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

"Dynamic Portfolio Choice with Frictions" (with Lasse Heje Pedersen). Appendix.
*Journal of Economic Theory*, vol. 165 (2016), pp. 487-516.

Tractable continuous-time model of portfolio choice with transaction costs and many securities and predictors. Conditions for transitory transaction costs in continuous time. Broad applicability to economics and even beyond.
Abstract.

"Financial Entanglement: A Theory of Incomplete Integration, Leverage, Crashes, and Contagion" (with Stavros Panageas and Jianfeng Yu).

* American Economic Review*, vol. 105 (2015), issue 7, pp. 1979-2010.

Tractable model of incomplete integration, which generates contagion. Leverage may arise endogenously, and can cause crashes.
Abstract.

"Young, Old,
Conservative, and Bold: The Implications of Heterogeneity and Finite Lives for Asset
Pricing" (with Stavros Panageas).

* Journal of Political Economy*, vol. 123 (2015), issue 3, pp. 670-685.

Solution of the two-person problem with recursive
utilities and overlapping generations. Highlight implications for asset pricing. Abstract.

"Dynamic Trading with Predictable Returns and Transaction Costs" (with Lasse Heje Pedersen).
* Journal of Finance*, vol. 68 (2013), issue 6, pp. 2309-2340.

The optimal dynamic portfolio policy when security returns are predictable --
possibly by several predictors with different precisions and persistence -- and
trading is costly.
Abstract.

"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.

"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.

"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.
"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.

"Impediments to Financial Trade: Theory and Applications" (with Stavros Panageas and Jianfeng Yu).

Theoretical model showing how information asymmetries can translate into bilateral taxes on investing in various different ''locations.'' This can justify observed portfolio biases, including non-participation in certain asset classes. Abstract.

"Efficiently Inefficient Markets for Assets and Asset Management" (with Lasse Heje Pedersen).

*AIM Investment Center Best Paper Award, 2016.*

Model investors having to pay cost to match with good asset managers. The equilibrium links the efficiency of the asset market with that of the market for managers.

Abstract.

"Drifting Apart: The Pricing of Assets when the Benefits of Growth are not Shared Equally" (with Stavros Panageas, Dimitris Papanikolau, and Jianfeng Yu).

Market dividends grow about 2% more slowly than aggregate dividends, due to firm entry. The identified wedge between aggregate and market is priced and can explain about one third of equity premium.
Abstract.

"What to Expect when Everyone is Expecting: Self-Fulfilling Expectations and Asset-Pricing Puzzles" (with Stavros Panageas). Coming soon.

Grapes-to-wine approach to building asset-pricing models. Using extrinsic uncertainty as device, can specify asset prices and derive and evaluate necessary properties of fundamentals.
Abstract.

- Cheit Award for Excellence in Teaching, PhD Program, 2012

- Smith Breeden Prize (first prize) for the best paper published in Journal of Finance in areas other than corporate finance, 2012 ("Technological Growth and Asset Prices")
- Michael Brennan Award for Best Paper in the RFS, 2012 ("Margin-Based Asset Pricing and the Law of One Price")
- Best-Paper Award at the Utah Winter Finance Conference, 2011 ("Displacement Risk and Asset Returns")
- The Geewax, Terker, & Company First Prize in Investment Research, Rodney White Center, 2006 ("Demand-Based Option Pricing")
- NYSE Award for best paper on equity trading, Western Finance Association, 2002 ("Securities Lending, Shorting, and Pricing")
- Graham and Dodd Award of Excellence, Association for Investment Management and Research, 2001 ("Risk and Valuation of Collateral Debt Obligations")

- Miguel Palacios, 2009. Placement: Vanderbilt. Other notable offers: Indiana University.
- Andres Donangelo, 2011. Placement: UT Austin. Other notable offers: Ohio State University, Indiana University, Arizona State University.
- Matteo Maggiori, 2012. Placement: NYU (Stern and Econ). Other notable offers: U Chicago (Booth), (MIT) Sloan, Kellogg, LBS. Review of Economic Studies Tour.
- Paulo Issler, 2013.
- Matthew Leister, 2015. Placement: Monash University.

"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"

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.

"Auctions with Endogenous Selling"

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.

"Demand-Based Option Pricing"

We model demand-pressure effects on option prices. The model shows
that demand pressure in one option contract increases its price by
an amount propor- tional to the variance of the unhedgeable part of
the option. Similarly, the de- mand pressure increases the price of
any other option by an amount proportional to the covariance of the
unhedgeable parts of the two options. Empirically, we identify
aggregate positions of dealers and end users using a unique dataset,
and show that demand-pressure effects make a contribution to
well-known option- pricing puzzles. Indeed, time-series tests show
that demand helps explain the overall expensiveness and skew
patterns of index options, and cross-sectional tests show that
demand impacts the expensiveness of single-stock options as well.

"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 agents' 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.

