On the economics of financial guarantees

In the Credit Risk lecture note and in Problem Set 9, we study how credit enhancement of risky debt works. Examples of credit enhancement in the real world include federal deposit insurance, federally guaranteed student loans, public and private bond insurance, pension insurance, mortgage insurance, government loan guarantees, etc.; the list goes on.

Most credit enhancement schemes work in the following fashion. Creditors loan money to “risky” borrowers who own risky assets worth $V(F) today (at date t = 0).  Borrowers are risky in the sense that at date T, they will default (in whole or in part) if $F < $B.  The shortfall suffered by creditors resembles a put option with date T payoff of –Max[0, BF]. Therefore, without credit enhancement, the value of risky debt today (at t = 0) is

V(D) = B{e^{ - rT}} - V(Max[0,B - F]).

However, when credit risk is intermediated by a guarantor (e.g., an insurance company or government agency), credit risk is transferred to the guarantor who receives an upfront “premium” worth V(Max[0,B - F]) at t=0 in exchange for having to cover a shortfall of Max[0,B - F] which may occur at date T. If all credit risk is transferred to the guarantor, then from the creditors’ perspective it is as if the borrowers have issued riskless debt. Therefore, creditors charge borrowers the riskless rate of interest and receive the promised payback from two sources: 1) borrowers pay D = B - Max[0,B - F], and 2) the guarantor pays Max[0,B - F].  Therefore, creditors get paid back B - Max[0,B - F] + Max[0,B - F] = B.

 

A (non-technical) Summary of Portfolio Theory and Capital Market Theory

I would like to provide everyone with some historical context for the portfolio theory and capital market theory topics which we have been covering lately in Finance 4335. Work done by Harry Markowitz on the portfolio theory topic early in his academic career subsequently (in 1990) won him the Nobel Prize in Economics, as did William F. Sharpe‘s (early career) work on capital market theory that same year.

One of the better non-technical summaries of portfolio theory and capital market theory that I am aware of appears as part of a press release put out by The Royal Swedish Academy of Sciences in commemoration of the prizes won by Markowitz and Sharpe thirty years ago (see http://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/1990/press.html). I have included an appropriately edited version of that press release below for your further consideration.

==========================

Financial markets serve a key purpose in a modern market economy by allocating productive resources among various areas of production. It is to a large extent through financial markets that saving in different sectors of the economy is transferred to firms for investments in buildings and machines. Financial markets also reflect firms’ expected prospects and risks, which implies that risks can be spread and that savers and investors can acquire valuable information for their investment decisions.

The first pioneering contribution in the field of financial economics was made in the 1950s by Harry Markowitz who developed a theory for households’ and firms’ allocation of financial assets under uncertainty, the so-called theory of portfolio choice. This theory analyzes how wealth can be optimally invested in assets which differ in regard to their expected return and risk, and thereby also how risks can be reduced.

A second significant contribution to the theory of financial economics occurred during the 1960s when a number of researchers, among whom William Sharpe was the leading figure, used Markowitz’s portfolio theory as a basis for developing a theory of price formation for financial assets, the so-called Capital Asset Pricing Model, or CAPM.

Harrv M. Markowitz
The contribution for which Harry Markowitz now receives his award was first published in an essay entitled “Portfolio Selection” (1952), and later, more extensively, in his book, Portfolio Selection: Efficient Diversification (1959). The so-called theory of portfolio selection that was developed in this early work was originally a normative theory for investment managers, i.e., a theory for optimal investment of wealth in assets which differ in regard to their expected return and risk. On a general level, of course, investment managers and academic economists have long been aware of the necessity of taking returns as well as risk into account: “all the eggs should not be placed in the same basket”. Markowitz’s primary contribution consisted of developing a rigorously formulated, operational theory for portfolio selection under uncertainty – a theory which evolved into a foundation for further research in financial economics.

Markowitz showed that under certain given conditions, an investor’s portfolio choice can be reduced to balancing two dimensions, i.e., the expected return on the portfolio and its variance. Due to the possibility of reducing risk through diversification, the risk of the portfolio, measured as its variance, will depend not only on the individual variances of the return on different assets, but also on the pairwise covariances of all assets.

Hence, the essential aspect pertaining to the risk of an asset is not the risk of each asset in isolation, but the contribution of each asset to the risk of the aggregate portfolio. However, the “law of large numbers” is not wholly applicable to the diversification of risks in portfolio choice because the returns on different assets are correlated in practice. Thus, in general, risk cannot be totally eliminated, regardless of how many types of securities are represented in a portfolio.

