Associate Professor of
Finance, Paul H. Stephens Chair in Applied Investment Analysis, Haas School of Business, University of California, Berkeley
Research Associate,
National Bureau of Economic Research (NBER)
Research Fellow,
Centre for Economic Policy Research (CEPR)
Contact Information
F628 Faculty Building
Berkeley
CA 94720
E-mail: garleanu@haas.berkeley.edu
Office phone: (1) 510 642 3421
Fax : (1) 510 643 1420
"Displacement Risk and Asset Returns" (with
Leonid Kogan and Stavros Panageas). Journal of Financial Economics, vol. 105 (2012), issue 3, pp. 491-510.
Best-Paper Award at the Utah Winter Finance Conference, 2011.
If innovation benefits the
young at the expense of the old, then growth firms are a good hedge, while risk premia are larger
and interest rates smaller than in the classical Lucas-tree model. Theory, supporting empirical
evidence, and numerical calibration. Abstract.
"Technological Growth and Asset Prices" (with Stavros Panageas
and Jianfeng Yu). Journal of Finance, vol. 67 (2012), issue 4, pp. 1265-1292.
Smith Breeden Prize (first prize), 2012.
Large-scale technological innovations followed with some delay
by increased investment and consumption can help explain a number of properties
of the joint behavior of consumption and asset prices.
Abstract.
"Margin-Based Asset Pricing and the Law of One Price" (with Lasse Heje
Pedersen). Review of Financial Studes, vol. 24 (2011), no. 6, pp. 1980-2022.
Michael Brennan Award for Best Paper in the RFS, 2012.
Higher-margin securities have higher returns and volatilities, especially during credit crises.
Theory and empirics. Abstract.
"Two Monetary Tools: Interest Rates and Haircuts" (with Adam
Ashcraft and Lasse Heje Pedersen).
NBER Macroeconomics Annual (2010).
Reducing
security margins, e.g., as the TALF did, can have significant pricing implications. Theory and
empirics. Abstract.
"Pricing and Portfolio Choice in Illiquid Markets"
Journal of Economic Theory, vol. 144 (2009), no. 2, pp. 532-564.
The effect of the inability to trade immediately on optimal portfolio
choice and equilibrium price.
Abstract.
"Demand-Based Option Pricing" (with Lasse Heje Pedersen and Allen Poteshman).
The Geewax, Terker, & Company First Prize in Investment Research,
Rodney White Center, 2006.
Review of Financial Studies, vol. 22 (2009), no. 10, pp. 4259-4299.
The effect of end-user demand on option prices when dealers cannot perfectly hedge. Theory and supportive empirics.
Abstract.
"Liquidity and Risk Management"
(with Lasse Heje Pedersen).
American Economic Review Papers and Proceedings, vol. 97 (2007), pp. 193-197.
Stricter risk-management requirements can reduce liquidity (and prices), especially if they are tied to the liquidity level.
Abstract.
"Valuation in Over-the-Counter Markets"
(with Darrell Duffie and Lasse Heje Pedersen).
Review of Financial Studies, vol. 20 (2007), no. 5, pp. 1865-1900.
The effect of search and bargaining on asset prices.
Abstract.
"Design and Renegotiation of Debt Covenants" (with Jeffrey Zwiebel)
Review of Financial Studies, vol. 22 (2009), no.2, pp. 749-781.
The creditor, having inferior information, receives stronger control rights -- i.e., covenants are stricter -- than optimal.
Abstract.
"Over-the-Counter Markets"
(with Darrell Duffie and Lasse Heje Pedersen).
Econometrica, vol 73 (2005), pp. 1815-1847.
Marketmakers' spread is narrower for sophisticated investors with better search options (NB: reverse of information-based models).
Abstract.
"Adverse Selection and the Required Return"
(with Lasse Heje Pedersen).
Review of Financial Studies,
vol. 17 (2004), no. 3, pp. 643-665.
Future adverse-selection based bid-ask spreads need not constitute a trading cost. Abstract.
"Securities Lending,
Shorting, and Pricing"
(with Darrell Duffie and Lasse Heje Pedersen).
NYSE Award for best paper on equity trading, Western Finance Association,
2002.
Journal of Financial Economics,
vol. 66 (2002), pp. 307-339.
Short sellers search for stock owners and pay a lending fee. The lending fee, acting as a dividend, increases the stock's price.
Abstract.
"Risk and Valuation of Collateral Debt Obligations"
(with Darrell Duffie).
Graham and Dodd Award of Excellence, Association for Investment Management and Research,
2001.
Financial Analysts Journal,
vol.57 (2001), no. 1 (January-February), pp. 41-59.
Model CDOs to calcluate value of each tranche. Compare risk estimates with those of rating
agencies.
Abstract.
"Auctions with Endogenous Selling" (with Lasse Heje Pedersen).
