Yanmin Gao

Integrating Illiquid Assets into the Portfolio Decision Process

We consider the issues associated with modeling the decision to invest in an illiquid asset, such as real estate, over an extended period of time. Markets for illiquid assets tend to display certain characteristics: for example, significant time‐till‐sale and correlation in the rates of return over time. More importantly, as the liquidity of a market cannot be an issue if an investor never needs to liquidate an asset, we focus on how the liquidity of a market interacts with an individuals uncertain need to liquidate. We show that the optimal strategy is state contingent, if possible. We also show that the penalty associated with an illiquid investment depends on the characteristics of other assets being held in the portfolio, on the characteristics of liquidity shocks and on the interaction between time and behavior. We show that borrowing to pay for a liquidity shock cannot overcome all of the costs of owning an illiquid asset. In contrast, borrowing at t = 0 benefits from the complementarity in the assets. In a simpler model, we show that the portfolio perspective makes illiquid assets more valuable to an investor with a longer time horizon.

Accounting Conservatism and Board Efficiency

This paper provides a theoretical foundation for findings in empirical studies that document a positive association between conservatism and strong corporate governance through the board’s monitoring efficiency. We construct a model with a board that decides whether to replace the incumbent manager based on accounting information and the outcome of its monitoring strategy, which also depends on the accounting information. If accounting is used only for the replacement decision, conservatism is harmful. However, conservatism is beneficial if accounting is relevant to the monitoring decision because it enhances the net benefit of monitoring. The net benefit of conservatism increases if the board becomes more efficient in monitoring. We also discuss earnings management and specific empirical implications.

The Dynamics of Incentives, Productivity, and Operational Risk

Abstract This paper develops a dynamic principal-agent model and applies it to understand changes in labor productivity and operational risk. Our analysis demonstrates the importance of matching the terms of the job contract to the technology. Such issues would be especially important in service industries and in the knowledge-based economy where discretionary effort tends to play a greater role. We show that the production technology needs to be characterized by at least two parameters: one parameter which measures output independent of the worker’s effort and a second parameter which measures the effect of the effort. We solve for the Renegotiation-Proof Nash Equilibrium. We show that there can be a tension between increasing expected productivity and controlling costs per worker. Our analysis also adds to the growing interest in “operational risk”, which is associated with human actions. The closed form solutions provided by our model provide a natural way to consider the impact and possibility of this type of risk. Our analysis demonstrates why the effect of a negative event should be considered relative to a concept of normal which is based on an equilibrium, that uncertainty in the external environment enables (but does not cause) operational risk events and that both the equilibrium and the effects vary with the production technology.