We introduce uncertainty into Holmstrom and Milgrom (1987) to study optimal long-term contracting with learning. In a dynamic relationship, the agent’s shirking not only reduces current performance, but also increases the agent’s information rent due to the persistent belief manipulation effect. We characterize the optimal contract using the dynamic programming technique in which information rent is the unique state variable. In the optimal contract, the optimal effort is front-loaded and stochastically decreases over time. Furthermore, the optimal contract exhibits an option-like feature in that incentives increase after good performance. Implications about managerial incentives and asset management compensations are discussed. Received August 31, 2015; editorial decision October 20, 2016 by Editor Francesca Cornelli.

What makes an asset a “safe” asset? We study a model where two countries each issue sovereign bonds to satisfy investors’ safe asset demands. The countries differ in the float of their bonds and the fundamental resources available to rollover debts. A sovereign’s debt is safer if its fundamentals are strong relative to other possible safe assets, not merely strong on an absolute basis. If demand for safe assets is high, a large float enhances safety through a market depth benefit. If demand for safe assets is low, then large debt size is a negative as rollover risk looms large.

US government bonds are considered to be the world's safe store of value, especially during periods of economic turmoil such as the events of 2008. But what makes US government bonds “safe assets”? We highlight coordination among investors, and build a model in which two countries with heterogeneous sizes issue bonds that may be chosen as safe asset. Our model illustrates the benefit of a large absolute debt size as safe asset investors have “nowhere else to go” in equilibrium, and the large country's bonds are chosen as the safe asset. Moreover, the effect becomes stronger in crisis periods.

We study how competition between asymmetrically informed banks, one specialized and one nonspecialized, affects loan prices. Both banks possess “general” signals regarding the borrower’s quality, which they use to screen loans. The specialized bank also has access to a “specialized” signal on which it bases its loan pricing. This private information-based pricing makes the specialized bank bid more aggressively, mitigating the informational rent effect that gives it monopolistic power. Our findings explain why loans from specialized lenders feature lower interest rates and better ex post performance. Supporting empirical evidence emphasizes the role of specialized information in shaping credit market outcomes.

We develop a structural credit model to examine how interactions between default and liquidity affect corporate bond pricing. The model features debt rollover and bond-price-dependent holding costs. Over the business cycle and in the cross-section, the model matches average default rates and credit spreads in the data, and captures variations in bid-ask and bond-CDS spreads. A structural decomposition reveals that default-liquidity interactions can account for 10%–24% of the level of credit spreads and 16%–46% of the changes in spreads over the business cycle. Further, liquidity-related corporate bond financing costs amount to 6% of the total issuance amount from 1996 to 2015. Received July 12, 2015; editorial decision April 15, 2017 by Editor Andrew Karolyi.

Using granular data covering both regulated (brokerage‐financed) and unregulated (shadow‐financed) margin accounts in China, we provide novel evidence on retail investors' margin trading behavior and its price implications. We first show that retail investors' decisions to lever up in stock trading despite the hefty borrowing cost is related to their lottery preferences. We then show that margin borrowing affects investors' trading behavior—investors are more likely to liquidate their holdings as they approach margin calls. Finally, we show that margin‐induced trading aggregates to affect asset prices and contributes to shock spillovers across stocks (e.g., from lottery stocks to nonlottery stocks).

We provide causal evidence on the value of asset pledgeability by exploiting a unique feature of Chinese corporate bond markets: bonds with identical fundamentals are traded on two segmented markets with different rules for repo transactions. Using a policy shock that rendered AA+ and AA bonds ineligible for repo on one market only, we compare how bond prices changed across markets and rating classes around this event. When the haircut increases from 0% to 100%, bond yields increase by 39 bps to 85 bps. These estimates help us infer the magnitude of the shadow cost of capital in China.

We introduce dynamic agency into the neoclassical q theory of investment. Costly external financing arises endogenously from dynamic agency, and influences firm value and investment. Agency conflicts drive a history-dependent wedge between average q and marginal q, and make the firm’s investment policy dependent on realized profits. A larger realized profit induces higher investment, and hence a larger firm. Investment is relatively insensitive to average q when the firm is “financially constrained ”(i.e. has low financial slack). Conversely, investment is sensitive to average q when the firm is relatively “financially unconstrained,” (i.e. has high financial slack). Moreover, the agent’s optimal compensation is in the form of future claims on the firm’s cash flows when the firm’s past profits are relatively low and the firm has less financial slack, whereas cash compensation is preferred when the firm has been profitable, agency concerns are less severe, and the firm is growing rapidly. To study the effect of serial correlation of productivity shocks on investment and firm dynamics, we extend our model to allow the firm’s output price to be stochastic. We show that, in contrast to static agency models, the agent’s compensation in the optimal dynamic contract will depend not only on the firm’s past performance, but also on output prices, even though they are beyond the agent’s control. This dependence of the agent’s compensation on exogenous output prices (for incentive reasons) further feeds back on the firm’s investment, and provides a channel to amplify and propagate the response of investment to output price shocks via dynamic agency.

We identify exposure to political risk by exploiting a unique variation around land lease extension protection after 2047 in Hong Kong’s housing market due to historical arrangements. Relative to properties that have been promised an extension protection, those with unprotected leases granted by the current government are sold at a discount of 8 percent; those with colonial leases suffer an additional discount of 8 percent. Incorporating estimated structural parameters that suggest an additional 20 percent ground rent after 2047, our model matches empirical discounts well across lease horizons. Discounts increase over time, particularly in areas with greater pessimism about the city’s future.