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Cambridge Endowment for Research in Finance (CERF)



Portfolio Selection, Periodic Evaluations and Risk Taking

By Alex Tse, former CERF Research Associate and winner of the CERF Alumni Association (CERFAS) Best Paper Award

December 2022


Portfolio managers in real life can be selfish, where they care about their own short-term periodic incentives rather than the long-term portfolio growth. How will their risk-taking behaviours change in such a case? Are there ways to combat undesirable risk-taking behaviours of such “myopic” portfolio managers? In the paper “Portfolio Selection, Periodic Evaluations and Risk Taking” that I co-authored with Harry Zheng, we explore a theoretical model to answer the above questions.

Classical optimal investment models typically consider utility derived from the terminal portfolio value at some fixed horizon as the optimisation criterion. But is it consistent with real life practices? For example, fund managers usually receive rewards at the end of a financial year based on their performance, which could include bonuses in monetary terms, gain or loss of professional reputation and other indirect payoffs such as change in client flow. Such rewards recur periodically over time, where each of them is individually linked to the portfolio performance over a short time horizon only. In a more general corporate setting beyond delegated portfolio management, staff appraisal tends to happen every year where employees will receive tangible or intangible benefits based on how well they have been performing in a given year. There are many practical contexts where an agent needs to make risky investment decision with objective driven by the periodic performance of the underlying portfolio instead of its terminal value at some arbitrary time point.

In this paper, we develop a continuous-time portfolio selection model where the agent’s utilities are derived from the portfolio periodic performance evaluated on a deterministic sequence of dates over an infinite horizon. The portfolio performance in a given period is measured by its ending value in excess of its starting value scaled by an exogenous performance benchmark parameter. Finally, the periodic performance measures are converted into agent’s utilities via an S-shaped function to capture limited liability protection, option-based compensation or behavioural preferences.

Before introducing our theoretical results, it is useful to compare our framework against a standard model with a single terminal evaluation date only (see for example Berkelaar et al. (2004) and Carpenter (2000)). Due to the S-shaped utility function, the agent is insensitive to large losses (e.g. because they have limited liability protection) in the bad states of the world. Hence if they are falling behind, they opt to gamble by taking excessively large risky investment with the hope of getting out from the portfolio losses. In such a standard model, there is no incentive tied to the portfolio value beyond the single terminal evaluation date so the agent does not care even if the portfolio becomes insolvent at the maturity date.

However, the incentive structure changes significantly once the performance criterion becomes periodic. The agent now has to balance the reward obtained from the current period (short-term component) as well as all the subsequent rewards in the future periods (long-term component). The agent now cares about portfolio insolvency because it leaves the agent no capital to be invested if the portfolio goes bust in the current period and then all the future rewards would be zero. The optimal risk-taking decision is determined via the trade-off between the short-term and long-term benefits, which is heavily influenced by the model parameters such as the exogeneous performance benchmark. In general, the future rewards component encourages value preservation. The existing literature on the “one-off models” therefore has the intuition that under a repeated, periodic setup, the risk-taking behaviours should be moderated. Nonetheless, such conjecture has not been formalised and examined in a proper theoretical model to date. Our results show that such intuition is incomplete at best.

In our model, it turns out that there are three main regimes of risk-taking behaviours which are primarily dependent on the performance benchmark parameter. The first regime is “risk-moderation”, where risky investment is bounded across all possible states of the world. The second regime is “risk-seeking”, where investment in the risky asset tends to infinity in the bad states of the world and there is a strictly positive chance of portfolio insolvency at the end of each evaluation period (this regime is the one consistent with the existing literature which considers a single evaluation date only). The final regime is “underinvestment”, where not only the risky investment becomes unbounded in the bad states of the world so insolvency is possible (as per the “risk-seeking” regime), but the investment level also tends to zero in the good states of the world and thus the agent is disinvesting when the portfolio performs well. The portfolio gross return then has an upper bound under this regime. 

So why do the multiple regimes exists? Whether the repeated game nature of investment encourages value preservation (and in turn, moderates risk-taking behaviours) depends on the value of the future benefits relative to the one from the current period. When the performance benchmark is low or the market is favourable, the value of the investment game is high and the agent has incentive to ensure solvency so they can perpetually extract periodic benefits by managing a healthy portfolio. This is achieved by adopting a bounded investment strategy across all possible states of the world and results in the “risk-moderation” regime. But for a moderately high value of performance benchmark, the long-term value of the investment game is not high enough to outweigh the short-term benefit from the current period. The agent will then put more decision weight on the short-term reward and consequently behave as in the standard “one-off model” where unboundedly high level of risk is taken in the bad states of the world – this is the “risk-seeking” regime.

The “underinvestment” regime is perhaps the more interesting one. When the performance target becomes excessively high, the agent understands that it will be difficult to outperform their yesterday’s self.  They will hence intentionally underinvest to prevent the portfolio from growing too much. Otherwise, a realisation of good outcome in the current period will lead to a high starting portfolio value in the next period, which forms the basis of a much higher (i.e. demanding) benchmark for the performance evaluation in the next period. The intentional manipulation of performance benchmark via underinvesting can be viewed as a symptom of “underperformance-aversion”.

Clearly, the regimes “risk-taking” and “underinvestment” are not ideal from a welfare perspective since the portfolio managers’ myopia will lead to capped portfolio growth but more devastatingly the inevitable ruin of the portfolio in the long run due to unbounded risk-taking during downturns. Incentives should therefore be properly set up or “nudged” to encourage managers to act in accordance with the “risk-moderation” regime. Two important factors include reasonable performance target and avoidance of excessive punishment on underperforming agents.

In summary, periodic evaluation can be a useful mechanism to contain excessive risk-taking even if the agent exhibits S-shaped preference due to convex payoff scheme or behavioural biases. This suggests, for example, that cliquet-style contracts can be superior to standard instruments like long-dated call options within employee compensation package. The risk-taking moderation effect is not universal, however, as revealed by the different possible regimes within our theoretical model.  It also raises a deeper question over how the short-term periodic interest of the agents can be better aligned with the long-term investment goal of the stakeholders. In the future, I am interested in understanding such issues better via a principal-agent extension of the current model.



Berkelaar, A. B., Kouwenberg, R., and Post, T. (2004). Optimal portfolio choice under loss aversion. Review of Economics and Statistics, 86(4): 973–987.

Carpenter, J. N. (2000). Does option compensation increase managerial risk appetite? The Journal of Finance, 55(5): 2311–2331.



Resuscitating the London Stock Exchange

By Bobby V. Reddy, CERF Fellow

November 2022


This blog was first published on the Oxford Business Law Blog on 1 June 2022, available at


Whichever way you look at it, the London Stock Exchange is in secular decline.  The number of companies listed on the exchange’s Main Market has fallen from over 4,400 in the early 1960s to less than 1,200 now.  One could argue that a similar pattern is evident in the US.  However, unlike the US, the London Stock Exchange’s total market capitalisation has also plummeted relative to the size of the UK’s economy over the last 20 years.  Notably, the FTSE 100 has significantly underperformed the US’s S&P 500 and the blue chip indices in Germany and Japan over the same time period.  In recent years, the decline of the London Stock Exchange has attracted regulatory, media and public attention, and the future of the exchange is now front and centre in the minds of policymakers.

In a recent co-authored paper with Professor Brian R. Cheffins, in The Modern Law Review, we first consider the merits of prioritising strong equity markets in the UK before evaluating whether recent changes by the Financial Conduct Authority to the Listing Rules, which govern London Stock Exchange Main Market-listed companies, will successfully resuscitate the exchange.  With the plethora of private capital available to companies, the argument in favour of strong equity markets is not a slam dunk.  The prospects for retail investors, though, are substantially impaired by a weak stock exchange.  Moreover, wider economic benefits can stem from a strong exchange, especially in the context of developing a robust tech-industry ecosystem, and the shadow of Brexit looms large with some tying the fortunes of the London Stock Exchange to the self-confidence of the City.  It is not therefore surprising that policymakers have sought to rejuvenate the exchange, with Listing Rules reform seemingly a material part of the solution.

The recent changes to the Listing Rules include a more permissive environment for ‘dual-class shares’ that enable company founders to list their companies and divest of a majority of their equity while retaining voting control.  The reforms also include provisions intended to attract special purpose acquisition companies (SPACs), which are listed cash-shells established purely for the purpose of acquiring private companies, giving those companies a potentially streamlined pathway to listing.   Finally, changes to the Listing Rules reduce the minimum ‘free-float’ of equity that Main Market-listed companies must maintain in public hands.  On their face, these changes could increase the numbers of initial public offering (IPOs) on the London Stock Exchange.  However, in our paper, we note that a lack of ambition in relation to dual-class shares and the free-float rules will likely encumber the allure of the exchange to high growth, innovative, early-stage companies that have many other options for growth.  In relation to SPACs, the dynamics that will develop from the new regulations mean that there can be no assurances that more UK-listed SPACs will result in numerous good quality SPAC-acquired operating companies listing on the London Stock Exchange.  Those very dynamics also potentially create hazards for unsophisticated investors, and the danger exists that promoting SPACs in the UK could conversely damage the reputation of the London Stock Exchange.  Ultimately, the Listing Rules reforms may spur an annual increase in IPOs at the margins, but the results will certainly not move the needle.

