Financial Engineering

Post-2008 financial regulatory changes largely have been a failure. They have produced high compliance costs, while constructing regulatory mechanisms that are unlikely to achieve their intended objectives. Furthermore, financial regulation increasingly has adopted processes that are inconsistent with adherence to the rule of law, which not only threaten the fundamental norms on which our democracy is founded but also undermine the effectiveness of regulation.

We demonstrate a novel link between relationship-specific investments and risk in a setting where division managers operate under moral hazard and collaborate on joint projects. Specific investments increase efficiency at the margin. This expands the scale of operations and thereby adds to the compensation risk borne by the managers. Accounting for this investment/risk link overturns key findings from prior incomplete contracting studies.

Columbia Business School’s position in the heart of New York City places it at the most important nexus of the global financial industry. It’s no coincidence that finance and economics are at the very core of Columbia Business School’s research and scholarship.

We would like to share some of our general observations on activism, economics and the macro environment.

A monopolist offers a product to a market of consumers with heterogeneous quality preferences. Although initially uninformed about the product quality, they learn by observing past purchase decisions and reviews of other consumers. Our goal is to analyze the social learning mechanism and its effect on the seller's pricing decision. This analysis borrows from the literature on social learning and on pricing and revenue management.

We examine short-horizon return predictability using a novel proprietary dataset of institutional traders with known identities. We estimate investor-specific short-term trading skill and find that there is pronounced heterogeneity in predicting short-term returns among institutional investors. Incorporating short-term predictive ability, our model explains much higher fraction of variation in asset returns. Ignoring the heterogeneity in short-term trading skill has major implications in modeling price impact.

Firms often use both objective/verifiable and subjective/non-verifiable performance measures to provide employees with effort incentives. We study a principal/two-agent model in which an objective team-based performance measure and subjective individual performance measures are available for contracting. A problem with tying rewards to subjective measures is that the principal may have incentives to understate the realization of those measures in order to reduce compensation. We compare two mechanisms for overcoming this credibility problem: bonus pools and reputation.

We develop a tractable incomplete-markets model with an earnings process Y subject to permanent shocks and borrowing constraints. Financial frictions cause the marginal (certainty equivalent) value of wealth W to be greater than unity and decrease with liquidity w=W/Y. Additionally, financial frictions cause consumption to decrease with this endogenously determined marginal value of liquidity. Risk aversion and the elasticity of inter-temporal substitution play very different roles on consumption and the dispersion of w.

We document that contractual disclosures by intermediaries during the sale of mortgages contained false information about the borrower's housing equity in 7–14% of loans. The rate of misrepresented loan default was 70% higher than for similar loans. These misrepresentations likely occurred late in the intermediation and exist among securities sold by all reputable intermediaries. Investors — including large institutions — holding securities with misrepresented collateral suffered severe losses due to loan defaults, price declines, and ratings downgrades.