Framework

1. Framework Joseph V. Rizzi Finance 342, 2013

2. Agenda • Main Decisions • Fundamental Building Blocks • Separation Principles/Decision Rules • Statistics • Financial Markets • Decisions at Risk (DAR)

3. A. Main Decisions • Objective Function– what are we to maximize? • Investment Decision – how do we invest and manage, and why? • Dividend Decision – level (and form) of funds returned to the shareholders? • Capital Structure – how do we fund ourselves?

4. B. Fundamental Building Blocks • Efficient Capital Markets – price behavior in speculative markets. Complex Adaptive Systems Efficient Learning

5. B. Fundamental Building Blocks • Portfolio Theory – optimal security selection procedures. • Asset Pricing Models – determining asset prices by investors utilizing portfolio theory. • Option Pricing Theory – pricing of contingent claims. • Agency Theory – incentive conflict when benefits are concentrated but costs are disbursed. Heightened by moral hazard when you cannot observe behavior. Enhanced by behavioral bias.

6. B. Fundamental Building Blocks – Agency Theory • Manifestation 1) Insufficient effort 2) Overinvest 3) Entrenchment 4) Self Dealing

7. B. Fundamental Building Blocks – Agency Theory • Information asymmetries: heightened conflict between agent/managers and principals/investors Disbursement BeforeAfter Adverse Monitoring Costs Selection Moral Hazard 1)Chance vs. uncertainty 2) Ignorance vs. adverse selection 3) Dishonesty vs. moral hazard

8. B. Fundamental Building Blocks – Agency Theory • Moral hazard = f (private benefit from misbehaving, 1/verification) • Adverse Selection • Responses 1) Signaling – debt levels, dividends, reputation 2) Incentives 3) Monitoring 4) Contracts – warranties, deductibles, pricing

9. B. Fundamental Building Blocks – Agency Theory • Value implications – wedge between value and income pledge, between opportunity and financing. 1) Value – may not be externally determined 2) Financing – Agency problems/concerns may deprive firms from financing. Borrowers may make concessions to Lender to achieve funding. 3) Pecking Order

10. B. Fundamental Building Blocks – Game Theory • Game Theory: Economics of decision making; uncertainty lies in the intention/reaction of others. Focus on how individuals behave, anticpate and respond. Components – players, action, motives, and rules.

11. B. Fundamental Building Blocks – Behavioral Finance • Behavioral Finance: Prices influenced by herd vs. lead steers. The issue is whether markets are inefficient or just noisy. Requirement: arbitrage limit. Implications: (1) Investors irrational – Shield managers (2) Managers irrational – Limit discretion

12. B. Fundamental Building Blocks – Behavioral Finance • Bias: Optimism Overconfidence Confirmation Illusion of Control • Heuristics: Representation I/n equal weight Availability – overweight recent Anchoring – overweight initial

13. B. Fundamental Building Blocks – Behavioral Finance • Framing: Reference points • Manifestations: Winners curse Gamblers fallacy Sunk cost – regret avoidance (prospect theory) Reputation loss Valuation

14. B. Fundamental Building Blocks – Arbitrage • Arbitrage: Law of one price – equal rate of return principle

15. C. Separation Principles/Decision Rules • Market Value Rule: Maximize shareholder wealth. Separating ownership from management raises conflict issues. Control mechanisms: • Management incentive compensation contract provisions. • Management ownership interest. • Management labor market (Reputation) • Market for corporate control • Internal control mechanisms (Board of Directors)

16. C. Separation Principles/Decision Rules • NPV Rule: Choose projects whose returns exceed their cost of capital (r ≥ c*). Need to consider multiple risk adjusted discount rates and option value of strategic investments. Discount rate is a function of the risk class.

17. C. Separation Principles/Decision Rules • Dividend Irrelevance: (except for: agency cost, signaling, and option pricing issues).

18. C. Separation Principles/Decision Rules • Capital Structure Irrelevance: (except for: taxes, agency cost, signaling, and option pricing issues).

19. D. Statistics Statistics: beware data mining, which is prevalent in non-experimental sciences lacking controlled experiments. 1. Reliance on past as prolog vs. history. 2. Descriptive vs. predictive. 3. Issues – normality, suvivorship, stationary, independence. 4. Movements – go beyond mean and variance to skew and tails. 5. Beyond the data – out of sample issues. 6. Correlations – state dependent and lack integrating model covering both default and spread widing. 7. VAR – best of worst. Need expected shortfall analysis to get into tail.

20. D. Statistics Statistics: beware data mining, which is prevalent in non-experimental sciences lacking controlled experiments – continued. • Goodhart’s Law – sociological uncertainty principle – when a measure becomes a target it ceases to be a good measure (behavior change).

21. E. Financial Markets Financial Markets: • Merton – neoclassical benchmark anomolies/inhibitions/transactions cost institutional solutions – overcoming inefficiencies to get back to benchmark. Means of creating missing markets. • Machines – converting danger (uncontrollable damages) into risk (decision-related controllable damage) which can be traded or transferred. Focus on unintended consequences and conservations of risk principle.

22. F. Decisions at Risk (DAR) Decisions at risk (DAR): DAR Agency Asymmetric Bias Problem Information