bounded rationality climate risks and insurance is there a market for natural disasters this paper examines the role of insurances to reduce uncertainty associated with climate change losses for individuals of special interest is the value individuals place on the reduction of increased flood risks by insurance coverage using rank dependent utility and prospect theories risk premiums are estimated under different climate change scenarios for the netherlands the study delivers two main insights first estimation results suggest that a profitable flood insurance market could be feasible second climate change has the potential to increase the profitability of offering flood insurance 2009 by the board of regents of the university of wisconsin system

individual risk attitudes measurement determinants and behavioral consequences this paper studies risk attitudes using a large representative survey and a complementary experiment conducted with a representative subject pool in subjects homes using a question asking people about their willingness to take risks in general we find that gender age height and parental background have an economically significant impact on willingness to take risks the experiment confirms the behavioral validity of this measure using paid lottery choices turning to other questions about risk attitudes in specific contexts we find similar results on the determinants of risk attitudes and also shed light on the deeper question of stability of risk attitudes across contexts we conduct a horse race of the ability of different measures to explain risky behaviors such as holdings stocks occupational choice and smoking the question about risk taking in general generates the best all round predictor of risky behavior

optimal bank reorganization and the fair pricing of deposit guarantees abstract when should regulators close a financially ailing bank fdic practice in the us has moved in the direction of early closure in contrast banking regulators in japan continue to follow a more patient approach this paper analyses a series of models in which closure rules and bailout policies arise endogenously through the interaction of i regulators attempts to minimize discounted expected bankruptcy costs and ii equity holders incentives to recapitalise banks we characterize subsidy policies for distressed banks that implement socially optimal closure rules at minimum financial cost to regulators and which reduce moral hazard

alternative forms of deposit insurance pricing and bank incentive issues abstract this paper derives formulas for a deposit insuring agency s liability and hence a fair value deposit insurance premium and the equilibrium value of bank equity considering a wide variety of factors affecting individual bank risk both fixed rate and variable rate risk sensitive insurance systems are analyzed consideration is made as to whether the deposit insuring agency makes direct payments to depositors or arranges mergers following bank closings the effect of these various policy choices on banks incentive for risk taking is also analyzed

debt in industry equilibrium this article shows 1 how entry and exit of firms in a competitive industry affect the valuation of securities and optimal capital structure and 2 how given a trade off between tax advantages and agency costs a firm will optimally adjust its leverage level after it is set up we derive simple pricing expressions for corporate debt in which the price elasticity of demand for industry output plays a crucial role when a firm optimally adjusts its leverage over time we show that total firm value comprises the value of discounted cash flows assuming fixed capital structure plus a continuum of options for marginal increases in debt article published by oxford university press on behalf of the society for financial studies in its journal the review of financial studies

insuring banks against liquidity shocks the role of deposit insurance and lending of last resort it has long been recognized that banks simultaneous provision of monitoring and liquidity services is advantageous but leaves them susceptible to liquidity shocks that may culminate in a system failure because a system failure is costly this provides a rationale for adopting arrangements including a lender of last resort and deposit insurance di to insure banks against liquidity shocks these arrangements have proven themselves very successful but they have also been the source of problems researchers have identified some of the main sources of these problems and have suggested ways to improve the design of these arrangements but there are still many issues that remain unaddressed this paper reviews the literature on the two arrangements that most countries have adopted to insure banks against liquidity shocks a lender of last resort and di and compares the design of these arrangements across countries the paper ends with a brief summary of the key lessons learned about the design of these arrangements and the issues related to them that remain unaddressed copyright blackwell publishers ltd 2006

