My Research
(My SSRN,
IDEAS, and GOOGLE
links)
"The classical theorists resemble Euclidean geometry in a non-Euclidean world, who, discovering that in experience straight lines apparently parallel often meet, rebuke the lines for not keeping straight -- as the only remedy for the unfortunate collisions which are occurring. Yet, in truth, there is no remedy except to throw over the axiom of parallels and to work out a non-Euclidean geometry. Something similar is required in economics." --Keynes (1936, p.16)
"The sense in which I am using the terms (uncertainty) is that …there is no scientific basis on which to form any calculable probability whatever. We simply do not know." -- Keynes (1937, p. 113)
My research fields are: finance and macroeconomics. My main research areas are:
· Investment and financial policies and firm dynamics with market frictions (costly external finance, uninsurable idiosyncratic risk, and taxation)
· Real options approach to investment under uncertainty
· Dynamic general equilibrium models and incomplete markets models
· Asset pricing and market microstructure
· Applications of decision theory and behavioral economics
Published
or Forthcoming Papers
1. Option Exercise with Temptation, Economic Theory
34 (2008), 473-501.
Abstract: This paper adopts the Gul
and Pensendorfer self-control utility model to analyze an agent's option exercise
decision under uncertainty over an infinite horizon. The agent decides whether
and when to do an irreversible activity. He is tempted by immediate
gratification and suffers from self-control problems. The cost of self-control
lowers the benefit from continuation or stopping and may erode the option value
of waiting. When applied to the investment and exit problems, the model can
generate the behavior of procrastination and preproperation. In addition,
unlike the hyperbolic discounting model, the model here provides a unique
prediction.
2. Investment, Consumption and Hedging
under Incomplete Markets, with Neng Wang, Journal of Financial Economics 86 (2007), 608-642.
Abstract: Entrepreneurs often face undiversifiable
idiosyncratic risks from their business investments. Motivated by this
observation, we extend the standard real options approach towards investment to
an incomplete markets environment and analyze the joint decisions of business
investments, consumption-saving and portfolio selection. We show that
precautionary saving motive affects the investment timing decision in an
important way. Moreover, the precautionary saving motive interacts with the
timing of investment payoffs. When the investment payoffs are given in lump
sum, risk aversion accelerates investment. For an agent with sufficiently
strong precautionary motive, an increase in volatility may accelerate
investment, opposite to the standard real options analysis. When the agent can
trade the market portfolio to partially hedge against the investment risk, the
systematic volatility is compensated via the standard CAPM argument, and the
idiosyncratic volatility generates a private equity premium. Finally, for the
flow payoff case, the agent's idiosyncratic risk exposure alters both the
implied option value and the implied project value, causing the reversal of the
results in the lump sum payoff case.
3.
Capital Structure, Credit Risk, and
Macroeconomic Conditions, with Dirk Hackbarth, and Erwan Morellec, Journal of Financial Economics 82 (2006),
519-550.
Abstract:
This paper
develops a framework for analyzing the impact of macroeconomic conditions on
credit risk and dynamic capital structure choice. We begin by observing that
when cash flows depend on current economic conditions, there will be a benefit
for firms to adapt their default and financing policies to the position of the
economy in the business cycle phase. We then demonstrate that this simple
observation has a wide range of empirical implications for corporations.
Notably, we show that our model can replicate observed debt levels and the
countercyclicality of leverage ratios. We also demonstrate that it can
reproduce the observed term structure of credit spreads and generate strictly
positive credit spreads for debt contracts with very short maturities. Finally,
we characterize the impact of macroeconomic conditions on the pace and size of
capital structure changes, and debt capacity.
4.
A
Search Model of Centralized and Decentralized Trade, Review of Economic Dynamics 9
(2006), 68-92.