Even if our assessment of the capacity of the Listing Rules reforms to increase IPOs proves to be overly pessimistic, simply focusing on the Listing Rules will not resuscitate the London Stock Exchange.  Two deeper-seated issues endure.  Firstly, over-regulation can deter companies from seeking listings on the London Stock Exchange.  Companies face a cosier existence remaining private rather than succumbing to the extensive disclosure and governance requirements to which Main Market-listed companies are subject.  Second, depressed share prices on the Main Market dissuade companies from listing on the London Stock Exchange.  With depressed share prices, the perception exists, especially in the tech industry, that companies will be undervalued when they undertake an IPO on the London Stock Exchange.  Such a perception can lead investors in private companies to the warm embrace of private capital, corporate acquirors and flotations on overseas exchanges when they seek to grow their companies or simply exit their investments.

Furthermore, a sole focus on IPOs may be misguided.  In our paper, we show that exits from the Main Market routinely outstrip IPOs.  It is those exits, rather than a dearth of IPOs, that have primarily impacted the market capitalisation to UK gross domestic product ratio of the London Stock Exchange.  Although financial distress sometimes leads to de-listings, the principal cause of exits is acquisitions by other companies or private equity.  To truly resuscitate the London Stock Exchange, policymakers need to be sensitive to the drivers of the relentless leak of companies from the market.  For example, easing the governance burden on listed companies in a sensible manner may not only have a sizeable impact on IPOs, but could also stem the exodus of companies from the exchange.  The onerous requirements of the Main Market can become draining for boards and stymie company innovation, making de-listing attractive.  Additionally, as well as deterring IPOs, depressed share prices post-IPO can make Main Market-listed companies easy prey for, often overseas, corporate raiders.  We have canvassed some of the areas for future research on improving share valuations.  Although the Brexit-related currency shocks that contributed to undervaluations are not easy to reverse, encouraging British institutional investors, who have been forsaking the UK equity markets in recent times, to invest in Main Market-listed companies could materially improve flagging share prices.  Policymakers should holistically reassess the regulatory package applicable to British pension funds and insurance companies and the incentives that derive therefrom.

The fresh impetus displayed by policymakers to revitalise the UK’s equity markets is welcome.  However, policymakers must coherently evaluate the qualities of the market as a whole rather than focusing on individual elements isolated from the bigger picture.  Although the new Listing Rules reforms may encourage some positive stock market activity, the regulators have a long way to go to resuscitate the London Stock Exchange.

This blog is based upon my paper, co-authored with Brian R. Cheffins, ‘Will Listing Rule Reform Deliver Strong Public Markets for the UK?’ (2022) The Modern Law Review



Gambling for Redemption or Ripoff?

By Xinyu Hou, CERF Research Associate, Cambridge Judge Business School, University of Cambridge

October 2022


In the early days of Federal Express, the company once was down to $5,000 in its checking account, not able to cover the $24,000 jet fuel bill due the following Monday. With the firm hanging on the edge, the founder, Fred Smith, flew to Las Vegas and gambled the $5,000 to $32,000 – saving the business at a critical time. When asked by another partner of the firm how he could do that, Fred shrugged, “What difference did it make? Without the funds for the fuel company, we couldn’t have flown anyway.”

Gambling, or in another word risk-taking, certainly made a difference – it saved the owners and avoided bankruptcy costs with some probability. It may even benefit other claimants, including the fuel company, who were unlikely to get much in bankruptcy. However, gambling oftentimes has a bad reputation as in asset substitution, which says that the shareholders would be willing to take on a project with higher volatility and even negative net present value, so that they can benefit from the upside of the volatility but substitute out the downside to the bondholders (thanks to limited liability).

So, when is gambling good and when is it bad? Phil Dybvig and I recently have a theory paper, Gambling for Redemption or Ripoff, and the Impact of Superpriority, that studies pure gambling by the firm using derivatives. Gambling using derivatives is a sharper tool, allowing the firm owners to have more control over the payoff distribution and without sacrificing project efficiency as in a typical asset substitution (for example, you can write a digital option which pays £100 twenty percent of the time and 0 eighty percent of the time). We have a simple single-period model which shows that the impact of gambling can be understood through two polar cases: gambling for redemption, which means gambling just enough to stay in business, is good for the owners, the creditors, and for overall efficiency, similar to the FedEx gambling. Redemption is optimal for the owners when the owners’ net gain from bankruptcy is negative (in the simplest case, when firm’s continuation value in excess of cash, i.e., the total non-cash asset value which reflects firm’s future investment decisions if the firm continues, is greater than the face value of the debt).  Gambling for ripoff, which means taking a very big risk, benefiting the owners at the expense of the creditors and overall efficiency – like an “asset substitution on steroids.” Ripoff is optimal when the owners’ net gain from bankruptcy is positive (again in the simplest case, when their continuation value in excess of cash is smaller than the face value of the debt). This is because to obtain the continuation value, the owners need to repay the debt – a negative net gain from continuation. Therefore, the owners choose gambling that fails as often as possible, even if the short-term assets such as cash could cover the debt.

Gambling for ripoff is of special current interest because of controversial legislation in the US before the financial crisis that exempts repos and other derivatives from important provisions of bankruptcy, including the automatic stay and clawbacks, causing some people to call them superpriority claims. In the United States, it has traditionally been difficult to redeploy assets for large gambles. While the Common Law allows for asset seizure in satisfaction of debts, the bankruptcy automatic stay provision “stays” the assets in the firm’s estate, stopping the creditors from taking further actions against the firm. Even if the assets were seized before bankruptcy, seizure or sales can be clawed back by the court. One important purpose of these laws is to prevent “asset rat race” in which claimants rush to take a piece from the firm, similar to a bank run. This gives a breathing space to the firm when the firm is in financial destress and ensures orderly resolution. Consequently, any promise by the firm to transfer assets to pay off on a failed gamble would not be credible unless the gambling counterparties are sure that the firm will not be pushed into bankruptcy, and gambling is only operating at a limited scale. However, the superpriority treatment for derivatives sidesteps the laws. The owners of a shacky firm can now pledge their assets as their gambling bets because the gambling counterparties know that the assets would not be stayed in bankruptcy.  With more funds to gamble, the paper shows that gambling for ripoff becomes more appealing to the owners.

This is consistent with the claim of Mark Roe, a Harvard law professor, who suggests that the superpriority laws have made the firms more fragile and accelerated the 2008 financial crisis. Roe argues that superpriority provides a cheaper way of financing, facilitating more liquidity that otherwise would not occur. This shifts the firms away from using traditional financing and lower the incentives of derivatives counterparties to monitor the firm. Because of the heavily used superpriority claims, the “too big to fail” problem was worsened.  Our paper provides another angle to look at the impact of law. In our single-period model, superpriority laws seem good for firm owners because they enable large-scale gambling, but perhaps only because the amount of debt and the continuation value are both exogenous. We also provide a multiperiod model that endogenizes these variables and some others. The results show that superpriority typically reduces firm value because bond investors realize that superpriority increases the likelihood of gambling for ripoff, and this is reflected in bond pricing.

If the firm owners are potentially worse off because of the laws, as claimed in the multi-period model, the owners would have incentives to use more defensive measures (operating leverage, secured debt, short-term debt, and even repos) to protect against the laws. Also, the bondholders cannot rely on protections in bankruptcy through negative pledge covenants which preclude asset sales but may rely more on perfected security interests (collateral) which are still honoured under UCC Article 9. This is supported by some empirical evidence that shows an overall increase of these “more defensive assets” in recent years, but more rigorous empirical work needs to be done to test the theory.



P. H. Dybvig and X. Hou. Gambling for Redemption or Ripoff, and the Impact of Superpriority (working paper link:

R. Frock. Changing How the World Does Business: Fedex’s Incredible Journey to Success-the Inside Story. Berrett-Koehler Publishers, 2006.

S. C. Myers. Determinants of Corporate Borrowing. Journal of financial economics, 5(2):147–175, 1977.

M. J. Roe. The Derivatives Market’s Payment Priorities as Financial Crisis Accelerator. Stan. L. Rev., 63:539, 2010.

S. L. Schwarcz and O. Sharon. The Bankruptcy-law Safe Harbor for Derivatives: A Path-dependence Analysis. Wash. & Lee L. Rev., 71:1715, 2014.



The Downside Risk Channel of Monetary Policy 

By Niklas Schmitz, Winner of the Cambridge Finance Best Student Paper Award 2022, PhD Student, Faculty of Economics, University of Cambridge 

September 2022 


During recessions, central banks play a key role to support the economy. They are often concerned with avoiding bad outcomes for macroeconomic growth or mitigating “downside risks”. Stock markets follow monetary policy decisions closely and respond to policymakers’ actions. But what exactly explains the response of stock prices to monetary policy announcements, especially in crisis times? 

