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You will prepare a word-processed write-up (10 pages of text plus supporting material such as figures and tables) that is due the last day of the course. The write-up contains materials partly from your presentation, and partly your own analysis, expansion, or thoughts of the subject matter.


General guidelines for preparing the write-up:

  • identify the objective and the main issues.
  • highlight your main conclusions in an executive summary (no more than one page) that contain specific results from your analysis.
  • highlight your contributions.
  • the main body of your analysis should be self-explanatory.
  • state clearly the inputs to your analysis and the chosen methodology (if any). If you feel that certain assumptions need to be made to justify a solution, make them explicit.
  • justify your finding by providing intuition.
  • cite all references properly.


about the paper

Posted on: Monday, March 16, 2020 2:03:01 PM EDT

Some of you seem to be confused about what the paper is about.


Think about it as a write-up that contains materials partly from your presentation, and partly your own analysis, expansion, or thoughts of the subject matter. Grading of the paper will be primarily based on: originality, clarity, depth of your analysis. See also the exposition from an early announcement. If you have no/little idea beyond what you present, then a summary of the paper/materials used from presentation will be the minimum.

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Long-Term Finance and Investment with Frictional Asset Markets Julian Kozlowski∗ PRESENTED BY QIMING HUANG ECON 558 Frictional Asset Market What is Frictional Asset market ? ◆ Asset market: the entire set of markets in which people buy and sell real and financial assets. ◆ Trading friction: It could mean any reason which influences the process of decision-making of the investor. ◆ Both in advanced and emerging economies, corporate debt markets exhibit trading frictions. Frictional Asset Market How does the trading friction affect the firm? ◆ More severe frictions make long-term finance relatively more expensive ◆ Firms borrow and invest at shorter horizons with detrimental effects on productivity and the aggregate economy 1.Introduction Motivation ◆ Firms in emerging economies tend to borrow and invest at shorter maturities compared to those in advanced countries which may have adverse effects on the aggregate economy. The lower prevalence of long-term financing and investment is thought of by many as a contributor to poor aggregate performance. As a result, there is a policy debate on how to stimulate long-term finance. ◆ This paper contributes to this literature and policy debate by developing a theoretical framework of maturity choice and its aggregate effects. 1. Introduction Central mechanism ◆ Borrow and invest at shorter maturities have adverse effects on the aggregate economy ◆A long-maturity asset will trade in the secondary market more times than a shorter one ◆The trading liquidity spread increases with maturity ◆Economies with more severe frictions exhibit a steeper yield curve which further affects maturity and investment choices of firms. 1. Introduction The Process of this paper ◆ Create a model show that variations in trading frictions change the steepness of the yield curve ◆ Use a calibrated model matches key features of the yield curve in US and Argentina and predicts about one-half of the differences in maturity and output between these countries. ◆ Finally, get policy intervention with subsidized financial intermediaries can improve liquidity, stimulate long-term finance. 2. Model (process) Firms start financing Borrow in the primary market and choose the maturity structure Firms balance the tradeoff between projects of higher productivity and more expensive financing 2. Model (factors of investment) Liquidity in secondary markets shapes interest rates in two ways ◆ The liquidity spread is increasing in maturity. ◆ Improvements in liquidity generate a flattening of the yield curve 2. Model (factors of investment) From figure 1, we can see the liquidity spread is increasing in maturity. 2. Model(factors of investment) Figure 2 shows the characterization of the equilibrium in the space of liquidity and maturity. The solid red and blue curves show the lenders and borrowers locus, respectively. The intersection of these curves characterizes the equilibrium of the economy. 2. Model(factors of investment) Free entry to the secondary market determines the equilibrium liquidity. ◆ When there is a lower search cost, more buyers are willing to enter the secondary market, and this increases liquidity in equilibrium. ◆Therefore, financial development generates more liquid markets in which liquidity spreads diminish for all maturities, but in particular for long-term debt and induces firms to invest in more profitable and high productivity longer-term projects. ◆This result suggests that the empirical evidence that firms in emerging economies borrow at short maturities can be the result of a substitution effect between maturity and liquidity of secondary markets. 