joseph v. rizzi finance 342, 2013 1. a. main decisions b. fundamental building blocks c. separation...
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FrameworkJoseph V. Rizzi
Finance 342, 2013
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A. Main DecisionsB. Fundamental Building BlocksC. Separation Principles/Decision RulesD. StatisticsE. Financial MarketsF. Decisions at Risk (DAR)
Agenda
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1. Objective Function – what are we to maximize?
2. Investment Decision – how do we invest and manage, and why?
3. Dividend Decision – level (and form) of funds returned to the shareholders?
4. Capital Structure – how do we fund ourselves?
A. Main Decisions
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1. Efficient Capital Markets – price behavior in speculative markets.
Complex Adaptive Systems
Efficient Learning
B. Fundamental Building Blocks
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2. Portfolio Theory – optimal security selection procedures.
3. Asset Pricing Models – determining asset prices by investors utilizing portfolio theory.
4. Option Pricing Theory – pricing of contingent claims.
5. Agency Theory – incentive conflict when benefits are concentrated but costs are disbursed. Heightened by moral hazard when you cannot observe behavior. Enhanced by behavioral bias.
B. Fundamental Building Blocks
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a) Manifestation
1) Insufficient effort
2) Overinvest
3) Entrenchment
4) Self Dealing
B. Fundamental Building Blocks – Agency Theory
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b) Information asymmetries: heightened conflict between agent/managers and principals/investors
Disbursement
Before After
Adverse Monitoring Costs
Selection Moral Hazard
1) Chance vs. uncertainty
2) Ignorance vs. adverse selection
3) Dishonesty vs. moral hazard
B. Fundamental Building Blocks – Agency Theory
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c) Moral hazard = f (private benefit from misbehaving, 1/verification)
d) Adverse Selection
e) Responses
1) Signaling – debt levels, dividends, reputation
2) Incentives
3) Monitoring
4) Contracts – warranties, deductibles, pricing
B. Fundamental Building Blocks – Agency Theory
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f) Value implications – wedge between value and income pledge, between opportunity and financing.
1) Value – may not be externally determined
2) Financing – Agency problems/concerns may deprive firms from financing. Borrowers may make concessions to Lender to achieve funding.
3) Pecking Order
B. Fundamental Building Blocks – Agency Theory
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6. Game Theory:
Economics of decision making; uncertainty lies in the intention/reaction of others.
Focus on how individuals behave, anticpate and respond.
Components – players, action, motives, and rules.
B. Fundamental Building Blocks – Game Theory
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7. Behavioral Finance:
Prices influenced by herd vs. lead steers.
The issue is whether markets are inefficient or just noisy. Requirement: arbitrage limit.
Implications:(1) Investors irrational – Shield managers(2) Managers irrational – Limit discretion
B. Fundamental Building Blocks – Behavioral Finance
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a) Bias:OptimismOverconfidenceConfirmationIllusion of Control
b) Heuristics:RepresentationI/n equal weightAvailability – overweight recentAnchoring – overweight initial
B. Fundamental Building Blocks – Behavioral Finance
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c) Framing:Reference points
d) Manifestations:Winners curseGamblers fallacySunk cost – regret avoidance (prospect theory)Reputation lossValuation
B. Fundamental Building Blocks – Behavioral Finance
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8. Arbitrage:Law of one price – equal rate of return principle
B. Fundamental Building Blocks – Arbitrage
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1) Market Value Rule:Maximize shareholder wealth. Separating ownership from management raises conflict issues. Control mechanisms:
a) Management incentive compensation contract provisions.
b) Management ownership interest.
c) Management labor market (Reputation)
d) Market for corporate control
e) Internal control mechanisms (Board of Directors)
C. Separation Principles/Decision Rules
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2) NPV Rule:Choose projects whose returns exceed their cost of capital (r ≥ c*).
Need to consider multiple risk adjusted discount rates and option value of strategic investments.
Discount rate is a function of the risk class.
C. Separation Principles/Decision Rules
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3) Dividend Irrelevance:(except for: agency cost, signaling, and option pricing issues).
C. Separation Principles/Decision Rules
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4) Capital Structure Irrelevance:(except for: taxes, agency cost, signaling, and option pricing issues).
C. Separation Principles/Decision Rules
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Statistics: beware data mining, which is prevalent in non-experimental sciences lacking controlled experiments.
1. Reliance on past as prolog vs. history.
2. Descriptive vs. predictive.
3. Issues – normality, suvivorship, stationary, independence.
4. Movements – go beyond mean and variance to skew and tails.
5. Beyond the data – out of sample issues.
6. Correlations – state dependent and lack integrating model covering both default and spread widing.
7. VAR – best of worst. Need expected shortfall analysis to get into tail.
D. Statistics
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Statistics: beware data mining, which is prevalent in non-experimental sciences lacking controlled experiments – continued.
8. Goodhart’s Law – sociological uncertainty principle – when a measure becomes a target it ceases to be a good measure (behavior change).
D. Statistics
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Financial Markets:
1) Merton – neoclassical benchmark anomolies/inhibitions/transactions cost institutional solutions – overcoming inefficiencies to get back to benchmark. Means of creating missing markets.
2) Machines – converting danger (uncontrollable damages) into risk (decision-related controllable damage) which can be traded or transferred. Focus on unintended consequences and conservations of risk principle.
E. Financial Markets
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Decisions at risk (DAR):
DAR
Agency Asymmetric BiasProblem Information
F. Decisions at Risk (DAR)
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