In this paper we model the derivative strategies optimally undertaken by a manager (or head of a profit center in a hedge fund) when the detailed derivative positions taken are not contractible. We show that with commonly-used incentive features in the compensation structure, managers have incentives to implement complex derivative strategies that lead to a slight reduction in default probabilities (or a slight increase in performance measures) with a high probability at the cost of allowing for the possibility of disaster states involving large losses, although with a very small probability. Such disaster states cause systemic instability (similar to the experience of Long-Term Capital Management in September 1998). We discuss possible audit strategies, governance mechanisms and incentive structures that will ameliorate the probability of systemic instability arising from such incentives in a market with a rich enough menu of derivatives. We characterize the optimal intensity of audit effort with and without the presence of such derivative strategies. The dependence of the optimal audit intensity on the legal liability regime and different rules for apportioning the auditor's liability is derived. Our results also relate the optimal audit intensity to the cost and efficiency parameters of the audit firm.

Existing studies of the effects of college quality on wages typically rely on a single proxy variable for college quality. This study questions the wisdom of using a single proxy given that it likely contains substantial measurement error. We consider four econometric approaches to the problem that involve the use of multiple proxies for college quality: factor analysis, instruments variables, a method recently proposed by Lubotsky and Wittenberg, and a GMM estimator. Our estimates suggest that the existing literature understates the wage effects of college quality and illustrate the value of using multiple proxies in this and other similar contexts.

Steven Shavell's Foundations of Economic Analysis of Law (Harvard University Press, 2004) is a major theoretical contribution to “law and economics,” the applied field of economics that studies the economic properties and consequences of legal doctrines and institutions. It is a field of immense practical importance, but unfamiliar to many economists—a situation that Shavell's book bids fair to rectify. This review essay situates Shavell's book in the history of economic scholarship about law and uses the book as a springboard for speculation about new directions in that scholarship.

We discuss the thorny issue of how to define financial stability, and conclude that the best approach is to define the characteristics of an episode of financial instability, and to define financial stability as a state of affairs in which episodes of instability are unlikely to occur. We then discuss public policies to achieve financial stability, distinguishing between preventive and remedial measures, and explore the costs and benefits of such policies. We conclude with some comments on current issues in financial regulation, including Basel 2.

We investigate how shareholder-level taxes are capitalized into stock prices using a model that incorporates the investment and payout decisions of a firm and the investment alternatives available to investors. Shareholder taxes affect stock prices both indirectly, via the effect of taxes on corporate investment decisions, and directly, by reducing both the mean and variance of after-tax returns. In our model, tax capitalization is not eliminated by the presence of tax-exempt investors, does not depend on whether equity is composed of contributed capital or retained earnings, and does not depend on the tax rate faced by a hypothetical marginal investor.

When a loan is sold, it goes to a lower-cost financing source than its originator. Yet, lending markets are less than perfectly competitive. Despite the lower funding cost, therefore, the loan price is not necessarily more favorable to the borrower. However, corporate borrowers are averse to the participation of their loans to other lenders because of the complexity of dealing with multiple banks and the potential information costs of the sale announcement. Consequently, I conjecture that the borrower extracts a price concession in exchange for allowing the bank to sell participations in the loan. Using a hand-matched dataset of loans, borrowers, and lenders, I find that the average yield spread on loans originated by active loan sellers is about 20 basis points lower than the average spread on loans originated by moderate loan sellers.

When a loan is sold, it goes to a lower-cost financing source than its originator. Yet, lending markets are less than perfectly competitive. Despite the lower funding cost, therefore, the loan price is not necessarily more favorable to the borrower. However, corporate borrowers are averse to the participation of their loans to other lenders because of the complexity of dealing with multiple banks and the potential information costs of the sale announcement. Consequently, I conjecture that the borrower extracts a price concession in exchange for allowing the bank to sell participations in the loan. Using a hand-matched dataset of loans, borrowers, and lenders, I find that the average yield spread on loans originated by active loan sellers is about 20 basis points lower than the average spread on loans originated by moderate loan sellers. Copyright 2006, Oxford University Press.

The existence of counteroffers can lead to a variety of important labor‐market features. This article develops a model of the selective use of counteroffers in which a firm decides whether to extend counteroffers after a worker informs the firm of an alternative offer. We outline factors that can influence the employer’s net value of making a counteroffer and, thus, affect the likelihood of a counteroffer. We provide a new empirical analysis that examines whether proxies for these factors do, in fact, influence the likelihood that a firm would consider a counteroffer to an employee with a competing offer.

Bradshaw, Richardson, and Sloan (BRS) find a negative relation between their comprehensive measure of corporate financing activities and future stock returns and future profitability. Noticing that accounting accruals are increases in net operating assets on a company's balance sheet, we question whether it is possible to distinguish between the ‘external financing anomaly’ documented by BRS and the ‘accrual anomaly’ first documented by Sloan [1996. Do stock prices fully reflect information in accruals and cash flows about future earnings? The Accounting Review 71, 289–315]. We show that once controlling for total accruals, the relation between external financing activities and future stock returns is attenuated and not statistically significant. These findings are consistent with Richardson and Sloan [2003. External financing, capital investment and future stock returns. Working Paper, University of Pennsylvania and University of Michigan].