Abstract: This paper presents a search
model of centralized and decentralized trade. In a centralized market, trades
are intermediated by market makers at publicly posted bid-ask prices. In a
decentralized market, traders search counterparties. Prices are negotiated and
transactions are conducted in private meetings among traders. Traders can
choose which market to enter. The determinants of bid-ask spreads and liquidity
are analyzed. The welfare consequence of the market fragmentation is also
analyzed. It is shown that compared to the competitive market-making,
monopolistic market-making may improve social welfare.
5.
Competitive Equilibria of Economies with a Continuum of
Consumers and Aggregate Shocks, Journal of Economic Theory 128
(2006), 274-298.
Abstract: This paper studies competitive equilibria of
a production economy with aggregate productivity shocks and with a continuum of
consumers subject to borrowing constraints and individual labor endowment
shocks. The dynamic economy is described in terms of sequences of aggregate
distributions. The existence of competitive equilibrium is proven and a
recursive characterization is established. In particular, it is shown that for
any competitive equilibrium, there is a payoff equivalent competitive
equilibrium that is generated by a recursive equilibrium with the state space
including expected discounted utilities.
6.
Irreversible Investment with Regime Shifts,
with Xin Guo and Erwan Morellec, Journal
of Economic Theory 122 (2005), 37-59.
Abstract: Under the real options approach to investment under
uncertainty, agents formulate optimal policies under the assumption that firms'
growth prospects do not vary over time. This paper proposes and solves a model
of investment decisions in which the growth rate and volatility of the decision
variable shift between different states at random times. A value-maximizing
investment policy is derived such that in each regime the firm's investment
policy is optimal and recognizes the possibility of a regime shift. Under this
policy, investment is intermittent and increases with marginal q. Moreover,
investment typically is very small but, in some states, the capital stock
jumps. Implications for marginal $q$ and the user cost of capital are also
examined.
7.
Optimal Capital
Structure and Industry Dynamics, Journal
of Finance 6 (2005), 2621-2659
Abstract: This
paper provides a competitive equilibrium model of capital structure and
industry dynamics. In the model, firms make financing, investment, entry, and
exit decisions subject to idiosyncratic technology shocks. The capital
structure choice reflects the tradeoff between the tax benefits of debt and the
associated bankruptcy and agency costs. The interaction between financing and
production decisions influences the stationary distribution of firms and their
survival probabilities. The analysis demonstrates that the equilibrium output
price has an important feedback effect. This effect has a number of testable
implications. For example, high growth industries have relatively lower
leverage and turnover rates.
8.
Informed Trading when Information Becomes Stale,
with Dan Benhardt, Journal
of Finance 59 (2004), 339-390.
Abstract: This paper characterizes informed
trade when speculators can acquire distinct signals of varying quality about an
asset’s value at different dates. The most reasonable characterization of
private information about stocks is that while information is long-lived, new
information will arrive over time, information that may be acquired by other
agents. Hence, while a speculator may know more than others at a moment, in the
future, his information will become stale, but not valueless. In an environment
that allows for arbitrary correlations among signals, we characterize equilibrium
outcomes including trading, prices, and profits. We provide explicit numerical
characterizations for different informational environments.
9.
A Note on
Consumption and Savings Under Knightian Uncertainty, Annals of Economics and Finance 5 (2004) 299-311.
Abstract: This
paper studies consumption/saving problem under Knightian uncertainty in a two
period setting. The multiple-priors utility model is adopted. The effects of income
uncertainty and capital uncertainty on optimal savings are analyzed by deriving
closed form solutions.
10.
A
Two-Person Dynamic Equilibrium under Ambiguity, with Larry Epstein, Journal
of Economic Dynamics and Control 27 (2003) 1253-1288.
Abstract: This paper describes a pure-exchange,
continuous-time economy with two heterogeneous agents and complete markets. A
novel feature of the economy is that agents perceive some security returns as
ambiguous in the sense often attributed to Frank Knight. The equilibrium is
described completely in closed-form. In particular, closed-form solutions are
obtained for the equilibrium processes describing individual consumption, the
interest rate, the market price of uncertainty, security prices and trading
strategies. After identifying agents as countries, the model is applied to
address the consumption home-bias and equity home-bias puzzles.
