Bruno Biais

• Toulouse School of Economics

Incentive problems make securities’ payoffs imperfectly pledgeable, limiting agents’ ability to issue liabilities. We analyze the equilibrium consequences of such endogenous incompleteness in a dynamic exchange economy. Because markets are endogenously incomplete, agents have different intertemporal marginal rates of substitution, so that they valu...

In order to share risk, protection buyers trade derivatives with protection sellers. Protection sellers’ actions affect the riskiness of their assets, which can create counterparty risk. Because these actions are unobservable, moral hazard limits risk sharing. To mitigate this problem, privately optimal derivative contracts involve variation margin...

We study the dynamics of an innovative industry when agents learn about its strength, i.e., the likelihood that it gets hit by negative shocks. Managers can exert risk-prevention effort to mitigate the consequences of such shocks. As time goes by, if no shock occurs, confidence improves. This attracts managers to the innovative sector. But, when co...

We study the dynamics of an innovative industry in which agents learn about the likelihood of negative shocks. Managers can exert risk prevention effort to mitigate the consequences of shocks. If no shock occurs, confidence improves, attracting managers to the innovative sector. But, when confidence becomes high, inefficient managers exerting low r...

We study the interaction between contracting and equilibrium pricing when risk- averse hedgers purchase insurance from risk-neutral investors subject to moral hazard. Moral hazard limits risk-sharing. In the individually optimal contract, margins are called (after bad news) to improve risk-sharing. But margin calls depress the price of investors' a...

Information collection and processing in financial institutions is challenging. This can delay the observation by traders of the exact capital charges and constraints of their institution. During this delay, traders face preference uncertainty. In this context, we study optimal trading strategies and equilibrium prices in a continuous centralized m...

High-speed market connections and information processing improve …nancial institutions'ability to seize trading opportunities, which raises gains from trade. They also enable fast traders to process information before slow traders, which generates adverse selection. We fi…rst analyze trading equilibria for a given level of investment in fast-tradin...

This research was conducted within the Paul Woolley Research Initiative on Capital Market Dysfunctionalities at IDEI, Toulouse. Support from the Europlace Institute of Finance is gratefully aknowledged. Many thanks to participants in the first conference of the Centre for the Study of Capital Market Dysfunctionality at the London School of Economic...

The paper studies the optimal design of clearing systems. The paper analyzes how counterparty risk should be allocated, whether traders should be fully insured against that risk, and how moral hazard affects the optimal allocation of risk. The main advantage of centralized clearing, as opposed to no or decentralized clearing, is the mutualization o...

We analyze optimal hedging contracts and show that although hedging aims at sharing risk, it can lead to more risk-taking. News implying that a hedge is likely to be loss-making undermines the risk-prevention incentives of the protection seller. This incentive problem limits the capacity to share risks and generates endogenous counterparty risk. Op...

Algorithms enable investors to locate trading opportunities, which raises gains from trade. Algorithmic traders can also process information on stock values before slow traders, which generates adverse selection. We model trading in this context and show that, for a given level of algorithmic trading, multiple equilibria can arise, some of which ge...

We study the problem of an entrepreneur who faces two investors with private informa-tion about his project's profitability. We analyze the entrepreneur's optimal negotiation strategy. Importantly, we assume that the entrepreneur derives a private benefit of control so that he cares not only about expected monetary profits, but also about the proba...

We develop an incentive-based theory of margins in the context of a tradeoff between the benefits of hedging in terms of enhanced risk-sharing and its costs in terms of financial instability. We model hedging as the design of a contract between a protection buyer, seeking to reduce his risk exposure, and a protection seller. If the seller learns th...

Introduction Taking stock of Modigliani and Miller's (1958) celebrated result that, with perfect capital markets, financial structure is irrelevant, corporate finance has studied how various market imperfections make different capital structures more or less attractive. In line with the seminal insights of Jensen and Meckling (1976), a large fracti...

The competition between Island and Nasdaq at the beginning of the century offers a natural laboratory to study competition between and within trading platforms and its consequences for liquidity supply. Our empirical strategy takes advantage of the difference between the pricing grids used on Island and Nasdaq, as well as of the decline in the Nasd...

