Andrea Gamba

Valuing Modularity as a Real Option

We provide a general valuation approach for capital budgeting decisions involving the modularization in the design of a system. Within the framework developed by Baldwin and Clark (Baldwin, C. Y., K. B. Clark. 2000. Design Rules: The Power of Modularity. MIT Press, Cambridge, MA), we implement a valuation approach using a numerical procedure based on the least-squares Monte Carlo method proposed by Longstaff and Schwartz (Longstaff, F. A., E. S. Schwartz. 2001. Valuing American options by simulation: A simple least-squares approach. Rev. Financial Stud.14(1) 113--147). The approach is accurate, general, and flexible.

Capital Regulation, Liquidity Requirements and Taxation in a Dynamic Model of Banking

This paper studies the impact of bank regulation and taxation in a dynamic model where banks are exposed to credit and liquidity risk and can resolve financial distress in three costly forms: bond issuance, equity issuance or fire sales. We find an inverted U-shaped relationship between capital requirements and bank lending, efficiency, and welfare, with their benefits turning into costs beyond a certain threshold. By contrast, liquidity requirements reduce lending, efficiency and welfare significantly. On taxation, corporate income taxes generate higher government revenues and entail lower efficiency and welfare costs than taxes on non-deposit liabilities.

Corporate Risk Management: Integrating Liquidity, Hedging, and Operating Policies

We analyze the value created by a dynamic integrated risk management strategy involving liquidity management, derivatives hedging, and operating flexibility, in the presence of several frictions. We show that liquidity serves a critical and distinct role in risk management, justifying high levels of cash. We find that the marginal value associated with derivatives hedging is likely to be low, though we explain why some empirical studies find a higher value. We explore the complex interactions between operating flexibility and financial risk management, finding that substitution effects are nonmonotonic and are affected by operating leverage, the nature of operating flexibility, and the effectiveness of the hedging instrument. This paper was accepted by Jerome Detemple, finance.

An Improved Binomial Lattice Method for Multi‐Dimensional Options

A binomial lattice approach is proposed for valuing options whose payoff depends on multiple state variables following correlated geometric Brownian processes. The proposed approach relies on two simple ideas: a log‐transformation of the underlying processes, which is step by step consistent with the continuous‐time diffusions, and a change of basis of the asset span, to transform asset prices into uncorrelated processes. An additional transformation is applied to approximate driftless dynamics. Even if these features are simple and straightforward to implement, it is shown that they significantly improve the efficiency of the multi‐dimensional binomial algorithm. A thorough test of efficiency is provided compared with most popular binomial and trinomial lattice approaches for multi‐dimensional diffusions. Although the order of convergence is the same for all lattice approaches, the proposed method shows improved efficiency.

A three-moment based portfolio selection model

This article studies a portfolio selection model based on Expected return, Variance and Skewness (E-V-S), under a distributional hypothesis that allows 3-funds separation. The efficient portfolio is the solution of a non-linear problem that maximizes skewness under a specified level of expected return and variance. The analysis of the efficient frontier shows that the return of any efficient portfolio is the sum of a riskless return (if available), a variance premium and a skewness discount. Furthermore, the strategy based on the maximization of skewness is equivalent to adding a definite non-zero arbitrage portfolio (with null expected return) to an efficient E-V portfolio.RiassuntoQuesto lavoro studia un modello di selezione del portafoglio basato su rendimento atieso, varianza e indice di asimmetria (skewness), nell’ipotesi che la distribuzione congiunta dei rendimenti consenta la separazione in tre fondi mutui. Il portafoglio efficiente è soluzione di un problema non lineare che massinizza loskewness dato un certo rendimento atteso e una certa varianza. L’analisi della frontiere efficiente mostra che il rendimento di un qualsiasi portafoglio cfficiente risulta dalla somma del rendimento certo (qualora questo sia disponibile), un premio sulla varianza e uno sconto sulloskewness. Inoltre la strategia basata sulla massimizzazione delloskewness di portafoglio risulta equivalente all’aggiungere un portafoglio di arbitraggio non nullo (che conferisco rendimento atteso nullo) ad un portafoglio efficiente secondo il criterio media-varianza.

Investment under Uncertainty, Debt and Taxes

It is common practice in financial derivative valuation to use a discount factor based on the riskless debt rate. But, to what extent is this discount factor appropriate for cash flows emerging in capital budgeting? To answer this question, we introduce a framework for real asset valuation that considers both personal and corporate taxation. We first discuss broad circumstances under which personal taxes do not affect valuation. We show that the appropriate discount rate for equity-financed flows in a risk-neutral setting is an equity rate that differs from the riskless debt rate by a tax wedge due to the presence of personal taxation. We extend this result to the valuation of the interest tax shield for exogenous debt policy with default risk. Interest tax shields, which accrue at a net rate corresponding to the difference between the corporate tax rate and a tax rate related to the personal tax rates, can have either positive or negative values. We also provide an illustrative real options application of our valuation approach to the case of an option to delay investment in a project, showing that the application of Black and Scholes formula may be incorrect in presence of personal taxes. Copyright 2008 The Authors Journal compilation 2008 Banca Monte dei Paschi di Siena SpA.

How Effectively Can Debt Covenants Alleviate Financial Agency Problems

We examine the effectiveness of debt covenants in alleviating financial agency problems. Distortions in both investment and financing policies with long--term debt are captured in a structural dynamic model where both policies are endogenously determined by shareholders. The combined and compounding effect of these distortions is shown to be large. We impose covenants that restrict the level of debt, or control the use of proceeds from asset sales or debt issuance, and analyze how, and how much, they mitigate financial agency costs. We investigate the direct and indirect impact of covenants on financing and investment policies, including at the point where covenants are violated, providing alternative interpretations of recent empirical evidence. We conclude that the presence and enforcement of debt covenants significantly alters dynamic financing and investment policies, not only at the point of covenant violations, and thus should be an important element of structural models.

Firm Policies and the Cross-Section of CDS Spreads

We solve the credit spread puzzle with a structural model of firm’s policies that endogenously replicates the empirical cross-section of credit spreads. Structural estimation of the models parameters reveals that the model cannot be rejected by the data, and that endogenous investment decisions are major determinants of CDS spreads. We also verify that controlling for financial leverage, CDS spreads are positively related to operating leverage, and negatively related to growth opportunities. Consistent with the idea that growth options reduce credit risk, investments are negatively correlated with changes in CDS spreads.

Dynamic Bank Capital Regulation in Equilibrium

We study optimal bank regulation in an economy with aggregate uncertainty. Bank liabilities are used as “money” and hence earn lower returns than equity. In laissez faire equilibrium, banks maximize market value, trading off the funding advantage of debt against the risk of costly default. The capital structure is not socially optimal because external costs of distress are not internalized by the banks. The constrained efficient allocation is characterized as the solution to a planner’s problem. Efficient regulation is procyclical, but countercyclical relative to laissez faire. We show that simple leverage constraints can get the decentralized economy close to the constrained efficient outcome.

Inventory and Corporate Risk Management

We consider a dynamic model of investment in which a firm can hold inventory to mitigate the price risk of an input commodity. Our model predicts that inventory allows to hedge against net worth risk by smoothing investment in capital, irrespective of the level of current net worth. Savings enhance the operational hedge offered by inventory, because they better conserve net worth when the commodity price is low. These predictions are confirmed in a sample of U.S. manufacturing corporations. We find that the empirical sensitivity of inventory investment to price changes is positive for any level of the firm’s net worth. While savings and inventory are both positively related to financing constraints and cash flow risk, investment is more sensitive to inventory.