Empirical evidence on the effect of monetary policy surprises on equity returns shows that the equity premium accounts for a large share of the return response: Policy decisions affect equity returns to a large extent via the equity premium, i.e. the compensation that investors require to hold the risk associated with stocks in their portfolios (Bernanke and Kuttner, 2005). But why should monetary policy affect the risk premium? 

In a recent paper, I argue that monetary policy can affect equity premia during recessions because its interventions reduce downside risks to future macroeconomic growth. The motivation for this channel comes from a long-standing literature of consumption-based asset pricing models. This literature suggests there should be a close link between the (expected) state of the macroeconomy – usually measured via aggregate consumption – and stock returns (Lucas 1978). Since stocks tend to fall in price when the state of the macroeconomy is bad, they offer low returns in times when investors value returns most strongly, which implies the equity premium. Models incorporating the potential for large negative shocks to the economy have emerged as a promising avenue to realistically connect macroeconomic aggregates and stock market returns (Rietz 1988, Barro 2006, Gabaix 2012). 

To empirically test this logic of the “downside risk channel of monetary policy”, we require a measure of downside risks to aggregate consumption growth. Inspired by a recent literature in macroeconomics (Adrian et al. 2019), I obtain this measure by forecasting the conditional distribution of future aggregate consumption growth in the United States. This distribution provides the answer to the question: Given the information about economic and financial conditions available today, what are the possible scenarios for future realizations of consumption growth? Uncertain times are reflected by a large spread in the conditional distribution. Distinctly bad times may be represented by a low mean and a long left tail. Based on the estimated distribution, I construct an index of downside risk that reflects the probability of below-average realizations for consumption growth. 

This approach has several advantages over existing measures of risk or uncertainty. First, the index is a clean measure of risk perceptions without any risk aversion component. Especially risk measures obtained from financial market data often struggle to disentangle these two components since market prices necessarily reflect both expected risks and the valuation of these risks. To test the logic of the downside risk channel, we want to focus on the first component only. Similarly, since the index measures risks to a macroeconomic variable, it does not pick up any financial stress that does not spill over into the macroeconomy. Other commonly used measures such as the VIX index do not guarantee this. The downside risk index also allows for a distinction between upside and downside risks. An important result of the paper is that the downside risk channel is strong, whereas there is less clear evidence on the importance of “upside risks”. 

The estimation results for the downside risk index show that increases in the probability of bad realizations for future consumption growth occur in line with economic intuition: In the build-up of recessions, downside risks generally rise. Downside risks also increase around specific events such as the collapse of Lehman Brothers in September 2008. Following the Great Recession, downside risks remain elevated for several years, during which the Fed continued to implement its Quantitative Easing. The Covid shock is associated with another rise in downside risk. 

Given the downside risk index, I test the existence of the downside risk channel in two steps. First, I study the predictive ability of the downside risk index for equity premia in the US. Second, I test whether Federal Reserve policy affects the downside risk index. 

Changes in the downside risk index are a significant predictor of the equity premium. An increase in the downside risk index predicts higher excess market returns over the next three to six months. The predictive ability of the downside risk index is concentrated in crisis times, whereas the association between downside risk and future returns is weak outside of recessions. The index also predicts future returns on industry portfolios. Industries such as healthcare or non-durable goods consumption show a low sensitivity to changes in downside risk, whereas procyclical industries such as manufacturing or finance show a high sensitivity to changes in downside risk. 

Monetary policy has a powerful effect on downside risk. This effect is again concentrated in recession, whereas I find no measurable effect of monetary policy changes on downside risk outside of recessions. This suggests that changes in the monetary policy stance are effective at reducing downside risks during recessions, which can support equity prices by reducing the risk premium investors require to hold equities. 

The downside risk channel of monetary policy implies central banks have a powerful lever on stock prices that goes beyond any effect on realized or expected macroeconomic growth rates. Downside risks to future growth may play a particularly important role in explaining the effectiveness of monetary policy in crisis times. 


Link to the paper: 



Adrian, T., Boyarchenko, N. & Giannone, D. (2019) ‘ Vulernable Growth’, American Economic Review 109(4), 1263-1289. 

Barro, R. J. (2006) ‘Rare disasters and asset markets in the twentieth century’, The Quarterly Journal of Economics 131(4), 1593-1636. 

Bernanke, B. S. &Kuttner, K. N. (2005) ‘What Explains the Stock Market’s Reaction to Federal Reserve Policy?’, Journal of Finance 60(3), 1221-1257. 

Gabaix, X. (2012) ‘Variable rare disasters: An exactly solved framework for ten puzzles in macro-finance’, The Quarterly Journal of Economics 127(2), 645-700. 

Lucas, R. E. (1978) ‘Asset Prices in an Exchange Economy’, Econometrica 46(6), 1429-1445. 

Rietz, T. A. (1988) ‘The equity risk premium – a solution’, Journal of Monetary Economics 22(1), 117-131. 



Can members with heterogeneous preferences achieve their first-best within a group?

By Shiqi Chen, CERF Research Associate, Cambridge Judge Business School, University of Cambridge

August 2022


One standard assumption of the existing corporate finance literature is firms' policies are set to maximize total shareholders' value, irrespective of individual stockholders' personal preferences. Shareholders who disagree with the firm's policies can sell off their holdings and invest in alternative investment opportunities. However, this assumption is only valid for public traded firms with well-diversified investors, which is not the norm when we look at the existing business entities in the economy. Indeed, many business entities are not traded on the public market and are governed by a small group of investors with heterogenous preferences, beliefs, investment horizons etc. For example, many small family firms are often owned and run by a few family members whose preferences are different, and whose livelihoods are tied to the firm's income. Another example is mutual fund management teams, which consist of several managers with different preferences, career stages, risk tolerance etc. These differences are reflected in their choices of assets and therefore determine their compensation. Similarly, VC syndicates often involve partners with different investment preferences and horizons. Under such circumstances, what entities involving heterogeneous stockholders should maximize in the absence of a stock price is less clear. Even in public firms, as long as there are restrictions on the trading of managers' holdings, this question, to some extent, still applies. Chava and Purnanandam (2010) show that CEOs' risk preferences affect leverage and cash-holding policies, while CFOs' risk preferences are relatively more important in explaining debt maturity structure and accrual decisions. They conclude that "closer attention should be paid to the risk preferences and attitudes of managers to better understand the corporate financial decision making".


Heterogeneous preferences mean that group members have their own preferred investment, financing and payout policies. Hence, one might jump to a conclusion that heterogeneous stockholders inevitably have to settle for a second-best compromise. The paper by Chen and Lambrecht (2022) shows that it is indeed possible for all members to achieve their first-best life-time utility even without trading. The first-best outcome can be achieved by adopting financial policies that maximize the weighted average of investors' life-time utility. The utility weights are fixed at the startup of the firm and pinned down uniquely by the individuals' participation constraints, which are characterized by their outside investment options. These utility weights play an important role in determining how the group synergies are shared.


More specifically, the paper shows that the firm allows members to achieve their first-best life-time utility by issuing financial claims that are tailor-made to individual members' risk preferences and adopting investment and financing policies that adjust dynamically in response to economic shocks. The least risk averse investor receives an equity claim while all other more risk averse investors receive claims that resemble preferred equities with different seniority and payout yields. This implies that an investor's payout and claim value depend not only on her own preference but also on her co-investors' preferences. When collaborating with less risk averse co-investors, more risk averse investors prefer contracts that are less performance-sensitive, which could protect them from the downside at the expense of upside benefits. Such findings provide a rationale for the combination of equity and preferred equities within a firm that is widely observed in practice. Furthermore, these findings also generate new empirical hypotheses regarding the relative compensation within small business entities, which are currently underexplored.


The paper further shows that the firm's investment and leverage are pro-cyclical. This is because the optimal investment and financing decisions are not merely a weighted average of the individual optimal policies. But more importantly, the weights are time-varying, with more weight shifting toward the less (more) risk averse investors in good (bad) times. Consequently, the group's risky investment and net debt ratio rise when the firm is doing well and drop when the firm is in trouble. The model, therefore, predicts that startups are often initially all-equity financed, holding a negative net debt position. As its net worth grows, a line of credit is gradually introduced, and a positive net debt position is observed. Such intertemporal variation originates from the misalignment of risk preferences among group members. The dynamic rebalancing financial policies reconcile the heterogeneity in risk preferences and allow members to share risk efficiently thereby achieving their first-best life-time utility.


In the model, each investor has her own outside investment opportunity, and the lead investor ('entrepreneur') has an investment opportunity with the highest Sharpe ratio. Therefore, synergies can be generated by pooling all members' capital into the lead investor's 'superior' project. The paper focuses on the case where capital is supplied competitively such that all synergies accrue to the lead investor, leaving all co-investors indifferent between joining the group or investing in her outside project as a sole proprietorship. In other words, the co-investors receive utility weights such that their participation constraints are binding, while the lead investor receives a weight that makes her strictly better off. The paper shows the utility weights are non-linear and increasing in capital contribution. Moreover, each co-investor's weight becomes zero in the absence of capital contribution, whereas the lead investor's weight remains strictly positive even when she contributes zero dollars to the joint pocket. Indeed, the lead investor's net worth stake in the firm is larger than the monetary capital she contributes, which reflects the synergies she brings into the group with her human capital.   In contrast,  the co-investors' stakes are smaller than the capital they contribute. The wedge reflects the 'fee' the co-investors need to pay to access better investment opportunities. The model can also accommodate more general sharing rules that allow co-investors to share part of the synergy. 