We develop a novel continuous-time equilibrium microstructure model based on the premise that, because their cognition is imperfect, investors cannot continuously make new trading decisions. We use our theoretical financial market setup to study price, trading dynamics, and welfare in the aftermath of a liquidity shock. We pursue three objectives....

We analyze theoretically and empirically the implications of information asymmetry for equilibrium asset pricing and portfolio choice. In our partially revealing dynamic rational expectations equilibrium, portfolio separation fails, and indexing is not optimal. We show how uninformed investors should structure their portfolios, using the informatio...

We analyze optimal hedging contracts and show that, although they are designed for risk-sharing, they can breed risk-taking. Bad news about the hedged risk increases the expected liability of the protection seller, undermining her own risk prevention incentives. This limits risk-sharing, creates endogenous counterparty risk and triggers contagion f...

As equity trading becomes predominantly electronic, is there still value to a traditional, intermediated dealer system? We address this question by ana-lyzing the impact of the organization of trading on volume, liquidity, and price efficiency for three systems: an isolated dealer market, an electronic limit order book, and a setting where the two...

We study a continuous-time principal–agent model in which a risk-neutral agent with limited liability must exert unobservable effort to reduce the likelihood of large but relatively infrequent losses. Firm size can be decreased at no cost or increased subject to adjustment costs. In the optimal contract, investment takes place only if a long enough...

This paper proposes a dynamic model of financial markets where some investors are prone to the confirmation bias. Following insights from the psychological literature, these agents are assumed to amplify signals that are consistent with their prior views. In a model with pub-lic information only, this assumption provides a unified explanation of a...

We provide a three way theoretical comparison of dealer, limit order, and hybrid markets and analyze the impact that the organization of trading has on volume, liquidity, and price efficiency. We find, in particular, that trading volume is highest in the limit order market and lowest in the dealer market. Small order price impacts are lowest and la...

Once they have observed information, hindsight biased agents fail to remember how ignorant they were initially, they knew it all along. We formulate a theoretical model of this bias, providing a foundation for empirical measures, and implying that hindsight biased agents learning about volatility will underestimate it. In an experiment involving 67...

We propose a dynamic competitive equilibrium model of limit order trading, based on the premise that investors cannot monitor markets continuously. We study how limit order markets absorb transient liquidity shocks, which occur when a significant fraction of investors lose their willingness and ability to hold assets. We characterize the equilibriu...

Recent empirical evidence on traders'order submission strategies in elec-tronic limit order markets (LOB) shows the growing use of hidden orders. This paper provides a theory of the optimal order submission strategies in an LOB, where traders can choose among limit, market and hidden orders. The dynamic model we propose allows traders to take the s...

We experimentally analyze equilibrium discovery in i) a pure call auction, ii) a call auction preceded by a nonbinding preopening period, and iii) a call auction preceded by a binding preopening period. We examine whether a preopening period can facilitate coordination on the Pareto dominant equilibrium. During the nonbinding preopening period, tra...

We propose a dynamic equilibrium model of limit order trading, based on the premise that investors submit limit orders because they can't monitor the market con- tinuously. We study how our theoretical limit order market reacts to a transient liquid- ity shock, when a significant fraction of investors loose their willingness and ability to hold the...

Abstract In this document, we give complete proofs for the results exposed in \Large Risks, Limited Liability and Dynamic Moral Hazard." A precise description of the stochastic environment is provided in Appendix A. In Appendix B, we use martingale techniques to formulate the agent’s incentive compatibility constraint. Appendix C is devoted to the...

We study innovative industries subject to two risks. First, it is uncertain whether the innovation is strong or fragile. Second, it is difficult to monitor managers, which creates moral hazard and agency rents. As time goes by and profits are observed, beliefs about the industry are updated. As long as no default occurs, confidence builds up. Initi...

This paper studies the impact of public R&D subsidies on investment decisions of recip-ient firms. I use quantile regression methods to characterize the effect of the subsidy at various points of firms' R&D investment distribution. The identification strategy exploits a discontinuity in the probability of receiving the subsidy which results from pr...

Après la crise, il n’y aura pas de retour au statu quo. Même si les bonnes résolutions émises lors des précédentes crises financières sont restées lettre morte, les États, seuls capables de réagir dans l’urgence, auront des contreparties à demander aux acteurs financiers. Ceux-ci ne pourront plus rejeter les contrôles publics au nom de leur compéte...