In this way, the complicated and multidimensional problem of portfolio choice with respect to a large number of different assets, each with varying properties, is reduced to a conceptually simple two-dimensional problem – known as mean-variance analysis. In an essay in 1956, Markowitz also showed how the problem of actually calculating the optimal portfolio could be solved. (In technical terms, this means that the analysis is formulated as a quadratic programming problem; the building blocks are a quadratic utility function, expected returns on the different assets, the variance and covariance of the assets and the investor’s budget restrictions.) The model has won wide acclaim due to its algebraic simplicity and suitability for empirical applications.

Generally speaking, Markowitz’s work on portfolio theory may be regarded as having established financial micro analysis as a respectable research area in economic analysis.

William F. Sharpe

With the formulation of the so-called Capital Asset Pricing Model, or CAPM, which used Markowitz’s model as a “positive” (explanatory) theory, the step was taken from micro analysis to market analysis of price formation for financial assets. In the mid-1960s, several researchers – independently of one another – contributed to this development. William Sharpe’s pioneering achievement in this field was contained in his essay entitled, Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk (1964).

The basis of the CAPM is that an individual investor can choose exposure to risk through a combination of lending-borrowing and a suitably composed (optimal) portfolio of risky securities. According to the CAPM, the composition of this optimal risk portfolio depends on the investor’s assessment of the future prospects of different securities, and not on the investors’ own attitudes towards risk. The latter is reflected solely in the choice of a combination of a risk portfolio and risk-free investment (for instance treasury bills) or borrowing. In the case of an investor who does not have any special information, i.e., better information than other investors, there is no reason to hold a different portfolio of shares than other investors, i.e., a so-called market portfolio of shares.

What is known as the “beta value” of a specific share indicates its marginal contribution to the risk of the entire market portfolio of risky securities. Shares with a beta coefficient greater than 1 have an above-average effect on the risk of the aggregate portfolio, whereas shares with a beta coefficient of less than 1 have a lower than average effect on the risk of the aggregate portfolio. According to the CAPM, in an efficient capital market, the risk premium and thus also the expected return on an asset, will vary in direct proportion to the beta value. These relations are generated by equilibrium price formation on efficient capital markets.

An important result is that the expected return on an asset is determined by the beta coefficient on the asset, which also measures the covariance between the return on the asset and the return on the market portfolio. The CAPM shows that risks can be shifted to the capital market, where risks can be bought, sold and evaluated. In this way, the prices of risky assets are adjusted so that portfolio decisions become consistent.

The CAPM is considered the backbone of modern price theory for financial markets. It is also widely used in empirical analysis, so that the abundance of financial statistical data can be utilized systematically and efficiently. Moreover, the model is applied extensively in practical research and has thus become an important basis for decision-making in different areas. This is related to the fact that such studies require information about firms’ costs of capital, where the risk premium is an essential component. Risk premiums which are specific to an industry can thus be determined using information on the beta value of the industry in question.

Important examples of areas where the CAPM and its beta coefficients are used routinely, include calculations of costs of capital associated with investment and takeover decisions (in order to arrive at a discount factor); estimates of costs of capital as a basis for pricing in regulated public utilities; and judicial inquiries related to court decisions regarding compensation to expropriated firms whose shares are not listed on the stock market. The CAPM is also applied in comparative analyses of the success of different investors.

Along with Markowitz’ portfolio model, the CAPM has also become the framework in textbooks on financial economics throughout the world.

Fair Price of Insurance Policy

A Finance 4335 student asked the following question earlier today:

Q: “I have a quick homework question. How do you find the fair price of an insurance policy?”

Here’s the answer I provided, which I now share with all Finance 4335 students:

A: “I believe you are referring to the “actuarially fair” price, or insurance premium. The actuarially fair premium corresponds to the expected value of the insurance indemnity; the indemnity is the amount of coverage offered by an insurance policy. Under “full coverage”, 100% of the loss is indemnified, and in such a case, the actuarially fair premium is equal to the expected value of the loss distribution.

