Knowledge that Transforms

Compensation contracts have been criticized for encouraging managers to manipulate information. This includes bonus schemes that encourage earnings smoothing, and option packages that allow managers to cash out early when the firm is overvalued. We show that the intransparency induced by these contract features is critical for giving long-term incentives. Lack of transparency makes it harder for the owner to engage in ex post optimal but ex ante inefficient liquidity provision to the manager. For the same reason, it is often optimal to “pay for luck ” (i.e., tie long-term compensation to variables that the manager has no influence over, but may have private information about, such as future profitability of the whole industry). (JEL G34, J33) How can effective executive compensation be set up when managers can manipulate short-term information? Although it is a long-standing question in corporate governance, public focus on this issue reached new heights at the beginning of the millennium after governance scandals at Enron and WorldCom and many other corporations. A common thread in these scandals was that accounting manipulation was used to increase stock prices. In a number of cases,

We study holdings in M&A targets by financial conglomerates which affiliated investment banks advise the bidders. We show that advisors take positions in the targets before M&A announcements. These stakes are positively related to the probability of observing the bid and to the target premium. We argue that this can be explained in terms of advisors, privy to important information about the deal, investing in the target in the expectation of its price to increase. We document the high profits of this strategy. We also document a positive relationship between the advisory stake and the deal characteristics. The advisory stake is positively related to the likelihood of deal completion and to the termination fees. However, these deals are not wealth-creating: there is a negative relation between the advisory stake and the viability of the deal. These results provide new insights into the conflicts of interest affecting financial

Despite the central importance of investors to all initial public offering (IPO) theories, relatively little is known about their role in practice. This article is based on a survey of how institutional investors assess IPOs, what information they provide to the investment banking syndicate, and the factors they believe influence allocations. We find that investor characteristics, in particular brokerage relationships with the bookrunner, are perceived to be the most important factors influencing allocations, which supports the view that IPO allocations are part of implicit quid pro quo deals with investment banks. The survey raises doubts as to the extent of information production or revelation.

Previous research concludes that options are mispriced based on the high average returns, CAPM alphas, and Sharpe ratios of various put selling strategies. One criticism of these conclusions is that these benchmarks are ill-suited to handle the extreme statistical nature of option returns generated by nonlinear payoffs. We propose an alternative way to evaluate the statistical significance of option returns by comparing historical statistics to those generated by option pricing models. The most puzzling finding in the existing literature, the large returns to writing out-of-the-money puts, is not inconsistent (i.e., is statistically insignificant) relative to the Black-Scholes model or the Heston stochastic volatility model due to the extreme sampling uncertainty associated with put returns. This sampling problem can largely be alleviated by analyzing market-neutral portfolios such as straddles or delta-hedged returns. The returns on these portfolios can be explained by jump risk premia and estimation risk.

By generalizing the Leland and Pyle (1977) model to the case of multiple correlated assets, this paper studies the signaling and hedging behavior of an intermediary who sells multiple assets in financial markets. Based on information asymmetry, this paper demonstrates the intrinsic interdependence of risk management and asset selling for intermediaries, and obtains several testable empirical implications. For instance, an intermediary with a more diversified underlying portfolio will face greater liquidity (a smaller price impact) when selling assets to the market. Several applications are discussed, including bank loan sales and selling mechanisms. (JEL D40, D82, G20) Financial intermediaries manage and trade large portfolios of assets. For in-stance, Fannie Mae, a leading firm in the Mortgage Backed Securities (MBS) industry, issued 32 Fannie Mae MBS pools on 1 November 2004.1 Meanwhile, active risk management is becoming increasingly important for financial inter-mediaries,2 possibly due to the longterm capital management crisis in the fall of 1998. Motivated by these facts, this paper generalizes the Leland and Pyle (1977,

This paper considers optimal compensation for a CEO who is entrusted with administering corporate assets honestly. Optimal compensation designs maximize integrity at minimum cost. These designs are very “low powered,” i.e., while specifying a lower bound for performance and increasing pay with performance, they increase compensation at a rapidly decreasing rate. Thus, integrity considerations engender optimal compensation packages that closely resemble the very pervasive 80/120 bonus plans, exactly the sort of compensation that Jensen (2003) argues should compromise integrity. Under optimal designs, expected compensation increases linearly with firm size, and increases in the market/book ratio. Moreover, given optimal compensation, CEO asset diversion is limited to high market-to-book firms that have received negative productivity shocks.