Working
Papers:
·
Corporate
Tax Policy and Long-Run Capital Formation: The Role of Irreversibility and
Fixed Costs, PDF, May 2008. New
Abstract: This paper presents an
analytically tractable continuous-time general equilibrium model with
investment irreversibility and fixed adjustment costs. In the model, there is a
continuum of firms that are subject to idiosyncratic shocks to capital.
Although the presence of investment frictions lowers consumer welfare, it may
raise or reduce the long-run average capital stock, depending on the degree of
idiosyncratic uncertainty. An increase in this uncertainty may raise
equilibrium aggregate capital, but reduce welfare. An unexpected permanent
change in the corporate income tax rate affects the investment trigger and
target values, and hence the size and rate of capital adjustment. Following
this tax policy, the percentage changes in equilibrium quantities are larger
when fixed adjustment costs are larger. These changes are significantly smaller
in a general equilibrium model than in a partial equilibrium model.
Abstract: To study the long-run effect
of dividend taxation on aggregate capital accumulation, we build a dynamic
general equilibrium model in which there is a continuum of firms subject to
idiosyncratic productivity shocks. We show that at any point in time, a firm
may lie in one of three finance regimes: dividend distribution regime,
liquidity constrained regime, and equity issuance regime. Firms in different
finance regimes respond to dividend taxation in different ways. We calibrate
our model to the
Abstract: This article develops a
real options model to study the interaction of industry structure and
takeovers. In an asymmetric industry equilibrium, firms have an endogenous
incentive to merge when restructuring decisions are motivated by operating and
strategic benefits. The model predicts that (i) merger activities are more
likely in more concentrated industries or in industries that are more exposed
to industrywide shocks; (ii) returns to merger and rival firms arising from
restructuring are higher in more concentrated industries; (iii) increased
industry competition delays the timing of mergers; and (iv) in sufficiently
concentrated industries, bidder competition induces a bid premium that declines
with product market competition.
Abstract: This paper provides an
explanation for momentum and reversal in stock returns within a rational
expectations equilibrium framework in which investors are heterogeneous in
their information and investment opportunities. We assume that informed
investors privately receive advance information about company earnings that
materializes into the future. This information is immediately incorporated into
prices, and thus stock prices may move in ways unrelated to current
fundamentals. Investors' speculative and rebalancing trades in response to
advance information generate short-run momentum, mimicking an underreaction
pattern. When this information materializes, the stock price reverts back to
its long-run mean, mimicking an overreaction pattern.
Abstract:
Empirical and experimental evidence documents that money
illusion is persistent and widespread. This paper incorporates money illusion
into two stochastic continuous-time monetary models of endogenous growth.
Motivated by psychology, we model an agent's money illusion behavior by
assuming that he maximizes nonstandard utility derived from both nominal and
real quantities. Money illusion affects an agent's perception of the growth and
riskiness of real wealth and distorts his consumption/savings decisions. It
influences long-run growth via this channel. We show that the welfare cost of
money illusion is second order, whereas its impact on long-run growth is first
order relative to the degree of money illusion. A monetary policy can eliminate
this cost by correcting the distortions on a money-illusioned agent's
consumption/savings decisions.
Abstract: We develop a consumption-based
asset-pricing model in which the representative agent is ambiguous about the
hidden state in consumption growth. He learns about the hidden state under
ambiguity by observing past consumption data. His preferences are represented
by the smooth ambiguity model axiomatized by Klibanoff et al. (2005, 2006).
Unlike the standard Bayesian theory, this utility model implies that the
posterior of the hidden state and the conditional distribution of the
consumption process given a state cannot be reduced to a predictive
distribution. By calibrating the ambiguity aversion parameter, the subjective
discount factor, and the risk aversion parameter (with the latter two values
between zero and one), our model can match the first moments of the equity
premium and riskfree rate found in the data. In addition, our model can
generate a variety of dynamic asset pricing phenomena, including the
procyclical variation of price-dividend ratios, the countercyclical variation
of equity premia and equity volatility, and the mean reversion and long horizon
predictability of excess returns.