risk attitudes to low probability climate change risks wtp for flood insurance abstract natural disasters may increase in frequency and severity in the future as a result of climate change which is likely to have an impact on the demand for natural disaster insurance insights about individual risk beliefs and behavioural responses to changing risks are relevant for insurers as it allows them for example to estimate the demand for new insurance products that cover weather related damage this study elicits individual risk beliefs and the demand for low probability high impact flood insurance using the contingent valuation survey method among approximately 1000 homeowners in the dutch river delta this study is of practical relevance since currently flood insurance is not available in the netherlands while insurers have been considering to provide such insurance individuals generally do not behave in accordance with the expected utility model since a significant proportion of homeowners neglect the low probability flood risk the willingness to pay wtp of those individuals who demand flood insurance is on average considerably higher than the expected value of the flood risk they face moreover the wtp for flood insurance is less than proportionally related to increased flood probabilities that were presented to respondents in the questionnaire individuals follow a process of bayesian updating of flood probabilities since perceptions of flood risk are an important determinant of the wtp while objective risks derived from geographical characteristics influence the wtp to a lesser extent communication of baseline probabilities and changes in flood probabilities using risk ladders facilitate the comprehension of risk by respondents and has a considerable effect on the level of the wtp and its sensitivity to probability changes the results indicate that the current ex post public compensation scheme of flood damage lowers demand for private insurance

in search of the exchange risk premium a six currency test assuming mean variance optimization abstract a number of authors examining deviations of actual rates of currency depreciation from forward discounts have claimed to find evidence of risk premiums if these deviations are indeed partly due to risk premiums rather than being entirely due to expectational errors then they should be systematically related to those variables on which risk premiums are thought to depend finance theory tells us that if investors optimize with respect to mean and variance the risk premium depends in a specific way on 1 the supplies of assets denominated in the various currencies 2 the variance covariance matrix of the rates of return and 3 the coefficient of risk aversion the null hypothesis of this paper is that the coefficient of risk aversion is zero countries assets are perfect substitutes and risk premiums are nonexistent the alternative hypothesis is that rates of return are systematically related to asset supplies by a macroeconomic portfolio balance function the maximum likelihood technique used dominates previous attempts to find such a relationship in that the parameters of the portfolio balance function are constrained to depend on the variance covariance matrix as the finance theory says they should on the other hand the technique also dominates previous applications of the finance theory in that the expected returns are allowed to vary over time as the macroeconomic portfolio balance theory says they should the paper s finding is a statistical inability to reject the null hypothesis for a portfolio of six currencies although this could be due to low power in the test

the implications of mean variance optimization for four questions in international macroeconomics abstract the hypothesis of mean variance optimization has powerful implications transcending particular methods used for variance covariance estimation 1 for conventional estimates of risk aversion substitutability between domestic and foreign securities is close to perfect in the sense that risk premiums are small in magnitude a few basic points and thus cannot explain much bias in forward rates 2 nevertheless as long as risk aversion is not zero foreign exchange intervention still affects the level of the exchange rate proportionately at least to asset supply changes 3 current account deficits also have effects 4 finally dollar depreciation should not be accompanied by appreciation of the mark against the franc

appearance and reality in deposit insurance the case for reform abstract this paper argues that the staffs and explicit insurance reserves of u s deposit insurers have been overwhelmed by de facto financial disaster the full costs of financing federal deposit insurance have become enormous and increasingly inequitable in distribution to reduce voluntary risk taking authorities must reprice and redesign the system of de facto deposit insurance coverage six complementary reforms are discussed 1 accounting for institutional assets liabilities and net worth at market value 2 enhancing opportunities for deposit insurers to manage their risk exposure 3 recalibrating insurance coverages 4 imposing risk rated premiums 5 mixed private and governmental competition in deposit insurance and 6 constraining insurance agency and federal reserve authority to bail out insolvent institutions

speculative efficiency and risk premium in the market for foreign exchange abstract i show that while the unbiasedness hypothesis does not hold for the deutsche mark u s dollar exchange rate market during the period 1979 1986 a risk premium cannot be detected either in light of this inconclusiveness regarding the true model specification of exchange rate movements the davidson and mackinnon approach of selecting models from amongst non nested models is used to show that a model with risk premium is closer to the true specification than a model that implies unbiasedness

optimal bank capital with costly recapitalization we study optimal bank capital choice as a dynamic trade off between the opportunity cost of equity the loss of franchise value following a regulatory minimum capital violation and the cost of recapitalization we introduce a recapitalization delay that results in a strictly positive probability of capital adequacy violation we calibrate the model to bank accounting return data and evaluate the model s ability to explain observed bank capital ratios differences in return volatility explain a significant fraction of the cross sectional variation in bank capital ratios differences in the level of capital market imperfections across banks constitute a secondary explanation

