This paper proposes a novel approach to estimating the probability weighting function (PWF) of investors in the option market. We match observed option prices to the option pricing bounds under stochastic dominance rules. Using 1-month S&P 500 index option data, we find that investors could subjectively employ an inverse S-shaped probability weighting function, which increases the weights on extreme returns and asymmetrically assigns greater weights to extremely low returns than to extremely high returns. Our findings suggest that the inverse S-shaped nature of the PWFs is robust across various estimation specifications, such as adopting an alternative methodology to construct the return distribution, and employing option data with different times to maturity. (JEL G12)

In many credit risk and pricing applications, credit transition matrix is modeled by a constant transition probability or generator matrix for Markov processes. Based on empirical evidence, we model rating transition processes as piecewise homogeneous Markov chains with unobserved structural breaks. The proposed model provides explicit formulas for the posterior distribution of the time-varying rating transition generator matrices, the probability of structural break at each period and prediction of transition matrices in the presence of possible structural breaks. Estimating the model by credit rating history, we show that the structural break in rating transitions can be captured by the proposed model. We also show that structural breaks in rating dynamics are different for different industries. We then compare the prediction performance of the proposed and time-homogeneous Markov chain models.

This paper aims to provide a theoretical underpinning of the dynamic efficiency model pioneered by [Ahn, S.C., Good, D.H., Sickles, R.C., 2000. Estimation of long-run inefficiency levels: A dynamic frontier approach. Econometric Reviews 19, 461–492]. In the context of a quadratic loss function this paper formulates a multi-period forward-looking rational expectations model on the evolution of the technical inefficiency level, which correctly produces a dynamic panel data model. The model is illustrated using panel data of 112 French banks. Encouraging evidence of superiority in favor of the model is reached. Substantial cost inefficiency prevails in this industry, where the constituent banks are characterized as having volatile adjustment speeds toward their long-run steady states. The sample banks exhibit increasing returns to scale and product-mix economies.

Mandatory audit partner rotation has been adopted in certain countries while audit firm rotation is still being debated in many places. Most of the extant research on the relation between auditor tenure and earnings quality provides evidence at the audit firm level. However, since audit firm tenure is correlated with partner tenure and audit firm rotation is more costly than partner rotation, it is important to know whether earnings quality is related to audit firm tenure, partner tenure, or both. We investigate this issue using a sample of Taiwanese companies for which the audit report must be signed by two partners with their names disclosed in the report. Using performance adjusted discretionary accruals as a proxy for earnings quality, we find that the absolute and positive values of discretionary accruals decrease significantly with partner tenure. After controlling for partner tenure, we find that absolute discretionary accruals decrease significantly with audit firm tenure. Our findings are not consistent with the arguments that earnings quality decreases with extended audit partner tenure and that audit firm rotation in addition to partner rotation would improve earnings quality. Our results are robust to alternative ways of measuring partner tenure under the dual signature system. However, since the audit reports do not disclose which partner is responsible for maintaining the auditor-client relationship, measurement errors in partner tenure remain an issue that cannot be fully addressed in the context of our study.

Do mandatory spending programs such as Medicare improve efficiency? We analyze a model with two parties allocating a fixed budget to a public good and private transfers each period over an infinite horizon. We compare two institutions that differ in whether public good spending is discretionary or mandatory. We model mandatory spending as an endogenous status quo since it is enacted by law and remains in effect until changed. Mandatory programs result in higher public good spending; furthermore, they ex ante Pareto dominate discretionary programs when parties are patient, persistence of power is low, and polarization is low. (JEL C78, E62, H41, H61)

There are typically multiple equilibrium outcomes in the Crawford–Sobel (CS) model of strategic information transmission. This paper identifies a simple condition on equilibrium payoffs, called NITS (no incentive to separate), that selects among CS equilibria. Under a commonly used regularity condition, only the equilibrium with the maximal number of induced actions satisfies NITS. We discuss various justifications for NITS, including perturbed cheap-talk games with nonstrategic players or costly lying. We also apply NITS to other models of cheap talk, illustrating its potential beyond the CS framework.