Frictions in firms and markets

Yu, Yingjie

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https://hdl.handle.net/2142/120552 Copy

Description

Title

Frictions in firms and markets

Author(s)

Yu, Yingjie

Issue Date

2023-04-25

Director of Research (if dissertation) or Advisor (if thesis)

Johnson, Timothy

Doctoral Committee Chair(s)

Johnson, Timothy

Committee Member(s)

• Pennacchi, George
• Kargar, Mahyar
• Choi, Jaewon

Department of Study

Finance

Discipline

Finance

Degree Granting Institution

University of Illinois at Urbana-Champaign

Degree Name

Ph.D.

Degree Level

Dissertation

Keyword(s)

• Exchange-traded funds
• Corporate bonds
• Liquidity

Abstract

This dissertation has three chapters that study different frictions in firms and markets. The first chapter exams the effect of corporate bond exchange-traded funds (CBETFs) on underlying bond illiquidity. I demonstrate that corporate bond exchange-traded funds (CBETFs) are effective in reducing illiquidity of the underlying corporate bonds in times of stress. The model predicts that the presence of ETFs helps to ease illiquidity during stressful times through the arbitrage of authorized participants (APs). The empirical findings suggest that an increase in ETF ownership of one standard deviation could potentially result in a decrease in spread1 by 5.8 basis points during periods of stress, with the reduction in illiquidity accounting for $13\%$ of a standard deviation of bid-ask spread. Consistent with the theory predictions, the effect of CBETFs are more pronounced for less liquid and riskier bonds. CBETFs are more effective in providing liquidity during bond downgrades than CBMFs(corporate bond mutual funds). The second chapter investigates the agency friction of a firm, and suggests that heterogeneous beliefs between the stockholders and the CEO could explain anomalies in executive compensation. The dramatic rise in CEO compensation during the 1990s and early 2000s is a long-standing puzzle. I present a continuous-time principal-agent model in which the principal and the agent have different opinions about the growth of the project's cashflows. The differences of opinions induce a wedge in the optimal contract that encourages the principal and agent to bet against each other. The optimal contract can be resembled by a number of real-world financial contracting apparatuses, including performance-vesting provisions in executive compensation. This paper helps to explain why performance-vesting provisions gradually replace conventional time-vesting provisions in becoming the major component in executive compensation packages since 2000. In addition, it shows ``pay for luck" naturally arises in a shareholder view model with heterogeneous beliefs. In the third chapter, we focus on examining situations where managers of a company may not be dedicated to policies that aim to maximize the value of the company as a whole, but instead prioritize the interests of stockholders by increasing debt levels. As a consequence, the rights and benefits of previous debtholders may be diminished, leading to a form of expropriation. We analyze dynamic stationary models of capital structure, in partial and general equilibrium, when managers cannot commit to firm value maximization. Our setting includes time-varying economic and firm characteristics, as well as valuation under generalized preferences. We quantify both the private cost to firms of the commitment problem, and also the aggregate cost of its externality. The model provides an explanation for the procyclical use of unprotected debt: the private costs of non-commitment increase in bad times. Likewise, expropriation incentives rise when firm valuations are low. Hence, without commitment, leverage can be countercyclical. This dynamic amplifies the effect of excess debt on aggregate risk. A range of calibrations suggests that the social cost of unprotected debt can be very large. We present evidence supportive of the prediction that firms with unprotected debt increase their borrowing in bad times.

Graduation Semester

2023-05

Type of Resource

Thesis

Copyright and License Information

Copyright 2023 Yingjie Yu

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