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Note: Electronic versions of published papers/working papers are provided as a professional courtesy to ensure timely dissemination of the research for individual non-commercial purposes. Copyright, and all other rights therein, reside with the respective copyright holders, as stated within each paper. These files may not be reposted without permission.
Credit Spreads with Dynamic Debt, with Sanjiv Das, 2015, Journal of Banking and Finance, vol.50, p.121-140
This paper extends the baseline Merton (1974) structural default model, which is intended for static debt spreads, to a setting with dynamic debt, where leverage can be ratcheted up as well as written down through pre-specified exogenous policies. We provide a different and novel solution approach to dynamic debt than in the extant literature. For many dynamic debt covenants, ex-ante credit spread term structures can be derived in closed-form using modified barrier option mathematics, whereby debt spreads can be expressed using combinations of single barrier options (both knock-in and knock-out), double barrier options, double-touch barrier options, in-out barrier options, and one-touch double barrier binary options. We observe that debt principal swap down covenants decrease the magnitude of credit spreads but increase the slope of the credit curve, transforming downward sloping curves into upward sloping ones. On the other hand, ratchet covenants increase the magnitude of ex-ante spreads without dramatically altering the slope of the credit curve. These covenants may be optimized by appropriately setting restructuring boundaries, which entails a trade-off between the reduction in spreads against restructuring costs. Overall, explicitly modeling this latent option to alter debt leads to term structures of credit spreads that are more consistent with observed empirics.
Coming Up Short: Managing Underfunded Portfolios in a LDI-BPT Framework, with Sanjiv Das and Meir Statman, 2014, Journal of Portfolio Management, vol.41, p.95-108
We employ a liability directed investment (LDI) framework built on behavioral portfolio theory (BPT), which we refer to as LDI-BPT, to prescribe remedies for an underfunded portfolio. Investors in the LDI-BPT framework face a risky asset, such as a stock index, and a risk-free bond. They begin with some level of current wealth and set their target wealth at the end of N periods, and their tolerance for shortfalls from that target wealth. Portfolio rebalancing in the LDI-BPT framework is quite different from the common fixed-proportions rebalancing, where portfolio allocations are rebalanced to ratios, such as 60:40, at the beginning of each of N periods. We consider critical issues of underfunding, where there is no portfolio that can meet the shortfall constraint, and we explore the effectiveness of portfolio infusions in resolving underfunded situations, relative to other measures such as increasing risk, cutting back on target liabilities/goals, and extending the portfolio horizon.
Going for Broke: Restructuring Distressed Debt, with Sanjiv Das, 2014, lead article, Journal of Fixed Income, vol.24, p.5-27
This paper discusses how to restructure a portfolio of distressed debt, what the gains are from doing so, and attributes these gains to restructuring and portfolio effects. This is an interesting and novel problem in fixed-income portfolio management that has received scant modeling attention. We show that debt restructuring is Pareto improving and lucrative for borrowers, lenders, and investors in distressed debt. First, the methodological contribution of the paper is a parsimonious model for the pricing and optimal restructuring of distressed debt, i.e., loans that are under-collateralized and are at risk of borrower default, where willingness to pay and ability to pay are at issue. Distressed-debt investing is a unique portfolio problem in that (a) it requires optimization over all moments, not just mean and variance, and (b) with debt restructuring, the investor can endogenously alter the return distribution of the candidate securities before subjecting them to portfolio construction. Second, economically, we show that post-restructuring return distributions of distressed debt portfolios are attractive to fixed-income investors, with risk-adjusted certainty equivalent yield pick-ups in the hundreds of basis points, suggesting the need for more efficient markets for distressed debt, and shedding light on the current policy debate regarding the use of eminent domain in mitigating real estate foreclosures.
Structured Finance Deals: A Review of the Rating Process and Recent Evidence Thereof, 2012, Journal of Investment Management, vol.10, 0.103-115
The pooling and tranching of assets into prioritized cash-flow claims has become a substantial source of revenue for issuers as well as rating agencies in the last decade. With the recent demise of vehicles used to operationalize these structured deals, a natural question arises as to the quality of standards applied in structuring, managing, and ultimately rating these products. The purpose of this paper is to review rating practices in the area of structured finance, and to summarize the research and empirical evidence pertaining to these questions.
It Pays to Have Friends, with Byoung-Hyoun Hwang, 2009, Journal of Financial Economics, vol.93, p.138-158
Currently, a director is classified as independent if he/she has neither financial nor familial ties to the CEO or to the firm. We add another dimension: social ties. Using a unique data set, we find that 87% of boards are conventionally independent, but that only 62% are conventionally and socially independent. Furthermore, firms whose boards are conventionally and socially independent award a significantly lower level of compensation, exhibit stronger pay performance sensitivity, and exhibit stronger turnover-performance sensitivity than firms whose boards are only conventionally independent. Our results suggest that social ties do matter, and that consequently, a considerable percentage of the conventionally independent boards are substantively not.