For what it’s worth, the concept of “actuarially fair” insurance prices/premiums, along with implications for the demand for insurance, are explained in two of the September 8th assigned readings; e.g.,

  1. on page 4 of the Supply of Insurance reading (just prior to the section entitled “Example 2: Correlated Identically Distributed Losses), the following sentence appears, “A premium that is equal to the expected outcome is called an actuarially fair premium”;
  2. on page 30 of the Basic Economics: How Individuals Deal with Risk (Doherty, Chapter 2) reading, consider the following excerpt: “Ignoring transaction costs, an insurer charging a premium equal to expected loss would break even if it held a large portfolio of such policies. This premium could be called a fair premium or an actuarially fair premium, denoting that the premium is equal to the expected value of loss (sometimes called the actuarial value of the policy). The term fair is not construed in a normative sense; rather it is simply a reference point”; and
  3. on page 43 of Doherty, Chapter 2, in the first sentence of the first full paragraph: “We know from the Bernoulli principle that a risk averter will choose to fully insure at an actuarially fair premium.””

On the Determinants of Risk Aversion

This week, we began a series of five Finance 4335 class meetings (scheduled for September 8 – 22) devoted to decision-making under risk and uncertainty. We shall study how to measure risk, model consumer and investor risk preferences, and explore implications for the pricing and management of risk. We will focus especially on the concept of risk aversion. Other things equal, risk averse decision-makers prefer less risk to more risk. Risk aversion helps to explain some very basic facts of human behavior; e.g., why investors diversify, why consumers purchase insurance, etc.

A few years ago, The Economist published a particularly interesting article about various behavioral determinants of risk aversion, entitled “Risk off: Why some people are more cautious with their finances than others”. Here are some key takeaways from this article:

  1. Economists have long known that people are risk-averse, yet the willingness to run risks varies enormously among individuals and over time.
  2. Genetics explains a third of the difference in risk-taking; e.g., a Swedish study of twins finds that identical twins had “… a closer propensity to invest in shares” than fraternal ones.
  3. Upbringing, environment, and experience also matter; e.g., “… the educated and the rich are more daring financially. So are men, but apparently not for genetic reasons.”
  4. People’s financial history has a strong impact on their taste for risk; e.g., “… people who experienced high (low) returns on the stock market earlier in life were, years later, likelier to report a higher (lower) tolerance for risk, to own (not own) shares and to invest a bigger (smaller) slice of their assets in shares.”
  5. “Exposure to economic turmoil appears to dampen people’s appetite for risk irrespective of their personal financial losses.” Furthermore, a low tolerance for risk is linked to past emotional trauma.

St. Petersburg Paradox…

During today’s class meeting, we will discuss (among other things) the famous St. Petersburg Paradox. The source for this is Daniel Bernoulli’s famous article entitled “Exposition of a New Theory on the Measurement of Risk“. As was the standard practice in academia at the time, Bernoulli’s article was originally published in Latin in 1738. It was subsequently translated into English in 1954 and published a second time that same year in Econometrica (Volume 22, No. 1): pp. 22–36. Considering that this article was published 282 years ago in an obscure (presumably peer-reviewed) academic journal, it is fairly succinct and surprisingly easy to read.

Also, the Wikipedia article about Bernoulli’s article is worth reading. It provides the mathematics for determining the price at which the apostle Paul would have been indifferent about taking the apostle Peter up on this bet. The original numerical example proposed by Bernoulli focuses attention on Paul’s gamble per se and does not explicitly consider the effect of Paul’s initial wealth on his willingness to pay. However, the quote on page 31 of the article (“… that any reasonable man would sell his chance … for twenty ducats”) implies that Bernoulli may have assumed Paul to be a millionaire, since (as shown in the Wikipedia article) the certainty-equivalent value of this bet to a millionaire who has logarithmic utility comes out to 20.88 ducats.

On the ancient origin of the word “algorithm”

During class last week, I mentioned that the September 1 assigned reading entitled “The New Religion of Risk Management” (by Peter Bernstein, March-April 1996 issue of Harvard Business Review) is a synopsis of the same author’s 1996 book entitled “Against the Gods: The Remarkable Story of Risk”.  Here’s a fascinating quote from page 33 which explains the ancient origin of the word “algorithm”:

“The earliest known work in Arabic arithmetic was written by al­Khowarizmi, a mathematician who lived around 825, some four hun­dred years before Fibonacci. Although few beneficiaries of his work are likely to have heard of him, most of us know of him indirectly. Try saying “al­Khowarizmi” fast. That’s where we get the word “algo­rithm,” which means rules for computing.”

