Corporate Finance, Financial Institutions and Markets, Behavioural Finance, Derivatives.
How does a creditor's learning from a firm's strategic actions affect bankruptcy prediction, debt values, and optimal capital structure? We investigate a Leland (1994) setting augmented by asymmetric information on the firm's asset value. Before learning starts, the expected bankruptcy threshold, asset value and state price of bankruptcy can lie above or below their symmetric information versions. However, we point out that a higher-than-expected asset value does not imply a lower-than-expected state price of bankruptcy. Observing the firm's survival of apparently distressed periods, the creditor excludes asset value estimates that are too low to be consistent with the observed survival. We show that the expected bankruptcy threshold decreases as result of the learning. While expected asset and debt values decrease upon reaching new all-time-low asset values, they are persistently higher once the observed asset value recovers to a given level, but the creditor remembers the all-time low. First results on optimal capital structure show ambiguous effects of asymmetric information on optimal leverage.
This paper incorporates contagious surrender behavior, a critical risk on life insurance markets, into the valuation and risk management of life insurance policies, allowing for structural default of the insurance company. Our heterogeneous policyholder pool contains a minority of financially guided policyholders and a majority of individual policyholders. In a calibrated model, we demonstrate that contagion cannot provide an informative benefiting signal to individual policyholders who follow the optimal surrender of financially guided policyholders once their surrenders trigger public attention. Contagion robustly benefits the insurance company at the expense of individual policyholders but leaves the default probability largely unchanged.
We propose a novel framework for investigating learning dynamics on a competitive debt market. Observing a firm's survival of apparently distressed periods, the market eliminates asset value estimates that are too low to be consistent with the observed survival. Therefore, the firm's cost of debt becomes lower for given financials. Relative to a perfect information setting, the firm strategically delays default to benefit from a subsequently lower cost of debt. The market's fair assessment in expectation implies a debt price drop upon default: It reveals the currently worst possible asset value as correct. Debt with higher performance sensitivity and lower information asymmetry mitigates this surprise effect.
Previous Title: "History Matters: Rating under Asymmetric Information".
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.
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".
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.