Peter M. DeMarzo

A Liquidity Based Model of Security Design

The authors consider the problem of design and sale of a security backed by specified assets. Given access to higher-return investments, the issuer has an incentive to raise capital by securitizing part of these assets. At the time the security is issued, the issuers or underwriters private information regarding the payoff of the security may cause illiquidity in the form of a downward-sloping demand curve for the security. The authors characterize the optimal security design in several cases. They also demonstrate circumstances under which standard debt is optimal and show that the riskiness of the debt is increasing in the issuers retention costs for assets.

Corporate Financial Hedging with Proprietary Information

Abstract If a firm has information pertinent to its own dividend stream that is not made available to its shareholders, it may be in the interests of the firm and its shareholders to adopt a financial hedging policy. This is in contrast with the Modigliani-Miller Theorem, which implies that, with informational symmetry, such financial hedging is irrelevant. In certain cases, hedging policies are identified that are unanimously supported by shareholders.

Bidding with Securities: Auctions and Security Design

We study security-bid auctions in which bidders compete by bidding with securities whose payments are contingent on the realized value of the asset being sold. Such auctions are commonly used, both formally and informally. In formal auctions, the seller restricts bids to an ordered set, such as an equity share or royalty rate, and commits to a format, such as first or second-price. In informal settings with competing buyers, the seller does not commit to a mechanism upfront. Rather, bidders offer securities and the seller chooses the most attractive bid, based on his beliefs, ex-post. We characterize equilibrium payoffs and bidding strategies for formal and informal auctions. For formal auctions, we examine the impact of both the security design and the auction format. We define a notion of the steepness of a set of securities, and show that steeper securities lead to higher revenues. We also show that the revenue equivalence principle holds for equity and cash auctions, but that it fails for debt (second-price auctions are superior) and for options (a first-price auction yields higher revenues). We then show that an informal auction yields the lowest possible revenues across all possible formal mechanisms. Finally, we extend our analysis to consider the effects of liquidity constraints, different information assumptions, and aspects of moral hazard.

Ownership Dynamics and Asset Pricing with a Large Shareholder

We analyze the optimal trading and ownership policy of a large shareholder who must trade off diversification and monitoring incentives. Without commitment, the problem is similar to durable goods monopoly: the share price today depends on expected future trades. We show that the large shareholder ultimately trades to the competitive price‐taking allocation, even though it entails inefficient monitoring. With continuous trading, the large shareholder trades immediately to this allocation if moral hazard is weak enough that her private valuation of a share is decreasing in her stake. Otherwise, the large shareholder adjusts her stake gradually. We consider implications for asset pricing, IPO underpricing, and lockup provisions.

Optimal Long-Term Financial Contracting with Privately Observed Cash Flows

We characterize the optimal long-term financial contract in a setting in which a risk-neutral agent with limited capital seeks financing for a project that pays stochastic cash flows over many periods. These cash flows are observable to the agent but not to investors. The agent can be induced to pay investors via the threat of the loss of control of the project. After solving for the contract as an optimal mechanism, we demonstrate that it can be implemented by a combination of equity, long-term debt and a line of credit - very simple, standard securities. Thus our model provides a theory of capital structure, capturing both optimal debt maturity and debt vs. equity financing. Equity is issued to investors and is also used for the agents compensation. In equilibrium, the agent may default on the debt and control of the project may pass to debt holders. The optimal capital structure is robust in the sense that it is independent of the amount financed and under certain circumstances, independent of the severity of the moral hazard problem. We also show how our characterization applies to settings in which the agent undertakes hidden effort, or can alter the risk of cash flows.

Majority Voting and Corporate Control: The Rule of the Dominant Shareholder

This paper incorporates a model of corporate control into a general equilibrium framework for production economies with incomplete markets. The classical objective of value maximization is extended, but is indeterminate. Instead, firms are viewed as being subject to shareholder control via some decision mechanism. As long as this decision mechanism is responsive to a unanimous preference by shareholders, shareholder control is consistent with but stronger than value maximization. Next, the particular institution of majority voting by shareholders is examined. It is shown that for generic economies, a majority rule equilibrium for a firm implies that production is optimal for the largest, or dominant, shareholder. Finally, a more realistic control mechanism is considered in which majority voting by shareholders is constrained by a group of shareholders, or Board of Directors, who control the voting agenda. The result is that shareholders not on the Board have no influence on the equilibrium production choice of the firm.

The Optimal Enforcement of Insider Trading Regulations

Regulating insider trading lessens the adverse selection problem facing market makers, enabling them to quote better prices. An Optimal enforcement policy must balance these benefits against the costs of enforcement. Such a policy must specify (i) the conditions under which the regulator conducts an investigation, (ii) the penalty schedule imposed if an insider is caught, and (iii) a transaction tax to fund enforcement. We derive the policy that maximizes investors welfare. This policy entails investigations following large trading volumes or large price movements or both. Insiders caught making large trades are assessed the maximum penalty, but small trades are not penalized. Given this policy, insiders trade most aggressively on news with an intermediate price impact but refrain from trading on moderate or extreme news.

A Continuous-Time Agency Model of Optimal Contracting and Capital Structure

We consider a principal-agent model in which the agent needs to raise capital from the principal to finance a project. Our model is based on DeMarzo and Fishman (2003), except that the agents cash flows are given by a Brownian motion with drift in continuous time. The difficulty in writing an appropriate financial contract in this setting is that the agent can conceal and divert cash flows for his own consumption rather than pay back the principal. Alternatively, the agent may reduce the mean of cash flows by not putting in effort. To give the agent incentives to provide effort and repay the principal, a long-term contract specifies the agents wage and can force termination of the project. Using techniques from stochastic calculus similar to Sannikov (2003), we characterize the optimal contract by a differential equation. We show that this contract is equivalent to the limiting case of a discrete time model with binomial cash flows. The optimal contract can be interpreted as a combination of equity, a credit line, and either long-term debt or a compensating balance requirement (i.e., a cash position). The project is terminated if the agent exhausts the credit line and defaults. Once the credit line is paid off, excess cash flows are used to pay dividends. The agent is compensated with equity alone. Unlike the discrete time setting, our differential equation for the continuous-time model allows us to compute contracts easily, as well as compute comparative statics. The model provides a simple dynamic theory of security design and optimal capital structure.

Online trading algorithms and robust option pricing

In this work we show how to use efficient online trading algorithms to price the current value of financial instruments, such as an option. We derive both upper and lower bounds for pricing an option, using online trading algorithms.Our bounds depend on very minimal assumptions and are mainly derived assuming that there are no arbitrage opportunities.

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.