Category Archives: The Real World

Is There Real Virtue Behind the Business Roundtable’s Signaling?

At the beginning of the fall semester, I published a blog posting entitled “Milton Friedman on CEOs” which was highly critical of the  Business Roundtable decision to throw Milton Friedman’s shareholder-centric model of corporate governance under the bus in favor of the more politically fashionable “stakeholder” model.  A couple weeks later, I followed that blog posting up with a subsequent posting entitled “The Business Roundtable’s Recipe for Confusion” which links to a WSJ op-ed which argues, among other things, that when companies try to do the government’s job, inefficiency and uncertainty result.  In yesterday’s WSJ, two professors from LSE and Columbia provide empirical support for these hypotheses in an article entitled “Is There Real Virtue Behind the Business Roundtable’s Signaling?“, claiming  that ‘stakeholder capitalism’ fails on its own terms.”

Options and credit risk in the news…

See “Bridgewater Makes $1.5 Billion Options Bet on Falling Market” – this article details how Bridgewater has purchased $1.5 billion worth of put options written on the S&P 500 and Euro Stoxx 50 indices which would pay off if either the S&P 500 or the Euro Stoxx 50—or both—fall in value by this coming March.  However, the notional value of this options position is small relative to the firm’s net long positions in equities, so apparently Bridgewater has for all intents and purposes merely purchased some insurance against downside risk.

Also see “Lenders Brace for Private-Equity Loan Defaults” on how financial institutions have been raising their default probability estimates for loans to private-equity-owned companies; article notes a 10% deterioration in credit risk in these so-called leveraged loans.

How Do Energy Companies Measure the Temperature? Not in Fahrenheit or Celsius

Instead of Fahrenheit or Celsius, a metric called “degree days” is used to capture variability in temperature. The risk management lesson here is that this metric makes it possible to create risk indices which companies can rely upon for pricing and hedging weather-related risks with weather derivatives.

How insurance premiums and deductibles work

CNBC presents Health insurance 101 – premiums, deductibles, coinsurance, and stop loss (AKA maximum out-of-pocket cost):

Health-care costs can add up fast. Understanding how medical costs and insurance are related and structured may help you anticipate expenses and budget better for your health. Watch this video to find out how premiums and deductibles affect your coverage – and what you can do to lower your medical bills.

Adverse Selection – a definition, some examples, and some solutions

During today’s Finance 4335 class meeting, we will delve deeper into the topic of adverse selection. Adverse selection is often referred to as the “hidden information” problem. This concept is particularly easy to understand in an insurance market setting; if you are an insurer, you have to be concerned that the worst possible risks are the ones that want to purchase insurance. However, it is important to note that adverse selection occurs in many market settings other than insurance markets. Adverse selection occurs whenever one party to a contract has superior information compared with his or her counter-party. When this occurs, often the party with the information advantage is tempted to take advantage of the uninformed party.

In an insurance setting, adverse selection is an issue whenever insurers know less about the actual risk characteristics of their policyholders than the policyholders themselves. In lending markets, banks have limited information about their clients’ willingness and ability to pay back on their loan commitments. In the used car market, the seller of a used car has more information about the car that is for sale than potential buyers. In the labor market, employers typically know less than the worker does about his or her abilities. In product markets, the product’s manufacturer often knows more about product failure rates than the consumer, and so forth…

The problem with adverse selection is that if left unchecked, it can undermine the ability of firms and consumers to enter into contractual relationships, and in extreme cases, may even give rise to so-called market failures. For example, in the used car market, since the seller has more information than the buyer about the condition of the vehicle, the buyer cannot help but be naturally suspicious concerning product quality. Consequently, he or she may not be willing to pay as much for the car as it is worth (assuming that it is not a “lemon”). Similarly, insurers may be reticent about selling policies to bad risks, banks may be worried about loaning money to poor credit risks, employers may be concerned about hiring poor quality workers, consumers may be worried about buying poor quality products, and so on…

A number of different strategies exist for mitigating adverse selection. In financial services markets, risk classification represents an important strategy. The reason insurers and banks want to know your credit score is because consumers with bad credit not only often lack the willingness and ability to pay their debts, but they also tend to have more accidents than consumers with good credit. Signaling is used in various settings; for example, one solution to the “lemons” problem in the market for used cars is for the seller to “signal” by providing credible third party certification; e.g., by paying for Carfax reports or vehicle inspections by an independent third party. Students “signal” their quality by selecting a high-quality university (e.g., like Baylor! :-)). Here the university provides potential employers with credible third-party certification concerning the quality of human capital. In product markets, if a manufacturer provides a long-term warranty, this may indicate that quality is better than average.

Sometimes it’s not possible to fully mitigate adverse selection via the methods described above. Thus, insurers commonly employ pricing and contract design strategies which incentivize policyholders to reveal their actual risk characteristics according to their contract choices. Thus, we obtain what’s commonly referred to as a “separating” (Rothschild-Stiglitz) equilibrium in which high-risk insureds select full coverage “high-risk” contracts whereas low-risk insureds select partial coverage “low risk” contracts:


The Rothschild-Stiglitz equilibrium cleverly restricts the menu of available choices in such a way that the insurer induces self-selection. Here, the insurer offers contract L, which involves partial coverage at an actuarially fair price (based upon the loss probability of the low risk insured), and contract H, which provides full coverage at an actuarially fair price (based upon the loss probability of the high risk insured). The differences in the shapes of the indifference curves are due to the different accident probabilities, with a lower accident probability resulting in a more steeply sloped indifference curve. Here, the high-risk policyholder optimally chooses contract H and the low-risk policyholder optimally chooses contract L. The high-risk policyholder prefers H to L because L would represent a point of intersection with a marginally lower indifference curve (here, the Ih curve lies slightly above contract L, which implies that contract H provides the high-risk policyholder with higher expected utility than contract L). The low-risk policyholder will prefer L, but would prefer a full coverage contract at the point of intersection of APl line with the full insurance (45 degrees) line. However, such a contract is not offered since both the low and high-risk policyholders would choose it, and this would cause the insurer to lose money. Thus, one of the inefficiencies related to adverse selection is that insurance opportunities available to low-risk policyholders are limited compared with the world where there is no adverse selection.

There is a very practical implication of this model. If you are a good risk, then you owe it to yourself to select high-deductible insurance, since insurers price low-deductible insurance with the expectation that high-risk policyholders will be the primary purchasers of such coverage (and therefore, low-deductible policies will be more costly per dollar of coverage than high-deductible policies.