Guenter Franke

When are Options Overpriced? The Black-Scholes Model and Alternative Characterizations of the Pricing Kernel

This paper examines the convexity bias introduced by pricing interest rate swaps off the Eurocurrency futures curve and the markets adjustment of this bias in prices over time. The convexity bias arises because of the difference between a futures contract and a forward contract on interest rates, since the payoff to the latter is non-linear in interest rates. Using daily data from 1987-1996, the differences between market swap rates and the swap rates implied from Eurocurrency futures prices are studied for the four major interest rate swap markets -

Risk taking with additive and multiplicative background risks

, £, DM and ¥. The evidence suggests that swaps were being priced off the futures curve (i.e. by ignoring the convexity adjustment) during the earlier years of the study, after which the market swap rates drifted below the rates implied by futures prices. The empirical analysis shows that this spread between the market and futures-implied swap rates cannot be explained by default risk differences, liquidity differences or information asymmetries between the swap and the futures markets. Using alternative term structure models (one-factor Vasicek, Cox-Ingersoll and Ross, Hull and White, Black and Karasinski, and the two-factor Heath, Jarrow and Morton), the theoretical value of the convexity bias is found to be related to the empirically observed swap-futures differential. We interpret these results as evidence of mispricing of swap contracts during the earlier years of the study, with a gradual elimination of that mispricing by incorporation of a convexity adjustment in swap pricing over time.

Information asymmetries and securitization design

We examine the effects of background risks on optimal portfolio choice. Examples of background risks include uncertain labor income, uncertainty about the terminal value of fixed assets such as housing and uncertainty about future tax liabilities. While some of these risks are additive and have been amply studied, others are multiplicative in nature and have received far less attention. The simultaneous effect of both additive and multiplicative risks has hitherto not received attention and can explain some paradoxical choice behavior. We rationalize such behavior and show how background risks might lead to seemingly U-shaped relative risk aversion for a representative investor.

Optimal Tranching in CDO-Transactions

The strong growth in collateralized debt obligation transactions raises the question how these transactions are designed. The originator designs the transaction so as to maximize her benefit subject to requirements imposed by investors and rating agencies. An important issue in these transactions is the information asymmetry between the originator and the investors. First Loss Positions are the most important instrument to mitigate conflicts due to information asymmetry. We analyse the optimal size of the First Loss Position in a model and the actual size in a set of European collateralized debt obligation transactions. We find that the asset pool quality, measured by the weighted average default probability and the diversity score of the pool, plays a predominant role for the transaction design. Characteristics of the originator play a small role. A lower asset pool quality induces the originator to take a higher First Loss Position and, in a synthetic transaction, a smaller Third Loss Position. The First Loss Position bears on average 86 % of the expected default losses, independent of the asset pool quality. This loss share and the asset pool quality strongly affect the rating and the credit spread of the lowest rated tranche.

Foundation Owned Firms in Germany - A Field Experiment for Agency Theory

This paper empirically investigates the tranching of European securitizations of corporate loans and bonds. Loans or bonds are pooled together in a portfolio which then is sliced into a First Loss Position and rated bond tranches. The originator tranches so as to minimize the sum of the credit spreads paid on the rated tranches. We find that the number of rated tranches is inversely related to the asset pool quality. The price for transferring a unit of expected default risk is inversely related to the number of subordinated tranches, it is higher for the lowest rated tranche, it is very high for the AAA-tranches in true sale-transactions. The price increases with the credit support of a tranche, but declines when the default probability of the portfolio increases.

Risk-Taking-Neutral Background Risk

This paper analyzes the governance and performance of firms which, according to simplistic agency theory, should not be viable. These firms are fully or partially owned by a foundation which itself is not owned by natural or legal persons. Therefore, residual claimholders have restricted or no influence on corporate governance. The lack of owners strengthens other stakeholders, in particular employees. Relative to matching family firms, German foundation owned firms are larger in terms of employees and operating revenue, and substitute labor for material, but not for capital. Their hiring and firing policy is about the same. They follow a more conservative financing policy, their financial performance is somewhat weaker.This paper analyzes the governance and performance of firms which, according to agency theory, should not be viable. These firms are fully or partially owned by a foundation which itself is not owned by natural persons. Therefore, residual claimholders have restricted or no influence on corporate governance. Relative to matching firms German foundation owned firms substitute labor for material, but not for capital. They follow a more conservative financing policy. Their financial performance is somewhat weaker, possibly due to stronger employee orientation.

Foundation owned firms: a comparative study of stakeholder approaches

We define a class of risk-taking-neutral (RTN) background risks. These background risks have the property that they will not alter decisions made with respect to another risk, for individuals with HARA utility. If we wish to compare a decision made with and without some exogenous background risk, it is often easier to compare the decision made to one made with a RTN background risk. We use this methodology to prove and extend a well-known theorem about dynamic investment strategy, due to Mossin (1968a). We also use this methodology to analyze investment behavior in the presence of an income tax as well as to analyze investment behavior in the presence of particular types of background risks.

Approximated Portfolio Choice - Do We Dance on a Pinhead?

How do policy and performance of firms change with variations in the stakeholder approach? We compare foundation owned firms (FoFs) and family firms, with and without codetermination. As foundations have no owners, the impact on corporate governance of residual claimants might be weaker and the impact of other stakeholders stronger. We find that German foundation owned firms are more labor intensive relative to matching firms. But their wages and their hiring and firing policy are about the same. Their financing policy is more conservative. Their financial performance is slightly weaker. Apart from financing policy, codetermination has similar effects. These findings indicate a stronger impact on corporate governance of employees in FoFs, combined with long-term orientation.

Default Risk Sharing between Banks and Markets: The Contribution of Collateralized Debt Obligations

HARA-utility investors allocate their money to a risk-free fund and to a risky fund (two fund separation). The paper shows that under weak conditions, the risky fund can be approximated by the risky fund derived from exponential utility, without material effects on the certainty equivalent of the portfolio payoff. Also, effects of changes in asset return parameters on the risky fund can be approximated using the exponential utility function, thereby simplifying the analysis. The approximation is of high quality if extreme portfolio returns have a very small probability and if the investors level of relative risk aversion exceeds 2.