Essays on financial economics
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This dissertation explores the role of information frictions in the design of financial securities, the pricing of securities, and their business cycle implications. The first essay studies the risk- shifting problem between bondholders and shareholders, and the moral hazard problem between shareholders and the manager. Although, these two problems have been studied separately, my model is the first tractable frame-work to study these two frictions jointly. Using my model, I explore: i) How the presence of managerial moral hazard affects the risk-shifting problem, and ii) How optimal policies of the firm change in terms of leverage, managerial compensation, and investment decisions when the two problems are considered jointly. I show that the optimal amount of risk-shifting is amplified in the presence of managerial moral hazard. Moreover, my model delivers a non-monotonic relation between risk-shifting and leverage. This non-monotonicity has the potential to reconcile seemingly contradictory empirical evidence on the sign of this relation. The second essay (coauthored with Jianjun Miao) studies the design of an optimal contract for the manager when the shareholders are concerned about model misspecification. The model delivers counter-cyclical firm level equity premium, and has interesting implications for security design. The third essay incorporates accounting practices into models that generate business cycles through borrowing constraints. I show that the interaction of accounting frictions with the borrowing constraint has implications for the persistence and amplification of macroeconomic shocks.