Does market demand volatility facilitate collusion?

This paper develops a real options model of a price-setting cartel under uncertainty to examine whether market demand volatility facilitates collusion or not. We show that there is a critical level of market demand (the optimal defection trigger) above which firms find it desirable to defect from the cartel. We show further that an increase in the underlying market demand uncertainty has two opposing effects on the optimal defection trigger. First, the increased market demand volatility gives rise to the usual positive effect on option value that lifts up the optimal defection trigger. Second, the increased market demand volatility calls for an upward adjustment of the discount rate and thus creates a negative effect on option value that pushes down the optimal defection trigger. We show that the negative effect dominates (is dominated by) the positive effect when the underlying market demand uncertainty is trivial (significant), thereby rendering a U-shaped pattern of the optimal defection trigger against the market demand volatility. © 2007 Elsevier B.V. All rights reserved.postprin

Production and insurance under regret aversion

This paper examines the behavior of a regret-averse producer facing revenue risk. To insure against the revenue risk, the producer can purchase a coinsurance contract with an endogenously chosen coinsurance rate. Regret-averse preferences are characterized by a utility function that includes disutility from having chosen ex-post suboptimal alternatives. We show that the regret-averse producer never fully insures against the revenue risk even though the coinsurance contract is actuarially fair. When the producer is sufficiently regret averse and the loss probability is high, we further show that the regret-averse producer chooses not to purchase the actuarially fair coinsurance contract. Even when purchasing the actuarially fair coinsurance contract is optimal, we derive sufficient conditions under which the regret-averse producer reduces the optimal output level as compared to that without the coinsurance contract. These results are distinct from those under pure risk aversion, thereby making the consideration of regret aversion crucial. © 2012 Elsevier B.V.postprin

Operating Leverage and the Interaction between Abandonment Options and Exotic Hedging

This paper examines the interaction between operational and financial hedging in the context of the competitive firm under output price uncertainty. The firm is endowed with an abandonment option in that its production decision is made after the true realization of the random output price has been observed. If the realized output price is less than its marginal cost, the firm optimally exercises its abandonment option and ceases from production. Otherwise, the firm lets its abandonment option extinguish and produces at its capacity. The existence of the abandonment option is shown to induce the firm to opt for a concave payoff risk-sharing rule that can be perfectly replicated by writing call options with a single strike price set equal to the marginal cost. We derive necessary and sufficient conditions that ensure a positive (negative) effect of operational hedging via the abandonment option on the firm's optimal operating leverage. In contrast, we show that the effect of financial hedging via customized exotic derivatives on the firm's optimal operating leverage is unambiguously positive. These results suggest that the interaction between abandonment options and exotic hedging is multi-dimensional and deserves further scrutiny.postprin

Production and futures hedging with state-dependent background risk

This paper examines the production and futures hedging decisions of the competitive firm under output price uncertainty and with state-dependent background risk. We show that the firm's optimal production decision is independent of the underlying uncertainty and of the firm's risk attitude. We further show that the firm's optimal futures position is a full-hedge that completely eliminates the output price risk if either the background risk is state-independent, or the firm's utility function is quadratic. When the firm's preferences exhibit prudence, an under-hedge or an over-hedge is optimal should the magnitude of the background risk vary in a monotonic manner with changes in the realized state. When the prudent firm has access not only to the unbiased futures contracts but also to fairly priced options, we construct a reasonable example wherein the firm optimally includes the options in its hedge position. Hence, we offer a rationale for the hedging role of options, which is over and above that of futures, in the case of state-dependent background risk. © 2012 Elsevier Inc.postprin

Precautionary Self-Insurance-cum-Protection

Precautionary self-insurance-cum-protection (SICP) arises when an individual spends more on SICP when background risk is introduced. We develop a two-period model wherein additive/multiplicative background risk prevails in the second period. Using the theory of monotone comparative statics and risk apportionment, we derive necessary and sufficient conditions under which the individual spends more on SICP when the background risk deteriorates via higher-order stochastic dominance. Prudence is called for to create a precautionary motive that induces the individual to shift his wealth in a way to reduce the loss of expected utility caused by the addition of background risk, thereby giving rise to the precautionary SICP.postprin

A Smooth Ambiguity Model of the Competitive Firm

This paper examines the optimal production decision of the competitive firm under price uncertainty when the firm's preferences exhibit smooth ambiguity aversion. Ambiguity is modeled by a second-order probability distribution that captures the firm's uncertainty about which of the subjective beliefs govern the price risk. Ambiguity preferences are modeled by the (second-order) expectation of a concave transformation of the (first-order) expected utility of profit conditional on each plausible subjective distribution of the price risk. Within this framework, we derive necessary and sufficient conditions under which the ambiguity-averse firm optimally produces less in response either to the introduction of ambiguity or to greater ambiguity aversion when ambiguity prevails. In the case that the price risk is binary, we show that ambiguity and greater ambiguity aversion always adversely affect the firm's production decision.postprin

Operational and financial hedging for exporting firms

This paper examines the interaction between operational and financial hedging in the context of an internationally competitive but domestically monopolistic firm under exchange rate uncertainty. Operational hedging is modeled by letting the firm make its export decision after it has observed the true realization of the then prevailing spot exchange rate. Financial hedging, on the other hand, is modeled by allowing the firm to trade fairly priced exotic derivatives that are tailor-made for the firm's hedging need. We show that both operational and financial hedging unambiguously entice the firm into producing more. We further derive sufficient conditions under which operational hedging dominates (is dominated by) financial hedging in terms of promoting the firm's optimal output. © 2005 Elsevier Inc. All rights reserved.postprin

Ambiguity and the Multinational Firm

This paper examines the optimal production and hedging decisions of the multinational firm under exchange rate uncertainty when the multinational firm possesses smooth ambiguity preferences. Ambiguity is modeled by a second-order probability distribution that captures the multinational firm's uncertainty about which of the subjective beliefs govern the exchange rate risk. Ambiguity preferences are modeled by the (second-order) expectation of a concave transformation of the (first-order) expected utility of home currency profit conditional on each plausible subjective distribution of the exchange rate risk. Within this framework, we show that the separation and full-hedging theorems are robust to the incorporation of ambiguity and ambiguity preferences. The presence of the currency hedging opportunity induces the multinational firm to produce more and sell less at home, and export more abroad. When the forward exchange rate is biased, we derive necessary and sufficient conditions under which the multinational firm optimally opts for a forward position that is closer to a full-hedge in response to either the introduction of ambiguity or greater ambiguity aversion.postprin

Regret theory and the competitive firm

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The effect of uncertainty on investment timing in a real options model

This paper examines the effect of uncertainty on investment timing in a canonical real options model. We show that the critical value of a project that triggers the exercise of the investment option exhibits a U-shaped pattern against the volatility of the project. This is due to the two countervailing risk and return factors in effect. We further show that such a U-shaped pattern is inherited by the expected time to exercise the investment option. Thus, for relatively safe projects, greater uncertainty shortens the expected exercise time and thus enhances investment. This is in sharp contrast to the negative investment-uncertainty relationship commonly found in the extant literature. Finally, we show that the positive investment-uncertainty relationship is more likely for high growth projects than for low growth projects. © 2006 Elsevier B.V. All rights reserved.postprin