Updating, Upgrading, Refining, Calibration and Implementation of Trade-Off Analysis Methodology Developed for INDOT

As part of the ongoing evolution towards integrated highway asset management, the Indiana Department of Transportation (INDOT), through SPR studies in 2004 and 2010, sponsored research that developed an overall framework for asset management. This was intended to foster decision support for alternative investments across the program areas on the basis of a broad range of performance measures and against the background of the various alternative actions or spending amounts that could be applied to the several different asset types in the different program areas. The 2010 study also developed theoretical constructs for scaling and amalgamating the different performance measures, and for analyzing the different kinds of trade-offs. The research products from the present study include this technical report which shows how theoretical underpinnings of the methodology developed for INDOT in 2010 have been updated, upgraded, and refined. The report also includes a case study that shows how the trade-off analysis framework has been calibrated using available data. Supplemental to the report is Trade-IN Version 1.0, a set of flexible and easy-to-use spreadsheets that implement the tradeoff framework. With this framework and using data at the current time or in the future, INDOT’s asset managers are placed in a better position to quantify and comprehend the relationships between budget levels and system-wide performance, the relationships between different pairs of conflicting or non-conflicting performance measures under a given budget limit, and the consequences, in terms of system-wide performance, of funding shifts across the management systems or program areas

Portfolio Choice when Managers Control Returns

This paper investigates the allocation decision of an investor with two projects. Separate managers control the mean return from each project, and the investor may or may not observe the managers’ actions. We show that the investor’s risk-return trade-off may be radically different from a standard portfolio choice setting, even if managers’ actions are observable and enforceable. In particular, feedback effects working through optimal contracts and effort levels imply that expected terminal wealth is nonlinear in initial wealth allocation. The optimal portfolio may involve very little diversification, despite projects that are highly symmetric in the underlying model. We also show that moral hazard in one of the projects need not imply lower allocation to that project. Expected returns are generally lower than under the first-best, but the optimal contract shifts more of the idiosyncratic risk in the hidden action project to the manager in charge of it. The minimum-variance position of the investor’s (net) terminal wealth would in most cases involve a portfolio shift towards the hidden action project, and there are plausible cases where this would dominate the overall effect on the second-best optimal portfolio when comparing with the first-best.Portfolio choice; diversification; optimal contracts

Pricing Illiquid Assets

The present paper investigates the portfolio allocation decisions of an investor with infinite horizon when available financial assets differ in their degrees of liquidity. A model with risk neutral agents allows us to endogenously determine the liquidity premium. With risk averse agents, we develop a nontrivial portfolio allocation problem, which enables us to calculate the demand for an illiquid asset for any given yield premium. We calibrate and numerically simulate both models. Reasonable parameter values imply a liquidity premium of 1.7% for the risk neutral case. In the portfolio allocation problem we find that a reasonable amount of illiquidity can cause a substantial drop of demand for the asset. We are also able to calculate the price discount at which an agent would be indifferent between immediate sale and waiting for a buyer with a fundamentally justified price.

Intergenerational risk sharing and labour supply in collective funded pension schemes with defined benefits

Collective funded pension schemes with defined benefits (DB) raise welfare through intergenerational risk sharing, but may lower welfare through distortion of the labour-leisure decision. This paper compares the welfare gains with the welfare losses. In many countries, collective funded pension schemes with defined benefits (DB) are being replaced by individual schemes with defined contributions. Collective funded DB pensions may indeed reduce social welfare when the schemes feature income-related contributions that distort the labour-leisure decision. However, these schemes also share risks between generations and�add to welfare if these risks cannot be traded on capital markets. Do�the�gains outweigh the losses? For answering this question, we adopt a two-period overlapping-generations model for a small open economy with risky returns to equity holdings. We derive analytically that the gains dominate the losses for the case of Cobb-Douglas preferences between labour and leisure. Numerical simulations for the more general CES case confirm these findings, which also withstand a number of other model modifications (like the introduction of a short-sale constraint for households and the inclusion of a labour income tax). These results suggest that collective funded schemes with well-organized risk sharing are preferable over individual schemes, even if labour market distortions are taken into account.