"Pricing and Portfolio Choice in Illiquid Markets"

A significant fraction of the growth of aggregate market capitalization is due to new firm entry.
With incomplete markets, the gains from new firm creation are not shared equally; these gains accrue to a small part of the population, while constituting a risk for the marginal investor who holds a portfolio of existing firms, which face potential displacement by the arriving firms.
We propose a simple model to capture these notions. We use the model to develop a simple methodology to measure this displacement risk, which relies on the discrepancy in the growth rates of aggregate dividends and
of the gains from the self-financing trading strategy associated with maintaining a market-weighted portfolio.
We find that our measure of displacement risk is closely linked to certain cross-sectional asset-pricing phenomena and can explain a sizable fraction of the equity premium. We argue more generally that dispersion in capital income, a source of risk overlooked in representative agent models, has first-order implications for asset pricing.

"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. We find that separating IES and risk aversion heterogeneity can have a substantive impact on the model's (qualitative and quantitative) ability to address some key asset pricing issues.

"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 significant effect on prices. Further, unique survey evidence suggests the effect
could be more than 3% and provides broader evidence on the demand sensitivity to haircuts.

"Financial Entanglement: A Theory of Incomplete Integration, Leverage, Crashes, and Contagion"

We propose a unified model of limited market integration, asset-price determination, leveraging, and contagion.
Investors and firms are located on a circle, and
access to markets involves participation costs that increase with distance.
Despite the ex-ante symmetry of investors, their strategies may (endogenously) exhibit
diversity, with some investors in each location following high-leverage,
high-participation, and high-cost strategies and some
unleveraged, low-participation, and low-cost strategies. The capital allocated to high-leverage
strategies may be vulnerable even to small changes in market-access costs, which can lead to discontinuous price drops, de-leveraging, and portfolio-flow reversals.
Moreover, the market is subject to contagion, in that an adverse shock to investors at a subset of locations affects prices everywhere.

"Dynamic Portfolio Choice with Frictions"

We show that the optimal portfolio can be derived explicitly in a large class of mod- els with transitory and persistent transaction costs, multiple signals predicting returns, multiple assets, general correlation structure, time-varying volatility, and general dynamics. Our tractable continuous-time model is shown to be the limit of discrete-time models with endogenous transaction costs due to optimal dealer behavior. Depending on the dealers' inventory dynamics, we show that transitory transaction costs survive, respectively vanish, in the limit, corresponding to an optimal portfolio with bounded, respectively quadratic, variation. Finally, we provide equilibrium implications and illustrate the model's broader applicability to economics.

"Impediments to Financial Trade: Theory and Applications"

We propose a tractable model of an informationally inefficient market featuring non-revealing prices, no noise traders, and general assumptions on preferences and payoff distributions. We show the equivalence between our model and a substantially simpler model whereby investors face distortionary investment taxes depending both on their identity and the asset class. This equivalence allows us to account for such phenomena as under-diversification. We further employ the model to assess approaches to performance evaluation, and find that it provides a theoretical basis for some
intuitive practices adopted by finance professionals, such as style analysis.

"Efficiently Inefficient Markets for Assets and Asset Management"

We consider a model where investors can invest directly or search for an asset manager, information about assets is costly, and managers charge an endogenous fee. The efficiency of asset prices is linked to the efficiency of the asset management market: if investors can find managers more easily, more money is allocated to active management, fees are lower, and asset prices are more efficient. Informed managers outperform after fees, uninformed managers underperform after fees, and the net performance of the average manager depends on the number of ''noise allocators.'' Small investors should be passive, but large and sophisticated investors benefit from searching for informed active managers since their search cost is low relative to capital. Hence, managers with larger and more sophisticated investors are expected to outperform.

"Drifting Apart: The Pricing of Assets when the Benefits of Growth are not Shared Equally"

A significant fraction of the growth of aggregate market capitalization is due to new firm entry.
With incomplete markets, the gains from new firm creation are not shared equally; these gains accrue to a small part of the population, while constituting a risk for the marginal investor who holds a portfolio of existing firms, which face potential displacement by the arriving firms.
We propose a simple model to capture these notions. We use the model to develop a simple methodology to measure this displacement risk, which relies on the discrepancy in the growth rates of aggregate dividends and
of the gains from the self-financing trading strategy associated with maintaining a market-weighted portfolio.
We find that our measure of displacement risk is closely linked to certain cross-sectional asset-pricing phenomena and can explain a sizable fraction of the equity premium. We argue more generally that dispersion in capital income, a source of risk overlooked in representative agent models, has first-order implications for asset pricing.

"What to Expect when Everyone is Expecting: Self-Fulfilling Expectations and Asset-Pricing Puzzles"

We construct equilibria of continuous-time, overlapping generations economies whereby interest rates and asset prices affect the distribution of wealth and consumption between existing and arriving cohorts of investors. Such economies are prone to self-fulfilling expectations and a multitude of equilibria; anticipations of future discount rates impact asset prices and the wealth distribution, causing savings and investment responses that end up confirming the discount rate anticipations. Extrinsic uncertainty can thus be a source of volatility. Moreover, this volatility implies a non-trivial risk premium for stocks even in a world where aggregate consumption follows a deterministic time trend and investors have standard recursive preferences with only moderate degrees of risk aversion.