tests of the hypothesis of the existence of risk premium in the foreign exchange market abstract this paper tests for a risk premium in the foreign exchange market the null hypothesis of the test is the random walk hypothesis in the foreign exchange market the alternative hypothesis is that biases of current spot rates or forward rates from future spot rates are systematically related to a set of economic variables on which a risk premium may depend this paper provides firm evidence for a risk premium in the foreign exchange market the risk premium explains 10 20 of the total variance in future spot rates when the us dollar mark quarterly rates are used the magnitudes are smaller less than 10 for monthly rates

creditor races and contingent claims abstract recent research has begun the task of integrating contingent claims analysis with modern corporate finance by incorporating strategic behaviour in dynamic models of corporate security valuation this paper reports on and illustrates these developments by presenting a simple pricing model in which two debt holders with incomplete information about each other s type decide when to foreclose on a financially distressed firm

as time goes by examination of temporal stability across stated preference question formats we evaluate the temporal stability of willingness to pay values obtained from two identical stated preference surveys undertaken in 2004 and 2012 the surveys employ two discrete choice elicitation formats to value reductions in two health endpoints related to tap water consumption and are explicitly designed to make direct comparisons between formats we find no significant differences in real willingness to pay between the two surveys for either format a result that is robust to the structure of heterogeneity used to model respondent preferences findings lend support at least within the context of tap water quality to the temporal transfer of nonmarket benefits over extended time periods

flood insurance wealth redistribution and urban property values abstract this paper examines the economics of the wealth transfer created by the national flood insurance program nfip by its very nature nfip is unique in that it subsidizes existing homeowners but not new construction thus for comparable properties the gain captured by existing homeowners is the difference between selling prices of equivalent qualified and nonqualified properties using standard hedonic pricing models we empirically test the impact of subsidized and nonsubsidized flood insurance on property values

bank capital regulation with random audits we consider a model of optimal bank closure rules cum capital replenishment by banks with poisson distributed audits of the bank s asset value by the regulator with the goal of eliminating ameliorating the incentives of levered bank shareholders managers to take excessive risks in their choice of underlying assets the roles of tax or other subsidies on deposit interest payments by the bank and of the auditing frequency are examined c 2002 elsevier science b v all rights reserved

allocating bank regulatory powers lender of last resort deposit insurance and supervision abstract we examine the optimal institutional allocation of bank regulation we find that centralizing the lending of last resort and deposit insurance functions in a regulator leads to excessive forbearance it also leads the bank to invest suboptimally in loans giving this regulator supervision improves on both problems but it still does not lead to the efficient outcome in the multi regulator arrangement we find that it is beneficial to give supervision to the deposit insurer the choice between the unified regulator arrangement and the multi regulator arrangement involves a trade off the multi regulator arrangement reduces the forbearance problem at high levels of liquidity shortage but may exacerbate it at low levels these results assume the absence of information frictions when banks are better informed than regulators we show that regulators may have an incentive not to share private information suggesting it is important to consider regulators informational advantages when deciding on the allocation of regulation

optimal hedged portfolios the case of jump diffusion risks abstract the paper derives rules for optimal hedged portfolios when the foreign spot exchange rate changes follow a mixed jump diffusion process the paper shows that the sign of the third order derivative of the utility function plays a crucial role in differentiating the jump risk from the diffusion risk the result of the paper is compared to earlier ones under a diffusion process for the foreign exchange rate changes the paper also draws some important implications along the line of the issue of the time varying risk premiums in the foreign exchange market jel 431

optimal bank reorganization policies and the pricing of federal deposit insurance optimal dynamic regulatory policies for closing ailing banks and for deposit insurance premia are derived as functions of the rate of flow of bank deposits and interest rate on deposits the economy s risk free interest rate and the regulators bank audit administration costs under competitive conditions the threshold assets to deposits ratio below which a bank should be optimally closed is shown to be greater than or equal to one optimal deposit insurance premia and probabilities of bank closure are shown to be nondecreasing in the bank s risk on investment and nonincreasing in the bank s current assets to deposits ratio should regulatory agencies close reorganize an ailing federally insured financial institution if so when the recent record rate of failures of savings and loans associations s ls has renewed the urgency of this question the regulatory agencies are empowered but not required to reorganize financial institutions that are statutorily insolvent i e have zero or negative regulatory net worth recently regulators have in many instances permitted insolvent financial institutions to remain in operation 2 also while debating on the increase of the proposed funding of the federal deposit insurers the u s congress argued whether it would be desirable and if so when to close more s ls thus when regulators should close a troubled financial institution has become a major question of bank regulatory policy while the existing academic literature provides powerful insights into the structure and pricing of the insurers liability this literature offers very little guidance regarding the timing of bank reorganizations 3 indeed to the best of our knowledge the value of the federal

