Corporate Finance, Behavioral Finance, Risk Management and Insurance.
This paper incorporates contagious surrender behavior into the valuation and risk management of participating life insurance contracts, allowing for structural default of the insurance company. The insurance pool features a financially sophisticated (professional) policyholder and many retail (non-professional) policyholders. A surrender-history-dependent intensity process is introduced to capture the non-professionals’ contagious surrender behavior. While contagion aligns the non-professionals’ surrender behavior closer to the optimal surrender of the professional, it jeopardizes the non-professionals’ financial position in favor of equity holders as a strict regulatory intervention or a riskier investment strategy is imposed.
We propose a novel framework for investigating the interplay between firm behavior and the opinion of corporate bond markets, represented by a rating agency. The two parties interact strategically via a feedback loop consisting of the rating, the firm’s cost of capital and its liquidation decision. The rating agency refines an imperfect estimate of the firm’s asset value. Observing the survival of apparently distressed periods, it eliminates estimates of low asset value. Eventually, the expected default threshold thus persistently undercuts the true default threshold, leaving the firm’s credit risk underestimated. Calibrated to market data, the credit spread decreases by 32%.
Previous Title: "History Matters: Rating under Asymmetric Information".
The popularity of technical analysis is puzzling. We propose a simple model of how investors evaluate a trading rule, and show that the market timing of technical trading rules induces lottery-like trading profits. Therefore, investors' preference for positive skewness caters to the popularity of technical analysis. Since prospect theory implies strong skewness preference, it can explain the puzzle of why investors trade extensively on chart patterns that are meaningless in light of the efficient market hypothesis. Advocates of technical analysis often invoke behavioral finance as its theoretical foundation. Contrary to this view, our paper shows that ideas from behavioral finance can explain why technical analysis is popular despite its lack of theoretical foundation and empirical success.
Previous Title: "The Trend is Your (Imaginary) Friend: A Behavioral Perspective on Technical Analysis".
We price equity-linked life insurance with surrender guarantees and account for risk preferences in the form of risk-averse and loss-averse policyholders in continuous time. Risk-averse policyholders surrender their policy for higher equity index values. Compared to optimally surrendered policies, this behavior creates substantial policy value losses. In contrast, loss-averse policyholders surrender once the surrender benefit realizes a gain but keep under-performing policies. This disposition effect reduces the policy value relative to both optimally surrendered policies and policies surrendered by risk-averse policyholders. Insurers in competitive markets need to estimate their policyholders’ risk preferences accurately.
Collar offers and walking-away rights have become popular tools in merger and acquisition transactions. In this paper, we price "fixed price collars" and "fixed ratio collars" and value the commonly included right to terminate the M&A transaction before the closing date. We show that the right to walk away from the M&A deal can increase the value of the deal substantially. Collar offers are usually beneficial to the target company's investors with power-utility compared to the traditional all-cash payment and stock-for-stock payment of the transaction. In our model, the feature of terminating the deal before the closing date does not always increase expected utility of target investors.
Many equity-linked life insurance products offer the possibility to surrender policies prematurely. Secondary markets for policies with surrender guarantees influence both policyholders and insurers. We show that secondary markets lead to a gap in policy value between insurer and policyholder. Insurers increase premiums to adjust for higher surrender rates of customers and optimized surrender behavior by investors acquiring the policies on secondary markets. Hence, the existence of secondary markets is not necessarily profitable for the primary policyholders. The result depends on the demand for and the supply of the contracts brought to the secondary markets.