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Joseph V. Rizzi Finance 342, 2013 1
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A. Main Decisions B. Fundamental Building Blocks C. Separation Principles/Decision Rules D. Statistics E. Financial Markets F. Decisions at Risk (DAR) 2
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1. Objective Function – what are we to maximize? 2. Investment Decision – how do we invest and manage, and why? 3. Dividend Decision – level (and form) of funds returned to the shareholders? 4. Capital Structure – how do we fund ourselves? 3
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1. Efficient Capital Markets – price behavior in speculative markets. Complex Adaptive Systems Efficient Learning 4
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2. Portfolio Theory – optimal security selection procedures. 3. Asset Pricing Models – determining asset prices by investors utilizing portfolio theory. 4. Option Pricing Theory – pricing of contingent claims. 5. 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. 5
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a) Manifestation 1) Insufficient effort 2) Overinvest 3) Entrenchment 4) Self Dealing 6
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b) Information asymmetries: heightened conflict between agent/managers and principals/investors Disbursement BeforeAfter AdverseMonitoring Costs SelectionMoral Hazard 1) Chance vs. uncertainty 2) Ignorance vs. adverse selection 3) Dishonesty vs. moral hazard 7
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c) Moral hazard = f (private benefit from misbehaving, 1/verification) d) Adverse Selection e) Responses 1) Signaling – debt levels, dividends, reputation 2) Incentives 3) Monitoring 4) Contracts – warranties, deductibles, pricing 8
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f) 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 9
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6. 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. 10
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7. 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 11
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a) Bias: Optimism Overconfidence Confirmation Illusion of Control b) Heuristics: Representation I/n equal weight Availability – overweight recent Anchoring – overweight initial 12
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c) Framing: Reference points d) Manifestations: Winners curse Gamblers fallacy Sunk cost – regret avoidance (prospect theory) Reputation loss Valuation 13
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8. Arbitrage: Law of one price – equal rate of return principle 14
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1) Market Value Rule: Maximize shareholder wealth. Separating ownership from management raises conflict issues. Control mechanisms: a)Management incentive compensation contract provisions. b)Management ownership interest. c)Management labor market (Reputation) d)Market for corporate control e)Internal control mechanisms (Board of Directors) 15
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2) 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. 16
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3) Dividend Irrelevance: (except for: agency cost, signaling, and option pricing issues). 17
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4) Capital Structure Irrelevance: (except for: taxes, agency cost, signaling, and option pricing issues). 18
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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. 19
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Statistics: beware data mining, which is prevalent in non-experimental sciences lacking controlled experiments – continued. 8. Goodhart’s Law – sociological uncertainty principle – when a measure becomes a target it ceases to be a good measure (behavior change). 20
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Financial Markets: 1) Merton – neoclassical benchmark anomolies/inhibitions/transactions cost institutional solutions – overcoming inefficiencies to get back to benchmark. Means of creating missing markets. 2) 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. 21
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Decisions at risk (DAR): DAR AgencyAsymmetricBias ProblemInformation 22
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