We study the degree of overreaction and its potential causes and consequences in a controlled experimental setting with 104 participants. In our setup the majority of subjects tend to overreact, however, the degree of overreaction is very heterogenous as few subjects even underreact. Analyzing potential psychological traits that could cause subject...

We study how early-stage new ideas are turned into successful businesses. Even promising ideas can be unprofitable if they fail on one dimension, such as technical feasibility, correspondence to market demand, legality, or patentability. To screen good ideas, the entrepreneur needs to hire experts who evaluate the idea along their dimensions of exp...

We study the impact of different bankruptcy laws in general equilibrium, taking into account the interactions between the credit and labour markets, as well as wealth heterogeneity. Soft bankruptcy laws often preclude liquidation, to avoid ex-post inefficiencies. This worsens credit rationing, depresses investment and reduces aggregate leverage. Ye...

This paper shows that under a global games approach banks may be subject to risk of failure even when fundamentals are strong due to a coordination problem among debtors. As a result of collective strategic default a …nancially sound …rm may claim inability to repay if it expects a su¢ cient number of other …rms to do so as well, thus reducing bank...

A firm is subject to accident risk, which the manager can mitigate by exerting eort. An agency problem arises because eort is unobservable and the manager has limited liability. The occurrence of accidents is modelled as a Poisson process, whose intensity is controlled by the manager. We use martingale techniques to formulate the manager's incentiv...

Abstract We analyze theoretically and empirically the implications of information asymmetry for equilib-

This paper investigates a firm's decision to retain or fire a poorly performing CEO when the CEO's choice of strategy has long-term cash flow implications beyond the CEO's tenure (he leaves behind a legacy). Replacing a CEO be-comes expensive and entrenchment emerges, because the firm's future perfor-mance can only partially be attributed to a newl...

A firm is subject to accident risk, which the manager can mitigate by exerting eort. An agency problem arises because eort is unobservable and the manager has limited liability. The occurrence of accidents is modelled as a Poisson process, whose intensity is controlled by the manager. We use martingale techniques to formulate the manager's incentiv...

An entrepreneur with limited liability needs to finance an infinite horizon investment project. An agency problem arises because she can divert operating cash flows before reporting them to the financiers. We first study the optimal contract in discrete time. This contract can be implemented by cash reserves, debt, and equity. The latter is split b...

We study career choices of employees willing to become entrepreneurs and facing credit constraints. We show that they need reputation and financial capital. We consider their choice to work for transparent or opaque firms. Transparent firms disclose more information about their employees. It has two consequences. First, it eases the updating of the...

This note deals with the conditional form of the law of large numbers (LLN). Let $T$ be a separable metric space, equipped with a non atomic probability $Q$, and $\mathcal{H}$ the class of Borel subsets $H\subset T$ satisfying $Q(H)>0$. Let $\mathcal{P}$ be any consistent set of finite dimensional distributions indexed by $T$. If $\mathcal{H}_0\sub...

This paper addresses the question how individual saving rates and equity hold-ings vary with income. The joint understanding of the cross section of individuals' total and equity savings is crucial regarding various policy issues. In particular, it is important to understand why lower-income households do not participate in the stock market, which...

We analyze a game between citizens and governments, whose type (benevolent or predatory) is unknown to the public. Opportunistic governments mix between predation and restraint. As long as restraint is observed, political expectations improve, people enter the modern sector, and the economy grows. Once there is predation, the reputation of the gove...

We survey the literature analyzing the price formation and trading process, and the consequences of market organization for price discovery and welfare. We offer a synthesis of the theoretical microfoundations and empirical approaches. Within this framework, we confront adverse selection, inventory costs and market power theories to the evidence on...

We study how securities and issuance mechanisms can be designed to mitigate the adverse impact of market imperfections on liquidity. In our model, asset owners seek to obtain liquidity by selling claims contingent on privately observed future cash-flows. Liquidity suppliers can be competitive or strategic. In the optimal trading mechanism associate...

Operational risk and capital requirements in the European investment fund industry This paper analyses the sources of operational risk in the investment fund industry. An empirical survey documents the extent and origin of operation losses across European fund management companies. We then construct a simple model to highlight the role of capital...

