Increases in Risk Aversion and Portfolio Choice in a Complete Market

This note examines the effect of changes in risk aversion on the optimal portfolio choice in a complete market. It is shown that an agent who is less risk averse in the Pratt (1964) sense than another will choose a portfolio whose payoff is distributed as the other’s payoff plus a nonnegative random variable plus conditional-mean-zero noise. The proof of the result uses simple first order conditions and basic results from stochastic dominance

Inefficient Dynamic Portfolio Strategies or How to Throw Away a Million Dollars in the Stock Market

A number of portfolio strategies followed by practitioners are dominated because they are incompletely diversified over time. The Payoff Distribution Pricing Model is used to compute the cost of following undiversified strategies. Simple numerical examples illustrate the technique, and computer-generated examples provide realistic estimates of the cost of some typical policies using reasonable parameter values. The cost can be substantial and should not be ignored by practitioners. A section on generalizations shows how to extend the analysis to term structure models and other general models of returns

Distributional Analysis of Portfolio Choice

We compare trading in a market with receiving some particular consumption bundle, given increasing state-independent preferences and complete markets. The analysis focuses on the distributional price of the particular bundle. The distributional price is the price of the cheapest utility-equivalent bundle sold in the market. The distributional price is determined by the distributional functions of the outside bundle and the state price density. Simple portfolio performance measures illustrate the value of the approach. Unlike CAPM-based measures, these measures are valid even when superior information is the source of superior performance

Bank runs, deposit insurance, and liquidity

This article develops a model which shows that bank deposit contracts can provide allocations superior to those of exchange markets, offering an explanation of how banks subject to runs can attract deposits. Investors face privately observed risks which lead to a demand for liquidity. Traditional demand deposit contracts which provide liquidity have multiple equilibria, one of which is a bank run. Bank runs in the model cause real economic damage, rather than simply reflecting other problems. Contracts which can prevent runs are studied, and the analysis shows that there are circumstances when government provision of deposit insurance can produce superior contracts.Deposit insurance ; Liquidity (Economics)

The new risk management: the good, the bad, and the ugly

At one time, risk management was limited to insurance and the avoidance of lawsuits and accidents. The new risk management also includes using tools developed for pricing financial options for the management of financial risks within the firm. Trading in financial markets based on these tools can insulate companies from the risk of changes in interest rates, input prices, or currency fluctuations. In this article Philip H. Dybvig and William J. Marshall introduce the new risk management and the policy choices firms should be considering.Management ; Risk

Discussion of Improving Bankruptcy Procedure by Philippe Aghion, Oliver Hart, and John Moore

By bringing together a wide range of bankruptcy scholars and practitioners, this Conference has made very clear the broad extent of opinions about current bankruptcy law. One extreme view suggests bankruptcy is a mysterious and wonderful process that has many benefits that are difficult or impossible to quantify or enumerate. A polar extreme view, presented in the paper I am discussing by Aghion, Hart, and Moore (AHM), is that bankruptcy is a complicated and costly solution to a very simple problem. I suspect the truth (or at least the most useful view of the world) lies between the two extremes. It certainly should be possible to quantify and enumerate the functions of the bankruptcy process, and the resulting demystification should be an input to improved policy decisions. On the other side, the existing proposed simple alternatives to bankruptcy, such as that of AHM, neglect important functions of bankruptcy. The AHM paper in particular weakens its own case by neglecting existing institutions. Perhaps because of our shared economic training, I am predisposed to be sympathetic with the central motivation of AHM. For example, I have a casual perception that Chapter 11 works poorly for large firms. Based on what I know about large publicized bankruptcies, the bankruptcy process is unnecessarily slow, arbitrary, manipulable, and destructive of prior contracting. Unfortunately, the hard evidence I am aware of neither confirms nor refutes my perception To the extent that my perception is accurate, each of the shortcomings of the bankruptcy process causes avoidable economic damage, the cost of which must be borne by somebody and is a dead-weight loss to society as a whole

Capital Structure and Dividend Irrelevance with Asymmetric Information

The Modigliani and Miller propositions on the irrelevancy of capital structure and dividends are shown to be valid in a large class of models with asymmetric information. The main assumption is that managerial compensation is chosen optimally. This differs from most recent papers on this topic, which impose by fiat a suboptimal contract. Even when imperfections internal to the firm preclude optimal investment, there is a separation between incentives and financing. We also show that making prices reflect idiosyncratic information more accurately does not make investors better off, thus negating the motivation of many of the signalling models

Warranties, Durability, and Maintenance: Two Sided Moral Hazard in a Continuous-Time Model

We consider the provision of an optimal warranty in a continuous-time model with two-sided moral hazard. The optimal warranty must balance the producer’s durability incentive and the buyer’s maintenance incentive. Too little warranty protection gives the producer too much incentive to produce low durability, while too much warranty protection gives the consumer too much incentive to neglect maintenance. The derived optimal warranty is a “block warranty” that is high for an initial block of time and zero thereafter. The first-best would be available under a very high warranty for a very short time interval, except for the incentive this would create for the consumer to abuse the product to collect the warranty

What is the expected return on a stock?

We derive a formula for the expected return on a stock in terms of the risk-neutral variance of the market and the stock's excess risk-neutral variance relative to that of the average stock. These quantities can be computed from index and stock option prices; the formula has no free parameters. The theory performs well empirically both in and out of sample. Our results suggest that there is considerably more variation in expected returns, over time and across stocks, than has previously been acknowledged