Essays in Financial Economics

Abstract

This dissertation consists of two chapters. The first chapter studies the spillover effect of fire sales transmitted by dealers in the corporate bond market. I use the monthly exclusion events from the Bloomberg Barclays US Corporate Index to identify dealers stressed from taking an unusually large amount of excluded bonds. Stressed dealers actively offload non-excluded bonds. Due to the fact that a stressed dealer is more effective at trading bonds in which she has a higher market share of volume, she sells more of those bonds. On the bond level, non-excluded bonds that are collectively traded more by stressed dealers experience lower returns and worse liquidity even 6 months after the event. Finally, I examine the impact of the Volcker Rule on the fire sale spillover and find that the spillover effect is stronger under the Volcker Rule than under the preceding Dodd-Frank Act. The results are consistent with the view that the Volcker Rule hinders liquidity provision of bank-affiliated dealers. The second chapter is joint work with Lucas Rooney and Mark Westerfield. We present a model in which an agent exerts hidden effort to create unobservable and durable expertise (human capital) that generates noisy cash flows. The impact of the agent's effort is long-lasting, so the agent responds to the entire stock of future cash-flow rights (pay-for-performance). The principal manages this promise of future cash flow rights, which must be consistent across time. The optimal contract features two regions. When the stock of future cash flow rights is low, the contract resembles training in which the principal builds up a stock of future pay-for-performance sensitivities by offering none today -- pushing cash flow sharing into the future. Once the stock future cash flow rights reaches a threshold, the contract enters the active region in which the principal uses short-term cash flow rights to control the growth of the package of incentives and the path of the agent's effort. In the active region, the correlation between cash flows and future cash flow rights is optimally negative, meaning good performance results in higher future consumption and lower future expertise.