Optimal Short-Termism

This paper develops a dynamic contracting (multitasking) model of a levered firm. In particular, the manager selects long-term and short-term efforts, and shareholders choose optimal debt and default policies. Excessive short-termism ex post is optimal for shareholders because debt has an asymmetric effect: shareholders receive all gains from short-term effort but share gains from long-term effort. We find that grim growth prospects and shareholder impatience imply higher optimal levels of short-termism. Also, an incentive cost effect and a real option effect create nontrivial patterns for the endogenous default threshold. Finally, we quantify agency costs of excessive short-termism, which underscore the economic significance of our results. This paper was accepted by Gustavo Manso, finance.

European Puts, Credit Protection, and Endogenous Default

In a default corridor [Formula: see text] that the stock price can never enter, a deep out-of-the-money American put option replicates a pure credit contract (Carr and Wu, 2011, A Simple Robust Link between American Puts and Credit Protection, Review of Financial Studies 24, 473–505). Assuming discrete (one-period-ahead predictable) cash flows, we show that an endogenous credit-risk model generates, along with the default event, a default corridor at the cash-outflow dates, where [Formula: see text] is given by these outflows (i.e., debt service and negative earnings minus dividends). In this endogenous setting, however, the put replicating the credit contract is not American, but European. Specifically, the crucial assumption that determines an endogenous default corridor at the cash-outflow dates is that equityholders’ deep pockets absorb these outflows; that is, no equityholders’ fresh money, no endogenous corridor.

Optimal Collateralized Contracts

We examine the role of collateral in a dynamic model of optimal credit contracts in which a borrower values both housing and nonhousing consumption. The borrower’s private information about his income is the only friction. An optimal contract is collateralized when in some state, some portion of the borrower’s net worth is forfeited to the lender. We show that optimal contracts are always collateralized. The total value of forfeited assets is decreasing in income, highlighting the role of collateral as a deterrent to manipulation. Some assets—those that generate consumable services—will necessarily be collateralized, while others may not be. Endogenous default arises when the borrower’s initial wealth is low, as with subprime borrowers, and/or his future earnings are highly variable. (JEL D82, D86, G21, G51)

Investigating the origin and consequences of endogenous default options in repeated economic choices

Classical value-based decision theories state that economic choices are solely based on the value of available options. Experimental evidence suggests, however, that individuals’ choices are biased towards default options, prompted by the framing of decisions. Although the effects of default options created by exogenous framing – such as how choice options are displayed – are well-documented, little is known about the potential effects and properties of endogenous framing, that is, originating from an individual’s internal state. In this study, we investigated the existence and properties of endogenous default options in a task involving choices between risky lotteries. By manipulating and examining the effects of three experimental features – time pressure, time spent on task and relative choice proportion towards a specific option –, we reveal and dissociate two features of endogenous default options which bias individuals’ choices: a natural tendency to prefer certain types of options (natural default), and the tendency to implicitly learn a default option from past choices (learned default). Additional analyses suggest that while the natural default may bias the standard choice process towards an option category, the learned default effects may be attributable to a second independent choice process. Overall, these investigations provide a first experimental evidence of how individuals build and apply diverse endogenous default options in economic decision-making and how this biases their choices.

Option Pricing for Path-Dependent Options with Assets Exposed to Multiple Defaults Risk

In the present paper, we derive analytical formulas for barrier and lookback options with underlying assets exposed to multiple defaults risks which include exogenous counterparty default risk and endogenous default risk. The endogenous default risk leads the asset price drop to zero and the exogenous counterparty default risk induces a drop in the asset price, but the asset can still be traded after this default time. An original technique is developed to valuate the barrier and lookback options by first conditioning on the predefault and the afterdefault time and then obtaining the unconditional analytic formulas for their price. We also compare the pricing results of our model with the default-free option model and exogenous counterparty default risk option model.