Dynamic Corporate Finance and Real Options, Behavioral Finance, and Risk Management and Insurance.
In a dynamic signaling game, a rating agency observes a firm’s cash flow blurred by a persistent measurement error. Higher measurement errors imply earlier default. The firm’s owner can signal quality by cash injection in distress. With Bayesian directional learning, the rating agency eliminates high measurement errors, resulting in a lower cost of capital for the same level of observed cash flow. Thus, the rating feeds back into the owner’s cash injection decision and vice versa. The model provides a novel explanation for rating inflation and delayed default at lower asset values, despite the rating agency aiming for unbiased ratings.
Previous Title: "History Matters: Rating under Asymmetric Information".
We value equity-linked life insurance contracts with surrender guarantees from the perspective of risk averse and loss averse policyholders in continuous time. With increasing risk aversion, policyholders surrender their insurances for higher values of the underlying equity fund, compared to optimally stopped insurance contracts, leading to substantial losses. Moreover, high discounting amplifies suboptimal surrender. Loss averse policyholders display a different surrender behavior: They surrender only policies for which the surrender benefit represents a large gain, while holding on to unsuccessful contracts, so that the disposition effect increases the contract value relative to a contract stopped by a risk averse policyholder.
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.