The paper shows that even though the group's policies are very different from individual optimal policies, members of the group can still achieve their first-best life-time utility in the absence of trading. The mechanism that allows a group with heterogenous risk preferences to achieve the first-best outcome contains a capital structure consisting of safe debt, equity and preferred equity, as well as pro-cyclical investment and financing strategies.



Chava, S., and A. Purnanandam (2010): “CEOs versus CFOs: Incentives and corporate policies,” Journal of Financial Economics, 97(2), 263–278.

Chen, S., and B. Lambrecht (2021): “Optimal Financial Policies for a Group,” Available at SSRN: or




Strategic Voting and Shareholder Voting

By Adam Meirowitz (Yale University) and Shaoting Pi (CERF Research Associate, Cambridge Judge Business School, University of Cambridge)

July 2022

Starting with Marquis de Condorcet (1785), a large literature seeks to understand voting in settings where agents possess private information about the desirability of choices. A key intuition is the finding by Austen-Smith and Banks (1996) that equilibrium behavior requires that in evaluating their information agents must also condition on the event that they are pivotal. This equilibrium phenomenon has been shown to lead to interesting distortions and accounting for these distortions is central to work on institutional design, for example, the choice of voting rule (Feddersen and Pesendorfer (1998), Duggan and Martinelli (2001), Meirowitz (2002)). Recent work seeks to understand how seemingly fine differences in the informational environment affect the nature of voting behavior and whether information is efficiently aggregated when there are a large number of voters (Feddersen and Pesendorfer (1997), Bhattacharya (2013), Mandler (2012), Acharya and Meirowitz (2017)).


The connections between strategic voting (in political economy) and shareholder voting are natural. For instance, Maug (1998) introduces proxy voting to this framework. Maug and Rydqvist (2009) consider natural questions about shareholder control in this setting. Levit and Malenko (2011) and Ekmekci et al. (2019) explore non-binding voting. Malenko and Malenko (2019) add shareholder information acquisition from proxy advisory firms. Bar-Isaac and Shapiro (2020) study blockholder voting. Bond and Eraslan (2010) consider strategic voting over proposals that are strategically chosen. Brav and Mathews (2011) study the effects of empty voting by a single strategic actor that can acquire additional votes and then make call orders prior to voting. They show that there are incentives to deviate from one-share one vote and that the welfare consequences can go either way. Bouton et al. (2021) compare the informational efficiency of the one-share-one-vote mechanism (1S1V) and that of the one-person-one-vote mechanism (1P1V). Considering that management has the right to decide whether to put the proposal to a vote, they find that the higher voting efficiency of 1S1V implies worse selection incentives, and the negative effect of worse selection can outweigh the higher voting efficiency of 1S1V.


A critical difference between civic voting and shareholder voting is that shareholders can trade shares as well as vote. Recent literature considers the link between shareholders’ ability to vote and their opportunity to trade. Meirowitz and Pi (2022) find that voting for the better policy maximizes a shareholder’s portfolio value only when pivotal; otherwise, it is better to vote against one’s information, distort the market, and then trade at the distorted price. In equilibrium, voting informativeness balances these forces and is demonstrably low. As the number of shareholders grows, the probability of making the correct decision is lower than the informational quality of just one shareholder’s private signal. Moving away from models of information, Levit et al. (2019) study the link between trading and voting when shareholders have heterogeneous preferences but there is no asymmetric information. The model develops an intuition for how shareholder support endogenously forms through trading before voting. Levit et al. (2021) study voting premium and develop a model in which a minority blockholder and dispersed shareholders vote on a proposal after trading shares. They show that voting premium can arise from the blockholder’s desire to influence who excises control and is unrelated to measures of the voting power. There is also a growing empirical literature on the relationship between voting and trading. For example, Li et al. (2022) find that trading volume is high around shareholder meetings. Fos and Holderness (2021) find that activist investors buy marginal votes.




Acharya, A. and A. Meirowitz (2017): “Sincere voting in large elections,” Games and Economic Behavior, 101, 121–131.

Austen-Smith, D. and J. S. Banks (1996): “Information aggregation, rationality, and the Condorcet jury theorem,” American political science review, 90, 34–45.

Bar-Isaac, H. and J. Shapiro (2020): “Blockholder voting,” Journal of Financial Economics, 136, 695–717.

Bhattacharya, S. (2013): “Preference monotonicity and information aggregation in elections,” Econometrica, 81, 1229–1247.

Bond, P. and H. Eraslan (2010): “Strategic voting over strategic proposals,” The Review of Economic Studies, 77, 459–490.

Bouton, L., A. Llorente-Saguer, A. Mace´, and D. Xefteris (2021): “Voting in shareholders meetings,” Tech. rep., National Bureau of Economic Research.

Brav, A. and R. D. Mathews (2011): “Empty voting and the efficiency of corporate governance,” Journal of Financial Economics, 99, 289–307.

Duggan, J. and C. Martinelli (2001): “A Bayesian model of voting in juries,” Games and Economic Behavior, 37, 259–294.

Ekmekci, M., S. Lauermann, et al. (2019): “Informal elections with dispersed information,” Tech. rep., University of Bonn and University of Mannheim, Germany.

Feddersen, T. and W. Pesendorfer (1997): “Voting behavior and information aggregation in elections with private information,” Econometrica: Journal of the Econometric Society, 1029–1058.

——— (1998): “Convicting the innocent: The inferiority of unanimous jury verdicts under strategic voting,” American Political science review, 92, 23–35.

Fos, V. and C. G. Holderness (2021): “The distribution of voting rights to shareholders,” European Corporate Governance Institute–Finance Working Paper.

Levit, D. and N. Malenko (2011): “Nonbinding voting for shareholder proposals,” The Journal of Finance, 66, 1579–1614.

Levit, D., N. Malenko, and E. G. Maug (2019): “Trading and shareholder democracy,” European Corporate Governance Institute–Finance Working Paper.

——— (2021): “The voting premium,” .

Li, S. Z., E. Maug, and M. Schwartz-Ziv (2022): “When shareholders disagree: Trading after shareholder meetings,” The Review of Financial Studies, 35, 1813– 1867.

Malenko, A. and N. Malenko (2019): “Proxy advisory firms: The economics of selling information to voters,” The Journal of Finance, 74, 2441–2490.

Mandler, M. (2012): “The fragility of information aggregation in large elections,” Games and Economic Behavior, 74, 257–268.

Marquis de Condorcet, M. J. A. (1785): Essai sur l’application de l’analyse a la probabilite des decisions: rendues a la pluralite de voix, De l’Imprimerie royale.

Maug, E. (1998): “Large shareholders as monitors: Is there a trade-off between liquidity and control?” The journal of finance, 53, 65–98.

Maug, E. and K. Rydqvist (2009): “Do shareholders vote strategically? Voting behavior, proposal screening, and majority rules,” Review of Finance, 13, 47–79.

Meirowitz, A. (2002): “Informative voting and Condorcet jury theorems with a continuum of types,” Social Choice and Welfare, 19, 219–236.

Meirowitz, A. and S. Pi (2022): “Voting and trading: The shareholders dilemma,” Journal of Financial Economics.



Institutional Investor Monitoring and Earnings Management: A Network Approach

Wolfgang Drobetz (University of Hamburg)

Sadok El Ghoul (University of Alberta)

Omrane Guedhami (University of South Carolina)

Marwin Mönkemeyer (University of Hamburg, CERF Visiting Associate)

Henning Schröder (University of Hamburg)

June 2022

Ever since Berle and Means’ (1932) seminal work on the separation of ownership and control in modern firms, scholars have debated about the potential conflict of interests between managers and shareholders. According to the agency theory, this separation incentivizes managers to select and apply accounting estimates and techniques that increase their own managerial wealth. But because such opportunistic earnings management occurs to the detriment of the firms’ other stakeholders, auditors, regulators, and investors have their own motivation to detect and mitigate these self-serving managerial practices.

It is a common notion in the field of corporate governance that institutional investors can reduce the agency problem between managers and shareholders by monitoring managers’ actions (Jensen and Meckling (1976); Shleifer and Vishny (1986); Hartzell and Starks (2003)). Studies have put forward two main arguments supporting institutional investors’ comparative advantage in monitoring over individual (retail) investors. First, sophisticated institutions have professional research, traders, and portfolio managers that guide their decisions, allowing them to detect earnings management already in the first place. Second, because they are powerful and equipped with the right incentives to engage in monitoring, they can utilize their privileged access to information and effectively constrain opportunistic managerial behavior (Balsam et al. (2002); Ayers et al. (2011); Kang et al. (2018)).

