On derivatives with illiquid underlying and market manipulation

In illiquid markets, option traders may have an incentive to increase their portfolio value by using their impact on the dynamics of the underlying. We provide a mathematical framework to construct optimal trading strategies under market impact in a multi-player framework by introducing strategic interactions into the model of Almgren [Appl. Math. Finance, 2003, 10(1), 1–18]. Specifically, we consider a financial market model with several strategically interacting players who hold European contingent claims and whose trading decisions have an impact on the price evolution of the underlying. We establish the existence and uniqueness of equilibrium results for risk-neutral and CARA investors and show that the equilibrium dynamics can be characterized in terms of a coupled system of possibly nonlinear PDEs. For the linear cost function used by Almgren, we obtain a (semi) closed-form solution. Analysing this solution, we show how market manipulation can be reduced.     

Credit Ratings as Coordination Mechanisms

In this article, we provide a novel rationale for credit ratings.The rationale that we propose is that credit ratings serve asa coordinating mechanism in situations where multiple equilibriacan obtain. We show that credit ratings provide a "focal point"for firms and their investors, and explore the vital, but previouslyoverlooked implicit contractual relationship between a creditrating agency (CRA) and a firm through its credit watch procedures.Credit ratings can help fix the desired equilibrium and as suchplay an economically meaningful role. Our model provides severalempirical predictions and insights regarding the expected priceimpact of rating changes.     

Rating Agency Reputation,the Global Financial Crisis,and the Cost of Debt

Why do foreign firms obtain credit ratings by global rating agencies rather than from their home country's rating agencies even though global raters typically assign lower credit ratings when these foreign firms issue bonds in their home currencies? We find that bonds rated by a global agency decreased yields 11‐14 basis points (bps) when compared to those rated by Japanese rating agencies but, during the 2007‐2009 financial crisis, the yields on these Japanese bonds increased 12‐17 bps, thus fully negating the advantage of obtaining a bond rating from a global rater. This suggests that the reputation of global rating agencies declined during the 2007‐2009 crisis period.     

Determinants of biased subjective performance evaluations: evidence from a Taiwanese public sector organization

Drawing on the notion of guanxi, which is obligation-bound, in Confucian cultures, this study investigates whether rating leniency and rating compression in performance evaluation are based on supervisor–subordinate acquaintanceship, alma mater ties, and subordinates' physical proximity to their supervisor. After controlling for supervisor–subordinate gender similarity and age difference, this study first finds that public sector supervisors are willing to provide relatively lenient ratings and compressed ratings for their subordinates when their personal acquaintanceship with them is strong, and when there is close physical proximity between them. Second, an alma mater connection with a subordinate leads to rating leniency by the supervisor. Finally, it is worth noting where this study differs from Bol's research (from Western cultures). In particular, while Bol, J.C. [2011. The determinants and performance effects of managers’ performance evaluation biases. The Accounting Review, 86 (5), 1549–1575] demonstrates that age differences between supervisors and subordinates decrease rating leniency, this study documents insignificant results for similar demographic characteristics in age and gender. Bol, J.C. [2011. The determinants and performance effects of managers’ performance evaluation biases. The Accounting Review, 86 (5), 1549–1575] also demonstrates that if a private sector supervisor sharing a work location with subordinates faces relatively lower information-gathering costs, he or she will give less lenient and less compressed ratings. However, this study shows opposite findings for the guanxi norm in Confucian societies.     

