies

Under what conditions will a multinational corporation alter its operations to manage its risk exposure? We show that multinational firms will engage in operational hedging only when both exchange rate uncertainty and demand uncertainty are present. Operational hedging is less important for managing short-term exposures, since demand uncertainty is lower in the short term. Operational hedging is also less important for commodity-based firms, which face price but not quantity uncertainty. When the fixed costs of establishing a plant are low or the variability of the exchange rate is high, a firm may benefit from establishing plants in both the domestic and foreign location. Capacity allocated to the foreign location relative to the domestic location will increase when the variability of foreign demand increases relative to the variability of domestic demand or when the expected profit margin is larger. For firms with plants in both a domestic and foreign location, the foreign currency cash flow generally will not be independent of the exchange rate and consequently the optimal financial hedging policy cannot be implemented with forward contracts alone. We show that the optimal financial hedging policy can be implemented using foreign currency call and put options and forward contracts.

Resources, real options, and corporate strategy ☆

The types of investments a firm undertakes will depend in part on what it expects the outcome of those investments to reveal about its skills, capabilities, and assets (i.e., its resources). We predict that a firm will specialize when young, then experiment in a new line of business for some time, and then either expand into a large, multisegment business or focus and scale up its specialized business. We derive several empirical implications for firm valuations and the reaction of stock prices to news about firm prospects. We also offer a novel explanation for the well-documented ‘‘diversification’’ discount.

Leverage and Market Stability: The Role of Margin Rules and Price Limits

The authors show that, when some investors hold levered portfolios by engaging in margin borrowing, repeated rounds of trading can result in market instability--in the sense that prices can move rationally--even in the absence of any change in fundamentals. They show this with a simple model in which all agents are rational and symmetrically informed. The authors discuss welfare implications of price stability and explore the effects of market composition and market trading rules on the stability of the market. A major result of this article is that price limits might enhance market stability by excluding potentially destabilizing market prices. Copyright 1998 by University of Chicago Press.

Internal Financing of Multinational Subsidiaries: Debt vs. Equity

We show that an optimal tax management strategy for financing of subsidiaries by multinational corporations, that takes into account exploitation of tax-loss credits, may involve the use of both intra-firm parent debt as well as intra-firm parent equity. This is in contrast to the textbook argument that suggests a knife-edged subsidiary capital structure that, depending on the tax-rate differential between countries, uses either all debt or all equity. We develop a formal multi-period dynamic model to characterize the optimal dividend repatriation policy and the optimal choice of debt-equity mix. The model generates several testable empirical implications that are consistent with available empirical evidence and several others that have not been either discussed or empirically tested in the literature.

Incentivizing Impact Investing

We consider a project which produces both a public social good and a private good — an impact investment. When the project is financed with external capital, the owner may have an incentive to under or over invest in social good. Under investment arises when the owner does not fully internalize the social value of the public good. Over investment arises because repayment uses up only the private good, making the social good relatively more attractive. The model provides a theoretical foundation for funding impact investments through Social Impact Bonds — to discourage over investment — or Social Impact Guarantees — to discourage under investment. When social investors have sufficient capital, socially responsible investment strategies such as equity investments in socially responsible firms are also optimal. We would like to thank Maitreesh Ghatak, Archishman Chakraborty, Ivo Welch, Ed Van Wesep, Rob Dam, Kyle Matoba, and seminar participants at CU-Boulder Leeds School of Business, UCLA Anderson School of Management, the HKUST Conference on the Impact of Responsible and Sustainable Investing, the Emerging Markets Finance Conference, and the Geneva Summit on Sustainable Finance for their helpful insights and suggestions. Anderson School of Management, University of California, Los Angeles, 110 Westwood Plaza Suite C-411, Los Angeles, CA 90095, bhagwan@anderson.ucla.edu. Leeds School of Business, University of Colorado, Boulder, Campus Box 419, Boulder, CO 80309, shaun.davies@colorado.edu. Leeds School of Business, University of Colorado, Boulder, Campus Box 419, Boulder, CO 80309, brian.waters@colorado.edu.We study joint financing between profit-motivated and socially motivated (impact) investors and derive conditions under which impact investments improve social outcomes. When project owners cannot commit to social objectives, impact investors hold financial claims to counterbalance owners’ tendencies to overemphasize profits. Impact investors’ ownership stakes are higher when the value of social output is higher, and pure nonprofit status may be optimal for the highest valued social projects. We provide guidance about the design of contingent social contracts, such as social impact bonds and social impact guarantees.Received May 23, 2016; editorial decision April 28, 2018 by Editor Francesca Cornelli. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.

Why real interest rates, cost of capital and price/earnings ratios vary across countries

This paper examines how productivity changes affect real rates of return and price/earnings ratios in a small open economy. The model provides conditions under which increased productivity in a country’s traded goods sector causes prices of non-traded goods to increase relative to the price of traded goods. Under these conditions, real rates of interest decline and the production of certain non-traded durable goods (such as capital equipment and housing) immediately increase. This ‘overconstruction’ has two effects. First, the increase in capital relative to labor in these sectors increases the marginal product of labor and hence immediately causes an increase in wages and the prices of non-traded goods. Second, an ‘oversupply’ of capital goods and housing depresses their rental rates in the current period, thereby increasing their price to rental ratios or equivalently, their price/earnings ratios.

Possibility of Dying as a Unified Explanation of Why We Discount the Future, Get Weaker with Age, and Display Risk‐Aversion

I formulate a simple and parsimonious evolutionary model that shows that because most species face a possibility of dying because of external factors, called extrinsic mortality in the biology literature, it can simultaneously explain (a) why we discount the future, (b) get weaker with age, and (c) display risk-aversion. The paper suggests that testable restrictions—across species, across time, or across genders—among time preference, aging, and risk-aversion could be analyzed in a simple framework .

Defaults and Interest Rates in International Lending

Since lenders cannot observe the riskiness of the projects borrowers could choose, interest rates alone cannot be used as an instrument to discipline the borrowers. A credible threat to exclude borrowers who default more than a certain number of times from participating in the capital markets makes international debt contracts incentive compatible. Larger borrowers, since they get fewer chances to default, choose safer proejcts and are therefore charged smaller interest rates. Also, borrowers, after each successive default swtich to safer and safer projects which may result in smaller and smaller interest rates. This paper provides empirical evidence supporting these two predictions.

How Should Firms Hedge Market Risk

Consider a firm whose stock returns are affected by market returns and an idiosyncratic market-orthogonal factor. The level of the firm’s cash flows depends on the level of the market and the level of the idiosyncratic factor multiplicatively because of compounding. Although a large hedge against the market index minimizes the variance of cash flows, such a hedge does not minimize the costs of financial distress associated with low cash flow realizations below a debt threshold. A hedge ratio based on asset-rate-of-return regression estimates is then incorrect. This holds even in continuous time and with dynamic hedging policies. Our paper provides a simple heuristic for corporations wishing to hedge out the adverse consequences of market risk.