Acknowledging institutional investors’ superior monitoring abilities, studies typically use the level of institutional ownership or the heterogeneity among different types of institutional investors to explain the quality of financial reporting (Bushee (1998); Tsang et al. (2019); Ramalingegowda et al. (2021)). Despite a growing body of research, the literature so far has neglected the role of the network created by institutional investors holding stakes in the same firms. However, the structure of such network is likely to affect the dynamics of information dissemination between institutions as well as an investor’s influence and power in interacting with firm management. As a result, networks increase monitoring effectiveness. Central as compared to peripheral institutions are likely to obtain more timely and superior information necessary to constrain opportunistic managerial behavior. Moreover, due to their higher number of connections in the network, central institutions can effectively discipline managers by pursuing other investors to vote into the same direction (Bajo et al. (2020))

Given the above arguments, we propose shareholder centrality as a major determinant with an explanatory power that is incremental to traditional proxies for institutional monitoring. To provide empirical evidence on the relation between institutional investor centrality and earnings management, we use a comprehensive sample of 6,870 U.S. firms over the 1990–2019 period.

Our analyses reveal four key findings:

First, we find that the presence of central institutional shareholders is associated with lower levels of earnings management. This evidence is robust to the use of alternative earnings management proxies and network centrality measures. This effect is also economically relevant. Recognizing the potentially endogenous nature of the relation, we implement two identification strategies, which seem to suggest a causal relationship.

Second, turning to firms that have particular incentives to manipulate earnings (so-called suspect firms), we find that shareholder centrality plays an even more important role in limiting earnings management in such firms.

Third, we substantiate that information advantages obtained through institutional investor networks effectively drive reductions in earnings management. To this aim, we rerun our main analysis using measures of centrality among heterogeneous investor types. In line with an information-based explanation, we observe stronger reductions in earnings management in the presence of “monitoring institutions”, i.e., institutions that are most likely to use information to monitor management such as independent or long-term investors.

Finally, we examine the effect of network centrality on shareholder proposal outcomes to shed light on the role of power and reputation through which institutional investor networks affect earnings management. We find that shareholder proposals filed by central institutions are less likely to be omitted from proxy statements and more likely to be withdrawn or put to a vote. The results indicate that central institutions use their negotiation power to engage in governance via voice.

Overall, our results emphasize the role of the institutional shareholdings network as a corporate governance mechanism that influences accounting quality and shed light on how investors obtain valuable information for monitoring. The findings have implications for academics and practitioners alike. For academics, our results reveal how institutions obtain information through network centrality. Future studies on reporting quality should thus incorporate network-based proxies to avoid model misspecification. For practitioners, our work highlights a novel determinant of institutional investor monitoring and, more specifically, the quality of financial reporting.




Ayers, B., S. Ramalingegowda, and P. Yeung, 2011, Hometown advantage: The effects of monitoring institution location on financial reporting discretion, Journal of Accounting and Economics 52, 41–61.

Bajo, E., E. Croci, and N. Marinelli, 2020, Institutional investor networks and firm value, Journal of Business Research 112, 65–80.

Balsam, S., E. Bartov, and C. Marquardt, 2002, Accruals management, investor sophistication, and equity valuation: Evidence from 10–Q filings, Journal of Accounting Research 40, 987–1012.

Berle, A., and G. Means, 1932, The Modern Corporation and Private Property (Mac-Millan, New York, New York).

Bushee, B., 1998, The influence of institutional investors on myopic R&D investment behavior, The Accounting Review 73, 305–333.

Hartzell, J., and L. Starks, 2003, Institutional investors and executive compensation, Journal of Finance 58, 2351–2374.

Jensen, M., and W. Meckling, 1976, Theory of the firm: Managerial behavior, agency costs and ownership structure, Journal of Financial Economics 3, 305–360.

Kang, J., J. Luo, and H. Na, 2018, Are institutional investors with multiple blockholdings effective monitors? Journal of Financial Economics 128, 576–602.

Ramalingegowda, S., S. Utke, and Y. Yu, 2021, Common institutional ownership and earnings management, Contemporary Accounting Research 38, 208–241.

Shleifer, A., and R. Vishny, 1986, Large shareholders and corporate control, Journal of Political Economy 94, 461–488.

Tsang, A., F. Xie, and X. Xin, 2019, Foreign institutional investors and corporate voluntary disclosure around the world, The Accounting Review 94, 319–348.



Voting for Socially Responsible Corporate Policies

Adam Meirowitz, David Eccles School of Business, University of Utah

Shaoting Pi, CERF Research Associate, Cambridge Judge Business School, University of Cambridge

Matthew C. Ringgenberg. David Eccles School of Business, University of Utah

May 2022


Voting plays an important role in corporate governance. Shareholders vote to elect members of the board of directors and they vote on proposals that may directly affect the actions of the firm. Similarly, members of the board of directors vote to appoint the chief executive officer and vote on a variety of firm policies. Traditionally, these stakeholders broadly agreed on the objective of the firm – maximize firm value – and this one-dimensional objective simplified voting.[1]  Yet more recently, a number of academics, practitioners, and regulators have argued that firms ought to care about more than just value. While concern over ESG is exploding, there has been little conceptual work evaluating whether this shift in the scope of what matters to shareholders and board members impacts the performance of firm governance.[2]


How does one conceive of firm governance in the presence of ESG concerns? One defensible position is that now board members and shareholders have a multi-dimensional objective function; they must make tradeoffs between value creation and socially responsible behavior. (e.g., B´enabou and Tirole (2010), Hart and Zingales (2017)). This departure itself can be consequential. With agreement on just maximizing firm value, we might have thought of governance challenges as emerging from just differences of opinion about the best way to enhance firm value. Now shareholders or board members may genuinely disagree about how much value they are willing to give up in order to advance a social objective (and they may disagree about the best way to achieve any particular balancing of these goals). But, on further consideration, we find that this perspective itself is insufficiently nuanced. As the name, Environment, Social, and Governance, suggests, ESG may be multidimensional. In other words, we may think of board members facing disagreements over both the margin between value creation and socially responsible behavior as well as a potentially large number of margins between different aspects of socially responsible behavior. This is the perspective that we take. In this paper, we build a theory of corporate voting over policies that impact value as well as ESG dimensions. Our analysis fleshes out how the movement from concern over value to concern over value plus ESG impacts. In particular, we find that a narrow or focused notion of ESG can result in minimal challenges, while a broader or multi-dimensional notion may degrade governance in important ways.


Building on the literature on social choice theory, we theoretically examine voting for corporate policies when voters face a trade-off between maximizing firm value and one or more social policies (for example, reducing pollution and increasing employee satisfaction). Arrow (1951) famously shows that no method of aggregating preferences will satisfy a small set of naturally satisfying axioms. However, subsequent literature shows that stable choices can emerge under various restrictions on voter preferences. A well-studied restriction is the case of single-peaked preferences which is satisfied if the feasible policies can be arranged in a single dimension and on this dimension, all agents’ preferences are quasi-concave (informally, monotone or tent-shaped). When this restriction is satisfied, it is possible to identify choices that seem to reflect the will of a majority or aggregate preferences. We show that a number of challenges arise when the firm objective function is expanded to incorporate social policies. Interestingly, we show that adding just one social dimension does not lead to additional problems. After accounting for a feasibility constraint, preferences over firm value and one social dimension still satisfy an order restriction, and social choice is well-behaved. However, when more than one social dimension is present, challenges emerge – we show that the resulting choices are likely to be sensitive to institutional features that may vary or be difficult for investors to understand and track. In other words, our findings show that decision-makers may be able to add one social dimension to a firm’s objective function; however, the quality of the firm’s governance will decline if decision-makers care about too many objectives.


A simple example helps to illustrate our key findings. Imagine a firm with three possible policy choices. The firm can implement a policy, P, that maximizes firm value or a policy G that is less profitable but environmentally sustainable or a policy E that is less profitable still but mandates ethical treatment of workers. Consider three investors (or three board members) who are charged with making the policy choice, denoted as investors 1, 2, and 3. Suppose that investor 1 cares only about firm value and thus orders the alternatives by expected firm value: P, G, then E. Suppose that investor 2 most prefers to protect the environment, but would still rather support the ethical treatment of workers over just maximizing firm value and so ranks the alternatives, G, E, then P. Finally, suppose investor 3 cares about the ethical treatment of workers but is not willing to sacrifice returns for environmental policies and thus ranks the alternatives E, P, and then G. If any two of these policies are offered, a stable choice will emerge. In particular: given a choice between E and P, E wins. Given a choice between P and G, P wins. And given a choice between G and E, E wins.  However, if all three policies are offered, none of the alternatives beats the other two alternatives. While E beats P, G beats E, yet P beats G. As a result, when the three policies are offered, none of them is naturally preferred or stable under majority rule. The ultimate policy choice may thus depend on additional and less obvious features of the institution. This creates additional challenges for an investor who might face serious uncertainty about the firm’s likely policy choice.