The effect of market structure on volume, prices, and welfare, when owners and potential buyers have information.
Abstract.
"Young, Old,
Conservative, and Bold: The Implications of Heterogeneity and Finite Lives for Asset
Pricing" (with Stavros Panageas).
Solution of the two-person problem with recursive
utilities and overlapping generations. Highlight impact on asset-pricing moments. Abstract.
"Design and Renegotiation of Debt Covenants"
We analyze the design and renegotiation
of covenants in debt contracts as a particular example of the contractual
assignment of property rights under asymmetric information. In
particular, we consider a setting where future firm investments
are efficient in some states, but also involve a transfer from the
lender(s) to shareholders. While there is symmetric information
regarding investment efficiency, managers are better informed
about any potential transfer than the lender. The lender can
learn this information, but at a cost. In this setting, we show
that the simple adverse selection problem leads to the allocation
of greater ex-ante decision rights to the uninformed party than
would follow under symmetric information. Consequently, ex-post
renegotiation is in turn biased towards the uninformed party
giving up these excessive rights. In many settings, this result
yields the opposite implication from standard Property Rights
results regarding contracting under incomplete contracts and
ex-ante investments, whereby rights should be allocated to
minimize inefficiencies due to distortions in ex-ante investments.
Indeed, for debt contracts as well as other settings, the
uninformed party, who receives strong decision rights in our
setting, is likely to have few significant ex-ante investments to
undertake relative to the informed party.
"Over-the-Counter Markets"
We study how intermediation and asset prices in over-the-counter
markets are affected by illiquidity associated with search and
bargaining. We compute explicitly the prices at which investors
trade with each other, as well as marketmakers' bid and ask prices
in a dynamic model with strategic agents. Bid-ask spreads are lower
if investors can more easily find other investors, or have easier
access to multiple marketmakers. With a monopolistic marketmaker,
bid-ask spreads are higher if investors have easier access to the
marketmaker. We characterize endogenous search and welfare, and
discuss empirical implications.
"Adverse Selection and the Required Return"
An important feature of financial markets is that securities are
traded repeatedly by asymmetrically informed investors. We study
how current and future adverse selection affect the required
return. We find that the bid-ask spread generated by adverse
selection is not a cost, on average, for agents who trade, and
hence the bid-ask spread does not directly influence the required
return. Adverse selection contributes to trading-decision
distortions, however, implying allocation costs, which affect the
required return. We explicitly derive the effect of adverse
selection on required returns, and show how our result differs
from models that consider the bid-ask spread to be an exogenous
cost.
"Securities Lending, Shorting, and Pricing"
We present a model of asset valuation in which short-selling is
achieved by searching for security lenders and by bargaining over
the terms of the lending fee. If lendable securities are
difficult to locate, then the price of the security is initially
elevated, and expected to decline over time. This price decline is
to be anticipated, for example, after an initial public offering
(IPO), among other cases, and is increasing in the degree of
heterogeneity of beliefs of investors about the likely future
value of the security. The prospect of lending fees may push the
initial price of a security above even the most optimistic buyer's
valuation of the security's future dividends. A higher price can
thus be obtained with some shorting than if shorting is
disallowed.
"Risk and Valuation of Collateral Debt Obligations"
This paper addresses the risk analysis and market valuation of collateralized
debt obligations (CDOs). We illustrate the effects of correlation and prioritization for the market valuation, diversity score, and risk of CDOs, in a simple jump-diffusion setting for correlated default intensities.
"Valuation in Over-the-Counter Markets"
"Auctions with Endogenous Selling"
"Demand-Based Option Pricing"
We provide the impact on asset prices of search-and-bargaining
frictions in over-the-counter markets. Under certain conditions,
prices are lower and illiquidity discounts higher when
counterparties are harder to find, when sellers have less
bargaining power, when the fraction of qualified owners is
smaller, or when risk aversion, volatility, or hedging demand
are larger. If agents face risk limits, then higher volatility
leads to greater difficulty locating unconstrained buyers,
resulting in lower prices.
We discuss a variety of
financial applications and testable implications.
The seminal paper by Milgrom and Weber (1982) ranks the expected revenues of
several auction mechanisms, taking the decision to sell as
exogenous. We endogenize the sale decision. The owner decides
whether or not to sell, trading off the conditional expected revenue
against his own use value, and buyers take into account the
information contained in the owner's sale decision. We show that
revenue ranking implies volume and welfare ranking under certain
general conditions. We use this to show that, with affiliated
signals, English auctions have larger expected price, volume, and
welfare than second-price auctions, which in turn have larger
expected price, volume, and welfare than first-price auctions.
