We offer a rational expectations model of the dynamics of innovative industries. The fundamentalvalue of innovations is uncertain and one must learn whether they are solid or fragile. Also, when theindustry is new, it is difficult to monitor managers and make sure they exert the effort necessary toreduce default risk. This gives rise to moral hazard. In this context, initial successes spur optimismand growth. But increasingly confident managers end up requesting large rents. If these becometoo high, investors give up on incentives, and default risk rises. Thus, moral hazard gives rise toendogenous crises and fat tails in the distribution of aggregate default risk. We calibrate our modelto fit the stylized facts of the MBS industry’s boom and bust cycle.2
This paper sets up a model for analysing the problem of rational exit where the stopping time itself is part of the integration problem. The model development is for the case of smoking. Smoking produces pleasure, pain and addiction. Our model captures all these elements and using Brownian notion and continuous martingales establishes that “quit smoking” campaigns require a two pronged attack: educational and medical. It develops a new technique which can be applied to other stopping problems where stopping time itself is part of the integration problem.
In this article, we describe the various sorts of American Parisian options and propose valuation formulae. Although there is no closed-form valuation for these products in the non-perpetual case, we have been able to reformulate their price as a function of the exercise frontier. In the perpetual case, closed-form solutions or approximations are obtained by relying on excursion theory. We derive the Laplace transform of the first instant Brownian motion reaches a positive level or, without interruption, spends a given amount of time below zero. We perform a detailed comparison of perpetual standard, barrier and Parisian options
We show that prospect theory is a valuable paradigm for wealth management. It describes well how investors perceive
risk and with appropriate modeling it can be made consistent with rational decision making. Moreover, it can be
represented in a simple reward-risk diagram so that the main ideas are easily communicated to clients. Finally, we
show on data from a large set of private clients that there are considerable monetary gains from introducing prospect
theory instead of mean-variance analysis into the client advisory process.
We develop statistical methods to detect informed trading in options markets. We apply these methods to 31 companies from various sectors over 14 years analyzing approximately 9.6 million option prices. We find that option informed trading tends to cluster prior to certain events, takes place more in put than call options, generates easily large gains exceeding millions,is not contemporaneously reflected in the underlying stock price, involves around the money options during calm times and out-of-the-money options during turbulent times. These findings are not driven by false discoveries in informed trades which are controlled using multiple hypothesis testing techniques.
We review and examine three market-based instruments to address the challenge of climate change: emission trading, emission taxes, and hybrid instruments. Our main contribution is the illustration and comparison of these instruments using recent results from theoretical research and practical policy experience. Hybrid policies that aim to combine taxes and permits emerge as a promising way forward. An additional contribution is that we also comment on two other related concepts, namely, innovation strategies and prediction markets. For the former, we show that, to make economic sense, the much publicized Asia-Pacific Partnership on Clean Development and Climate has to rely on the same basic tool as the other instruments, namely, relative prices. For the latter, we discuss how prediction markets can complement traditional scenario analysis by experts. They are likely to improve the practical implementation of all previously discussed methods.
The article puts forward the view that the regulatory perspective on systemic risk should be changed drastically. The sub-prime crisis has indeed revealed many loopholes in the supervisory/regulatory framework for banks—in particular, the inability to deal with the too-big-to-fail syndrome and also the lack of resiliency of interbank and money markets. To a large extent, the contagion phenomena that took place in these markets were the necessary outcomes of the passive attitude of banking supervisors, who have let large banks develop a complex and opaque nexus of bilateral obligations. We propose two reforms: adopting a platform-based (instead of institutionbased) regulatory perspective on systemic risk and encouraging a generalized move to central counterparty clearing.
