Research overview
Corporate Governance
I am currently working on executive compensation and the role of the chief executive with Clara Raposo of ISCTE in Lisbon. In our first paper, Active Agents, Passive Principals: Does High-powered CEO Compensation Really Improve Incentives? we study executive compensation and the role of the chief executive in formulating strategy. We argue that powerful incentive packages can severely distort decisions towards riskier strategies because incentives are not set once for and all in advance, they are adjusted year by year. We study whether pre-committing to very high pay or pre-committting to strict limits on pay are better ways of controlling this problem. We are currently working on a sequel that explores the role of leadership.
Change
With Enrico Perotti (University of Amsterdam) and Vinay Nair (Wharton)
Since established firms enjoy various advantages ranging from the quality of employees to ongoing relationships with suppliers and financiers, it is natural to expect that new ideas should be executed inside these firms. Yet new firms are born. Often employees leave their existing firms to carry out projects elsewhere. Research on the "paradox of success" has documented that successful incumbents are less likely than newcomers to introduce new ideas. We argue that resistance from parties that are adversely affected by change can suffocate the process of change inside established firms. This resistance to change can make established firms hostile to new ideas. New ideas may be operationalized by creating new firms, even if the creation of a new firm entails additional costs or inefficiencies.
Market efficiency and the feedback effect
With Alex Guembel (Oxford) and Itay Goldstein (Wharton)
A fundamental role of financial markets is to gather information on firms, and so help allocate resources to their most efficient uses. This occurs when traders in financial markets produce information about firms' prospects to improve their own trading. The information gets into market prices, which guide investment decisions in the real sector either through managerial learning or through firms' access to capital. This idea goes back to Hayek (1945), who argues that markets are the most efficient system for information production and aggregation.
This paper explores the incentives for information production in a context where prices have this allocational role. Financial economics has studied how information gets reflected in market prices via the trading activities of speculators, who are motivated by the profits they make on their costly private information. However, in this literature, the cash flows from risky assets are assumed to be exogenous, and so there is no possibility for informative prices to perform an allocational role and create economic value. We argue that the way in which a firm responds to stock price movements in its investment decisions has itself important implications for information production incentives. Specifically, when a firm chooses its investments optimally contingent on the information available in prices, there may be very little incentive for speculators to produce information.
Previous research
You can download some of my articles here. This is only a partial list and the full list of papers is given in my CV.
Feedback Effect
Two papers study the feedback effect, whereby financial market prices not only reflect information about stock values, they also affect the decisions firms take (and hence the value of the stock). For example, if the stock price falls a firm may cut back investment and if it rises, a firm may expand investment.
Informed Trading, Investment and Welfare with Rohit Rahi (forthcoming Journal of Business).
Stock Market Efficiency and Economic Efficiency: Is There a Connection? with Gary Gorton (Journal of Finance 1997).
I have written several papers with Gary Gorton, and we are currently putting together a book based on them. Among our papers, my two favourites are:
Limited Arbitrage
In Arbitrage Chains (Journal of Finance 1994), we show how imperfections in financial market arbitrage lead to traders ignoring information unless they think others will focus on the same information leading to short-term biases in pricing. I like this paper because we were able to set up quite a clean, simple model to make our points, and also because the general topic of limits to arbitrage, financially constrained arbitrage, risky arbitrage, etc., has since become very active as a research area.
Trading volume and incentives for money managers
In Noise Trading, Delegated Portfolio Management, and Economic Welfare (Journal of Political Economy 1997) we model financial market investors as agents with distorted incentives and show how even with optimal incentive contracting, they will tend to trade too much. This paper is not as elegant as Arbitrage Chains, but I like it because I think that the whole area of agency problems and incentive distortions in financial markets - whether for analysts, fund managers, or investment bankers - has been mistakenly ignored in traditional finance theory.
Other papers include:
Risky arbitrage
Arbitrage, Hedging, and Financial Innovation (Review of Financial Studies 1998).
Knightian uncertainty
Uncertainty Aversion, Risk Aversion and the Optimal Choice of Portfolio with Sérgio Ribeiro da Costa Werlang, (Econometrica 1992)
Excess Volatility of Stock Prices and Knightian Uncertainty, with Sérgio Ribeiro da Costa Werlang, (European Economic Review 1992)
Limited memory
Finally, my PhD Thesis explored the economics of decision making when you can´t remember everything, but you can choose what information to remember and what to forget: Search Decisions with Limited Memory, (Review of Economic Studies 1991)