We model
"Pricing and Portfolio Choice in Illiquid Markets"
This paper studies portfolio choice and pricing in markets in which immediate trading may be
impossible. It departs from the literature by removing restrictions on asset holdings, and finds
that optimal positions depend significantly and naturally on liquidity: When expected future
liquidity is high, agents take more extreme positions, given that they do not have to hold those
positions for long when they become undesirable. Consequently, larger trades should be observed
in markets with more frequent trading. Liquidity need not affect the price significantly, however,
because liquidity has offsetting impacts on different agentsf demands. This result highlights the
importance of unrestricted portfolio choice. The paper draws parallels with the transaction-cost
literature and clarifies the relationship between the price level and the realized trading frequency
in this literature.
"Young, Old, Conservative, and Bold: The Implications
of Heterogeneity and Finite Lives for Asset Pricing"
We study the implications of
preference heterogeneity for asset pricing. We use recursive preferences in order to separate
heterogeneity in risk aversion from heterogeneity in the intertemporal elasticity of substitution,
and an overlapping-generations framework to obtain a non-degenerate stationary equilibrium. We
solve the model explicitly up to the solutions of ordinary differential equations, and highlight
the effects of overlapping generations and each dimension of preference heterogeneity on the market
price of risk, interest rates, and the volatility of stock returns.
"The Demographics of Innovation and Asset Returns"
We study an overlapping-generations economy in which new agents innovate and
introduce new products and firms. Innovation is stochastic. The new firms
increase overall productivity, but also steal business from pre-existing
firms. Furthermore, the human capital of existing agents decreases, relatively,
with innovation. Consequently, increased innovation activity hurts existing agents
at the same time that firms that benefit from innovation do well. This phenomenon
confers a hedging value to such firms, i.e., the model produces a value effect.
At the aggregate level the
human-capital risk makes agents reluctant to hold stock of existing firms,
since their profits are collectively at risk from new entrants. This leads
to a higher equity premium and a lower risk-free rate. We calibrate the
model so that it matches estimated cohort effects for individuals and
firms, and evaluate its quantitative implications.
"Dynamic Trading with Predictable Returns and Transaction Costs"
This paper derives in closed form the optimal dynamic portfolio
policy when trading is costly and security returns are predictable
by signals with different mean-reversion speeds. The optimal updated
portfolio is a linear combination of the existing portfolio, the
optimal portfolio absent trading costs, and the optimal portfolio
based on future expected returns and transaction costs. Predictors
with slower mean reversion (alpha decay) get more weight since they
lead to a favorable positioning both now and in the future. We
implement the optimal policy for commodity futures and show that the
resulting portfolio has superior returns net of trading costs
relative to more naive benchmarks. Finally, we derive natural
equilibrium implications, including that demand shocks with faster
mean reversion command a higher return premium.
"Margin-Based Asset Pricing and the Law of One Price"
In a model with multiple agents with different risk aversions facing
margin constraints, we show how securities' required returns are
characterized both by their beta and their margins. Negative shocks to
fundamentals make margin constraints bind, lowering risk free rates and
raising required Sharpe ratios of risky securities, especially for
high-margin securities. Such a funding liquidity crisis gives rise to a
``basis,'' that is, a price gap between securities with identical
cash-flows but different margins. In the time series, the basis depends on
the shadow cost of capital which can be captured through the interest-rate
spread between collateralized and uncollateralized loans, and, in the
cross section, it depends on relative margins. We apply the model
empirically to the CDS-bond basis and other deviations from the Law of One
Price, and to price the Fed's lending facilities.
"Technological Growth and Asset Prices"
In this paper we study the implications of general-purpose technological growth for asset prices.
The model features two types of shocks: ``small", frequent, and disembodied shocks to productivity
and ``large" technological innovations, which are embodied into new vintages of the capital stock.
While the former affect the economy on impact, the latter affect the economy with lags, since firms
need to first adopt the new technologies through investment. The process of adoption leads to
cycles in asset valuations and risk premia as firms convert the growth options associated with the
new technologies into assets in place. This process can help provide a unified, investment-based
view of some well documented phenomena such as the asset-valuation patterns around major
technological innovations, the countercyclical behavior of returns, the lead-lag relationship
between the stock market and output, and the increasing patterns of consumption-return correlations
over longer horizons.
"Two Monetary Tools: Interest Rates and Haircuts"
We study a production economy with multiple sectors financed by issuing securities to agents who
face capital constraints. Binding capital constraints propagate business cycles, and a reduction of
the interest rate can increase the required return of high haircut assets since it can increase the
shadow cost of capital for constrained agents. The required return can be lowered by easing funding
constraints through lowering haircuts. To assess empirically the power of the haircut tool, we
study the natural experiment of the introduction of the legacy Term Asset-Backed Securities Loan
Facility (TALF). By considering unpredictable rejections of bonds from TALF, we estimate that
haircuts had a signi - cant e ect on prices. Further, unique survey evidence suggests the effect
could be more than 3% and provides broader evidence on the demand sensitivity to haircuts.