Empirical research has shown that people tend to overweight small probabilities and underweight large probabilities when valuing risky prospects, but little is known about factors influencing the shape of the probability weighting curve. Based on a laboratory experiment with monetary incentives, we demonstrate that pre-existing good mood is significantly associated with women’s probability weights: Women in a better than normal mood tend to weight probabilities relatively more optimistically. Many men, however, seem to be immunized against effects of incidental mood by applying a mechanical decision criterion such as maximization of expected value.
Modern corporations use complex debt instruments and pursue acquisitions. In orderto analyze the properties of some of these contracts in the event of an acquisition, thispaper considers a company that has an incumbent capital structure, comprising one of five practically important structured debt contracts. An opportunity for an acquisition comes along that was not ex-ante contractible. The equityholder decides on the financing of this expansion by trading off tax advantages of debt against costs of bankruptcy. The modelyields a number of insights for structured debt and acquisitions, four of which are as follows: First, a seniority clause offers the bondholder protection from agency, but it also decreases the equityholder’s incentives to finance the acquisition. Second, embedded call options are valuable even if interest rates are constant, because they allow the equityholder to issue a new bond at fair value. Third, bankruptcy remoteness is valuable, if assets are very risky. Fourth, convertible bonds are vulnerable to agency and the conversion option bears the same incentive problem as a seniority clause. These properties explains, for example, the otherwise puzzling practice of companies buying out convertible bond holders prior to anacquisition.
We present a new and general technique for obtaining closed-form expansions for prices of options in the Heston model, in terms of Black–Scholes prices and Black–Scholes Greeks up to arbitrary order. We then apply the technique to solve, in detail, the cases for the second-order and third-order expansions. In particular, such expansions show how the convexity in volatility, measured by the Black–Scholes volga, and the sensitivity of delta with respect to volatility, measured by the Black–Scholes vanna, impact option prices in the Heston model. The general method for obtaining the expansion rests on the construction of a set of new probability measures, equivalent to the original pricing measure, and which retain the affine structure of the Heston volatility diffusion. Finally, we extend the method to the pricing of forward-starting options in the Heston model.
There is strong empirical evidence that the pricing kernel is U-shaped, which provides a way to explain the substantial coskewness premium. Existing studies typically use a polynomial approximation of the pricing kernel. Problematically, these polynomials have, in most cases, increasing parts by construction. Therefore, it is not clear whether the increasing parts are an artifact of the chosen functional form. Taking this concept into consideration, this paper shows that pricing kernels, as estimated by the generalized method of moments on equity data, are still U-shaped and that the increasing part is not a statistical artifact. This conclusion derives from the fact that the functional form of kernels, which allows for strictly decreasing kernels as well as for kernels with increasing parts, is still U-shaped. These results arise from checking for higher order polynomials, various time horizons, and different functional forms of the kernel.
Our goal is to provide a simple, intuitive and model-free motivation for the importance of volatility-of-volatility in pricing certain kinds of exotic and structured products.
We analyze complex bond portfolios within the framework of a dynamic general equilibrium asset-pricing model. Equilibrium bond portfolios are nonsensical and imply a trading volume that vastly exceeds observed trading volume on financial markets. Instead, portfolios that combine bond ladders with a market portfolio of equity assets are nearly optimal investment strategies. The welfare loss of these simple investment strategies, when compared to the equilibrium portfolio, converges to zero as the length of the bond ladder increases. This article, therefore, provides a rationale for naming bond ladders as a popular bond investment strategy.
We develop a dynamic model of a firm facing agency costs of free cash flow and externalfinancing costs, and derive an explicit solution for the firm’s optimal balance sheet dynamics. Financial frictions affect issuance and dividend policies, the value of cash holdings, and the dynamics of stock prices. The model predicts that the marginal value of cash varies negatively with the stock price, and positively with the volatility of the stock price. This yields novel insights on the asymmetric volatility phenomenon, on risk management policies, and on how business cycles and agency costs affect the volatility of stock returns.
We analyze the demand for hedging and insurance by a firm facingcash-flow risks. We study how the firm’s liquidity managementpolicy interacts with two types of risk: a Brownian risk that canbe hedged through a financial derivative, and a Poisson risk thatcan be insured by an insurance contract. We find that the patternsof insurance and hedging decisions are pole apart: cash-poor firmsshould hedge but not insure, whereas the opposite is true for cashrichfirms. We also find non-monotonic effects of profitability. Thismay explain the mixed findings of empirical studies on corporatedemand for hedging and insurance.