Impact of Imperfect Information on the Optimal Exercise Strategy for Warrants

In this paper, we determine the optimal exercise strategy for corporate warrants if investors suffer from imperfect information and we evaluate the impact of this friction on the value of a warrant. For this purpose, we address both exercises at maturity, where imperfect information about the firm value is present, and exercises before maturity which are impacted by imperfect information about the size of the dividend. We model imperfect information so that all warrant holders know that they obtain biased signals of the true state without observing the signals of other warrant holders. The optimal exercise strategy follows from a complex game among warrant holders in which every individual warrant holder must account for the potential signals of the other warrant holders and their resulting exercise decisions. The main findings are that due to imperfect information warrant holders optimally start to exercise their warrants later than without imperfect information. Moreover, a simple block exercise strategy is always an equilibrium strategy for a high degree of imperfect information before maturity, even though a partial exercise can be the unique strategy without imperfect information. Remarkably, imperfect information does not necessarily result in a lower warrant value. As long as a warrant holder has a signal that allows for correct exercise decisions, then imperfect information enhances the warrant value due to suboptimal exercises by other investors.     

Should more local governments purchase a bond rating?

We investigate whether issuers that choose to forgo a bond rating suffer an interest cost penalty greater than the cost of the rating. We use estimated ratings provided by Moody’s Investor Service to proxy for what the rating would have been if it had been purchased. We find that the primary factors associated with an issuer’s decision to purchase a rating are the rating expected by the issuer and the extent to which an issue is marketed locally. After controlling for self-selection bias, we find that the issuers that forgo a rating do not suffer an interest cost penalty.

Relational delegation

We analyze a cheap talk game with partial commitment by the principal. We first treat the principal's commitment power as exogenous and then endogenize it in an infinitely repeated game. We characterize optimal decision making for any commitment power and show when it takes the form of threshold delegation—in which case the agent can make any decision below a threshold—and centralization—in which case the agent has no discretion. For small biases, threshold delegation is optimal for any smooth distribution. Outsourcing can only be optimal if the principal's commitment power is sufficiently small.     

The market for lawyers and quality layers in legal services

We study the functioning of the market for lawyers, considering the strategic interaction among litigants, lawyers, and judges. We investigate the value of legal representation and of systems of quality certification, such as the Queen’s Counsel system. In our setting, higher quality lawyers obtain better‐quality evidence and are better able to interpret it. Judges receive information from the lawyers and have reputational concerns. We show that reputational concerns generate a decision bias in favor of certified lawyers and that this causes misallocation of lawyers at the market equilibrium. As a result, whereas a higher quality of lawyers increases welfare, public information over quality may be welfare reducing.     

Upfront payments and exclusion in downstream markets

Although upfront payments are often observed in contracts between manufacturers and retailers, little is known about their competitive effects or the role retailers play in securing them. In this article, we consider a model in which two competing retailers make take‐it‐or‐leave‐it offers to a common manufacturer. We find that upfront payments are a feature of equilibrium contracts, and in all equilibria, only one retailer buys from the manufacturer. These findings support the claims of small manufacturers who argue that they are often unable to obtain widespread distribution for their products because of upfront payments.     

On Cost Tradeoffs Between Conservative and Market Value Accounting

We identify a cost tradeoff relevant to the comparison of alternative accounting regimes. We compare equilibrium deadweight losses, due to transacting and auditing, across the historical cost, lower-of-cost-or-market, and market value regimes. We provide conditions for each of the regimes to dominate the other two. We show that while market-value accounting is likely to prevail in an inflationary setting, it may also be optimal under deflation. Similarly, lower-of-cost-or-market is likely to prevail in a deflationary setting, though it may also be optimal under inflation. Last, historical cost prevails only if the variation in asset prices is sufficiently high.     

Moral hazard,hold‐up,and the optimal allocation of control rights

I examine the optimal allocation of control rights in a model with manager moral hazard, where the manager and investor may hold up each other ex post. The control allocation determines both the likelihood of hold‐up and the agents’ renegotiation payoffs. In equilibrium, only two control allocations are optimal: either exclusive investor control or a contingent control allocation that allows the manager to remain in control if, and only if, interim performance is good. Thus, my model explains why it may be optimal to link control to the firm’s performance such that managers retain control only following good performance.     