I study the intergenerational transmission of knowledge in the presence of social externalities associated with individual investment decisions (learn-ing and respecting social norms, cooperation with others, human capital). The younger generation's decisions are based on beliefs about the quality of existing institutions, social norms and values;...

We analyse dynamic financial contracting under moral hazard. The ability to rely on future rewards relaxes the tension between incentive and participation constraints, relative to the static case. Managers are incited by the promise of future payments after several successes and the threat of liquidation after several failures. The more severe the...

We analyze empirically the determinants of Eurozone Treasury bills yields. Market microstructure as well as macroeconomic variables are found to significantly impact yields. Secondary trading in a centralized transparent electronic limit order book enhances liquidity and thus reduce yields. Irregularly issuing securities raises the yields governmen...

We study opening prices set simultaneously for German and French stocks in Frankfurt and Paris. In our model investors and traders based in the same country as the firm have better information on its value than foreign traders. Our theory implies that prices set on the domestic market differ from (and are more informationally efficient than) prices...

This paper builds on the case of West African banks to propose an analysis of the issues raised by government interference, privatisation to foreign investors and regulation in developing countries. In the late 1980s, there was a severe crisis in the West African banking system, partly due to government interference. The restructuring of the bankin...

The Internet reduces the cost of exchanging information. Electronic markets exploit this opportunity to enable investors to place quotes at very little cost and compete with incumbent trading systems. Does this quasi--free entry situation lead to competitive liquidity supply? We analyze trades and order placement on Nasdaq and a competing electroni...

This paper analyzes some determinants of profits and deal flows in the venture capital in-dustry. The model studies the problem of an entrepreneur who faces several investors with more information about his project's quality. We explore how the entrepreneur can optimally choose a fund raising strategy to maximize his expected utility. Importantly,...

We analyze theoretically and empirically the implications of heterogeneous information for equilibrium asset pricing and portfolio choice. Our theoretical framework, directly inspired by Admati (1985), implies that with partial information aggregation, portfolio separation fails, buy-and-hold strategies are not optimal, and investors should structu...

We analyze theoretically and empirically the implications of heterogeneous information for equilibrium asset pricing and portfolio choice. Our theoretical framework, directly inspired by Admati (1985), implies that with partial information aggregation, portfolio separation fails, buy-and-hold strategies are not optimal, and investors should structu...

We analyze theoretically and empirically the implications of heterogeneous information for equilibrium asset pricing and portfolio choice. Our theoretical framework, directly inspired by Admati (1985), implies that with partial information aggregation, portfolio separation fails, buy-and-hold strategies are not optimal, and investors should structu...

The Internet technology reduces the cost of transmitting and exchanging information. ECNs exploit this opportunity to enable investors to place quotes at very little cost and compete with incumbent stock exchanges. Does this quasi-free entry situation lead to competitive liquidity supply? We analyze trades and order book dynamics on Nasdaq and Isla...

An informed financial institution can trade on private information and also sell it to clients through a managed fund. To provide an incentive for the informed agent to trade in the interest of her client, the optimal contract requires that she be compensated as an increasing function of the profits of the fund. The optimal contract is also designe...

We survey the literature analysing the price formation and trading process, and the consequences of market organization for price discovery and welfare. We develop a united perspective on theoretical, empirical and experimental approaches. We discuss the evidence on transaction costs and the price impact of trades and its analyses in terms of adver...

In recent years, European financial economists have been brought together, via research projects and conferences, by the Centre for Economic Policy Research (CEPR). These fruitful interactions have contributed to the development of financial economics in Europe, and have generated a strong flow of interesting writing—both theoretical and empirical—...

We analyze politically motivated privatization in a bipartisan environment. When median-class voters a priori favor redistributive policies, a strategic privatization program allocating them enough shares can induce a voting shift away from left-wing parties whose policy would reduce the value of shareholdings. To induce median-class voters to buy...

We analyse the optimal Initial Public Offering (IPO) mechanism in a multidimensional adverse selection setting where institutional investors have private information about the market valuation of the shares, the intermediary has private information about the demand, and the institutional investors and intermediary collude. Theorem 1 states that uni...