Financial Market Frictions

Defined simply as anything that interferes with trade, financial market frictions can exist even in efficient markets. Understanding financial market frictions is important, this article argues, because they generate real costs to investors, because they generate business opportunities, and because they change over time. Financial market frictions depend in part on market structure. Market structure tends to evolve over time, as trading volume increases, from low fixed costs and high marginal costs to high fixed costs and low marginal costs. To help identify the best means of reducing market frictions costs, the authors classify and discuss five primary categories of frictions: transactions costs, taxes and regulations, asset indivisibility, nontraded assets, and agency and information problems. Looking for evidence of how frictions influence market participants behavior, the authors not only review the economic literature but also conduct an empirical exercise to illustrate and quantify frictions impact on investors risk-return trade-off. Their results show that market frictions impose utility costs on investors by making preferable investment portfolios unattainable. Their findings and other academic studies also suggest that investors who ignore market frictions compound the harm done by the frictions themselves

Labor Supply Flexibility and Portfolio Choice

This paper develops a model showing that people who have flexibility in choosing how much to work will prefer to invest substantially more of their money in risky assets than if they had no such flexibility. Viewed in this way, labor supply flexibility offers insurance against adverse investment outcomes. The model provides support for the conventional wisdom that the young can tolerate more risk in their investment portfolios than the old. The model has other implications for the study of household financial behavior over the life cycle. It implies that households will take account of the value of labor supply flexibility in deciding how much to invest in their own human capital and when to retire. At the macro level it implies that people will have a labor supply response to shocks in the financial markets.

A Portfolio Approach for the New Zealand Multi-Species Fisheries Management

Marine species are reproducible resource. Maintaining the stock level of marine species and the sustainability of fisheries development become critical issues in current scientific research areas due to the explosion of human population and exacerbation of natural environment. The traditional method that protects the marine species is the single species approach which set maximum sustainable yield (MSY) to prevent over-harvest. However, with the development of technology and comprehension of marine science, the single species approach has been found obsolete and incapable of dealing with problems of severe depletion of fish stocks and escalation of fisheries confliction. Studies show that when regulations are species specific and species are part of a multi-species fisheries, the catch levels of different species are correlated which result in correlation of net return from each species. This paper employ financial portfolio into fisheries, treat fish stocks as assets, model the fishers’ behaviour who face multiple targeting options to predict the optimal targeting strategies. This methodology is applied to New Zealand fisheries that are managed in Quota Management System (QMS) introduced in 1986. Species considered in this research are selected carefully based on two criteria. Efficient risk-return frontier will be generated that provides a combination of optimal strategies. Comparison between results and actual data will be presented. Potential explanations will be given so that further suggestions to fisheries can be made.Agribusiness, Environmental Economics and Policy, Production Economics, Productivity Analysis, Risk and Uncertainty,

A Dynamic Equilibrium Model of Real Exchange Rates with General Transaction Costs

We study the behavior of real exchange rates in a two­country dynamic equilibrium model. In this model, consumers can only consume domestic goods but can invest costlessly in capital stocks of both countries. Nevertheless, transporting goods between the two countries is costly and, hence, the rebalancing of the capital stock can only happen finitely often. We propose a realistic cost structure for goods transportation, wherein the total cost increases with the amount of shipment but the unit cost decreases with it due to economies of scale. Given such a cost structure, the optimal decisions on when and how much to transfer need to be determined jointly. The dual decision depends upon the magnitude of economies of scale, the production technology specifications, and the consumer preferences. The model can reconcile the observed large short­term volatility of the real exchange rate with its slow convergence to parity. Further, the drift and diffusion of the real exchange rate are not uniquely determined by the real exchange rate level. The dynamics of the real exchange rate can only be determined by a joint analysis of the real exchange rate and the underlying economic fundamentals such as the capital stock imbalance between the two countries.costs of goods transportation; economies of scale; real exchange rate; purchasing power parity; nonlinearity.