Christine A. Parlour

Limit Order Markets: A Survey 1

We thank the authors of the research reviewed here for their insights into the microstructure of limit order markets and apologize for any errors or misrepresentations in our discussion of their work. We thank Arnoud Boot for asking us to undertake this survey and Thierry Foucault, Gene Kandel, Ioanid Rosu, and Chester Spatt for helpful comments.

Competition in Loan Contracts

We present a model of an unsecured loan market. Many lenders simultaneously offer loan contracts (a debt level and an interest rate) to a borrower. The borrower may accept more than one contract. Her payoff if she defaults increases in the total amount borrowed. If this payoff is high enough, deterministic zero-profit equilibria cannot be sustained. Lenders earn a positive profit, and may even charge the monopoly price. The positive-profit equilibria are robust to increases in the number of lenders. Despite the absence of asymmetric information, the competitive outcome does not obtain in the limit.

Hedging Labor Income Risk

We use a detailed panel data set of Swedish households to investigate the relation between their labor income risk and financial investment decisions. In particular, we relate changes in wage volatility to changes in the portfolio holdings for households that switched industries between 1999 and 2002. We find that households do adjust their portfolio holdings when switching jobs, which is consistent with the idea that households hedge their human capital risk in the stock market. The results are statistically and economically significant. A household going from an industry with low wage volatility to one with high volatility ceteris paribus decreases its portfolio share of risky assets by up to 35%, or

Signaling Quality via Queues

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Rationing in IPOs

We consider an M/M/1 queueing system with impatient consumers who observe the length of the queue before deciding whether to buy the product. The product may have high or low quality, and consumers are heterogeneously informed. The firm chooses a slow or (at a cost) a fast service rate. In equilibrium, informed consumers join the queue if it is below a threshold. The threshold varies with the quality of the good, so an uninformed consumer updates her belief about quality on observing the length of the queue. The strategy of an uninformed consumer has a “hole”: she joins the queue at lengths both below and above the hole, but not at the hole itself. We show that if the prior probability the product has high quality and the proportion of informed consumers are both low, a high-quality firm may select a slower service rate than a low-quality firm. The queue can therefore be a valuable signaling device for a high-quality firm. Strikingly, in some scenarios, the high-quality firm may choose the slow service rate even if the technological cost of speeding up is zero. This paper was accepted by Assaf Zeevi, stochastic models and simulation.

Compensating for the winner's curse: Experimental evidence

We provide a model of bookbuilding in IPOs, in which the issuer can choose to ration shares. Before informed investors submit their bids, they know that, in the aggregate, winning bidders will receive only a fraction of their demand. We demonstrate that this mitigates the winner’s curse, that is, the incentive of bidders to shade their bids. It leads to more aggressive bidding, to the extent that rationing can be revenue-enhancing. In a parametric example, we characterize bid and revenue functions, and the optimal degree of rationing. We show that, when investors’ information is diffuse, maximal rationing is optimal. Conversely, when their information is concentrated, the seller should not ration shares. We provide testable predictions on bid dispersion and the degree of rationing. Our model reconciles the documented anomaly that higher bidders in IPOs do not necessarily receive higher allocations.

Markup Cycles, Dynamic Misallocation, and Amplification

We conduct experiments on common value auctions with rationing. In each auction, the good is randomly allocated to one of the k highest bidders, at the (k + 1) st highest price. When k > 1, bidders are rationed. As the degree of rationing increases, the equilibrium bid function increases. Consistent with prior literature, we find that bidders suer from the winner’s curse and lose money on average. However, bids in the experiments do adjust in the appropriate direction as the degree of rationing changes, providing support for the comparative statics implications of the theory. Our results are consistent with subjects having an intuitive understanding of the winner’s curse, but being unable to compute the equilibrium bid levels.

Competition, Managerial Slack, and Corporate Governance

We develop a tractable dynamic general equilibrium model of oligopolistic competition with a continuum of heterogeneous industries. Industries are exposed to aggregate and industry-specific productivity shocks. Firms in each industry set value-maximizing state-contingent markups, taking as given the behavior of all other industries. When consumers are risk-averse, industry markups are countercyclical with regards to the industry-specific component, but may be procyclical with regards to the aggregate shock. The general equilibrium dispersion of markups implied by the optimization of heterogeneous industries creates misallocation of labor across industries. The misallocation, in turn, generates aggregate welfare losses state-by-state that feed back into the industry problem via a representative agents marginal utility of aggregate consumption. Misallocation dynamics may transmit industry-specific shocks, or amplify small aggregate shocks, and so lead to aggregate fluctuations through these feedback effects.

Contracting on Credit Ratings: Adding Value to Public Information

We characterize how product market competition disciplines managers in a moral hazard setting. Competition has two effects on a firm. First, the expected revenue or the marginal benefit of effort declines, leading to weakly lower effort. Second, the cost of inducing high effort increases (decreases) if competition increases (decreases) the probability of failure at a firm. Both effects imply a change in the optimal level of effort as competition increases. The manager in our model enjoys slack if he supplies low effort in equilibrium. We show that, if competition increases the probability of failure, managerial slack increases with competition. The relationship between managerial slack and firm value is ambiguous: Exogenous changes in the private benefit of low effort can affect slack without changing firm value, and vice versa. As a result, empirical tests that identify changes in slack may not capture the effect of competition on the level of slack.We model the interaction between product market competition and internal governance at firms. Competition makes it more difficult to infer a manager’s action given the realized output, thus increasing the cost of inducing effort. An exogenous change in the incentive to shirk increases managerial slack. However, the effects on firm value are ambiguous; in particular, firm value can increase as slack increases. As a result, empirical tests that focus on changes in value may not capture changes in the level of slack. We also provide conditions under which increased competition leads all firms to switch from high to low effort.

Rationing and Common Values

We provide a novel interpretation of the role of credit ratings when contracts between investors and portfolio managers are incomplete. In our model, a credit rating on a bond provides a verifiable signal about an unverifiable state. We show that the rating will be contracted on only if it is sufficiently precise. Moderately precise ratings lead to wage contracts, and highly precise ones to contracts which directly restrict managers’ actions. In a market-wide equilibrium, surplus in the investor-manager transaction may decline when ratings become more precise. The widespread of use of credit ratings leads to excess volatility in bond returns.