Knowledge that Transforms

This paper complements theoretical studies on the Kelly rule in evolutionary finance by studying a Darwinian model of selection and reproduction in which the diversity of investment strategies is maintained through genetic programming. We find that investment strategies which optimize long-term performance can emerge in markets populated by unsophisticated investors. Regardless whether the market is complete or incomplete and whether states are i.i.d. or Markov, the Kelly rule is obtained as the asymptotic outcome. With price-dependent rather than just state-dependent investment strategies, the market portfolio plays an important role as a protection against severe losses in volatile markets.

This paper provides a unifying framework for the modeling of various types of credit risks such as contagion effects. We argue that Markov chains can efficiently be used to tackle these problems. However, our approach is not limited to pricing problems with contagion. On the theoretical side, we derive pricing formulas for three building blocks that are generalizations of contingent claims studied in Lando (1998). These claims can be thought of as atoms forming the basis for all credit risk payments. Furthermore, we demonstrate that, in general, all contingent claims exposed to credit risk satisfy a system of partial differential equations. This is the key result to calculate prices of credit risk claims explicitly and efficiently.

We study a firm in which the marginal productivity of agents' effort increases with the effort of others. We show that the presence of an agent who overestimates his marginal productivity may make all agents better off, including the biased agent himself. This Pareto improvement is obtained even when compensation contracts are set endogenously to maximize firm value. We show that the presence of a leader improves coordination, but self-perception biases can never be Pareto-improving when they affect the leader. Self-perception biases are also shown to affect job assignments within firms and the likelihood and value of mergers.

This paper presents a continuous time model of a firm that can dynamically adjust both its capital structure and its investment choices. In the model we endogenize the investment choice as well as firm value, which are both determined by an exogenous price process that describes the firm's product market. Within the context of this model we explore cross-sectional as well as time-series variation in debt ratios. We pay particular attention to interactions between financial distress costs and debtholder/equityholder agency problems and examine how the ability to dynamically adjust the debt ratio affects the deviation of actual debt ratios from their targets. Regressions estimated on simulated data generated by our model are roughly consistent with actual regressions estimated in the empirical literature.

We fully characterize the equilibria in a gme between a fund manager of unknown ability who control the riskiness of his portfolio and investors who only observe realized returns. We derive two types of equilibria. The first one is such that (i) investors invest in the fund if the realized return falls within some interval, i.e., is neither too low nor too high, (ii) a good manager picks a portfolio of minimal riskiness and (iii) a bad manager picks a portfolio with higher risk, “gambling” on a lucky outcome. The second type of equilibrium is more traditional: (i) investors invest in the fund if the observed return is larger than some threshold, and (ii) good and bad managers choose the same risk level.

The paper analyzes the effect of transaction costs on social learning in an asset market with asymmetric information, sequential trading, and a competitive price mechanism. Both fixed and proportional transaction costs reduce the information content of trading orders and lead to informational cascades. If transaction costs are very high, an informational cascade may occur not only when beliefs converge on a specific asset value but also when there is extreme uncertainty about the asset's fundamental value. Finally, if the value in the bad state is sufficiently low, proportional transaction costs lead to an informational cascade only when prices are very high.

We empirically study the economic benefits of giving investors access to index options in the standard portfolio problem, analyzing both expected-utility and nonexpected-utility investors in order to understand who optimally buys and sells options. Using data on S&P 500 index options, CRRA investors find it always optimal to short out-of-the-money puts and at-the-money straddles. The option positions are economically and statistically significant and robust to corrections for transaction costs, margin requirements, and Peso problems. Loss-averse and disappointment-averse investors also optimally hold short option positions. Only with highly distorted probability assessments can we obtain positive portfolio weights for puts (cumulative prospect theory and anticipated utility) and straddles (anticipated utility).

Preface Get access Franklin Allen, Franklin Allen Special Issue Editor Search for other works by this author on: Oxford Academic Google Scholar Marco Pagano Marco Pagano Special Issue Editor Search for other works by this author on: Oxford Academic Google Scholar Review of Finance, Volume 10, Issue 1, 2006, Page 1, https://doi.org/10.1007/s10679-006-6983-5 Published: 01 March 2006

The ownership of German corporations is quite different today from that of Anglo-American firms. How did this come about? To what extent is it attributable to regulation? A specially constructed data set on financing and ownership of German corporations from the end of the 19th century to the middle of the 20th century reveals that, as in the UK, there was a high degree of activity on German stock markets with firms issuing equity in preference to borrowing from banks, and insider and family ownership declining rapidly. However, unlike in the UK, other companies and banks emerged as the main holders of equity, with banks holding shares primarily as custodians of other investors rather than on their own account. The changing pattern of ownership concentration was therefore very different from that of the UK with regulation reinforcing the control that banks exercised on behalf of other investors.