2. Model (Compare US and Argentina) ◆ Estimates of the non-default component of credit spreads are abundant for the US but scarce for Argentina. ◆Estimation for the US and Argentina find that credit spreads increase more with maturity in Argentina than in the US. 2. Model (Compare US and Argentina) ◆ A calibration of the model to the US target the slope of the yield curve among other standard moments. ◆ Counterfactual exercises that introduce the trading frictions of Argentina— measure with the estimate of the slope of the yield curve—in the US economy explain about one-half of the maturity and output differences between Argentina and US. 3. Policy analysis (GSI) What is GSI? ◆ The paper evaluates one intervention that subsidizes financial intermediaries in the secondary market, named Government-Sponsored Intermediaries. What instrument does GSI have? 1. the size of the intervention, 2. the prices at which the government-sponsored dealers buy and sell from private investors, 3. a distortionary tax rate to finance the costs of GSIs 3. Policy analysis (GSI) How GIS works (Figure 5) ◆ GIS buy at higher prices than in private meetings to provide more gains from trade to private sellers which alleviates trading friction. ◆ On the other hand, government agents sell securities at a lower price than in private meetings to stimulate the entry of potential buyers to the market. The optimal policy increases liquidity which flattens the yield curve and stimulates the use of long-term finance. 3.Policy analysis (GSI) Results ◆ GIS policy generates an increase in maturity of five months for an economy like the US and eight months for an economy with a less-developed financial system as in Argentina. ◆ Improve the liquidity of financial markets, reduce long-term financial cost, and induce firms to borrow and invest at longer horizons 4. Conclusion ◆ This paper studies the linkages between the maturity of corporate debt, the liquidity of financial markets and the real economy. ◆Long-term finance is particularly more expensive in economies with severe trading frictions which induce firms to invest at shorter horizons. ◆ An intervention like GSIs can improve the liquidity of financial markets, reduce long-term financial cost, and induce firms to borrow and invest at longer horizons. ◆The framework and results developed in this paper transcend the particular application to corporate bonds and can be used to study other markets for long-term finance 5. Reference Cortina Lorente, J. J., T. Didier, and S. L. Schmukler (2016). How long do corporates borrow? evidence from capital raising activity. World Bank Working Paper . Demirg¨u¸c-Kunt, A., E. Feyen, and R. Levine (2013). The evolving importance of banks and securities markets. The World Bank Economic Review 27 (3), 476–490. Duffie, D., N. Gˆarleanu, and L. H. Pedersen (2005). Over-the-counter markets. Econometrica 73 (6), 1815–1847. Long-Term Finance and Investment with Frictional Asset Markets Julian Kozlowski∗ New York University November 8, 2017 [Click here for latest version] Abstract This paper develops a theory of investment and maturity choices and studies its implications for the macroeconomy. The novel ingredient is an explicit secondary market with trading frictions which leads to a liquidity spread which increases with maturity and generates an upward sloping yield curve. As a result, trading frictions induce firms to borrow and invest at shorter horizons than in a frictionless benchmark. Economies with more severe frictions exhibit a steeper yield curve which further affects maturity and investment choices of firms. A model calibrated to match cross-country moments suggests that reductions in trading frictions—a new channel of financial development—can promote economic development. A policy intervention with government-backed financial intermediaries in the secondary market can improve liquidity and reduce the cost of longterm finance which promotes investment in longer-term projects and generates substantial welfare gains. JEL Classifications: E44, G30, O16. Keywords: Debt maturity, Over-the-counter market, Liquidity, Secondary markets. ∗ My special thanks and gratitude to my advisor Ricardo Lagos and committee Thomas Sargent, Laura Veldkamp and Venky Venkateswaran for their encouragement and support. For helpful conversations I thank Eduardo Borensztein, Jarda Borovicka, Diego Daruich, Mark Gertler, Violeta Gutkowski, Virgiliu Midrigan, Simon Mongey, Cecilia Parlatore, Michael Peters, Pau Roldan, Juan Sanchez and Sergio Schmukler. I thank participants in seminars at NYU, St. Louis Fed, Minneapolis Fed, 2016 MFM Summer Session, 2016 UTDT Annual conference, 2017 AFA Annual meeting, SED 2017 meetings, and 10th NYU Search Theory Workshop for helpful comments. Juan Jose Cortina, Tatiana Didier and Sergio Schmukler have kindly shared data on corporate debt maturity. Email: kozjuli@nyu.edu. Address: 19 W 4th St Fl 6, New York, NY 10012. Rome was not built in a day. Li Proverbe au Vilain, 1190 1 Introduction Firms in emerging economies tend to borrow and invest at shorter maturities compared to those in advanced countries which may have adverse effects on the aggregate economy. The lower prevalence of long-term financing and investment is thought of by many as a contributor to poor aggregate performance. As a result, there is a policy debate on how to stimulate long-term finance.1 This paper contributes to this literature and policy debate by developing a theoretical framework of