Return Performance Surrounding Reverse Stock Splits, with April Klein and James Rosenfeld, 2008, lead article, Financial Management, vol.37, p.173-192
We examine the long-run return performance of over 1,600 firms with reverse stock splits. These stocks record statistically significant negative abnormal returns over the three-year period following the month of the reverse split. The sample firms experience poor operating performances over the four years that include and follow the year of the reverse split, which suggests informational inefficiencies. Because these stocks have unique financial characteristics, we also show that they would be very difficult to sell short. Thus, arbitrageurs would be restricted in their ability to earn abnormal profits, even if they correctly anticipated a price decline.
Working Papers / Works in Progress
Rollover Risk and Capital Structure Covenants in Structured Finance Vehicles, with Sanjiv Das, 2015
The shadow banking system comprises special purpose vehicles (SPVs) characterized by high debt, illiquid long-maturity assets funded predominantly by short-maturity debt, and tranched liabilities also known as the capital structure of the SPV. These three features lead to an adversarial game among senior-note holders, who solve for an optimal rollover policy based on the other senior tranches with varying rollover dates. This rollover policy is, in turn, taken into account by capital-note holders (i.e., investors in the equity tranche) when choosing the capital structure (i.e., the assets-to-debt ratio) of the SPV. Rollover risk increases in the number of tranches, resulting in a lower equilibrium (optimal) level of debt and higher cost of debt. The expected life of the SPV may also be shortened. We propose a covenant based capital structure that mitigates these problems and is Pareto-improving for equity and debt holders in the SPV.
Credit Spreads and the Correlation in Default Probabilities, with Siamak Javadi, Tim Krehbiel, and Ali Nejadmalyeri, 2015
This paper presents a novel method to measure the correlation in default probabilities across corporate bond issues and to examine its attendant bond pricing implications. Specifically, we construct a measure of the correlation in physical default probabilities from credit-default swap (CDS) spreads, and controlling for other known determinants of credit spreads, we show that default correlation is priced in the corporate bond market. Default correlation is more pronounced and commands a higher premium during periods of financial distress and for speculative issues. Overall, our results provide compelling evidence that the correlation in default probabilities is a priced factor in corporate bond spreads, and has important implications for future work on the cross-sectional determinants of fixed-income pricing.
Managing Risk in Structured Finance Vehicles: The Role of Contingent Capital, with Sanjiv Das, 2015 (coming soon)
We model the design of a structured finance deal, specifically, its capital structure, leverage risk controls, asset quality, and the rollover frequency of senior debt. Instead of providing safety, stringent risk management controls may accelerate failure, and optimal risk management choices depend critically on the rollover horizon of the senior notes. The expected losses on senior notes become increasingly sensitive to pool risk (i.e., spread volatility) when risk controls become more stringent, particularly under shorter rollover horizons. Post the recent subprime financial crisis, we intend to inform the creation of safer SPVs in structured finance, and we propose avenues of mitigating senior note risk through contingent capital.
Directors' Decision-Making Involvement on Corporate Boards, 2015
Using the full set of committee memberships for the directors of Fortune 100 firms (which I collect from annual proxy statements), I introduce a measure to capture the extent of a director's involvement in discussion and decisions that affect corporate strategy. I document substantial variation in directors' decision-making power both within and across boards, and I provide evidence that this more nuanced yet systematically available measure yields more powerful and better specified tests in examining the link between board composition, accounting performance metrics, and shareholder value. Overall, I argue that incorporating these differences in decision-making power has important implications for studies in corporate governance.
Measuring Luck in CEO Outperformance, 2015
Firm performance is a crucial factor in how CEOs are evaluated. However, a CEO can be repeatedly lucky or unlucky, adding noise to performance outcomes as a measure of managerial ability. In this study, I examine how much of the observed cross-sectional dispersion in outcomes can be attributed to differences in luck as opposed to differences in skill. Using bootstrap simulations, I show that, even if all CEOs were equally skilled, we can expect substantial differences in performance outcomes. When comparing the simulated distribution of outcomes to the actual empirical distribution, I find that the best performing CEOs perform too well relative to the median to be completely explained by luck alone. However, the true underlying differences in skill are substantially smaller than suggested by simply looking at the raw performance differential.
Social Ties and Earnings Management, with Byoung-Hyoun Hwang, 2012
We detect a significant presence of social ties between the CEO and audit committee members and our results suggest that these informal ties play a material role in audit-committee oversight. In particular, we find a substantially stronger, positive relation between abnormal (i.e., discretionary) accruals and the extent of an audit committee's connection to the CEO when we consider social ties in addition to the conventional ties. Moreover, we find that an audit committee's social affiliation is associated with an increased discontinuity in the earnings distribution surrounding earnings targets. Together, our findings suggest that informal ties play a material role in facilitating creative accounting practices.