Rangarajan K. Sundaram

• New York University

We address the paradox that financial innovations aimed at risk-sharing appear to have made the world riskier. Financial innovations facilitate hedging idiosyncratic risks among agents; however, aggregate risks can be hedged only with liquid assets. When risk-sharing is primitive, agents self-hedge and hold more liquid assets; this buffers aggregat...

In this paper, we examine a novel two-stage mechanism for selling government securities, wherein the dealers underwrite in the first stage the sale of securities, which are auctioned in stage 2 via either a discriminatory auction (DA) or a uniform price auction (UPA). Using proprietary data on auctions during 2006–2013, we find that (a) the first s...

This article studies bidding behavior in the novel and complex auctions that, since 2005, have determined recovery rates in the multi-trillion dollar credit default swap (CDS) market. We find that bids are substantially influenced by inventory effects (bidders' CDS positions entering the auction), market illiquidity, and "winners curse" considerati...

Two recent studies have found that the prices at which CDS auctions clear tend to differ substantially from both pre- and post-auction prices of the underlying bonds in the market. In particular, CDS "sell" auctions appear to result in systematic underpricing, and CDS "buy" auctions in systematic overpricing, of the bonds relative to market prices....

In 2005, the International Swaps and Derivatives Association (ISDA) introduced an auction mechanism to facilitate settlement following a credit event in the multi-trillion-dollar credit-default swap (CDS) market. The auction identifies a price for the defaulted instrument and this price is then used to cash-settle CDS contracts with protection sell...

Introduced in 2005 to identify recovery rates and so facilitate cash settlement in the multi-trillion dollar credit default swap market, credit-event auctions have a novel and complex two-stage structure that makes them distinct from other auction forms. Examining the efficacy of the auction's price-discovery process, we find that the auction price...

Credit-event auctions were introduced in 2005 to facilitate cash settlement in the credit default swap market following a credit event. They have a novel two-stage structure that makes them distinct from other auction forms. This paper studies outcomes in credit-event auctions over the period 2008-10.Our analysis is in three parts. In the first par...

The bursting of the housing price bubble during 2007 and 2008 was accompanied by high interbank spreads, and a partial breakdown of interbank lending. This paper models Knightian uncertainty over banks risk exposures and shows how it may have contributed to the collapse of interbank lending. The main finding is that institutional aspects of the Fed...

IntroductionCorporate Governance at LCFIsDid Governance Fail?Compensation at Financial FirmsNotes

The Rescue PackageThe Implications: Questions of InterestThe Capital Injection SchemeThe Commercial Paper Funding FacilityPolicy RecommendationsNotes

We investigate the impact of bankruptcy codes on firms’ capital-structure choices. We develop a theoretical model to identify how firm characteristics may interact with the bankruptcy code in determining optimal capital structures. A novel and sharp empirical implication emerges from this model: that the difference in leverage choices under a relat...

We develop a model for pricing securities whose value may depend simultaneously on equity, interest rate, and default risks. The framework may also be used to extract probabilities of default (PD) functions from market data. Our approach is entirely based on observables such as equity prices and interest rates, rather than on unobservable processes...

Though widely used in executive compensation, inside debt has been almost entirely overlooked by prior work. We initiate this research by studying CEO pension arrangements in 237 large capitalization firms. Among our findings are that CEO compensation exhibits a balance between debt and equity incentives; the balance shifts systematically away from...

Recent work in corporate finance has suggested that strategic debt-service by equity-holders works to lower debt values and raise yield spreads substantially. We show that this is not quite correct. With optimal cash management, defaults occassioned by deliberate underperformance (strategic defaults) and those forced by inadequate cash (liquidity d...

In recents years, some executives have been permitted by firms to rescind stock option exercise decisions by returning the stock to the company for a refund of the exercise price. Such rescissions have been widely condemned as weakening incentives. We find that rescissions often deliver the same incentive payoffs as a standard option but at a lower...

We develop a model for pricing derivative and hybrid securities whose value may depend on different sources of risk, namely, equity, interest-rate, and default risks. In addition to valuing such securities the framework is also useful for extracting probabilities of default (PD) functions from market data. Our model is not based on the stochastic p...

