This article studies equilibrium asset pricing when agents face nonnegative wealth constraints. In the presence of these constraints it is shown that options on the market portfolio are nonredundant securities and the economy's pricing kernel is a function of both the market portfolio and the nonredundant options. This implies that the options should be useful for explaining risky asset returns. To test the theory, a model is derived in which the expected excess return on any risky asset is linearly related (via a collection of betas) to the expected excess return on the market portfolio and to the expected excess returns on the nonredundant options. The empirical results indicate that the returns on traded index options are relevant for explaining the returns on risky asset portfolios. Copyright 2004, Oxford University Press.

https://www.jstor.org/stable/info/1262673

Options Trading and the CAPM

A distinguishing feature of contracted production is that the contractual terms must be agreed upon before the product exists. If the specified product is the result of an innovative and complex process, uncertainties as to its production cost estimates can be enormous. This renders the traditional cost-plus-fixed-fee and fixed-price contractual arrangements increasingly untenable. An alternative contractual arrangement that is currently gaining greater acceptance is the fixed-price-incentive contract, which may be as simple as a linear cost-sharing formula or as complex as a state-contingent reward penalty structure. The problem from the viewpoint of the contractee (principal) is to identify the optimal incentive structure in order to minimize his expected cost; the incentive affects the contractor (agent) through his risk aversion and his propensity for “moral hazard”, due to the co-insurance effect of cost-sharing incentives. Taking as premise the contractee's risk-neutrality, the problem is formulated as a constrained optimization problem, with the constraint arising from the returns to each of the parties to the contract. It is thereby demonstrated that the currently popular linear incentive mechanism is ineffective from the viewpoint of the contractee before the introduction of the problem of moral hazard. We then show that, the problem can be segregated into independent components of the contractor's risk aversion and his propensity for moral hazard. Having established this, we proceed to examine the incentive form as related to the “monitoring mechanism” instituted by the contractor during the performance of the contract. Acceptance of the conclusions necessitates that the contracting parties can interpret their objective as the maximization of the ratio of their expected profits to target profits, which is demonstrated as being equivalent to the minimization of the certainty equivalent of costs.

Financial incentives for cost control under moral hazard

The need to share or pool risk is an important economic determinant of cooperation among firms, but the economic theory of risk pooling has been clouded by an error made in a seminal paper in the 1960s. Even into this decade, writers on risk and insurance have asserted that the market mechanism cannot bring a risk pool to an economically efficient outcome, concluding therefore that the risk pool must be analyzed as an n-person cooperative game. This paper describes clearly the economic structure of a risk pool and shows how the market mechanism can function to solve the organizational problem of a risk pool. This analysis reveals a twin interpretation of risk pooling, both as a competitive market and as a centrally administered cooperative organization. One significant feature of organized risk pooling is that the centralized solution is not incentive compatible, meaning that self-interested participants could misrepresent their attitude toward risk and skew the allocation of risk in their favor. However, there are economic conditions that mitigate the incentive incompatibility and tend to restore efficiency to the centralized pooling solution.

The Organizational Economics of Risk Pooling

Following the recent financial crisis, many banks are finding itincreasingly difficult to book earning assets. To this end, many larger organiza-tions are attempting to expand their consumer operations because of theirrelatively high promised returns. One dramatic move is to focus on the histori-cally under-banked customers who do not have banking relationships. Anotheris to either create or purchase traditional consumer loan portfolios to achievehigher yields and to potentially transfer these assets to off-balance-sheet vehi-cles for capital requirement purposes. When purchasing these portfolios, regu-latory approval is required, using an approved valuation method. Twoalternative methods of valuing a portfolio of small, high-risk, high-overheadexpense loans are presented and compared in this article. The first method, oneapproved by federal bank regulators in private examination cases, uses theaccounting principle of valuation of an intangible asset. The present value ofidentifiable valuables (book value of the loan portfolio in this case) is addedto the present value of the unidentifiable valuables (the above average rateof return of the risky cash flows in this case). The second method uses a“certainty equivalent” or “expected value” approach in which the certaintyequivalent factors are estimated from historical data. The two methods producesimilar but different values of the loan portfolio. The similarities and differencebetween the two approaches should shed light on the usefulness of the twoalternatives in meeting government regulations as well as accurately valuingbank assets.Keywords: valuation, certainty equivalency

Valuing Installment Loan Receivables

This paper extends the notion of individual certainty equivalent to group certainty equivalent, in order to derive sharing rules that ensure unanimity on project rankings within a syndicate. A constrained maximization problem is set up with optimal project-specific sharing rules as the solution. It is shown that the group certainty equivalent construct allows for experimental derivation of a syndicate's preference function from a procedure parallel to that presently employed for deriving preference functions of individuals. The analysis potentially has a role in examining the nature of optimal compensation systems (sharing rules) for closely held (non-traded) corporations and partnerships.

On syndicate sharing rules for unanimous project rankings

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On syndicate sharing rules for unanimous project rankings