Estimating the Strategic Value of Long-Term Forward Purchase Contracts Using Auction Models

We demonstrate how an auction model can be used in a traditional capital budgeting context to assign a value to the strategic advantage of long-term forward contracts. Research in the field of industrial organization has pointed to the danger of ex post opportunistic bargaining as a motivation for the use of forward contracts in natural resources and manufactured products, but no operational procedure exists for estimating the value secured by these contracts. Arbitrage methods for valuing forward contracts assume a competitive market in which the factors creating the bargaining problem and motivating the use of long-term contracts are not present. Use of the model is illustrated in the case of take-or-pay contracts for natural gas.     

Why derivatives on derivatives? The case of spread futures

Recently, calendar spread futures, futures contracts whose underlying asset is the difference of two futures contracts with different delivery dates, have been successfully introduced for a number of financial futures contracts traded on the Chicago Board of Trade. A spread futures contract is not an obvious financial innovation, as it is a derivative on a derivative security: a spread futures position can be replicated by taking positions in the two underlying futures contracts, both of which may already be quite liquid. This paper provides a motivation for this innovation, demonstrating how the introduction of spread futures can, by changing the relative trading patterns of hedgers and informed traders, affect equilibrium bid–ask spreads, improve hedger welfare, and potentially improve market-maker expected profits. These results are robust both to allowing serial correlation of asset price changes, and investor preference for skewness.     

Community Asset Valuations by Non‐profit Government Entities

This paper examines an implication of applying International Financial Reporting Standards to the government sector in Australia. We posit both a self‐interest and a transparency motivation for local governments effecting revaluations of both infrastructure assets and community land. The self‐interest motivation was expected to manifest as a relationship between the amount of revaluation and CEO (or management team) remuneration. The transparency motivation was expected to result in a relationship between revaluation and the extent of spending on these assets, measured as both the quantum of materials and contracts expense, and as the quantum of contracts awarded by the entity above the disclosure threshold. We also speculated that revaluations may be used to signal to state governments a need for additional funds through capital and/or operating grants. At conventional levels of significance, we find no support for these relationships, suggesting that agency motivations at the local government level are either more subtle or non‐existent. As local government authorities in our study follow a reporting framework and standardised accounting procedures prescribed by the state government (in compliance with applicable AASB/IFRS standards), financial and public accountabilities are also likely to be a driver for the valuation of local infrastructure assets at fair value, and this is not likely to be undermined by the opportunistic incentives we have considered.     

Corporate Financial Policy and the Theory of Financial Intermediation

This paper examines the optimal structure of financial contracts in an economy subject to two forms of moral hazard. Multiple information problems are shown to generate a role for multiple classes of financial claimants. We then show that economic efficiency is enhanced if the financial structure of the economy consists of both direct and intermediated financial contract markets. Consequently, our results demonstrate a motivation for the complementarity between capital markets and depository financial institutions.     

The impact of accounting rule and economic differences on the firm’s choice of cash and share-puts

While prior literature has sought to explain why firms issue put options on their own stock (Gibson et al., 2006), no one has focused on examining why some firms choose to structure put contracts in a way that provides them the ability to settle future put obligations with their own common equity rather than cash. FAS 150, which changed the reporting requirements, highlights that under the prior rules firms included share-settlement terms in their put contracts to avoid showing their open put position as a balance sheet obligation. However, some evidence suggests that the choice between including cash or share settlement terms may be economically driven by the potential impact that each settlement-type has on firm solvency and equity holdings. Our results support the economic-based motivation for put-type choice by showing that firms elect to include share-settlement terms in their put contracts to provide themselves payment flexibility in the event internally generated cash flows are not sufficient to meet future contractual put obligations. These results support the FASB’s announcement that it is reconsidering homogeneous liability classification of cash and share-settled puts in its re-examination of FAS 150.     

Contracts offered by bureaucrats

We examine the power of incentives in bureaucracies by studying contracts offered by a bureaucrat to her agent. The bureaucrat operates under a fixed budget, optimally chosen by a funding authority, and she can engage in policy drift, which we define as inversely related to her intrinsic motivation. Interaction between a fixed budget and policy drift results in low‐powered incentives. We discuss how the bureaucrat may benefit from stricter accountability as it leads to larger budgets. Low‐powered incentives remain even in an alternative centralized setting, where the funding authority contracts directly with the agent using the bureaucrat to monitor output.     

Underwriter Compensation Structure: Can It Really Bond Underwriters?

Underwriter compensation can be structured as all cash or a combination of cash and warrants. Using a sample of small initial public offerings (IPOs), we find that underwriter compensation contracts that include warrants in exchange for cash can serve as certification for IPO firms by substituting for reputation capital. When underwriters accept warrants when they could have received more cash compensation, the IPOs avoid the well documented long‐run underperformance. However, when underwriters receive warrants after maximizing cash compensation, the IPO experiences higher underpricing and poorer long‐run performance. The findings are consistent with a motivation by the underwriters to circumvent regulatory constraints.     

Risk aversion,prudence, and compensation

In a standard principal-agent setting, we use a comparative approach to study the incentives provided by different types of compensation contracts, and their valuation by managers with utility function u who are risk averse (u″<0) and prudent (u″′>0). We show that concave contracts tend to provide more incentives to risk averse managers, while convex contracts tend to be more valued by prudent managers. This is because concave contracts concentrate incentives where the marginal utility of risk averse managers is highest, while convex contracts protect against downside risk. Thus, managerial prudence can contribute to explain the prevalence of stock-options in executive compensation. However, convex contracts are not optimal when the principal is sufficiently prudent relative to the manager.     

Dynamic Insurance Contracts and Adverse Selection

We take a dynamic perspective on insurance markets under adverse selection and study a dynamic version of the Rothschild and Stiglitz model. We investigate the nature of dynamic insurance contracts by considering both conditional and unconditional dynamic contracts. An unconditional dynamic contract has insurance companies offering contracts where the terms of the contract depend on time, but not on the occurrence of past accidents. Conditional dynamic contracts make the actual contract also depend on individual past performance (such as in car insurances). We show that dynamic insurance contracts yield a welfare improvement only if they are conditional on past performance. With conditional contracts, the first‐best can be approximated if the contract lasts long. Moreover, this is true for any fraction of low‐risk agents in the population.     

Insurance Rating Games: Strikes,Spares, and Bags

Carefully designed classroom activities and games can be used to increase student engagement, motivation, and learning. This article describes two games that have been used with students of risk management and insurance to help highlight the intricacies of insurance pricing. These two games, bowling insurance and bags insurance, help students experience the challenging nature of premium determination in risk transfer contracts and also connect the various actions taken by insurers during the insurance transaction.