Multiple equilibria in a monopoly market with heterogeneous agents and externalities

We explore the effects of social influence in a simple market model in which a large number of agents face a binary choice: to buy/not to buy a single unit of a product at a price posted by a single seller (monopoly market). We consider the case of positive externalities: an agent is more willing to buy if other agents make the same decision. We consider two special cases of heterogeneity in the individuals' decision rules, corresponding in the literature to the Random Utility Models of Thurstone, and of McFadden and Manski. In the first one the heterogeneity fluctuates with time, leading to a standard model in Physics: the Ising model at finite temperature (known as annealed disorder) in a uniform external field. In the second approach the heterogeneity among agents is fixed; in Physics this is a particular case of the quenched disorder model known as a random field Ising model, at zero temperature. We study analytically the equilibrium properties of the market in the limiting case where each agent is influenced by all the others (the mean field limit), and we illustrate some dynamic properties of these models making use of numerical simulations in an Agent based Computational Economics approach. Considering the optimization of the profit by the seller within the case of fixed heterogeneity with global externality, we exhibit a new regime where, if the mean willingness to pay increases and/or the production costs decrease, the seller's optimal strategy jumps from a solution with a high price and a small number of buyers, to another one with a low price and a large number of buyers. This regime, usually modelled with ad hoc bimodal distributions of the idiosyncratic heterogeneity, arises here for general monomodal distributions if the social influence is strong enough.     

A computational view of market efficiency

We study market efficiency from a computational viewpoint. Borrowing from theoretical computer science, we define a market to be efficient with respect to resources S (e.g., time, memory) if no strategy using resources S can make a profit. As a first step, we consider memory-m strategies whose action at time t depends only on the m previous observations at times t???m,?…?,?t???1. We introduce and study a simple model of market evolution, where strategies impact the market by their decision to buy or sell. We show that the effect of optimal strategies using memory m can lead to ‘market conditions’ that were not present initially, such as (1) market spikes and (2) the possibility for a strategy using memory m′?>?m to make a bigger profit than was initially possible. We suggest ours as a framework to rationalize the technological arms race of quantitative trading firms.     

Rating systems,procyclicality and Basel II: an evaluation in a general equilibrium framework

The introduction of Basel II has raised concerns about the potential impact of risk-sensitive capital requirements on the business cycle. Several approaches have been proposed to assess the procyclicality issue. In this paper, we adopt a general equilibrium model and conduct comprehensive analysis of different proposals. We set out a model that allows to evaluate different rating systems in relation to the procyclicality issue. Our model extends previous models by analysing the effects of different rating systems on banks’ portfolios (as in Catarineu et al. in Econ Theory 26:537–557, 2005) and the contagion effects relevant to financial stability (as in Goodhart et al. in Ann Finance 1:197–224, 2005). The paper presents comparative statics results comparing a cycle-dependent and a neutral rating system from the point of view of banks profit maximization. Our results suggest that banks’ preferences about point in time or through the cycle rating systems depend on the banks’ characteristics and on the business cycle conditions in terms of expectations and realizations.     

Risk Aversion,Downside Risk Aversion and Paying for Stochastic Improvements

This paper considers the relationship between risk preferences and the willingness to pay for stochastic improvements. We show that if the stochastic improvement satisfies a double-crossing condition, then a decision maker with utility v is willing to pay more than a decision maker with utility u, if v is both more risk averse and less downside risk averse than u. As the condition always holds in the case of self-protection, the result implies novel characterizations of individuals’ willingness to pay to reduce the probability of loss. By establishing a general result on the correspondence between an individual's willingness to pay, and his optimal purchase of stochastic improvement when there is a given relationship between stochastic improvements and the amount paid for them, we further show that all results on the willingness to pay can be applied directly to characterize the conditions under which a more risk averse individual will optimally choose to buy more stochastic improvement. Generalizations of existing results on optimal choice of self-protection can be obtained as corollaries.     

