We show theoretically that while cash allows financially constrained firms to hedge future investment against income shortfalls, reducing current debt is a more effective way to boost investment in future high cash flow states. Thus, constrained firms prefer higher cash to lower debt if their...

Insider trading in the credit derivatives market has become a significant concern for regulators and participants. This paper attempts to quantify the problem. Using news reflected in the stock market as a benchmark for public information, we report evidence of significant incremental...

We show that limited liability can induce profit-maximizing bank owners to herd with other banks. When bank loan returns have a systematic factor, the failure of one bank conveys adverse information about this systematic factor and increases the cost of borrowing for the surviving banks relative...

This paper studies equilibrium asset pricing with liquidity risk - the risk arising from unpredictable changes in liquidity over time. It is shown that a security's required return depends on its expected illiquidity and on the covariances of its own return and illiquidity with market return and...

Two aspects of systemic risk, the risk that banks fail together, are modeled and their interaction examined: First, the ex-post aspect, in which the failure of a bank brings down a surviving bank as well, and second, the ex-ante aspect, in which banks endogenously hold correlated portfolios...

We study two-period pure-exchange Capital Asset Pricing Model (CAPM) economies with a given degree of incompleteness of financial markets and given degrees of restricted participation of agents in the markets.We characterize the optimal financial asset structure and the optimal composition of...

This paper analyzes corporate bond valuation and optimal call and default rules when interest rates and firm value are stochastic. It then uses the results to explain the dynamics of hedging. Bankruptcy rules are important determinants of corporate bond sensitivity to interest rates and firm...

We examine the regulatory design problem of a central bank whose objective is to ensure an optimal level of individual as well as systemic risk of bank failure in an economy with possibly heterogeneous banks. We model systemic risk as the endogenously chosen correlation of returns on assets held...

I analyze the joint design of two bank regulatory mechanisms: minimum capital requirements, which are an ex-ante mechanism to prevent bank failures, and closure policy, which is an ex-post mechanism to manage the cost of bank failures. At the heart of the paper is a simple but fundamental point:...

What is the effect of financial crises and their resolution on banks' choice of liquid asset holdings? When risky assets have limited pledgeability and banks have relative expertise in employing risky assets, the market for these assets clears only at fire-sale prices following a large number...