# FTG Spring 2019 meeting at Carnegie Mellon University

May 03 - May 04, 2019

Carnegie Mellon University

# Friday, May 3, 2019

15:30 - 16:30       Parallel Session 1, Room 1

On the Magnificaction of Small Biases in Decision-making

Shaun William Davies, Edward Dickersin Van Wesep and Brian Waters

Misallocation and Risk Sharing

Hengjie Ai, Anmol Bhandari, Yuchen Chen and Chao Ying

15:30 - 16:30       Parallel Session 1, Room 2

Dealer Funding and Market Liquidity

Max Bruche and John C.F. Kuong

A Theory of Liquidity in Private Equity

Vincent Maurin, David T. Robinson and Per Str¨omberg

16:30 - 17:00                      Coffee Break

17:00 - 18:00       Parellel Session 2, Room 1

Endogenous Specialization and Dealer Networks

Batchimeg Sambalaibat

Inventory Management, Dealers’ Connections, and Prices in OTC Markets

Jean-Edouard Colliard, Thierry Foucault and Peter Hoffmann

17:00 - 18:00       Parallel Session 2, Room 2

FinTech Disruption, Payment Data, and Bank Information

Christine A. Parlour, Uday Rajan and Haoxiang Zhu

Lin William Cong and Yizhou Xiao

18:00 - 19:30          Members Happy Hour (in the Tepper School)

19:30 -                   Small Group Dinners

# Saturday, May 4, 2019

8:30 - 9:00             Breakfast and Registration

09:00 - 10:00        Learning in Financial Markets: Implications for Debt-Equity Conflicts

Jesse Davis and Naveen Gondhi

10:00 - 10:15          Break

10:15 - 11:15        Asymmetric Information and Security Design under Knightian Uncertainty

Andrey Malenko and Anton Tsoy

11:15 - 11:30           Break

11:30 - 12:30        Corporate Liquidity Management under Moral Hazard

Barney Hartman-Glaser, Simon Mayer and Konstantin Milbradt

12:30 - 14:00                    Lunch & Members Meeting

14:00 - 15:00        A Theory of Participation in OTC and Centralized Markets

Jerome Dugast, Semih Uslu and Pierre-Olivier Weill

15:00 - 15:15          Break

15:15 - 16:15        The Tragedy of Complexity

Organizers: Selman Erol, Deeksha Gupta, and Ariel Zetlin-Jones

Useful information:

https://www.cmu.edu/tepper/faculty-and-research/seminars-and-conferences/finance-theory-conference/index.html

We have reserved hotel rooms at the­ Hyatt House (Pittsburgh/Bloomfield/Shadyside) (Group Code: G-TFTC) and SpringHill Suites by Marriott (Bakery Square). Both hotels provide convenient access to the Tepper school. The Hyatt House rate is $132 per night and the SpringHill Suites rate is$149 per night. In either case, please reference "CMU-Tepper Finance Theory Conference" when making a reservation and book before April 3, 2019.

