Knowledge that Transforms

This paper investigates how firms manage risk by examining the relationship between financial and operational hedging using a sample of bank holding companies. Risk management theory holds that capital market imperfections make cash flow volatility costly. I investigate whether financial firms consider this cost or focus exclusively on managing tradable exposures. After documenting that acquisitions provide operational hedging by reducing potentially costly volatility, I find that postacquisition financial hedging declines even after controlling for the specific underlying risks. In addition, the decrease in financial hedging is related to the acquisition's level of operational hedging. Larger increases in operational hedging are followed by larger declines in financial hedging. These results indicate that firms in this sample manage aggregate risk, not just tradable exposures, and that operational hedging can substitute for financial hedging.

Keyword advertising, or sponsored search, is one of the most successful advertising models on the Internet. One distinctive feature of keyword auctions is that they enable advertisers to adjust their bids and rankings dynamically, and the payoffs are realized in real time. We capture this unique feature with a dynamic model and identify an equilibrium bidding strategy. We find that under certain conditions, advertisers may engage in cyclical bid adjustments, and equilibrium bidding prices may follow a cyclical pattern: price-escalating phases interrupted by price-collapsing phases, similar to an “Edgeworth cycle” in the context of dynamic price competitions. Such cyclical bidding patterns can take place in both first- and second-price auctions. We obtain two data sets containing detailed bidding records of all advertisers for a sample of keywords in two leading search engines. Our empirical framework, based on a Markov switching regression model, suggests the existence of such cyclical bidding strategies. The cyclical bid-updating behavior we find cannot be easily explained with static models. This paper emphasizes the importance of adopting a dynamic perspective in studying equilibrium outcomes of keyword auctions.

This paper highlights the rationale for exclusive territories in a model of repeated interaction between competing supply chains. We show that with observable contracts exclusive territories have two countervailing effects on manufacturers' incentives to sustain tacit collusion. First, granting local monopolies to retailers softens competition in a one-shot game. Hence, punishment profits are larger, thereby rendering deviation more profitable. Second, exclusive territories stifle deviation profits because retailers of competing brands adjust their prices to the wholesale contract offered by a deviant manufacturer, whereas intrabrand competition prevents such “instantaneous reaction.” We show that the latter effect tends to dominate, thereby making exclusive territories a more suitable organizational mode to cooperate. These insights are robust to endogenous communication between manufacturers. We also consider retailers' service investments. Here, a novel effect emerges that softens the procollusive value of exclusive territories: Retailers of a deviant manufacturer increase investments, which renders deviation more profitable.

Despite annual expenditures on public relations exceeding $19.42 billion, U.S. businesses lack practical guidance about the effectiveness of publicity in mass media. Here, we assemble a rich and novel data set to gauge the impact of news reports on consumer sign-ups with the U.S. Do Not Call (DNC) Registry. Using multiple identification strategies, we found robust evidence that news reports increased consumer registrations. Specifically, a 1% increase in the number of news reports increased DNC registrations by 0.018%. The impact increased with mention of the toll-free telephone number and URL, but decreased with the length of the headline and main text. Furthermore, we found evidence that reports affect behavior through persuasion as well as information—the impact on registration was higher for reports that mentioned the number of other people registering. Finally, the impact of news reports on consumer registration was stronger in national than local newspapers and in politically neutral and Democrat than Republican newspapers.

We consider a complex planning problem in integrated steel production. A sequence of coils of sheet metal needs to be color coated in consecutive stages. Different coil geometries and changes of colors necessitate time-consuming setup work. In most coating stages one can choose between two parallel color tanks. This can either reduce the number of setups needed or enable setups concurrent with production. A production plan comprises the sequencing of coils and the scheduling of color tanks and setup work. The aim is to minimize the makespan for a given set of coils. We present an optimization model for this integrated sequencing and scheduling problem. A core component is a graph theoretical model for concurrent setup scheduling. It is instrumental for building a fast heuristic that is embedded into a genetic algorithm to solve the sequencing problem. The quality of our solutions is evaluated via an integer program based on a combinatorial relaxation, showing that our solutions are within 10% of the optimum. Our algorithm is implemented at Salzgitter Flachstahl GmbH, a major German steel producer. This has led to an average reduction in makespan by over 13% and has greatly exceeded expectations.

Reference-dependent preferences have been well accepted in decision sciences, experimental economics, behavioral finance, and marketing. However, we still know very little about how decision makers form and update their reference points given a sequence of information. Our paper provides some novel experiments in a financial context to advance the understanding of reference-point formation over time. Our subjects' reference price is best described as a combination of the first and the last price of the time series, with intermediate prices receiving smaller and nondecaying weights. Hence, reference prices are not recursive. We provide a parsimonious formula to predict the reference points, which we test out-of-sample. The fit of the model is reasonably good.

This paper finds preference reversals in measurements of ambiguity aversion, even if psychological and informational circumstances are kept constant. The reversals are of a fundamentally different nature than the reversals found before because they cannot be explained by context-dependent weightings of attributes. We offer an explanation based on Sugden's random-reference theory, with different elicitation methods generating different random reference points. Then measurements of ambiguity aversion that use willingness to pay are confounded by loss aversion and hence overestimate ambiguity aversion.

Exploring the tension between theory and practice regarding complexity and performance in contract design is especially relevant. The goal of this paper is to understand why simpler contracts may commonly be preferred in practice despite being theoretically suboptimal. We study a two-tier supply chain with a single supplier and a single buyer to characterize the impact of contract complexity and asymmetric information on performance and to compare theoretical predictions to actual behavior in human subject experiments. In the experiments, the computerized buyer faces a newsvendor setting and has better information on end-consumer demand than the human supplier. The supplier offers either a quantity discount contract (with two or three price blocks) or a price-only contract, contracts that are commonplace in practice, yet different in complexity. Results show that, contrary to theoretical predictions, quantity discounts do not necessarily increase the supplier's profits. We also observe a more equitable distribution of profits between the supplier and the buyer than what theory predicts. These observations can be described with three decision biases (the probabilistic choice bias, the reinforcement bias, and the memory bias) and can be modeled using the experience-weighted attraction learning model. Our results demonstrate that simpler contracts, such as a price-only contract or a quantity discount contract with a low number of price blocks, are sufficient for a supplier designing contracts under asymmetric demand information.

Dynamic, intensity-based point process models are widely used to measure and price the correlated default risk in portfolios of credit-sensitive assets such as loans and corporate bonds. Monte Carlo simulation is an important tool for performing computations in these models. This paper develops, analyzes, and evaluates two simulation algorithms for intensity-based point process models. The algorithms extend the conventional thinning scheme to the case where the event intensity is unbounded, a feature common to many standard model formulations. Numerical results illustrate the performance of the algorithms for a familiar top-down model and a novel bottom-up model of correlated default risk.

This paper considers the desirability of aggregate performance measures in light of the fact that many individuals' performance incentives are driven by a desire to shape external perceptions (and thus future pay). In contrast to the case of explicit incentive contracts, we find that when individuals' actions are driven by career incentives, an aggregate measure (e.g., group or team output) can sometimes alleviate moral hazard concerns and improve efficiency. Aggregation intermingles performance measures that may be differentially affected by skill and effort of many agents. When such entanglement increases the prospect that the external market will attribute an employee's effort-driven contribution to transferable skills, the employee exerts higher effort as a means of posturing to the market. The incentive benefit of aggregation is weighed against the incentive cost because of information loss. Information loss from aggregation can reduce the market's reliance on the measure and thus diminish agents' desire to undertake effort to influence the measure.