Financial Engineering

In the classical principal-agent problem, a principal hires an agent to perform a task. The principal cares about the task's output but has no control over it. The agent can perform the task at different effort intensities, and that choice affects the task's output. To provide an incentive to the agent to work hard and since his effort intensity cannot be observed, the principal ties the agent's compensation to the task's output.

Using data on repurchase agreements by primary securities dealers, we show that three classes of securities (Treasury securities, securities issued by government-sponsored agencies, and mortgage-backed securities) can be formally ranked in terms of their collateral values in the general collateral (GC) market.

As we contemplate the raft of regulatory reforms currently being proposed, it is important not only to consider the content of regulation, but also its structure. In particular, it is important to ask how the role of the Fed as a regulator should change, and how the targets and the tools of monetary and regulatory policy should adapt to new regulatory mandates. For example, some reform proposals envision a dramatic expansion of Fed regulatory authority, while others do not, and some proposals envision the Fed's using monetary policy to prick asset bubbles, while others do not.

The paper provides empirical evidence that strategic complementarities among investors generate fragility in financial markets. Analyzing mutual fund data, we find that, consistent with a theoretical model, funds with illiquid assets (where complementarities are stronger) exhibit stronger sensitivity of outflows to bad past performance than funds with liquid assets. We also find that this pattern disappears in funds where the shareholder base is composed mostly of large investors.

This article provides a comprehensive analysis of a new and increasingly important phenomenon: the simultaneous holding of both equity and debt claims of the same company by non-commercial banking institutions ("dual holders"). The presence of dual holders offers a unique opportunity to assess the existence and magnitude of shareholder-creditor conflicts. We find that syndicated loans with dual holder participation have loan yield spreads that are 18–32 bps lower than those without. The difference remains economically significant after controlling for the selection effect.

We develop an importance sampling (IS) algorithm to estimate the lower tail of the distribution of returns for a discretely rebalanced portfolio-one in which portfolio weights are reset at regular intervals. We use a more tractable continuously rebalanced portfolio to design the IS estimator. We analyze a limiting regime based on estimating probabilities farther in the tail while letting the rebalancing frequency increase.

In this paper, we develop a structural model that captures the interaction between the cash balance and investment opportunities for a firm that already has some debt outstanding. We consider a firm whose assets produce a stochastic cash flow stream. The firm has an opportunity to expand its operations, which we refer to as an "option the expand." The exercise cost of the option can be financed either by cash or costly equity issuance.

This chapter considers several important areas of response (or nonresponse) of banking regulation to the crisis. I begin with an overview of the causes of the crisis and the ways in which the crisis has highlighted the need for regulatory reform. I review the prospects for the reform of regulatory content. I also consider and evaluate the potential changes in the structure of regulation and supervision coming out of the crisis.