What are the implications of this finding? If the firm faces more than two dimensions in its objective function, there is generally no natural policy choice. As a consequence, the choices that emerge will depend on the process by which policies are proposed, and the volatility of firm choices will tend to increase. This simple example illustrates a deep and practical concern about preference aggregation. Although majority rule (and other stronger super-majority rules) is not immune from Arrow’s impossibility theorem, there are still compelling reasons to use them. In particular, when preferences are single-peaked (or more general satisfy order restriction), the majority rule is known to be well-behaved; many systems that involve fairly decentralized proposal rights and majority voting will tend to select policies that are quite responsive to the preferences of the so-called median voter. But when preferences do not satisfy these types of restrictions, the outcomes can depend heavily on seemingly subtle institutional features. Whether a policy-making domain exhibits enough preference diversity for this problem to become important is an applied question, that to date, has not been extensively studied in finance contexts (such as choosing socially responsible corporate policies). Our paper fills this void. We show that when a group of voters have monotone preferences over at most two dimensions (firm value and one social dimension) and face a natural feasibility constraint, then we may think of the preference aggregation problem as nice or well-behaved. But this no longer holds with three or more dimensions.



Admati, A. R., Pfleiderer, P., & Zechner, J. (1994). Large shareholder activism, risk sharing, and financial market equilibrium. Journal of Political Economy, 102(6), 1097–1130.

Arrow, K. (1951). A difficulty in the concept of social welfare. Journal of Political Economy, 58, 328–346.

B´enabou, R., & Tirole, J. (2010). Individual and corporate social responsibility. Economica, 77, 1—19.

Berle, A. A., & Means, G. C. (1932). The Modern Corporation and Private Property. New York: Macmillan Publishing Co.

Burkart, M., Gromb, D., & Panunzi, F. (1997). Large shareholders, monitoring, and the value of the firm. The Quarterly Journal of Economics, 112(3), 693–728.

DeMarzo, P. M. (1993). Majority voting and corporate control: The rule of the dominant shareholder. Review of Economic Studies, 60(3), 713–734.

Demsetz, H. (1983). The structure of ownership and the theory of the firm. The Journal of

Law and Economics, 26(2), 375–390.

Hart, O., & Zingales, L. (2017). Companies should maximize shareholder welfare not market value. Journal of Law, Finance, and Accounting, 2, 247–274.

Jensen, M., & Meckling, W. (1976). Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics, 3(4), 305-360.

Maug, E. (1998). Large shareholders as monitors: is there a trade-off between liquidity and control? Journal of Finance, 53(1), 65–98.

Meirowitz, Adam and Pi, Shaoting and Ringgenberg, Matthew C., Voting for Socially Responsible Corporate Policies (March 14, 2022). Available at SSRN: or


[1] DeMarzo (1993) shows an exception: if markets are incomplete, then investors may also disagree on how to maximize firm value, which complicates the public choice problem.

[2] A large literature examines the challenges of corporate governance when the goal is to maximize firm value. For example there is extensive work on the agency conflict that arises between investors and managers when ownership and management are separate. See, for example, Berle and Means (1932); Jensen and Meckling (1976); Demsetz (1983); Admati, Pfleiderer, and Zechner (1994); Burkart, Gromb, and Panunzi (1997); Maug (1998).




Cross-Country Stock Market Comovement: a Macro Perspective

Elisa FaragliaCERF Fellow

April 2022

In the post WW2 period, the cross-country correlations between the stock markets in developed economies were fairly low, implying significant potential benefits from diversification. Beginning in the mid 1990s, stock market correlations started increasing and continued to do so up until the aftermath of the Great Recession. These increases have been quantitatively large; for example the correlation of US equity returns with the equity returns in an aggregate index of other developed economies has risen from below 0.4 in the 1980s to above 0.8 in the 2010s and a similar pattern emerges when looking at bilateral developed country pairs. The increase in stock market correlations has coincided with a concurrent strengthening in foreign direct investment (FDI) linkages between the largest economies with developed equity markets. The aim of the project is to explore the relationship between these two phenomena.

We propose an intuitive mechanism through which increases in bilateral FDI positions can lead to higher stock market correlations between two countries. Because multinational corporations engage in FDI abroad, they become exposed to country specific TFP shocks in the foreign country. In an environment with increased FDI, firms generate a larger fraction of their earnings abroad. This implies stronger incentives to increase investment in response to shocks in the foreign country. In the presence of intangible technology capital, increased investment abroad can also spill over to investment at home, due to the complementarity between tangible and intangible capital. Investment and capital are therefore more synchronized across multinationals and this implies their equity values are also more correlated. We first establish an empirical link between the comovement of stock returns with international stock markets and FDI. We provide evidence that the returns of multinational firms comove with foreign stock markets more than the returns of non-multinational firms; this is more so when multi-national firms have more intangible assets, or have high R&D expenditure, which is consistent with our theoretical mechanism. Additionally, using a panel of 21 developed economies, we also find that increases in FDI of the order of magnitude observed across these countries, are associated with in-creases in their bilateral stock market comovement that are sizeable, positive, and highly significant, even when controlling for trade.

With this empirical evidence in place, we propose a production-based asset pricing model (see Jermann, 1998) extended to two countries and, crucially, incorporating multinational firms investing in technology capital as in McGrattan and Prescott (2010). To quantify the importance of the mechanism, we add country-specific shocks, introduce incomplete international asset markets and calibrate the model to two regions, the US, and the rest of the world. We find that the observed increase in FDI positions leads to a rise in stock market correlation from 0.380 to 0.520, accounting for one third of the overall observed increase.

When markets are incomplete, a firm’s FDI operations provide access to foreign markets and, at the same time, offer diversification benefits for its shareholders. The model assigns FDI an important role in explaining stock market comovements, even when abstracting from the diversification channel.

To show this, we recompute our experiments assuming a complete set of contingent claims available to shareholders. In that case, firms’ investment decisions are decoupled from portfolio diversification considerations. We find that the level of stock market correlation increases as markets become more complete, as expected. However, the increase in stock market correlation when FDI linkages are strengthened is present for all asset market structures, including the two extremes of complete markets

and financial autarky. This is even though the correlation of dividends can be quite different across market structures and can go up or down in response to the FDI increase, depending on the degree of market incompleteness. Thus, the divergence between the comovement of dividends and the comovement of equity prices, highlighted in Jordà, Schularick, Taylor and Ward (2019), can be rationalized in our model by incomplete markets. The key insight from the production asset pricing model is that equity price comovements must reflect comovement in investment and capital across multinationals, but can be entirely independent of dividend comovements.

Concurrently with the increase in FDI, the US experienced moderate increases in cross-border equity holdings, as well as in goods trade with other developed economies. Our work also sheds light on the contribution of those two changes to the stock market comovement. Consider first cross-border equity holdings. In contrast to standard models of diversification as in Heathcote and Perri (2004, 2013) where FDI and portfolio diversification are treated as interchangeable, our model allows for a distinction and thus a non-trivial interaction between the two. When we introduce cross-border equity holdings to the model, and allow them to rise exogenously at the same time as FDI and in line with the data, this does not generate additional increases in the stock market correlation. We also extend our model to allow for trade as in McGrattan and Waddle (2020). In our setup, trade and FDI are substitutes reflecting the focus of the model on horizontal FDI between developed economies. As a result, an increase in trade tends to decrease FDI and hence stock market correlation. Thus, in our experiments, increased trade does not contribute to stock market comovement either.

The mechanism we propose highlights a key role for FDI in explaining stock market correlation over and above any indirect effects it might have through inducing GDP synchronization. Our calibration exercise suggests that increased GDP synchronization could have also played a role.

Link to the paper:


Heathcote, J. and F. Perri, 2004. “Financial Globalization and Real Regionalization”, Journal of

Economic Theory, 119(1): 207-243.

Heathcote, J. and F. Perri, 2013. “The International Diversification Puzzle is Not as Bad as you

Think”, Journal of Political Economy, 121(6): 1108-1159.

Jermann, U., 1998. “Asset Pricing in Production Economies”, Journal of Monetary Economics,

41(2): 257-275.

Jordà, O., M. Schularick, A. M. Taylor and F. Ward, 2019. “Global Financial Cycles and Risk

Premiums”, IMF Economic Review, 67(1): 109-150.

McGrattan, E.R. and E. C. Prescott, E.C., 2010. “Technology Capital and the US Current Ac-

Count”, American Economic Review, 100 (4): 1493-1522.

McGrattan, E.R. and A. Waddle, 2020. “The Impact of Brexit on Foreign Direct Investment and

Production”, American Economic Journal: Macroeconomics, 12 (1): 76-103.



How do climate risks affect trading behaviour?

Andreas Charisiadis, CERF Research Assistant

March 2022

Mitigating climate change has become one of the defining challenges of our time. Indeed, there is global concern about the potentially disastrous long-term consequences of unmitigated climate change. The risks arising from climate change have far-reaching implications for the real economy and financial markets in particular. Two types of climate risk are particularly prevalent: direct environmental risk and policy (or regulatory) risk. The former relates to the occurrence of extreme climatic events, such as storms, floods, droughts, or wildfires, whereas the latter refers to the uncertain impact and timing of regulations aimed at mitigating climate change, such as the introduction of carbon taxes or emission caps. Several recent contributions explore how such risks impact capital markets, and specifically how these risks – and the way they are perceived by investors – can affect trading behaviour.

