Paul Pfleiderer

Does It All Add Up? Benchmarks and the Compensation of Active Portfolio Managers

In this article, the authors examine theoretically the use of benchmark portfolios in the compensation of privately informed portfolio managers. They find that the use of a benchmark, and particularly the types of benchmarks often observed in practice, cannot be easily rationalized. Specifically, commonly used benchmark-adjusted compensation schemes are generally inconsistent with optimal risk-sharing and do not lead to the choice of an optimal portfolio for the investor. Moreover, benchmarks do not help in solving potential contracting problems such as inducing the manager to expend effort or trying to screen out uninformed managers. Copyright 1997 by University of Chicago Press.

Delegated portfolio management

Abstract A problem of screening agents with privately known forecasting abilities and reservation utilities and then eliciting truthful information from these agents once they are employed is considered. For the case of risk averse agents and large principals, an approximately optimal solution is constructively characterized under the assumption that payoffs are normally distributed. A significant extension of the deFinnetti-Savage probability elicitation result is developed. Under this extension knowledge of agent preferences is not required (when the underlying conditional distributions are symmetric) and this fact is exploited to solve the screening problem in a mean-variance formulation.

A monopolistic market for information

Abstract We analyze a model where traders buy information from a monopolistic seller, which is subsequently used in a speculative market. In order to overcome the dilution in the value of information due to its leakage through informative prices, the seller of information may prefer to sell noisier versions of the information he actually has. Moreover, to obtain higher profits, it is desirable for the seller to sell different signals to different traders, so that the added noise realizations do not affect equilibrium prices. One way of doing so, which does not require discrimination, is to sell identically distributed personalized signals to each of a large number of traders.

A Note on the Effect of Cost Changes on Prices [Measurement of Monopoly Behavior: An Application to the Cigarette Industry]

In a recent article in this Journal, Sumner (1981) took an ingenious approach to estimating the level of monopoly power in the cigarette industry. He noted that differences in marginal costs exist in the industry due to varying levels of state taxes. The sales prices established will satisfy the equation p[I + (lIq)l = MR = MC, where p = price and -q = the elasticity of demand for the product in question. If elasticity is a constant, observing the change in marginal cost and the change in price enables one to infer the elasticity of demand perceived by the firm. Elasticity could then be used as a proxy for the firms market power. This technique turns out to be of very limited applicability, however, because it is extremely sensitive to the functional form assumed for the demand curve. Consider the general problem of a firm facing constant marginal costs of c. In maximizing profits the firm solves

Direct and Indirect Sale of Information

The authors compare two methods for a monopolist to sell information to traders in a financial market. In a direct sale, information buyers observe versions of the sellers signal while in an indirect sale the seller sells shares in a portfolio based on his private information. It is shown that, when traders are identical and pricing is linear, there is a trade-off between optimal surplus extraction that is possible under direct sale and more effective control of the usage of information that is possible under indirect sale. The optimal selling method depends on how much information is revealed by equilibrium prices. Copyright 1990 by The Econometric Society.

Viable allocations of information in financial markets

Abstract We study, in the context of a financial market, allocations of information that are consistent with endogenous information acquisition. We focus on whether information is concentrated within a fraction of the market or is diffuse. The aggregation of information in prices tends to make signals more complementary than they would be if considered in isolation, favoring concentration of information. However, the ability to use some signals together with prices to predict other signals may increase the degree of substitutability among signals. We present conditions under which each of these effects is particularly strong.