• Learning in Financial Markets: Implications for Debt-Equity Conflicts : Despite the empirical prevalence of debt overhang, existing research has found little evidence of risk-shifting. To understand this discrepancy, we augment a traditional feedback model with an important feature: investors’ endogenous learning. We show that more ex-ante inefficient opportunities for risk-shifting encourage information acquisition. This lowers the ex-post likelihood a firm’s manager will choose such inefficient investments, attenuating risk-shifting. With debt overhang, this flips: more efficient projects discourage information acquisition. This increases the likelihood the manager forgoes efficient investment, amplifying debt overhang. Our analysis suggests a novel channel through which financial markets can differentially affect agency frictions between firm stakeholders.
• Asymmetric Information and Security Design under Knightian Uncertainty : We study a signaling game in which an issuer with private information about the distribution of the project’s cash flows designs a security to sell to an uninformed investor to raise financing for the project. The investor faces Knightian uncertainty and evaluates each security by the worst-case distribution at which she could justify the security being offered by the issuer. First, we show that both standard outside equity and standard risky debt arise as equilibrium securities. Thus, the model provides a common foundation for two most widespread financial contracts based on one market imperfection, information asymmetry. Second, we show that the equilibrium security differs depending on the degree of uncertainty and on whether issuer’s private information and investor’s uncertainty concern a new project or assets in place. If private information concerns a new project and uncertainty is sufficiently high, standard outside equity arises in equilibrium. When uncertainty is sufficiently small, the equilibrium typically features risky debt and never outside equity. In the intermediate case, both risky debt and standard equity arise in equilibrium. In contrast, if private information concerns assets in place, standard equity is never issued in equilibrium, irrespective of the level of uncertainty, and the equilibrium security is (usually) risky debt.
• Inventory Management, Dealers' Connections, and Prices in OTC Markets : We propose a new model of interdealer trading. Dealers trade together to reduce their inventory holding costs. Core dealers share these costs efficiently and provide liquidity to peripheral dealers, who have heterogeneous access to core dealers. We derive predictions about the effects of peripheral dealers' connectedness to core deal- ers and the allocation of aggregate inventories between core and peripheral dealers on the distribution of interdealer prices, the efficiency of interdealer trades, and trad- ing costs for the dealers' clients. For instance, the dispersion of interdealer prices is higher when fewer peripheral dealers are connected to core dealers or when their aggregate inventory is higher.
• A Theory of Participation in OTC and Centralized Markets : Should regulators encourage the migration of trade from over-the-counter (OTC) to centralized markets? To address this question, we consider a model of equilibrium and socially optimal market participation of heterogeneous banks in an OTC market, in a centralized market, or in both markets at the same time. We find that banks have the strongest private incentives to participate in the OTC market if they have the lowest risk-sharing needs and highest ability to take large positions. These banks endogenously assume the role of OTC market dealers. Other banks, with relatively higher risk-sharing needs and lower ability to take large positions, lie at the margin: they are indifferent between the centralized market and the OTC market, where they endogenously assume the role of customers. We show that more customer banks participation in the centralized market can be welfare improving only if investors are mostly heterogeneous in their ability to take large positions in OTC market, and if participation costs induce banks to trade exclusively in one market. Empirical evidence suggest that these necessary conditions for a welfare improvement are met.
• A Theory of Liquidity in Private Equity : We propose a model of Private Equity (PE) investment that can rationalize several empirical findings about fundraising and returns. General partners (GPs) possess superior investment skills and raise capital from Limited Partners (LPs) to finance illiquid projects within funds. The optimal fund contract incentivizes GPs to maximize the expected payoff of fund investments by giving them a profit share in the fund, while compensating LPs for the liquidity risk they face. The size of a PE fund increases with the amount of wealth the GP co-invests in the fund. When PE investments become attractive, GPs prefer to increase the size of their fund rather than increasing their profit share. In markets with low liquidity risk for LPs, expected returns to LPs are lower, and aggregate fundraising as well as average fund sizes are larger. When LPs can trade PE fund investments in a secondary market, partnership claims trade at a discount when aggregate liquidity is scarce. LPs with higher tolerance for liquidity risk will realize higher average returns compared to other LPs, and the difference is larger when liquid capital is more scarce. The introduction of a secondary market can lead to market segmentation, where LPs facing lower liquidity risk switching to the secondary market and those with higher liquidity risk staying in the primary market.