Climate risks and investor behaviour

Alok et al. (2020) explore whether professional money managers misestimate the risk of climatic disasters. The authors hypothesize that misestimation of such risks may be driven by salience bias, i.e. the behavioural tendency to overweight more readily available information. Tversky and Kahneman (1973) document that this type of bias can induce individuals to overestimate the risk of salient events depending on the ease with which instances thereof can be recalled. On that basis, Alok et al. (2020) hypothesize that fund managers may overestimate the risk of extreme climatic events if they have experienced such events in the (recent) past themselves and may therefore substantially reduce their holdings of assets exposed to such risks. The distance of funds from climatic disaster zones – defined as areas directly hit by an extreme weather event – serves as an exogenous source of variation in the salience of climatic disasters for money managers. While all funds tend to reduce their exposure to equities of firms located in a disaster area, this decrease in portfolio weights is significantly more pronounced for funds located closer to the affected area. Alok et al. (2020) attribute this asymmetric portfolio reallocation to overestimation of the disaster risk by fund managers located in the vicinity of the disaster zone. The trading behaviour ensuing from such salience bias can be shown to hurt financial returns: a zero-cost portfolio consisting of long positions in disaster zone stocks which closely located fund managers underweighted the most, and short positions in stocks which were underweighted the least, yields significant risk-adjusted excess returns for a holding period of two years following the disaster.

Choi et al. (2018) study how investors update their beliefs about climate risk. They find that investors revise their expectations about climate change when experiencing an episode of unusually high temperatures. During abnormally warm months there is a significant increase in attention to climate change as measured by the volume of Google searches for ‘global warming’. On that basis, Choi et al. (2018) explore whether and how the ensuing updated investor beliefs about climate risk affect prices and trading behaviour in financial markets. They document that retail investors exhibit a tendency to divest from carbon-intensive equities when experiencing abnormally warm episodes, resulting in a relative underperformance of such stocks vis-à-vis their low-carbon counterparts. The authors also find that institutional investors appear less prone to be swayed by such transitory weather events and therefore – in contrast to retail investors – do not systematically react to abnormal temperatures.

Hedging climate risks

An important strand of the literature explores the methods which investors can use to insure themselves against climate risks. For instance, Engle et al. (2020) study a dynamic approach for forming portfolios of publicly traded assets in order to hedge climatic risks. This method allows investors to (partially) insulate themselves from risks which would otherwise be difficult to insure, as the inherently long-run and systemic nature of climate risk impedes the implementation of standard insurance contracts. Rather than relying on securities which generate positive returns in the event that climate risks materialize, Engle et al. (2020) construct portfolios whose short-term returns hedge innovations in news about climate change. Using textual analysis of newspapers, the authors extract climate change related news, which carry information about the perceived and actual level of climate risk. This allows constructing a climate news index which tracks the intensity of climate change reporting over time. On that basis, equity portfolios which hedge innovations in the time series of climate news can be constructed. These portfolios overweight stocks which rise in value upon the arrival of (negative) climate change news, and contain short positions in stocks whose prices decline during such events. The resulting hedge portfolios require continuous rebalancing based on the latest information about the relationship between equity returns and climate news, similar to the dynamic hedging approach of Black and Scholes (1973) and Merton (1973). Continued updating will eventually yield a portfolio which provides compensation for losses incurred as a result of the materialization of climate risks over the long run. Interestingly, the resulting hedge portfolios do not necessarily align with the common prior that optimally hedging climate risks primarily relies on placing industry bets, i.e. holding long positions in ‘clean’ industries, such as renewable energy, and short positions in ‘dirty’ industries, such as fossil fuels. In a series of out-of-sample performance tests, Engle et al. (2020) document that their methodology yields hedge portfolios which outperform alternative methods of constructing climate risk hedges (for instance, using industry tilts via positions in energy ETFs).

Andersson et al. (2016) present a dynamic investment strategy with which long-term passive investors can hedge climate policy risks while avoiding substantial sacrifices in returns. They describe a procedure for ‘decarbonizing’ standard equity indices in order to construct a hedge against the risk of the introduction (or the tightening) of carbon reduction policies. The formation of their ‘green’ index follows a two-step procedure: First, the k most carbon-intensive stocks are excluded from the chosen benchmark (say, the S&P 500). These firms are the ones most vulnerable to climate change mitigation policies. The remaining stocks in the index are then optimally re-weighted in order to minimize the tracking error with respect to the benchmark. As a result, the only significant difference in aggregate risk exposure between the benchmark and the decarbonized index is with respect to carbon risk. The authors show that their approach allows the tracking error to be almost eliminated, while simultaneously achieving a substantial reduction in the exposure to carbon risk. In fact, as long as carbon reduction policies are pending, the decarbonized index achieves returns comparable to the reference index. However, once regulatory risks materialize (i.e., more stringent carbon reduction policies are introduced, or are expected to be introduced) the ‘green’ index is bound to outperform its benchmark.



Alok, S., Kumar, N., and Wermers, R. (2020) “Do fund managers misestimate climatic disaster risk?” Review of Financial Studies, 33(3): 1146-1183.

Andersson, M., Bolton, P., and Samama, F. (2016) “Hedging climate risk.” Financial Analysts Journal, 72(3): 13-32.

Black, F. and Scholes, M. (1973) “The pricing of options and corporate liabilities.” Journal of Political Economy, 81: 637-654.

Choi, D., Gao, Z., and Jiang, W. (2020) “Attention to global warming.” Review of Financial Studies, 33(3): 1112-1145.

Engle, R.F., Giglio, S., Kelly, B., Lee, H., and Stroebel, J. (2020) “Hedging climate change news.” Review of Financial Studies, 33(3): 1184-1216.

Merton, R.C. (1973) “Theory of rational option pricing.” Bell Journal of Economics and Management Science, 4: 141-183.

Tversky, A. and Kahneman, D. (1973) “Availability: A heuristic for judging frequency and probability.” Cognitive Psychology, 5(2): 207-232.



Dynamic Group Decision Making of Private Firms

Shiqi Chen, CERF Research Associate

February 2022


Unlike what is often assumed in the standard corporate finance literature that firms are often governed by a single representative agent on behalf of the principal, in reality, many corporate decisions are indeed determined by a group of agents or investors, who are heterogeneous in many dimensions (e.g. beliefs, risk preferences, investment horizons, capital contributions, etc). Group decision making is very prevalent in finance, for example, board meetings, partnerships, team-managed mutual funds, or general management teams within firms. All these mean that ignoring such heterogeneity and interactions within the decision coalition will miss out on an essential ingredient of the corporate decision-making process and lead to inconclusive results.

Existing experimental studies have shown that group behaviour is very different from individual behaviour. The literature offers two competing hypotheses for group decisions. The group shift hypothesis (e.g. Moscovici and Zavalloni (1969); Kerr (1992)) suggests that group decisions often shift toward one of the dominant individuals in a team, and this person usually has a prevalence preference. As a result, the team eventually gravitates toward extremes and makes more polarized decisions than its members. The diversification hypothesis (e.g. Sah and Stiglitz (1986, 1988)) suggests that the extreme preferences or opinions are averaged out, and teams make less extreme decisions than individual members. Although so far, the diversification hypothesis receives more empirical support (Bär, Kempf and Ruenzi (2011)), it struggles to explain the puzzling observation that the average group is more (less) risk-averse than the average individual in high (low) risk situations (Shupp and Williams (2008)). The working paper by Chen and Lambrecht (2021) reconciles the two hypotheses by examining a private firm's financial decision from the lenses of group decision making.

Compared to public firms, there are two distinct characteristics of private firms that are currently underexplored. First, the stakes are not traded on a public market, meaning that shares in private firms are highly illiquid, and investors cannot withdraw from the firm easily. Second, unlike public firms that are often run by management and owned by dispersed investors, private firms are often owned and run by a small group of investors, all of which are actively involved in the day-to-day running of the business. Taking into account these two properties, this paper studies a private firm founded and run by a group of investors with heterogeneous capital contributions and risk preferences, who cannot trade their claims on the firm. They group together because one of the investors (the entrepreneur) has a superior investment opportunity but not enough capital, while other co-investors have the required capital but no access to the investment opportunity, which incentivizes all the investors to join the firm. However, they have to jointly agree on the firm's investment, financing and payout decisions, as well as the internal governance structure.

Ideally, each investor prefers policies that maximize their own lifetime utility. Nevertheless, such policies cannot sustain because of the heterogeneity in preferences. This paper shows that the firm's optimal investment and financing policies are not merely a weighted of the investors' optimal policies. Interesting, these weights are time-varying, with more weight shifting toward the less (more) risk-averse investors in good (bad) times. This means that the firm will act more aggressively (conservatively) in good (bad) times by taking on more (less) debt and investing more (less) in the risky project. The resultant leverage is procyclical as the firm dynamically rebalances its assets and liabilities in response to income shocks. Even though all investors have constant levels of risk aversion and their compositions within the firm are fixed, the implied coefficient of relative risk aversion for the group is time-varying and spikes (declines) in bad (good) times.