We analyze capital allocation in a conglomerate where divisional managers with uncertain abilities compete for promotion to CEO. A manager can sometimes gain by unobservably adding variance to divisional performance. Capital rationing can limit this distortion, increase productive efficiency, and allow the owner to make more accurate promotion decisions. Firms for which CEO talent is more important for firm performance are more likely to ration capital. A rationed manager is more likely to be promoted even though all managers are identical ex ante. When the tournament payoff is relatively small, offering an incentive wage can be more efficient than rationing capital; however, when tournament incentives are paramount, rationing is more efficient.

Whom a CEO knows has a substantial impact on pay. An additional connection to an executive or director outside the firm increases a CEO‟s compensation by over $17,000 on average, and explains about 10% of total pay. An additional premium is associated with “important” members: insiders at other firms, geographically local connections, or those within the same industry. Needy firms – those whose non-CEO executives are poorly connected and those geographically isolated from industry peers pay the highest prices for a CEO‟s rolodex. Pay-for-connectivity is unrelated to several measures of corporate governance, evidence against rent extraction in favor of a market-based explanation for CEO pay. * We have benefited from discussions with Andres Almazan, Aydogan Alti, Shane Corwin, Adolfo de Motta, Charlie Hadlock, Jay Hartzell, Tim Loughran, Mitchell Petersen, Gordon Phillips, Anil Shivdasani, Antoinette Schoar, Paul Schultz, Geoffrey Tate, Sheridan Titman, and David Yermack. We thank seminar participants at the University of Texas (Austin) for helpful comments. We are grateful to the University Development Office at Notre Dame for funding the purchase of the BoardEx database. We wish to thank Jacqueline Higgins and Shoshana Zysberg at Management Diagnostic Limited for assistance with the BoardEx database. Xian Cai provided excellent research assistance. ‡ Contact: Joseph Engelberg, Kenan-Flagler Business School, University of North Carolina at Chapel Hill, (Email) [email protected], (Tel) 919-962-6889; Pengjie Gao, Mendoza College of Business, University of Notre Dame, (Email) [email protected], (Tel) 574-631-8048; and Christopher Parsons, Kenan-Flagler Business School, University of North Carolina at Chapel Hill, (Email) [email protected], (Tel) 919-962-4132. Please address all correspondence to Joseph Engelberg.

This article studies the causal effect of individuals' overconfidence and bounded rationality on information aggregation by using a new multiperiod game in which agents are rewarded for submitting accurate estimates of an unknown asset's value based on (i) their private information and (ii) others' past estimates. By carrying out laboratory sessions of this game in which subjects' overconfidence is a treatment variable, I find that overconfidence affects the information aggregation process by increasing the dispersion of estimates and decreasing the rate of estimates' convergence. However, even when subjects are not overconfident, qualitatively similar deviations from the fully rational model predictions are observed. I show that this can be explained by subjects' strategic response to errors. The Author 2008. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please email: [email protected], Oxford University Press.

This paper proposes a representative agent habit-formation model where preferences are defined for both luxury goods and basic goods. The model matches the equity risk premium, risk-free rate, and volatilities. From the intratemporal first-order condition, one can substitute out basic good consumption and the habit level, yielding a stochastic discount factor driven by two observable risk factors: luxury good consumption and the relative price of the two goods. I estimate these processes and find them to be heteroskedastic, implying time variation in the conditional volatility of the stochastic discount factor. These dynamics occur both at the business cycle frequency and at a lower, "generational" frequency. The findings reveal that the time variation in aggregate stock market and Treasury bond risk premiums are consistent with the predictions of the model. The Author 2009. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please email: [email protected], Oxford University Press.