We provide an economic basis for permitting freezeouts of nontendering shareholders following successful takeovers. We describe a specific freezeout mechanism based on easily verifiable information that induces desirable efficiency and welfare properties in models of both corporations with widely dispersed shareholdings and corporations with large...

We investigate the impact of bankruptcy codes on firms' capital-structure choices. We develop a theoretical model to identify how firm characteristics may interact with the bankruptcy code in determining optimal capital structures. A novel and sharp empirical implication emerges from this model: that the difference in leverage choices under a relat...

We develop a model for pricing derivative and hybrid securities whose value may depend on different sources of risk, namely, equity, interest-rate, and default risks. In addition to valuing such securities the framework is also useful for extracting probabilities of default (PD) functions from market data. Our model is not based on the stochastic p...

This paper develops a model for pricing securities that may be a function of several different sources of risk, namely, equity, interest-rate, default and liquidity risks. The model is also useful for extracting probabil- ities of default (PD) functions from market data. The model is not based on the stochastic process for the value of the firm, bu...

Recent work has suggested that strategic underperformance of debt-service obligations by equity holders can resolve the gap between observed yield spreads and those generated by Merton-style models. We show that this is not quite correct. The value of the option to underperform on debt-service obligations depends on two other optionalities availabl...

We develop a model for pricing risky debt and valuing credit derivatives that is easily calibrated to existing variables. Our approach is based on expanding the Heath-Jarrow-Morton (1990) term-structure model and its extension, the Das-Sundaram (2000) model to allow for defaultable debt with rating transitions. The framework has two salient feature...

We study executive stock options that permit the option holder to rescind an exercise decision, returning the shares acquired to the company and obtaining a refund of the exercise price. Rescissions occurred at a number of U.S. companies in 2000 after the large decline in internet stocks, and have been widely condemned as a weakening of incentives....

This article develops a simple approach to solving continuous-time portfolio choice problems. Portfolio problems for which no closed-form solutions are available may be handled by this technique, which substitutes the numerical solution of partial differential equations with a non-linear numerical algorithm approximating the solution. This paper co...

We study the relationship between rationality and economic survival in a simple dynamic model, where agents from different populations interact repeatedly through random matching. An explicit criterion ("bankruptcy") determines whether agents survive each interaction; all agents are presumed to be aware of this criterion. Survival in each interacti...

The fee structure used to compensate investment advisers is central to the study of fund design, and affects investor welfare in at least three ways: (i) by influencing the portfolio-selection incentives of the adviser, (ii) by affecting risk-sharing between adviser and investor, and (iii) through its use as a signal of quality by superior investme...

We present a cash-flow based model of corporate debt valuation that incorporates two novel features. First, we allow for the separation and optimal determination of the firm's debt-service and dividend policies; in particular, the firm is allowed to maintain cash reserves to meet future debt obligations. Second, our model admits the possibility tha...

The practice of resetting strike prices on underwater executive stock options has drawn criticism for weakening managerial incentives. Our model shows that although the anticipation of resetting can negatively affect initial incentives, resetting can still be an important, value-enhancing aspect of compensation contracts, even from an ex-ante stand...

This paper develops a framework for modelling risky debt and valuing credit derivatives that is flexible and simple to implement, and that is, to the maximum extent possible, based on observables. Our approach is based on expanding the Heath-Jarrow-Morton term-structure model to allow for defaultable debt. Rather than follow the procedure of implyi...

The Investment Advisers Act of 1940 (as amended in 1970) prohibits mutual funds in the US from offering their advisers asymmetric "incentive fee" contracts in which the advisers are rewarded for superior performance via-a-vis a chosen index but are not correspondingly penalized for underforming it. The rationale offered in defense of the regulation...

An extensive empirical literature in finance has documented not only the presence of anomalies in the Black-Scholes model, but also the term structures of these anomalies (for instance, the behavior of the volatility smile or of unconditional returns at different maturities). Theoretical efforts in the literature at addressing these anomalies have...

Recent empirical work has documented the tendency of corporations to reset strike prices on previously-awarded executive stock option grants when declining stock prices have pushed these options out-of-the-money. This practice has been criticized as counter-productive since it weakens incentives present in the original award. This paper sets up a t...