Optimal Incentive Contracts When Agents Can Save, Borrow, and Default

The standard Principal–Agent (PA) model assumes that the principal can control the agent's consumption profile. In an intertemporal setting, however, Rogerson (1985, Econometrica53, 69–76) shows that given the optimal PA contract, the agent has an unmet precautionary demand for savings. Thus the standard PA model is invalid if the agent has access to credit markets. In this paper we generalize the standard PA model to allow for saving and borrowing by the agent. We show that the impact of such access critically depends upon the treatment of default. If default is not permitted, efficiency is strictly reduced by the introduction of credit markets, and the equilibrium level of borrowing or saving is indeterminate in the model. If default is allowed, however, the optimal contract depends upon the level of bankruptcy protection in the economy, which is described by a minimum level of wage income. We show that there is an optimal intermediate range of bankruptcy protection. Within this range, allowing default increases efficiency in the economy relative to the case of no default. Also, the model predicts specific levels of consumer debt, interest rates, and default rates as functions of the level of bankruptcy protection level. Journal of Economic Literature Classification Numbers: D80, G21, G28, J30.     

An Option-Based Operational Risk Management Model for Pandemics

Abstract

In this paper we employ the theory of real option pricing to address problems in the area of operational risk management. We develop a two-stage model to help firms determine the optimal suspension-reactivation triggers in the events of pandemics. In the first stage, we propose a regime-dependent epidemic model to simulate the spread of the virus, depending on whether the firm is active or inactive. In the second stage, we view the reactivation decision as a call option and the suspension decision as a put option, and use dynamic programming methods to obtain the optimal switching thresholds. Our method can be regarded as a quantitative implementation of the CDC’s instructions for pandemic preparation. We find that when they take the uncertainty of disease transmission into consideration, firms are more conservative about the decisions of suspension and reactivation. We also find that when firms incur switching costs, the suspension threshold increases with costs, whereas the reactivation threshold decreases with costs. By adopting disease control policies, firms can increase their values in both regimes.     

Rating or no rating? That is the question: an empirical examination of UK companies

The aim of this paper is to examine the main determinants of the rating likelihood of UK companies. We use a binary probit specification to model the main drivers of a firm's propensity to be rated. Using a sample of 245 non-financial UK companies over the period 1995–2006, representing up to 2872 firm years, the study establishes important differences in the financial profiles of rated and non-rated firms. The results of the rating likelihood models indicate that the decision to obtain a rating is driven by a company's financial risk, solvency, default risk, public debt issuance, R&D, and institutional ownership, thus identifying a wider range of determinants and extending the current literature. The study also finds that the rating decision can be modelled by means of a contemporaneous or predictive specification without any loss of efficiency or classification accuracy. This offers support to the argument that the rating process is fundamentally forward-looking.     

Comonotonic Approximations for Optimal Portfolio Selection Problems

We investigate multiperiod portfolio selection problems in a Black and Scholes type market where a basket of 1 riskfree and m risky securities are traded continuously. We look for the optimal allocation of wealth within the class of “constant mix” portfolios. First, we consider the portfolio selection problem of a decision maker who invests money at predetermined points in time in order to obtain a target capital at the end of the time period under consideration. A second problem concerns a decision maker who invests some amount of money (the initial wealth or provision) in order to be able to fullfil a series of future consumptions or payment obligations. Several optimality criteria and their interpretation within Yaari's dual theory of choice under risk are presented. For both selection problems, we propose accurate approximations based on the concept of comonotonicity, as studied in Dhaene et al. (2002 a,b) . Our analytical approach avoids simulation, and hence reduces the computing effort drastically.     

Retailers' choice of product variety and exclusive dealing under asymmetric information

This article considers vertical relations between an upstream manufacturer and a downstream retailer that can independently obtain a low‐quality, discount substitute. The analysis reveals that under full information, the retailer offers both varieties if and only if it is optimal to do so under vertical integration. However, when the retailer is privately informed about demand, it offers both varieties even if under vertical integration it is profitable to offer only the manufacturer's product. If the manufacturer can impose exclusive dealing, then under asymmetric information it will do so and foreclose the low‐quality substitute even if under vertical integration it is profitable to offer both varieties.