• FinTech Disruption, Payment Data, and Bank Information : We study the impact of FinTech competition on a monopolist bank that bundles payment processing and lending. In our model, consumers' payment data contain information about their credit quality. This information is valuable to the bank when making loans. Surprisingly, under mild conditions, consumers in the loan market also benefit ex ante from the bank being informed. The bank internalizes the value of this information when pricing its payment services, as do consumers when choosing a payment processor. Competition from FinTech firms specializing in payment services disrupts this information spillover to lending decisions. We show that FinTech competition can reduce or increase the price of payment services charged by banks. Overall consumer welfare depends on the consumer's affinity for bank services. Those with a high affinity may be worse off, whereas those with a low affinity benefit from cheaper access to payment services. Policies that give consumers complete control of their payment data break the bank's vertical integration of payment and lending, but such policies can also harm consumers. Our results highlight the complex consequences of recent regulation such as PSD2 in the EU and the Open Banking initiative in the UK, especially their heterogeneous impact on consumers.
• Information Cascades and Threshold Implementation : Economic activities such as crowdfunding often involve sequential interactions, observational learning, and project implementation contingent on achieving certain thresholds of support. We incorporate endogenous all-or-nothing thresholds in a classic model of information cascade. We find that early supporters tap the wisdom of a later "gate-keeper" and effectively delegate their decisions, leading to uni-directional cascades and preventing agents' herding on rejections. Consequently, entrepreneurs or project proposers can charge supporters higher fees, and proposal feasibility, project selection, and information production all improve, even when agents have the option to wait. Novel to the literature, equilibrium outcomes depend on the crowd size, and in the limit, efficient project implementation and full information aggregation ensue.
• Capital Misallocation and Risk Sharing : This paper shows that factor misallocation is closely tied to the risk-sharing avenues available to firm owners. In contrast to the commonly studied bond-only economy with collateral constraints (for example Moll (2014)), we find that the degree of misallocation is \emph{increasing }in persistence of the idiosyncratic risk when firms have access to state-contingent contracts. The possibility to transfer wealth from high productivity states to low productivity states allows firm owners to trade off efficient allocation of consumption against efficient allocation of capital. We show that for reasonable values of risk aversion, insurance needs more than offset production efficiency concerns and thereby generates large capital misallocation.
• The Tragedy of Complexity : This paper presents an equilibrium theory of product complexity. Complex products generate higher potential value, but require more attention from the consumer. Because consumer attention is a limited common resource, an attention externality arises: Sellers distort the complexity of their own products to grab attention from other products. This externality can lead to too much or too little complexity depending on product features and the consumer's attention constraint. Products that are well understood in equilibrium are too complex, while products that are not well understood are too simple. Our theory sheds light on the absolute and relative complexity of different goods, including retail financial products.
• The Good, the Bad and the Complex: Product Design with Imperfect Information : This paper explores the incentives of product designers to complexify products, and the resulting implications for overall product quality. In our model, a consumer can accept or reject a product proposed by a designer, who can affect the quality and the complexity of the product. While the product's quality determines the direct benefits of the product to the consumer, the product's complexity primarily affects the information a Bayesian consumer can extract about the product's quality. Examples include policymakers who propose policies for approval by voters, or banks that design financial products that they later offer to retail investors. We find that complexity is not necessarily a feature of low quality products. For example, while an increase in alignment between the consumer and the designer leads to more complex but better quality products, higher product demand or lower competition among designers leads to more complex and lower quality products. Our findings can help rationalize the observed trends in quality and complexity of regulatory policies and financial products.
• Corporate Liquidity Management under Moral Hazard : We present a model of liquidity management and financing decisions under moral hazard in which a firm accumulates cash to forestall liquidity default. When the cash balance is high, a tension arises between accumulating more cash to reduce the probability of default and providing incentives for the manager. When the cash balance is low, the firm hedges against liquidity default by transferring cash flow risk to the manager via high powered incentives. Under mild moral hazard, firms with more volatile cash flows tend to transfer less risk to the manager and hold more cash. In contrast, under severe moral hazard, an increase in cash-flow volatility exacerbates agency cost, thereby reducing firm value, overall hedging and in particular precautionary cash-holdings. Agency conflicts lead to endogenous, state-dependent refinancing costs related to the severity of the moral hazard problem. Financially constrained firms pay low wages and instead promise the manager large rewards in case of successful refinancing.