maturity choice and its aggregate effects. It builds on a key feature of capital markets: both in advanced and emerging economies, corporate debt markets exhibit trading frictions. The main result is that more severe frictions make long-term finance relatively more expensive, inducing firms to borrow and invest at shorter horizons with detrimental effects on productivity and the aggregate economy. The central mechanism of the paper is that a long-maturity asset will trade in the secondary market more times than a shorter one. Hence, the lack of liquidity in secondary markets—a severe trading friction—affects more long- than short-maturity assets generating two important results for the yield curve. First, the liquidity spread increases with maturity. Second, economies with less liquid secondary markets have a steeper yield curve and firms invest at shorter horizons and lower productivity projects. A calibrated model matches key features of the yield curve in US and Argentina and predicts about one-half of the differences in maturity and output between these countries. Finally, a policy intervention with subsidized financial intermediaries can improve liquidity, stimulate long-term finance, and induce investment at longer horizons generating substantial welfare gains. The modeling framework combines a fairly standard production economy with an over-thecounter (OTC) secondary market for debt as in Duffie et al. (2005). To finance investment, firms borrow in the primary market and choose the maturity structure of their liabilities. When deciding the gestation period of their projects, firms balance the trade-off between projects of higher productivity and more expensive financing due to an upward sloping yield curve. Liquidity in secondary markets shapes interest rates in two ways. First, the liquidity spread is increasing in maturity. Liquidity needs shocks hit debt holders which cause them to become potential sellers. However, trading frictions prevent them from immediately sell the asset as 1 For empirical evidence see Demirgüç-Kunt and Maksimovic (1998) and Levine (2005), among others. Some policy concerns are expressed in World Economic Forum (2011); European Comission (2013); OECD (2013); Group of Thirty (2013); World Bank (2015). 1 they need to search for a counterpart and bargain over the terms of trade. Alternatively, the maturity of the asset also provides liquidity to debt holders. Hence, gains from trade in the secondary market increase with the maturity of the asset which delivers an upward sloping yield curve. Second, liquidity is more important for long-term assets in the sense that a reduction of the trading friction not only reduces the liquidity spread for all maturities but it also lowers the slope of the yield curve. Therefore, improvements in liquidity generate a flattening of the yield curve. Decentralized asset markets affect investment costs which propagate to the real economy. Long-maturity projects have high returns but need financing for a prolonged horizon. Hence, if the yield curve is upward sloping, short-term projects are relatively more attractive than longer ones. As a result, variations in trading frictions change the steepness of the yield curve and distort financial and investment choices which affect the aggregate economy. Free entry to the secondary market determines the equilibrium liquidity. To evaluate variations in trading frictions, i.e., financial development, we consider changes in the entry cost to the secondary market. When there is a lower search cost, more buyers are willing to enter the market, and this increases liquidity in equilibrium. Therefore, financial development generates more liquid markets in which liquidity spreads diminish for all maturities, but in particular for long-term debt and induces firms to invest in more profitable and high productivity longer-term projects. This result suggests that the empirical evidence that firms in emerging economies borrow at short maturities can be the result of a substitution effect between maturity and liquidity of secondary markets. Estimates of the non-default component of credit spreads are abundant for the US but scarce for emerging economies. One option to identify the slope of the yield curve is to compare credit spreads of the same firm issuing two bonds on the same day but at different maturities. This estimation only needs data on credit spreads and can be implemented in emerging economies. Estimation for the US and Argentina find that credit spreads increase more with maturity in Argentina than in the US. Then, a calibration of the model to the US target the slope of the yield curve among other standard moments. Next, validation exercises show that the model does a reasonable job of matching the level of the liquidity spread in the US which was not a target of the calibration. Counterfactual exercises that introduce the trading frictions of Argentina— measure with the estimate of the slope of the yield curve—in the US economy explain about one-half of the maturity and output differences between Argentina and US. Although the model is stylized and tractable, the quantitative results suggest that the theory captures important features of corporate debt markets. The presence of frictional asset markets suggests that a policy intervention may increase the liquidity