#06-03
Agency-Based Asset Pricing
Gary B. Gorton and Ping He, February 2006
Abstract: We analyze the interaction between managerial decisions and firm values/asset prices by embedding the standard agency model of the firm into an otherwise standard asset pricing model. When the manager-agent's compensation depends on the firm's stock price performance, stock prices are set to induce the creation of future cash flows, instead of representing the discounted value of exogenous cash flows, as is the standard model. In our case, stock prices are formed via trading in the market to induce the manager to hold the number of shares consistent with the optimal effort level desired by the outside investors. But this is complicated by risk-sharing between the manager and the outside investors. We compare two price formation mechanisms, corresponding to two firm ownership structures. In the first stock prices are formed competitively among a continuum of dispersed investors. In the second stock prices are set by single block shareholder, as a bargaining solution. Under both mechanisms there are persistent, dynamic patterns in asset prices. The level of the equity premium and the return volatility depend on the risk aversion of the agents in the economy and the ownership structure of firms.
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