We analyse the optimal Initial Public Offering (IPO) mechanism in a multidimensional adverse selection setting where institutional investors have private information about the market valuation of the shares, the intermediary has private information about the demand, and the institutional investors and intermediary collude. Theorem 1 states that uni...

This paper endeavours to shed light on the respective roles of the formal and the informal credit markets in developing countries. We use survey data for manufacturing firms in Côte d'Ivoire, documenting their access to informal credit markets, their investments, and their financing. We confront these data with a simple moral-hazard model of credit...

I study the effects of the heterogeneity of traders' horizon in the context of a 2-period NREE model where all traders are risk averse. Owing to inventory effects, myopic trading behavior generates multiplicity of equilibria. In particu-lar, two distinct patterns arise. Along the first equilibrium, short term traders anticipate higher second period...

This paper offers a counter-argument to Friedman's (In: Essays in Positive Economics, University of Chicago Press, Chicago, 1953) claim that irrational agents are bound to be eliminated by market forces. Consider a financial market where some traders irrationally over- or under-estimate the dividend flow. We show that this irrationality can enhance...

This paper builds on the case of West African banks to propose an analysis of the issues raised by government interference, privatization to foreign investors and regulation, in developing countries. In the late 80s, there was a severe crisis in the West African banking system, partly due to government interference. The restructuring of the banking...

Consider strategic risk-neutral traders competing in schedules to supply liquidity to a risk-averse agent who is privately informed about the value of the asset and his hedging needs. Imperfect competition in this common value environment is analyzed as a multi-principal game in which liquidity suppliers offer trading mechanisms in a decentralized...

Pigovian taxation of externalities has limited appeal if the tortfeaser has insufficient resources to pay the damage when it occurs. To defend Pigovian taxation in the presence of judgement-proof agents, its proponents point at the many institutions extending liability to third parties. Yet little is known about the validity of Pigou's analysis in...

Before the opening of the Paris Bourse, traders place orders and indicative prices are set. This offers a laboratory to study empirically the tatonnement process through which markets discover equilibrium prices. Since preopening orders can be revised or canceled before the opening, indicative prices could be noise. We test this against the hypothe...

We analyze the optimal financing of investment projects when managers must exert unobservable effort and can also switch to less profitable riskier ventures. Optimal financial contracts can be implemented by a combination of debt and equity when the risk-shifting problem is the most severe while stock options are also needed when the effort problem...

We analyse politically motivated privatization design in a bipartisan environment where politicians lack commitment power. Suppose the median class voters a priori favour redistributive policies. If the privatization programme succeeds in allocating enough shares to these citizens, they become averse to redistributive policies, which would be detri...

In dealer markets, liquidity suppliers have entire flexibility to bargain on the price with their customers. In limit order markets, they are restricted to convex schedules: they cannot sell the first share at a higher price than the second. Floor traders simply respond to the liquidity demand conveyed by brokers by crying out one price. In floor m...

Speculators buy an asset hoping to sell it later to investors with higher private valuations. If agents are uncertain about the distribution of private valuations and about the beliefs of others about this distribution, a beauty contest with an infinite hierarchy of beliefs arises. Under Harsanyi's assumption of a common prior the infinite beliefs...

Consider strategic risk-neutral traders competing in schedules to supply liquidity to a risk-averse agent who is privately informed about the value of the asset and his hedging needs. Imperfect competition in this common¨aluecommon¨alue en¨ironment is analyzed as a multi-principal game in which liquidity suppliers offer trading mechanisms in a dece...

In dealer markets, liquidity suppliers have entire flexibility to bargain on the price with their customers. In limit order markets, they are restricted to convex schedules: they cannot sell the first share at a higher price than the second. Floor traders simply respond to the liquidity demand conveyed by brokers by crying out one price. In floor m...

In the Paris Bourse some stocks are traded on a spot basis, while others are traded on a monthly settlement basis. The latter are likely to be less subject to leverage and short sales constraints. We empirically analyze the consequences of this difference on the order flow and the return process. Consistent with the theoretical analysis of Diamond...

Asymmetric information between banks and firms can preclude financing of valuable projects. Trade credit alleviates this problem by incorporating in the lending relation the private information held by suppliers about their customers. Incentive compatibility conditions prevent collusion between two of the agents (e.g., the buyer and the seller) aga...