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Essays in financial economics

Marco Naldi, 1998
Faculty Advisor: Lawrence Glosten
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Chapter 1 presents an agency model with career concerns, where managers choose among alternative projects on a mean-variance frontier. Their unobservable choice is intended to influence the market perception of their ability level, which in turn determines their future compensation. We show that the characteristics of the second-best solution crucially depend on the shape of the investment frontier. In contrast with the standard approach, we argue that within our framework the level of managers' risk aversion does affect the strength of the implicit incentive. In particular, we find that if the marginal expected return does not decrease too quickly as project risk increases, there may be an equilibrium in which more risk-averse managers will choose riskier projects. An immediate consequence of this is that the welfare loss due to the agency problem may well be inversely related to the degree of risk aversion.

In Chapter 2, we discuss the relation between internal monitoring, disclosure requirements and ownership structure. If a large shareholder sells part of her holding in the secondary market to achieve better diversification, her monitoring activity decreases to a level that is optimal according to her post-trade holding. This increases the welfare loss due to the public-good nature of internal monitoring. On the other hand, if a shareholder holds on to a large stake of the firm and monitors accordingly, investors are imperfectly hedged against the outflow of firm-specific information that takes place in the meantime. A welfare-maximizing ownership structure optimally solves this trade-off. Severe disclosure requirements tend to increase the volatitlity of the firm's market value and the costs of imperfect risk-sharing, thus decreasing the optimal level of concentration. Therefore, severe disclosure requirements, though they may increase the effectiveness of external monitoring and incentive contracts in reducing agency costs, will decrease the benefits from active stockholding. We argue that our simple theory is consistent with the observed differences between the United States and most European countries with regards to several matters of corporate governance.

In Chapter 3, we first propose a simple methodology that relies on the Arbitrage Pricing Theory (APT) and is intended to separate interest-rate factors from non-interest-rate factors in the return process of high-yield bonds. Then, we identify a set of proxies for non-interest-rate factors by studying a unique data set of high-yield issues. A time-series approach is employed to estimate factor loadings for several high-yield portfolios with markedly different risk-return profiles. We find that a rather parsimonious model specification captures a significant fraction of time-series variability and explains cross-sectional differences in expected returns. Our study also suggests that index trading may play an important role in designing effective hedging strategies for high-yield investors.

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