Note: The book cover shown above is a copy of a 1633 oil-on-canvas painting by the Dutch Golden Age painter Rembrandt van Rijn.

Also featured as one of “50 Things That Made the Modern Economy”: The Index Fund

Besides insurance, Tim Harford also features the index fund in his “Fifty Things That Made the Modern Economy” radio and podcast series. This 9 minute long podcast lays out the history of the development of the index fund in particular and the evolution of so-called of passive portfolio strategies in general. Much of the content of this podcast is sourced from Vanguard founder Jack Bogle’s September 2011 WSJ article entitled “How the Index Fund Was Born” (available at https://www.wsj.com/articles/SB10001424053111904583204576544681577401622). Here’s the description of this podcast:

“Warren Buffett is the world’s most successful investor. In a letter he wrote to his wife, advising her how to invest after he dies, he offers some clear advice: put almost everything into “a very low-cost S&P 500 index fund”. Index funds passively track the market as a whole by buying a little of everything, rather than trying to beat the market with clever stock picks – the kind of clever stock picks that Warren Buffett himself has been making for more than half a century. Index funds now seem completely natural. But as recently as 1976 they didn’t exist. And, as Tim Harford explains, they have become very important indeed – and not only to Mrs Buffett.”

Warren Buffett is one of the world’s great investors. His advice? Invest in an index fund

Insurance featured as one of “50 Things That Made the Modern Economy”

From November 2016 through October 2017, Financial Times writer Tim Harford presented an economic history documentary radio and podcast series called 50 Things That Made the Modern Economy. This same information is available in book form under the title “Fifty Inventions That Shaped the Modern Economy“. While I recommend listening to the entire series of podcasts (as well as reading the book), I would like to call your attention to Mr. Harford’s episode on the topic of insurance, which I link below. This 9-minute long podcast lays out the history of the development of the various institutions which exist today for the sharing and trading of risk, including markets for financial derivatives as well as for insurance.

“Legally and culturally, there’s a clear distinction between gambling and insurance. Economically, the difference is not so easy to see. Both the gambler and the insurer agree that money will change hands depending on what transpires in some unknowable future. Today the biggest insurance market of all – financial derivatives – blurs the line between insuring and gambling more than ever. Tim Harford tells the story of insurance; an idea as old as gambling but one which is fundamental to the way the modern economy works.”

Plans for next week’s Finance 4335 class meetings, along with a preview of future topics

We will devote next week in Finance 4335 to tutorials on probability and statistics. These tools are critically important in the measurement of risk and development of risk management strategies for individuals and firms alike. Next Tuesday’s class meeting will be devoted to introducing discrete and continuous probability distributions, calculating parameters such as expected value, variance, standard deviation, covariance, and correlation, and applying these concepts to measure expected returns and risks for portfolios comprising risky assets. The following Thursday will provide a deeper dive into discrete and continuous probability distributions, in which we showcase the binomial and normal distributions.

While I have your attention, let me briefly explain what the main “theme” will initially be in Finance 4335 (up to the first midterm exam on Tuesday, September 29). Starting on Tuesday, September 1, we will begin our discussion of decision theory. Decision theory addresses decision making under risk and uncertainty, which at the very heart of risk management. Initially, we’ll focus attention on variance as our risk measure. Most of the basic finance theories, including portfolio, capital market, and option pricing theories, define risk as variance. We’ll learn that while this is not necessarily an unreasonable assumption, circumstances may arise where it is not an appropriate assumption. Since individuals and firms encounter multiple sources of risk, we also need to take into consideration the portfolio effects of risk. Portfolio theory implies that risks often “manage” themselves by canceling each other out. Thus the risk of a portfolio is typically less than the sum of the individual risks which comprise the portfolio.

The decision theory provides a useful framework for thinking about concepts such as risk aversion and risk tolerance. The calculus comes in handy by providing an analytic framework for determining how much risk to retain and how much risk to transfer to others. Such decisions occur regularly in daily life, encompassing practical problems such as deciding how to allocate assets in a 401-K or IRA account, determining the extent to which one insures health, life, and property risks, whether to work for a startup or an established business and so forth. There’s also ambiguity when we have incomplete information about risk. This course will at least help you think critically about costs, benefits, and trade-offs related to decision-making whenever you encounter risk and uncertainty.

After the first midterm, the rest of the semester will be devoted to various other risk management topics, including the demand for insurance, asymmetric information, portfolio theory, capital market theory, option pricing theory, and corporate risk management.