This paper develops a framework for modelling risky debt and valuing credit derivatives that is flexible

An extensive empirical literature in finance has documented not only the presence of anamolies in the Black-Scholes model, but also the "term-structures" of these anamolies (for instance, the behavior of the volatility smile or of unconditional returns at different maturities). Theoretical efforts in the literature at addressing these anamolies hav...

This paper develops a framework for modelling risky debt and valuing credit derivatives that is exible and simple to implement, and that is, to the maximum extent possible, based on observables. Ourapproach is based on expanding the Heath-Jarrow-Morton term-structure model to allow for defaultable debt. We do not follow the procedure of implying ou...

This paper studies the interaction between a single long-lived principal and a series of short-lived agents in the presence of both moral hazard and adverse selection. We assume that the principal can influence the agents' behavior only through her choice of a retention rule; this rule is further required to be sequentially rational (i.e., no preco...

We examine the practice of resetting the terms of previously-issued executive stock options. We identify properties of reset options, develop a model for valuing resettable options, and characterize the firms that have reset options. We find the vast majority of options are reset at-the-money, resulting, on average, in the strike price dropping 40%...

There have been systematic attempts over the last twenty-five years to explore the implications of decision making with incomplete information and to model an 'economic man' as an information-processing organism. These efforts are associated with the work of Roy Radner, who joins other analysts in this collection to offer accessible overviews of th...

The Investment Advisors Act of 1940 (as amended in 1970) prohibits mutual funds in the US from offering their advisers asymmetric incentive fee' contracts in which the advisers are rewarded for superior performance via-a-vis a chosen index but are not correspondingly penalized for underperforming it. The rationale offered in defense of the regulati...

We offer an alternative framework for the analysis of mutual fund structure and use it to examine the rationale behind existing regulations that require mutual fund adviser fees to be of the “fulcrum” variety. We find little justification for the regulations. Indeed, we find that asymmetric “incentive fees” in which the adviser receives a flat fee...

This paper studies the interaction between a single long-lived principal and a series of short-lived agents in the presence of both moral hazard and adverse selection. We assume that the principal can influence the agents' behavior only through her choice of a retention rule; this rule is further required to be sequentially rational (i.e., no preco...

Existing regulations require fee structures used to compensate advisers in the mutual fund industry to be the "fulcrum" variety, decreasing for underperforming a given index in the same way in which they increase for outperforming it. In this paper, we offer a new model for analysing the mutual fund industry, and use this model to examine the impac...

It is widely acknowledged that many financial markets exhibit a considerably greater degree of kurtosis (and sometimes also skewness) than is consistent with the Geometric Brownian Motion model of Black and Scholes (1973). Among the many alternative models that have been proposed in this context, two have become especially popular in recent years:...

This paper describes basic auction concepts, and provides a summary of the theory in this area, particularly as it relates to Treasury auctions.

This 1996 book introduces students to optimization theory and its use in economics and allied disciplines. The first of its three parts examines the existence of solutions to optimization problems in Rn, and how these solutions may be identified. The second part explores how solutions to optimization problems change with changes in the underlying p...

The Theorem of Gittins and Jones (1974) is, perhaps, the single most powerful result in the literature on Bandit problems. This result establishes that in independent-armed Bandit problems with geometric discounting over an infinite horizon, all optimal strategies may be obtained by solving a family of simple optimal stopping problems that associat...

We provide a complete characterization of the set of Markov-Perfect Equilibria (MPE) of dynamic common-property resource games a la Levhari and Mirman (1980). We find that all MPE of such games exhibit remarkably regular dynamic behavior. Surprisingly, however, and despite their memoryless nature, MPE need not result in a "tragedy of the commons",...

We introduce a new hybrid approach to joint estimation of Value at Risk (VaR) and Expected Shortfall (ES) for high quantiles of return distributions. We investigate the relative performance of VaR and ES models using daily returns for sixteen stock market indices (eight from developed and eight from emerging markets) prior to and during the 2008 fi...

We provide a complete characterization of the set of Markov-Perfect Equilibrium (MPE) of dynamic common-property resource games a la Levhari and Mirman (1980). We find that all MPE of such games exhibit remarkably regular dynamic behavior. Surprisingly, however, and despite their memoryless nature, MPE need not result in a "tragedy of the commons",...

