Inequality aversion and externalities

We conduct a general analysis of the effects of inequality aversion on decisions by homogeneous players in static and dynamic games. We distinguish between direct and indirect effects of inequality aversion. Direct effects are present when a player changes his action to affect disutility caused by inequality. Indirect effects occur when the own action is changed to affect other players' actions. We provide necessary and sufficient conditions for the occurrence of either effect. Moreover, we examine the direction of the effects. Whereas indirect effects induce players to internalize externalities they impose on others, direct effects act in the opposite direction. --inequality aversion,externalities,direct effects,indirect effects

Pitfalls in modeling loss given default of bank loans

The parameter loss given default (LGD) of loans plays a crucial role for risk-based decision making of banks including risk-adjusted pricing. Depending on the quality of the estimation of LGDs, banks can gain significant competitive advantage. For bank loans, the estimation is usually based on discounted recovery cash flows, leading to workout LGDs. In this paper, we reveal several problems that may occur when modeling workout LGDs, leading to LGD estimates which are biased or have low explanatory power. Based on a data set of 71,463 defaulted bank loans, we analyze these issues and derive recommendations for action in order to avoid these problems. Due to the restricted observation period of recovery cash flows the problem of length-biased sampling occurs, where long workout processes are underrepresented in the sample, leading to an underestimation of LGDs. Write-offs and recoveries are often driven by different influencing factors, which is ignored by the empirical literature on LGD modeling. We propose a two-step approach for modeling LGDs of non-defaulted loans which accounts for these differences leading to an improved explanatory power. For LGDs of defaulted loans, the type of default and the length of the default period have high explanatory power, but estimates relying on these variables can lead to a significant underestimation of LGDs. We propose a model for defaulted loans which makes use of these influence factors and leads to consistent LGD estimates. --Credit risk,Bank loans,Loss given default,Forecasting

Two-Fund separation and positive marginal utility

The requirement of positive marginal utility only makes it possible to derive a restricted twofund separation theorem for portfolio selection problems replacing the original separation theorem of Cass and Stiglitz (1970). We use our findings for a re-examination of the bias-in-beta problem in mutual funds performance evaluation and of the relevance of the standard CAPM without borrowing restrictions. We also present empirical evidence for the only limited validity of the separation theorem when explicitly recognizing positive marginal utility. Moreover, quadratic utility functions are not apt to approximate the admissible range of risk preferences in the case of higher-order utility functions. --two-fund separation,HARA utility,positive marginal utility,borrowing restrictions,Capital Asset Pricing Model, bias in beta, performance evaluation

Shortcomings of a parametric VaR approach and nonparametric improvements based on a non-stationary return series model

A non-stationary regression model for financial returns is examined theoretically in this paper. Volatility dynamics are modelled both exogenously and deterministic, captured by a nonparametric curve estimation on equidistant centered returns. We prove consistency and asymptotic normality of a symmetric variance estimator and of a one-sided variance estimator analytically, and derive remarks on the bandwidth decision. Further attention is paid to asymmetry and heavy tails of the return distribution, implemented by an asymmetric version of the Pearson type VII distribution for random innovations. By providing a method of moments for its parameter estimation and a connection to the Student-t distribution we offer the framework for a factor-based VaR approach. The approximation quality of the non-stationary model is supported by simulation studies. --heteroscedastic asset returns,non-stationarity,nonparametric regression,volatility,innovation modelling,asymmetric heavy-tails,distributional forecast,Value at Risk (VaR)

The equity premium puzzle and emotional asset pricing

Since the equity premium as well as the risk-free rate puzzle question the concepts central to financial and economic modeling, we apply behavioral decision theory to asset pricing in view of solving these puzzles. U.S. stock market data for the period 1960-2003 and German stock market data for the period 1977-2003 show that emotional investors who act in accordance to Bell's (1985) disappointment theory - a special case of prospect theory − and additionally administer mental accounts demand a high equity premium. Furthermore, these investors reason a low risk-free rate. However, Barberis/Huang/Santos (2001) already showed that limited rational investors demand a high equity premium. But as opposed to them, our approach additionally supports dividend smoothing. --Behavioral Finance,Equity Premium Puzzle,CCAPM,Dividend Smoothing

Implied rates of return, the discount rate effect, and market risk premia

We show analytically under quite general conditions that implied rates of return based on analysts' earnings forecasts are only a downward biased estimator for future expected one-period returns and therefore not suited for computing market risk premia. The extent of this bias is substantial as verified by a bootstrap approach. We present an alternative estimation equation for future expected one-period returns based on current and past implied rates of return that is superior to simple estimators based on historical returns. The reason for this superiority is a lower variance of estimation results and not the circumvention of the discount rate effect typically stated as a major problem of estimators based on historical return realizations. The superiority of this new approach for portfolio selection purposes is verified numerically for our bootstrap environment and empirically for real capital market data. --analysts' earnings forecasts,discount rate effect,equity premium puzzle,implied rate of return

Kimball's prudence and two-fund separation as determinants of mutual fund performance evaluation

We consider investors with mean-variance-skewness preferences who aim at selecting one out of F different funds and combining it optimally with the riskless asset and direct stock holdings. Direct stock holdings are either exogenously or endogenously determined. In our theoretical section, we derive and discuss several performance measures for the investor's decision problems with a central role of Kimball's (1990) prudence and of several variants of Sharpe and Treynor measures. In our empirical section, we show that the distinction between exogenous and endogenous stock holding is less important than the issue of skewness preferences. The latter are most relevant for fund rankings, when an investor's skewness preferences are not derived from cubic HARA utility so that the two-fund separation theorem is not valid. Keywords: investor specific performance measure, performance evaluation, prudence, skewness preferences --

Crunch time: A policy to avoid the announcement effect when terminating a subsidy

If the government announces the termination of a subsidy paid for an irreversible investment under uncertainty, investors might decide to realize their investment so as to obtain the subsidy. These investors might have postponed an investment if future payment were assured. Depending on the degree of uncertainty and the time preference, the termination of the subsidy might cost the government more in toto than granting the subsidy on a continuing basis. A better strategy would be to reduce the subsidy in parts rather than to terminate the subsidy in its entirety. --Irreversibility,Investment,Announcement effect,Subsidy,Tax

Coherent banking capital and optimal credit portfolio structure

Coherent measures of a bank's whole risk capital imply a structure of a bank's optimal credit portfolio that is independent of its deposits and the expected deposit rate, of expected bankruptcy costs and of expected costs of regulatory capital. --Basel II,Regulatory Capital,Coherent Risk Capital,Separation

Behavioral dividend policy

In this paper we develop an optimal dividend policy in the presence of limited rational inves-tors. Concretely, investors with mental accounts for dividends and stock prices as well as emotions like disappointment and elation embody the limited rationality. Furthermore, investors evaluate changes in wealth instead of final wealth. A management maximizing investors' modified utility results in the optimality of dividend payments as well as dividend smoothing, which both have long been puz-zles to financial theorists. Moreover, a model specification leads to a gradual dividend adjustment to changes in net earnings as described by Lintner (1956). --dividend policy,dividend smoothing,behavioral finance