Knowledge that Transforms

Psychological research indicates that people have a cognitive bias that leads them to misinterpret new information as supporting previously held hypotheses. We show in a simple model that such confirmatory bias induces overconfidence: given any probabilistic assessment by an agent that one of two hypotheses is true, the appropriate beliefs would deem it less likely to be true. Indeed, the hypothesis that the agent believes in may be more likely to be wrong than right. We also show that the agent may come to believe with near certainty in a false hypothesis despite receiving an infinite amount of information.

There is strong evidence that people exploit their bargaining power in competitive markets but not in bilateral bargaining situations. There is also strong evidence that people exploit free-riding opportunities in voluntary cooperation games. Yet, when they are given the opportunity to punish free riders, stable cooperation is maintained, although punishment is costly for those who punish. This paper asks whether there is a simple common principle that can explain this puzzling evidence. We show that if some people care about equity the puzzles can be resolved. It turns out that the economic environment determines whether the fair types or the selfish types dominate equilibrium behavior.

Brian Huge, David Lando; Swap Pricing with Two-Sided Default Risk in a Rating-Based Model *, European Finance Review, Volume 3, Issue 3, 1 January 1999, Pa

With constrained portfolios contingent claims do not generally have a unique price that rules out arbitrage opportunities. Earlier studies have demonstrated that when there are constraints onthe hedge portfolio, a no-arbitrage price interval for any contingent claim exists. I consider the more realistic case where the constraints are imposed on the total portfolio of each investor and define reservation buying and selling prices for contingent claims. I derive properties of these prices, show how they can be computed numerically, and study two simple examples in which the reservation prices and the corresponding hedging strategies are compared to the Black–Scholes setting.

Under what conditions will a multinational corporation alter its operations to manage its risk exposure? We show that multinational firms will engage in operational hedging only when both exchange rate uncertainty and demand uncertainty are present. Operational hedging is less important for managing short-term exposures, since demand uncertainty is lower in the short term. Operational hedging is also less important for commodity-based firms, which face price but not quantity uncertainty. When the fixed costs of establishing a plant are low or the variability of the exchange rate is high, a firm may benefit from establishing plants in both the domestic and foreign location. Capacity allocated to the foreign location relative to the domestic location will increase when the variability of foreign demand increases relative to the variability of domestic demand or when the expected profit margin is larger. For firms with plants in both a domestic and foreign location, the foreign currency cash flow generally will not be independent of the exchange rate and consequently the optimal financial hedging policy cannot be implemented with forward contracts alone. We show that the optimal financial hedging policy can be implemented using foreign currency call and put options and forward contracts.

This paper discusses the pitfalls in the pricing of barrier options using approximations of the underlying continuous processes via discrete lattice models. To prevent from numerical deficiencies, the space axis is discretized first, and not the time axis. In a Black–Scholes setup, models with improved convergence properties are constructed: a trinomial model and a randomized trinomial model where price changes occur at the jump times of a Poisson process. These lattice models are sufficiently general to handle options with multiple barriers: the numerical difficulties are resolved and extrapolation yields even more accurate results. In a last step, we extend the Black–Scholes setup and incorporate unpredictable discontinuous price movements. The randomized trinomial model can easily be extended to this case, inheriting its superior convergence properties.

The main purpose of this paper is to examine empirically the time series properties of the French Market Volatility Index (VX1). We also examine the VX1's ability to forecast future realized market volatility and finds a strong relationship. More importantly, we show how the index can be used to generate volatility forecasts over different horizons and that these forecasts are reasonably accurate predictors of future realized volatility.

Edwin J. Elton, Martin J. Gruber, Christopher R. Blake; Common Factors in Active and Passive Portfolios, European Finance Review, Volume 3, Issue 1, 1 Janu

The privatization process through which governments transfer their holdings vary from one country to another. The coupon (or voucher) privatization process, which has been frequently utilized in Eastern Europe, is generally characterized by a transfer of government holdings to the public for less than their full economic value. The vouchers process in the Czech Republic, specifically, is a case in which the transfer was practically free and in which foreign participation was banned. As such, and in the absence of an actual flow of funds, the process constituted an interesting large-scale experiment of a price discovery mechanism whose empirical conclusions are inconclusive. On the one hand, the variance of the expected outcomes declines during this process, but on the other hand, the participants could obtain superior outcomes using public information, while some, who had access to private information, may performed even better. Thus, wondering whether the process in the Czech Republic served as an efficient price discovery mechanism, additional potential distortions should be investigated: (i) the specific rules of the process through which the public exchanged bidding points for shares, or (ii) the role that funds' managers played, in lieu of the potential conflict between their objective functions and those of the shareholders of these funds, and (iii) lack of uniformity in information reporting standards. Generally, a failure to discover prices may lead to inefficiency in capital markets, because of the potential distortion of relative prices. If, in fact, the process in the Czech Republic, during the ‘second wave’, in which most of the shares of over 800 companies were transferred to the private sector, did not serve as an immediate price discovery mechanism, the ‘damage’, if any, was probably not significant, since it was not associated with a massive reallocation of funds, and the market could eventually correct itself once real funds started to pour in, in reaction to post-process relative prices.

In January 1999, the European monetary union (EMU) was formally launched with 11 member countries. However, before May 1998 there was considerable uncertainty about who would join EMU, and whether the project would start on time. When a monetary union is formed, exchange rates between the member countries are irrevocably fixed, and yield spreads stemming from exchange-rate risk are eliminated. As a direct consequence, EMU affected the prices of long-term bonds well before 1999, but quantifying this effect can be difficult when there is uncertainty about the monetary union. We address these issues and develop a bond-pricing model which explicitly takes into account that a country may join a monetary union at a future, unspecified date. The empirical results show that a narrow EMU, consisting of Germany, France and the Benelux countries, has been priced with almost 100% probability throughout the period 1995—1998, whereas, on average, the implied probability of joining EMU has been somewhat lower for the other EU countries. However, in the period leading up to May 1998, the estimated probabilities have increased considerably for the countries that joined EMU in January 1999.