Abstract: Many economic decisions can be described as an option exercise or optimal stopping problem under uncertainty. Motivated by experimental evidence such as the Ellsberg Paradox, we follow Knight (1921) and distinguish risk from uncertainty. To afford this distinction, we adopt the multiple-priors utility model. We show that the impact of ambiguity on the option exercise decision depends on the relative degrees of ambiguity about continuation payoffs and termination payoffs. Consequently, ambiguity may accelerate or delay option exercise. We apply our results to firm investment and exit problems, and show that the myopic NPV rule can be optimal for an agent having an extremely high degree of ambiguity aversion.
Abstract: We develop a neoclassical partial equilibrium model to analyze the dynamic effects of permanent and temporary dividend tax policies on corporate investment and financing decisions. Facing a tax system with corporate and personal income taxes, dividend tax and capital gains tax, a firm decides how much to invest and how to finance investment by equity or debt subject to collateral constraints and capital adjustment costs. We characterize steady state and simulate transitional dynamics following tax policy changes. We find the following novel results: First, both temporary and permanent dividend tax changes do not have long-run effects on a firm's capital formation, but have short-run effects on its investment and financial policies. Second, an anticipated temporary dividend tax cut has a short-run effect of lowering investment, similar to an anticipated permanent dividend tax increase. Third, a firm responds asymmetrically to an anticipated permanent dividend tax increase versus an anticipated permanent dividend tax cut due to the collateral constraint. Finally, in anticipation of future tax changes, the firm engages in tax arbitrage by borrowing or saving in order to transfer corporate earnings across time so as to reduce shareholder's tax burden.
Abstract: This paper presents a
contracting model of governance based on the premise that CEOs are the main
promoters of governance change. CEOs use their power to extract higher pay or
private benefits, and different governance structures are preferred by
different CEOs as they favor one or the other type of compensation. The model
explains why good country-wide investor protection breeds good firm governance
and predicts a "race to the top" in firm-governance quality after the
Sarbanes-Oxley Act. However, such governance changes may be associated with
higher rather than lower CEO pay as CEOs substitute away from private benefits.
The model also provides an explanation for the observed correlation of CEO pay
and firm governance as driven by CEO power.
Abstract: We propose an analytically
tractable continuous-time model of experimentation in which a risk-averse
entrepreneur cannot fully diversify the idiosyncratic risk from his business
investment. He makes consumption/savings and business exit decisions jointly,
while learning about the unknown quality of the project over time. Using the
closed-form solutions, we show that (i) the entrepreneur may stay in business
even though the project's net present value (NPV) is negative; (ii)
entrepreneurial risk aversion erodes option value and lowers private project
value so that a sufficiently risk-averse entrepreneur may exit even when the
NPV is positive; (iii) a more risk-averse or a more pessimistic entrepreneur
exits earlier; and (iv) the model can generate a positive relation between
wealth and entrepreneurial survival duration from undiversifiable idiosyncratic
risk without liquidity constraints.
Abstract: This paper presents a
recursive method for the computation of sequential competitive equilibria for
dynamic models with heterogeneous agents and market frictions. We first
establish the existence of a Markovian equilibrium in a suitably expanded space
of state variables. Then, we lay out a convergent operator whose fixed-point
solutions correspond to the set of all Markov equilibria. We apply these
methods to a stochastic growth economy and two financial economies.
Work in
Progress
· Transitional Dynamics of Dividend Tax Reform in General Equilibrium, with Francois Gourio
· Entrepreneurial Investment and Financing Decisions under Uninsurable Idiosyncratic Risk, with Hui Chen and Neng Wang
· Dynamic Asset Allocation with Ambiguous Return Predictability, with Hui Chen and Nengjiu Ju
· Estimation of An Asset Pricing Model with Recursive Smooth Ambiguity Preferences, with Nengjiu Ju and Zhongjun Qu
The following papers are outdated and
need revisions. But they are still cited by a few papers.