An Equilibrium Analysis of Real Estate

This paper provides a unified equilibrium approach to valuing a wide variety of commercial real estate lease contracts. Using a game-theoretic variant of real options analysis, the underlying real estate asset market is modeled as a continuous-time Nash equilibrium in which developers make construction decisions under demand uncertainty. Then, using the economic notion that leasing simply represents the purchase of the use of the asset over a specified time frame, I use a contingent-claims approach to value many of the most common real estate leasing arrangements. In particular, the model provides closed-form solutions for the equilibrium valuation of leases with options to purchase, pre-leasing, gross and net leases, leases with cancellation options, ground leases, escalation clauses, lease concessions and sale-leasebacks.

Investment Under Uncertainty and Time-Inconsistent Preferences

The real options framework has been used extensively to analyze the timing of investment under uncertainty. While standard real options models assume that agents possess a constant rate of time preference, there is substantial evidence that agents are very impatient about choices in the short-term, but are quite patient when choosing between long-term alternatives. We extend the real options framework to model the investment timing decisions of entrepreneurs with such time-inconsistent preferences. Two opposing forces determine investment timing: while evolving uncertainty induces entrepreneurs to defer investment in order to take advantage of the option to wait, their time-inconsistent preferences motivate them to invest earlier in order to avoid the time-inconsistent behavior they will display in the future. We find that the precise trade-off between these two forces depends on such factors as whether entrepreneurs are sophisticated or naive in their expectations regarding their future time-inconsistent behavior, as well as whether the payoff from investment occurs all at once or over time. We extend the model to consider equilibrium investment behavior for an industry comprised of time-inconsistent entrepreneurs. Such an equilibrium involves the dual problem of entrepreneurs playing dynamic games against competitors as well as against their own future selves.

Risk-Based Capital Standards and the Riskiness of Bank Portfolios: Credit and Factor Risks

Bank risk-based capital (RBC) standards require banks to hold differing amounts of capital for different classes of assets, based almost entirely on a credit risk criterion. The paper provides both a theoretical and empirical framework for evaluating such standards. A model outlining a pricing methodology for loans subject to default risk is presented. The model shows that the returns on such loans are affected by the complicated interaction of the likelihood of default, the consequences of default, term structure variables, and the pricing of factor risks in the economy. When we examine whether the risk weights accurately reflect bank asset risk, we find that the weights fail even in their limited goal of correctly quantifying credit risk. For example, our findings indicate that the RBC weights overpenalize home mortgages, which have an average credit loss of 13 basis points, relative to commercial and consumer loans. The RBC rules also contain a significant bias against direct mortgages relative to mortgage- backed securities. In addition, we find large differences in the credit riskiness of loans within the 100 percent weight class and potentially large benefits to loan diversification, neither of which are considered in the RBC regulations. We also examine other types of bank risk by estimating a simple factor model that decomposes loan risk into term structure, default, and market risk. One implication of our findings is that although banks have reallocated their portfolios in ways intended by the RBC standards, they may have merely substituted one type of risk (term structure risk) for others (default and market risk), of which the net effect is unknown.

Stock and Bond Returns with Moody Investors

We present a tractable, linear model for the simultaneous pricing of stock and bond returns that incorporates stochastic risk aversion. In this model, analytic solutions for endogenous stock and bond prices and returns are readily calculated. After estimating the parameters of the model by the general method of moments, we investigate a series of classic puzzles of the empirical asset pricing literature. In particular, our model is shown to jointly accommodate the mean and volatility of equity and long term bond risk premia as well as salient features of the nominal short rate, the dividend yield, and the term spread. Also, the model matches the evidence for predictability of excess stock and bond returns. However, the stock-bond return correlation implied by the model is somewhat higher than in the data.

Timing Decisions in Organizations: Communication and Authority in a Dynamic Environment

We consider a problem where an uninformed principal makes a timing decision interacting with an informed but biased agent. Because time is irreversible, the direction of the bias crucially affects the agent's ability to credibly communicate information. When the agent favors late decision making, full information revelation often occurs. In this case, centralized decision making, where the principal retains authority and communicates with the agent, implements the optimal decision-making rule. When the agent favors early decision making, communication is partial, and the optimal decision-making rule is not implemented. Delegation adds value when the bias is for early decision making, but not for late decision making

Real options signaling games with applications to corporate finance,

We study games in which the decision to exercise an option is a signal of private information to outsiders, whose beliefs affect the utility of the decision-maker. Signaling incentives distort the timing of exercise, and the direction of distortion depends on whether the decision-maker's utility increases or decreases in outsiders' belief about the payoff from exercise. In the former case, signaling incentives erode the value of the option to wait and speed up option exercise, while in the latter case option exercise is delayed. We demonstrate the model's implications through four corporate finance settings: investment under managerial myopia, venture capital grandstanding, investment under cash flow diversion, and product market competition. (JEL G31, D82) The real options approach to investment and other corporate finance decisions has become an increasingly important area of research in financial economics. The main underlying concept is that an investment opportunity is valuable not only because of associated cash flows but also because the decision to invest can be postponed. As a result, when making the investment decision, one must take into account both the direct costs of investment and the indirect costs of foregoing the option to invest in the future. The applications of the real options framework have become quite broad. 1 We thank the anonymous referee, Anat Admati, Felipe Aguerrevere, Geert Bekaert, Nina Boyarchenko, Cecilia Bustamante, Nadya Malenko, Ilya Strebulaev, Pietro Veronesi (the editor), Neng Wang, Jeffrey Zwiebel, seminar participants at Stanford University, and participants at the 2010 Western Finance Association Annual Meeting in Victoria, BC; the 2010 UBC Winter Finance Conference; and the 9 th Trans-Atlantic Doctoral Conference at LBS for their helpful comments. Send correspondence to Steven R. Grenadier, Graduate School of Business, Stanford University, 655 Knight Way, Stanford, CA, 94305. E-mail: [email protected]. Andrey Malenko: MIT Sloan School of Management, 100 Main Street, E62-619, Cambridge, MA, 02142. E-mail: [email protected]. 1 The early literature, started b

The Strategic Exercise of Options: Development Cascades and Overbuilding in Real Estate Markets.

This article develops an equilibrium framework for strategic option exercise games. The author focuses on a particular example: the timing of real estate development. An analysis of the equilibrium exercise policies of developers provides insights into the forces that shape market behavior. The model isolates the factors that make some markets prone to bursts of concentrated development. The model also provides an explanation for why some markets may experience building booms in the face of declining demand and property values. While such behavior is often regarded as irrational overbuilding, the model provides a rational foundation for such exercise patterns. Copyright 1996 by American Finance Association.