deposit insurance and regulatory forbearance are caps on insured deposits optimal considerable academic and public policy attention has been focused on the deposit insurance contract and in particular its mispriced deposit insurance premium this has resulted in a burgeoning literature on the optimal pricing of deposit insurance guarantees see merton 1977 1978 pyle 1983 ronn and verma 1986 acharya and dreyfus 1989 and allen and saunders 1993 for examples in addition other authors have studied the ability of uninsured depositors or debtholders to provide market discipline in the form of marketbased risk premia in the absence of explicit risk based insurance premia see for example ellis and flannery 1989 and avery belton and goldberg 1988 however a third control instrument namely the setting of ceilings or caps on the amount of deposit insurance coverage has not been subject to rigorous investigation in particular while the fdic 1989 and others have considered the general pros and cons of limiting the scope of deposit insurance for instance by lowering the 100 000 ceiling on the amount of insurance per account or by restricting the brokering in of deposits l no formal analysis of the role of coverage caps can be

developments in non expected utility theory the hunt for a descriptive theory of choice under risk this article reviews recent developments in the economic theory of individual decision making under risk since the 1950s it has been known that individual choices violate the standard model of expected utility in predictable ways considerable research effort has now been devoted to the project of developing a superior descriptive model following an overview of non expected utility theories which distinguishes between conventional and non conventional approaches the paper seeks to assess these alternative models in terms of empirical success using laboratory and field data and theoretical usefulness the closing sections reflect on some new directions emerging in this literature

what makes a bank risky insights from the optimal capital structure of banks abstract assessing the risk of bank failures is the paramount concern of bank regulation this paper argues that in order to assess the default risk of a bank it is important to consider its financing decisions as an endogenous dynamic process we provide a continuous time model where banks choose the deposit volume in order to trade off the benefits of earning deposit premiums against the costs that occur at future capital structure adjustments the bank s asset value may suffer from shocks and follows a jump diffusion process our main finding is that the dynamic endogenous financing decision introduces an important self regulation mechanism where it is crucial to distinguish between the diffusion risk and the jump risk component