Debt Overhang and Capital Regulation

We analyze shareholders’ incentives to change the leverage of a firm that has already borrowed substantially. As a result of debt overhang, shareholders have incentives to resist reductions in leverage that make the remaining debt safer. This resistance is present even without any government subsidies of debt, but it is exacerbated by such subsidies. Our analysis is relevant to the debate on bank capital regulation, and complements Admati et al. (2010). In that paper we argued that subsidies that favor debt over equity are the key reason that banks funding costs would be lower if they “economize” on equity. Subsidies come from public funds, and reducing them does not represent a social cost. It is thus irrelevant for assessing regulation. Other arguments made to support claims that “equity is expensive” are flawed.Like reduction in subsidies, the effects of leverage reduction on bank managers or shareholders do not represent a social cost. In fact, we show that debt overhang creates inefficiency, since shareholders would resist recapitalization even when this would increase the combined value of the firm to shareholders and creditors. Moreover, debt overhang creates an “addiction” to leverage through a ratchet effect. In the presence of government guarantees, the inefficiencies of excessive leverage are not fully reflected in banks’ borrowing costs. Since banks’ high leverage is a source of systemic risks and imposes costs on the public, resistance to leverage reduction leads to social inefficiencies. The main beneficiaries from high leverage may be bank managers. The majority of the banks’ shareholders, who hold diversified portfolios and who are part of the public, are likely to be net losers. Our analysis highlights the critical importance of effective capital regulation and high equity requirements, especially for large and “systemic” financial institutions. We analyze shareholders’ preferences when choosing among various ways leverage can be reduced. We show that, with homogeneous assets, if the firm’s security and asset trades have zero NPV, and the firm has a single class of debt outstanding, then shareholders find it equally undesirable to deleverage through asset sales, pure recapitalization, or asset expansion with new equity. When these conditions are not met, shareholders can have strong preferences for one approach over another. For example, if the firm can buy back junior debt, asset sales are the preferred way to reduce leverage. This preference for asset sales, or “deleveraging,” can persist even if such sales are inefficient and reduce the total value of the firm.

On the Relevancy of Modigliani and Miller to Banking: A Parable and Some Observations

Discussions of bank capital regulation are often clouded by fundamental misunderstandings about how the insights presented over 50 years ago by Modigliani and Miller (M&M) relate to bank funding and the cost of bank equity. The claim is often made that banks are special and that the M&M insights do not apply in the banking context. This claim is misleading and false. The M&M insights, when properly interpreted, do apply to this discussion. These insights show that any analysis of capital regulation must be focused on how capital regulation rules affect the various frictions associated with funding and how this affects the social costs and benefits associated with the funding of banks. This short paper presents a parable that explains the relevance of M&M to banks and makes several observations about the errors and incorrect arguments that result when M&M insights are not properly recognized.

Noisytalk.com: Broadcasting Opinions in a Noisy Environment

We analyze a model where an altruistic sender, who may or may not be informed, broadcasts one of a finite set of messages to rational receivers. If broadcasting is costless and the sender is rational, there is an informationally efficient equilibrium, but this equilibrium is not necessarily unique nor symmetric. If the sender is overconfident, he tends to exaggerate, and in equilibrium extreme messages are sent more frequently. While overconfidence reduces informativeness in some cases, it may also eliminate less informative equilibria. We also show that overconfidence can improve informativeness when broadcasting is costly.

Flight to Quality and Asset Allocation in a Financial Crisis

With respect to the recent financial crisis, the authors argue that the appropriate adjustments to portfolio allocations in response to the market dislocation are determined by equilibrium considerations (supply must equal demand) and depend on individual investors’ characteristics relative to societal averages. Using a simple model that captures the magnitude of the recent crisis, the authors show that the optimal tactical adjustments for most portfolios require a turnover of less than 10%. In the recent financial crisis, investors suffered losses on their portfolios on the order of 20%–30%. In addition, they faced a market in which the volatility of most asset classes and the correlations among those asset classes surged, all of which served to greatly increase the risk of their portfolio positions. The challenging issue facing investors was the appropriate tactical adjustment they should make to their portfolio allocations in response to this market dislocation. In this article, the authors argue that the appropriate adjustment for any given investor is determined by equilibrium considerations (supply must equal demand) and depends on that investor’s characteristics relative to societal averages. Although this point should be obvious, it seems to have been ignored by many investors and their advisers. In a simple model calibrated to capture the magnitude of the 2007–09 crisis, the authors show that the optimal tactical portfolio adjustments for most investors are not large, requiring turnover of less than 10%, and that this finding is quite robust to changes in their assumptions.