Financial Structure and Market Equilibrium in a Vertically Differentiated Industry

This paper examines the effects of uncertainty and the choice of financial structure in a vertically differentiated duopoly. In the market model consumers are located along a continuum of taste parameters and prefer unanimously higher to lower qualities when quality prices are set at average variable cost. In such a model only two firms can survive with a positive market share. We introduce uncertainty in demand by varying the range of the consumer taste parameter and consider a simultaneous game of sequential choices of quality, financial structure and product price, with varying order of decision-making and revelation of information. We consider both restricted and free entry. It is shown that financial structure affects market equilibrium, which is also heavily dependent on the order of choice of structure and quality, as well as on whether uncertainty exists in the lower or the upper limit of the taste parameter. In all cases leverage increases the lower quality and in most cases it also increases the lower quality price. There are also welfare implications, with the use of leverage when it is optimal improving both total and consumer surplus.Vertical differentiation; uncertainty; financial structure; leverage; quality; sequential choice

Option Pricing and Replication with Transaction Costs and Dividends

This paper derives optimal perfect hedging portfolios in the presence of transaction costs within the binomial model of stock returns, for a market maker that establishes bid and ask prices for American call options on stocks paying dividends prior to expiration. It is shown that, while the option holder's optimal exercise policy at the ex-dividend date varies according to the stock price, there are intervals of values for such a price where the optimal policy would depend on the holder's preferences. Nonetheless, the perfect hedging assumption still allows the derivation of optimal hedging portfolios for both long and short positions of a market maker on the option.Pricing; Transaction costs; American options; Dividends

Option pricing with transaction costs and dividends

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