financial decision making are women really more risk averse 40 males 33 females gain gambling gain domain loss gambling loss domain a contextual frames b abstract gambling frames studies the application of experimental methods provided stronger control of the economic environment in which decisions were made we elicited data which call into question the prevalence of stereotypic risk attitudes in financial decision making first we find that the comparative risk propensity of male and female subjects is strongly dependent on the financial decision setting second and more important we observe no gender differences in risk propensity when subjects face contextual decisions since in practice financial decisions are always contextual our results suggest that the above gender stereotype may not reflect true male and female attitudes toward financial risks i gender specific risk behavior an experimental design our experiment was designed to examine gender specific risk propensity in decisions relevant for investors and managers table 1 gives an overview of the experimental design in the main treatment we implemented risky choices in the form of investment and insurance decisions choice behavior in this treatment henceforth called the context treatment directly measures the risk behavior of male and female subjects in contextual financial decisions we also ran a control treatment in which the same risky choices were presented as abstract gambling decisions this control treatment henceforth called the abstract treatment allows us to validate the risk behavior induced by our experimental procedure in the light of the above mentioned gambling evidence in the context treatment subjects were confronted with risky choices in two different decision contexts subjects first had to complete a series of investment decisions they were then presented with a series of identical choices this time however framed as insur1 wealth effects from income differences outside the laboratory may still affect risk behavior in our experiment they are controlled for in our model 2 experimental instructions are available in german from the authors or in english from our web page www wif ethz ch publikationen htm ance decisions each investment and insurance decision incorporated a choice between a risky lottery and a certain payoff with the series of choices implemented in the two frames we elicited our subjects certainty equivalents for the same four risky lotteries l1 l2 l3 l4 in both contexts we implemented two frames in the context treatment in order to measure the risk propensity of subjects toward both perceived gains and perceived losses in both frames all possible payoffs for each decision were positive in the investment frame these payoffs were also presented as gains while in the insurance frame the same payoffs were presented as losses relative to an initial endowment therefore elicited certainty equivalents in the investment frame measure subjects risk propensities in the gain domain while certainty equivalents in the insurance frame measure risk propensity in the loss domain if in contextual financial decisions female subjects are generally more risk averse than men our results should display ceteris paribus lower female certainty equivalents in both the investment and insurance frames 3 the four lotteries l1 l2 l3 and l4 each had two possible outcomes payoffs in swiss francs 1 sfr a 0 60 and their probabilities were 30 sfr 6 10 sfr 6 30 sfr 2 10 sfr 2 30 sfr 6 10 sfr 6 and 50 sfr 2 20 sfr 2 respectively 4 experimental evidence suggests that individual risk propensity will vary systematically between the gain and loss domain daniel kahneman and amos tversky 1979 383 vol 89 no 2 gender and economic transactions 3y16 my68 mp 383 friday dec 10 08 20 am lp aer my68 figure 1 differences in mean certainty equivalents ce between male and female subjects by frame note certainty equivalents and male female differences are measured in swiss francs in the abstract treatment we confronted a different group of subjects with exactly the same risky decisions as those in the main treatment however as mentioned before all choices in this control treatment were framed as abstract gambling decisions again two frames were implemented in the gaingambling and loss gambling frames we measured the risk attitudes of subjects toward gambles in the gain and loss domain respectively subjects in both treatments were told in advance that one of their choices would determine their experimental earnings further all subjects completed a post experimental questionnaire which yielded information on each subject s disposable income this information is necessary to exclude wealth effects due to income differences outside the laboratory as an explanation of gender specific choice behavior

are individuals bayesian decision makers there has been increasing interest in whether normative models of individual choice under uncertainty accord with actual behavior these concerns have been much greater than in other economic contexts because of the particularly severe demands such decisions place on the rationality of the decision maker the limitations of these decisions have widespread consequences as they provide the rationale for many governmental efforts to regulate the risks people face here i explore the issues raised by a bayesian decision framework focusing particularly on my analyses of worker and consumer behavior

foreign exchange market efficiency tests implications of recent empirical findings abstract the recent empirical literature on the efficiency of the foreign exchange market has been characterized by strikingly contradictory conclusions drawn from similar empirical evidence these contradictions result because 1 different maintained hypotheses are held and 2 different criteria e g micro versus macroeconomic are used to judge the evidence in this survey we organize the empirical literature under several headings the presence of risk premiums empirical regularities in regression tests profitable trading rules and advanced econometric techniques in integrating this material we consider the implications of the current evidence for investors forecasters policy makers and theorists

us bank credit spreads during the financial crisis this paper argues that first passage time models are likely to better than affine hazard rate models in modelling stressed credit markets and confirms their superior performance in explaining the behavior of credit default swap rates for the major us banking groups over the period of the financial crisis affine models find it hard to deal with periods of exceptionally high or low default risk given their assumption of a constant rate of mean reversion in the hazard rate in contrast first passage time models are specified in terms of the distance to default rather than the hazard rate the persistence of shocks varies with the distance to default allowing the default curve to invert sharply compress when the distance to default is low high i use an empirical version of the collin dufresne et al 2003 model which contains a smoothing parameter that allows it to control the relative effect of these shocks on the short spreads and can be interpreted as an information lag

loss aversion under prospect theory a parameter free measurement agrowing body of qualitative evidence shows that loss aversion a phenomenon formalized in prospect theory can explain a variety of field and experimental data quantifications of loss aversion are however hindered by the absence of a general preference based method to elicit the utility for gains and losses simultaneously this paper proposes such a method and uses it to measure loss aversion in an experimental study without making any parametric assumptions thus it is the first to obtain a parameter free elicitation of prospect theory s utility function on the whole domain our method also provides an efficient way to elicit utility midpoints which are important in axiomatizations of utility several definitions of loss aversion have been put forward in the literature according to most definitions we find strong evidence of loss aversion at both the aggregate and the individual level the degree of loss aversion varies with the definition used which underlines the need for a commonly accepted definition of loss aversion