Overreaction to Fearsome Risks

When risks threaten, cognitive mechanisms bias people toward action or inaction. Fearsome risks are highly available. The availability bias tells us that this leads people to overestimate their frequency. Therefore, they also overreact to curtail the likelihood or consequences of such risks. More generally, fear can paralyze efforts to think clearly about risks. We draw on a range of environmental risks to show the following: (1) Fear leads us to neglect probability of occurrence; (2) As fearsome environmental risks are usually imposed by others (as externalities), indignation stirs excess reaction; (3) We often misperceive or miscalculate such risks. Two experiments demonstrate probability neglect when fearsome risks arise: (a) willingness-to-pay to eliminate the cancer risk from arsenic in water (described in vivid terms) did not vary despite a 10-fold variation in risk; (b) the willingness-to-accept price for a painful but non dangerous electric shock did not vary between a 1 and 100% chance. Possible explanations relate to the role of the amygdala in impairing cognitive brain function. Government and the law, both made by mortals and both responding to public pressures, similarly neglect probabilities for fearsome risks. Examples relating to shark attacks, Love Canal, alar and terrorism are discussed.     

Voters prefer more qualified mayors,but does it matter for public finances? Evidence for Germany

This paper studies the importance of politicians’ qualification, in terms of education and experience, for fiscal outcomes. The analysis is based on a large panel for 2031 German municipalities for which we have collected information on municipal budgets as well as the election results and qualification levels of mayoral candidates. We principally use a regression discontinuity design focusing on close elections to estimate causal effects. We find that mayors with prior experience in office have a tendency to reduce the level of local public debt, lower total municipal expenditures and decrease the local taxes, even though these results are only significant in some specifications. In contrast, the education level of the mayor exerts no significant effects on the overall fiscal performance of the municipality. The results are partly surprising as both education and experience are shown to matter greatly in the electoral success of mayoral candidates.     

Migrate or not? The effects of regulation SHO on options trading activities

In this study, we investigate the effects of stock short-sale constraints on options trading by exploiting two US Securities and Exchange Commission rule changes under Regulation SHO: Rule 203 (locate and close-out requirements) and Rule 202T (temporary removal of short-sale price tests). We find that stock short selling activities decrease (increase) significantly after Rule 203 (Rule 202T) implementation, supporting the validity of Rule 203 (Rule 202T) as an exogenous increase (decrease) in short-sale constraints. Options volume increases significantly after Rule 203 went into effect and the result is more pronounced among firms with lower levels of institutional ownership and smaller options bid-ask spreads. Therefore, the evidence from Rule 203 suggests that investors may use options as substitutes for stock short sales when short selling is less feasible or more costly due to the locate and delivery requirements. In contrast, we find no significant change in the options trading volume of pilot stocks during the pilot program of Rule 202T. Overall, our results indicate that the impact of short-sale constraints on options trading varies with the types of constraints affected.     

Predictive Modeling in Long-Term Care Insurance

The accurate prediction of long-term care insurance (LTCI) mortality, lapse, and claim rates is essential when making informed pricing and risk management decisions. Unfortunately, academic literature on the subject is sparse and industry practice is limited by software and time constraints. In this article, we review current LTCI industry modeling methodology, which is typically Poisson regression with covariate banding/modification and stepwise variable selection. We test the claim that covariate banding improves predictive accuracy, examine the potential downfalls of stepwise selection, and contend that the assumptions required for Poisson regression are not appropriate for LTCI data. We propose several alternative models specifically tailored toward count responses with an excess of zeros and overdispersion. Using data from a large LTCI provider, we evaluate the predictive capacity of random forests and generalized linear and additive models with zero-inflated Poisson, negative binomial, and Tweedie errors. These alternatives are compared to previously developed Poisson regression models.

Our study confirms that variable modification is unnecessary at best and automatic stepwise model selection is dangerous. After demonstrating severe overprediction of LTCI mortality and lapse rates under the Poisson assumption, we show that a Tweedie GLM enables much more accurate predictions. Our Tweedie regression models improve average predictive accuracy (measured by several prediction error statistics) over Poisson regression models by as much as four times for mortality rates and 17 times for lapse rates.     

Short and long-term interactions between venture capital returns and the macroeconomy: evidence for the United States

The main purpose of this paper is to empirically model the influence of macroeconomic and financial variables on the performance of risk capital in the US. We start our investigation using a static long-run equilibrium model. In contrast to previous studies, we analyze the effect of several factors simultaneously within the framework of a vector error correction model (VECM). This allows us to study short- and long-term interactions to overcome the problem of endogeneity, and to discover causal mechanisms. The results show that the value of venture capital investments is positively related to industrial production, the exit channel Nasdaq, and the long-term interest rate. However, the value of venture capital investments is negatively related to the short-term interest rate. According to the short-term dynamics, VEC Granger causality confirms that only industrial production influences venture capital performance, while venture capital returns Granger causes Nasdaq performance.     

Value chain capability,value strategies and firm default risk

Firm stakeholders are paying more attention to the firm risks rather than merely focusing on returns. Among those risks, a firm's ability to repay its debt increasingly becomes a yardstick to evaluate a firm and predict the security level of returning its borrowings. This situation is directly related to a firm's default risk. The current article links the firm's value strategies and capabilities to firm default risk reduction. Specifically, this article conceptualizes and operationalizes a new firm capability, value chain capability, and examines how this capability and two firm value strategies, R&D and advertising, reduce the firm's default risk. Meanwhile, the authors formulate the value chain capability's moderating effects on the relationships between the two value strategies and firm default risk. The findings suggest that value chain capability and advertising help the firm reduce default risk. R&D will have the same effect only when a firm has high value chain capability.