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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)