of financial markets and improve credit conditions for the corporate sector which can 2 generate benefits for the real economy. Based on existing policies like Government-Sponsored Enterprises (i.e., Fannie Mae and Freddie Mac) or large-scale asset purchases (i.e., quantitative easing), the paper evaluates one intervention that subsidizes financial intermediaries in the secondary market, named Government-Sponsored Intermediaries (GSIs). The government has four instruments: the size of the intervention, the prices at which the government-sponsored dealers buy and sell from private investors, and a distortionary tax rate to finance the costs of GSIs. Under the optimal policy, government intermediaries buy at higher prices than in private meetings to provide more gains from trade to private sellers which alleviates trading friction. On the other hand, government agents sell securities at a lower price than in private meetings to stimulate the entry of potential buyers to the market. The optimal policy increases liquidity which flattens the yield curve and stimulates the use of long-term finance. Quantitatively, this policy generates an increase in maturity of five months for an economy like the US and eight months for an economy with a less-developed financial system as in Argentina. The main results are robust both quantitatively and qualitatively to several extensions. First, in the benchmark model firms can borrow only at the beginning of the project, so the maturity of the project matches the maturity of financing by assumption. An extension of the model allows entrepreneurs to rollover short-term contracts to finance long-term projects with a fixed cost of issuance. Quantitatively, the effect of a change in liquidity on the choice of projects is similar both with and without rollover opportunities regardless the value of the issuance cost. Second, in the benchmark model, there is a single secondary market for assets of different maturities. The paper also considers a specification in which buyers direct themselves to markets segmented by maturity. The main takeaway is that even though the market tightness (defined as the ratio of sellers-to-buyers) for short-term debt increases, the tightness for longterm assets remains similar to the benchmark model with a single market. As a result, the yield curve is similar to the curve for the benchmark economy. Related literature This paper contributes to the literature on maturity choice by proposing a novel channel based on trading frictions in the secondary market which generates an upward sloping yield curve. In the canonical models of Diamond (1991) and Leland and Toft (1996) frictions between lenders and borrowers shape maturity choices while in this paper the friction is within lenders in financial markets. More broadly, this paper provides a different perspective on how financial development can influence aggregate outcomes, the subject of a large body of work (e.g., Greenwood et al., 2010; Buera et al., 2011; Moll, 2014; Midrigan and Xu, 2014; Cole et al., 2016, among others). All these papers focus on contracting frictions between lenders and borrowers and interpret financial development as a reduction of that friction. Instead, this paper considers trading frictions within lenders in financial markets in which financial development is 3 an increase in the liquidity of the market and focuses on the choice of maturity which is absent in previous analyses. This paper is also related to the literature on OTC markets following the seminal work of Duffie et al. (2005). Some papers applied the theory to corporate bonds markets (e.g., Chen et al., 2012; He and Milbradt, 2014; Chen et al., 2017), while others consider the interaction between primary and secondary markets (Bruche and Segura, 2017; Arseneau et al., 2017; Bethune et al., 2017a). In particular, the financial structure is an hybrid between He and Milbradt (2014) and Bruche and Segura (2017). On the one hand, He and Milbradt (2014) studies the interaction between liquidity and default and abstracts from the effects on maturity. It applies the model to the US corporate debt market in a framework with exogenous elements such us output, maturity, and liquidity (in the sense that meeting intensities are not an equilibrium outcome). In contrast, this paper studies the interaction between liquidity and maturity to understand cross-country differences, and, for this application and the policy analysis, is key to have output, maturity, and liquidity as equilibrium outcomes. On the other hand, Bruche and Segura (2017) applies the theory to US commercial paper in a framework with endogenous maturity and liquidity. However, it assumes exogenous profits, maturity is stochastic (i.e., arrives at a Poisson rate rather than at a deterministic date) and does not provide quantitative evaluation nor policy analysis, which are important contributions of this paper. Many papers studied the term structure of interest rates through the lens of the consumptionbased capital asset pricing model (see Gürkaynak and Wright, 2012, for a recent review). Those papers extend the expectation hypothesis framework which posits that long-term interest rates are expectations of future average short-term rates. This paper is closer to a cl ...
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