Heterogenous preferences also give rise to a capital structure that consists of safe debt, equity and preferred equities. The claim for the least risk-averse investor is convex in the firm's total net worth, similar to an equity contract. The claims for the most risk-averse investor is concave, while for investors with intermediate levels of risk aversion, the claims are S-shaped, resembling preferred equities with different levels of seniority and payout caps. Such a finding helps explain the mixture of contracts adopted in private firms such as venture capitals.

The paper further reveals that the internal governance structure depends not only on the initial capital contribution but also on the heterogeneity in risk preferences and the investors' outside options. The internal governance weights (which resemble ownership shares) are fixed at the startup. In the equilibrium, a co-investor's weight shrinks toward zero as her capital contribution vanishes. In contrast, the entrepreneur retains a positive weight even without any capital contribution, reflecting the synergies she generates from her human capital! Meanwhile, the entrepreneurs' net worth stake in the firm is greater than the capital she contributes. This means the entrepreneur is buying her share at a discount, and the co-investors are paying a premium to access a better investment opportunity.

The paper demonstrates that the dynamics in the firm's financial policies and the diversity in equity claims resolve the divergence in preferences and compensate for the inability to trade. The paper also highlights the importance to take into account such 'group' elements in the analysis of corporate financial behaviour. Indeed, dynamic models of group decision making in corporate finance are very rare (see Garlappi, Giammarino and Lazrak (2017, 2021)). Nevertheless, we hope that the work we are currently working on can provide some insights into how firms make their decisions and serve as the first step for many more to come.



Bär, M., A. Kempf, and S. Ruenzi (2011): “Is a team different from the sum of its parts? Evidence from mutual fund managers,” Review of Finance, 15(2), 359–396.

Chen, S., and B. Lambrecht (2021): “The Dynamics of Financial Policies and Group Decisions in Private Firms,” Available at SSRN: or

Garlappi, L., R. Giammarino, and A. Lazrak (2017): “Ambiguity and the corporation: Group disagreement and underinvestment,” Journal of Financial Economics, 125(3), 417– 433.

Garlappi, L., R. Giammarino, and A. Lazrak  (2021): “Group-managed real options,” Review of Financial Studies, forthcoming, hhab100.

Kerr, N. L. (1992): “Group decision making at a multialternative task: Extremity, interfaction distance, pluralities, and issue importance,” Organizational Behavior and Human Decision Processes, 52(1), 64–95.

Moscovici, S., and M. Zavalloni (1969): “The group as a polarizer of attitudes,” Journal of Personality and Social Psychology, 12(2), 125–135.

Sah, R. K., and J. E. Stiglitz (1986): “The architecture of economic systems: Hierarchies and polyarchies,” The American Economic Review, 76(4), 716–727.

Sah, R. K., and J. E. Stiglitz (1988): “Committees, hierarchies and polyarchies,” The Economic Journal, 98(391), 451–470.

Shupp, R. S., and A. W. Williams (2008): “Risk preference differentials of small groups and individuals,” The Economic Journal, 118(525), 258–283.



The Gender Gap in Household Bargaining Power: A Portfolio-Choice Approach

Ran Gu (University of Essex) and Cameron Peng (London School of Economics and Political Science) and Weilong Zhang, CERF Fellow (University of Cambridge)

January 2022


When studying the allocation of household assets, virtually all existing papers start with the household as the primitive unit of analysis (Gomes et al. 2020). In most models, a household is an imagined individual solving the optimal portfolio problem with a well-defined set of goals and constraints. In empirical analysis, it is common to treat a household as an average of all its members or to use the head of the household to represent the entire household, without further considering how each household member may play a different role or have a different say. These treatments, by simplifying the portfolio-choice problem, allow researchers to focus on other important aspects of household finance. However, they embed a fundamental disconnect between individuals and households: household members may have different characteristics and need to resolve their differences to make financial decisions for the household.

Risk preference, for example, is a key determinant of portfolio choice under standard portfolio theory, and it has been observed that members of the same household often report different attitudes towards risk. When such internal disagreement occurs, household members will inevitably need to bargain with each other in order to make decisions for the entire household. What characteristics determine an individual's bargaining power when making financial decisions? Which characteristics are quantitatively more important? Between men and women, is there a gender gap in bargaining power? If so, what drives it?

Existing approaches

A budding literature begins to tackle these questions with two main approaches. The first approach links the variation in individual-level characteristics to household-level outcomes (e.g., Addoum 2017; Olafsson and Thornqvist 2018; Ke 2020). This approach can establish the relevance of a plausible factor, but is restricted by the availability of plausible instruments. Therefore, it usually does not allow for a quantitative comparison among multiple factors. A second approach finds an empirical proxy for bargaining power and studies its properties and determinants (e.g., Friedberg and Webb 2006; Yilmazer and Lich 2015; Zaccaria and Guiso 2020). A popular proxy is constructed based on so-called “final say” question, whereby each household is asked to report who has ultimate responsibility for making a decision in financial matters and acts as the “financial head” of the household. However, when separately surveyed, different household members often give different answers to the same question, suggesting nontrivial noise and disagreement. Furthermore, a common concern about survey responses directly used in this survey-based approach still lingers: is what people say consistent with what they do?


Our approach

We propose a novel approach that directly estimates bargaining power by combining individual risk preference with household portfolio choice. The basic intuition is that household members with more bargaining power are more able to incorporate their own risk preferences into the household's overall portfolio decision. This departs from the survey-based approach by examining what people actually do rather than what they say. By explicitly modeling the portfolio-decision process and the determinants of bargaining power, we also depart from earlier approaches by studying multiple channels—such as income, employment status, education, and personality traits—at the same time and quantifying each channel's relative importance.


With this idea in mind, we build a tractable model of intrahousehold financial decisions and structurally estimate it using detailed longitudinal data. In our model, spouses differ in their risk preferences and other individual characteristics, and they make portfolio decisions for the entire household portfolio in two steps. In the first step, they cooperatively decide on a household risk preference, which is the weighted average of their respective risk preferences. The weight represents each individual's bargaining power and is determined by spousal differences in individual characteristics and a gender effect. In the second step, the household makes portfolio decisions based on this household-level risk aversion as if it were a single individual, with additional considerations, such as wealth, participation cost, family size, literacy, and education, as suggested in the literature. The household then decides whether to participate in the stock market (the extensive margin) and by how much (the intensive margin), in the spirit of the Merton model. We estimate the model using panel datasets from three countries: Australia, Germany and US. We adopt maximum likelihood method in the estimation, with stock market participation and risky asset holdings as the two outcome variables.


Results 1: Men have more bargaining power in financial decisions

We estimate our model using panel samples from three different countries: Australia, Germany and US. Our estimation result shows a significant gender gap in the bargaining power: in the average Australia household, the weight placed on husband's risk preference is about 0.59, while the weight placed on the wife's is 0.41; in the average Germany household, the weight placed on husband's risk preference is about 0.68; and in the average US household, the weight placed on husband's risk preference is about 0.61. Consistent with a greater gender gap among the German population, German households show a much more traditional attitude towards gender roles according to the World Values Survey (Ke 2018).

Result 2: The gender gap in bargaining power can be traced back to observed characteristics as well as a gender effect

Our subsequent analysis tries to understand the sources of this gender gaps in bargaining power. While the gap is partially explained by gender differences in individual characteristics such as income and employment, it is also due to gender effects. Overall, income, employment, and age tilt bargaining power toward the husband, as men on average earn more, are more likely to be employed, and are older. However, all observable characteristics combined can only account for above half of the gap, leaving the other half unexplained. This suggests a gender effect that contributes to husbands' disproportionally high bargaining power.


Result 3: The gender effect is associated with gender norms

We link the gender effect to direct measures of gender norms. The Australian Survey includes three specific questions about gender norms, and husbands and wives need to answer these questions separately. The questions elicit attitudes toward traditional gender roles and how housework and childcare studies should be shared. We find that households with progressive attitudes toward gender norms are more likely to elect the wife as the head of the household, thereby empowering women with more say in financial decisions. In particular, we find that subjective perceptions of both the husband and the wife matter.




Addoum, J. M. (2017). Household portfolio choice and retirement. Review of Economics and Statistics, 99(5):870–883.


Friedberg, L. and Webb, A. (2006). Determinants and consequences of bargaining power in households. Technical report, National Bureau of Economic Research.


Gomes, F., Haliassos, M., and Ramadorai, T. (2020). Household finance. Journal of Economic

Literature, forthcoming.


Ke, D. (2018). Cross-country differences in household stock market participation: The role of

gender norms. In AEA Papers and Proceedings, volume 108, pages 159–62.


Ke, D. (2020). Who wears the pants? gender identity norms and intra-household financial decision making. Forthcoming at Journal of Finance.


Olafsson, A. and Thornqvist, T. (2018). Bargaining over risk: The impact of decision power on

household portfolios.


Yilmazer, T. and Lich, S. (2015). Portfolio choice and risk attitudes: a household bargaining

approach. Review of Economics of the Household, 13(2):219–241.


Zaccaria, L. and Guiso, L. (2020). From patriarchy to partnership: Gender equality and household finance. Available at SSRN 3652376.