This paper shows that the dynamic implications of strategic behavior can differ remarkably from those obtained under first-best or "competitive" solutions. We employ the framework of common-property resource models, whose first-best version is the familiar neoclassical growth paradigm. As is well known, Markovian first-best solutions always exist h...

We consider the class of bandit problems in which each of the n≥2 independent arms generates rewards according to one of the same two reward distributions, and discounting is geometric over an infinite horizon. We show that the dynamic allocation index of C. J. Gittins and D. M. Jones [Colloq. Math. Soc. János Bolyai (1974; Zbl 0303.62064)] in this...

We consider the class of bandit problems in which each of the n ≧ 2 independent arms generates rewards according to one of the same two reward distributions, and discounting is geometric over an infinite horizon. We show that the dynamic allocation index of Gittins and Jones (1974) in this context is strictly increasing in the probability that an a...

We study a strategic version of the neoclassical growth model under possible production uncertainty. For a general specification of the problem, we establish (1) the existence of stationary Markov equilibria in pure strategies for the discounted game, and (2) the convergence, under a boundedness condition, of discounted equilibrium strategies to a...

This paper studies the class of denumerable-armed (i.e., finite- or countably infinite-armed) Bandit problems with independent arms and geometric discounting over an infinite horizon in which each arm generates rewards according to one of a finite number of distributions. The authors derive certain continuity and curvature properties of the Gittins...

We examine conditions under which the solutions to parametric families of dynamic programming problems are continuous in the parameters. Our main results are that parametric continuity obtains whenever either (a) the family of dynamic programming problems satisfies strong (joint-) continuity properties in the parameter and state or (b) if it satisf...

In "Bayesian Economists ... Bayesian Agents I" (BBI), we generalized the results on Bayesian learning based on the martingale convergence theorem from the repeated to the sequential framework. In BBI, we showed that the variability introduced by the sequential framework is sufficient under very mild identifiability conditions to circumvent the inco...

This paper complements the findings of Atal, Ñopo and Winder (2009) on gender and ethnic wage gaps for 18 Latin American countries circa 2005 by analyzing gender wage gaps for the same countries between circa 1992 and circa 2007. During this span the overall gender earnings gaps dropped about 7 percentage points, while the unexplained component dro...

We study the framework of optimal decision making under uncertainty where the agents do not know the full structure of the model and try to learn it optimally. We generalize the results on Bayesian learning based on the martingale convergence theorem to the sequential framework instead of the repeated framework for which results are currently avail...

We study the structure of Nash equilibria in 2-player repeated games played with finite automata, when complexity considerations matter. We argue that the traditional number-of-states measure of complexity of an automaton neglects some essential features such as informational requirements at a state. We propose a criterion of complexity to remedy t...

This paper considers a class of infinite-horizon dynamic games that has immediate application to problems stemming from the oligopolistic exploitation of (renewable or non-renewable) common property resources. Under a symmetry assumption on the payoff structure, it is shown that the game admits a subgameperfect equilibrium in non-randomized Markovi...

In this work we examine the relationship between axiomatic structure and the classical derivation of a von Neumann⧸Morgenstern characteristic function for an N-person game. We show that it is possible to construct a von Neumann⧸Morgenstern characteristic function from weaker assumptions on the preference ordering on a mixture space that is generate...

A two-person discounted stochastic game (see, e.g., [15] and [17] for related references) is described by a tuple S,A 1 (s),A 2(s),q,r 1,r 2,β having the following interpretation: S, a non-empty Borel subset of a Polish space, is the set of all states of the system; A i (s), a non-empty Borel subset of a Polish space, is the set of actions availa...

This chapter examines a number of extensions of the multi-armed bandit framework. We consider the possibility of an infinite number of available arms, we give conditions under which the Gittins index strategy is well-defined, and we examine the optimality of that strategy. We then consider some difficulties arising from “parallel search,” in which...

Recent work in corporate finance has suggested that strategic debt-ser- vice by equity-holders works to lower debt values and raise yield spreads sub- stantially. We show that this is not quite correct. With optimal cash management, defaults occassioned by deliberate underperformance (strategic defaults) and those forced by inadequate cash (liquidi...