Itzhak Venezia

Equilibrium loan pricing under the bank-client relationship

Abstract We determine the loan interest rate policy of a lender who is better informed about a client than other potential lenders. The informational advantage possessed by the informed lender derives from the durability of information acquired as a result of an extant relationship. Given heterogeneous potential loan rate offers to the client by competitive lenders and client search costs, the incumbent lenders policy of loan interest rate offers is examined. We show that the optimal loan rate will exceed the incumbent lenders cost of funds and will exceed the average offer of competing lenders. The potential lenders will offer loan rates that are exceeded by their cost of funds, implying immediate losses in order to attract the client and to thereby earn expected profits in the future. Finally, we show that the expected remaining duration of a lender-client relationship is decreasing in the existing length of the relationship. Thus, clients that have been with a particular lender longer will be more likely to leave and establish a relationship with another lender.

Size and frequency of prizes as determinants of the demand for lotteries

Abstract Three variables were assumed to characterize lotteries: prizes, probability of winning, and the cost of a ticket. Two studies were conducted: The first study utilized data from the Israeli “Lotto” system for a period of 60 months. In the second study subjects indicated their preferences among different problem sets that consisted of hypothetical lotteries which were constructed so as to resemble real lotteries. The results of both studies indicate that the size of the first prize as well as the number of small prizes had the major effect on the demand for lotteries. The results are discussed in terms of classical utility theory and alternative theories that emphasize the role of attention to a few key aspects rather than moments of the distribution of outcomes.

On the statistical origins of the learning curve

Abstract This paper presents a statistical rationale for the existence of the learning curve phenomenon. We consider a firm which allocates a fixed amount of input into several activities under uncertainty concerning the values of the parameters of the production function. It is shown, under fairly reasonable assumptions, that if the firm learns about the parameters of the production function from previous observations of allocations and outputs, then a learning curve phenomenon will emerge. This result occurs since the estimates of the parameters become more precise over time, and thus the allocation of the production factor into the various activities becomes more efficient (i.e. closer to the optimum allocation that would have been determined if the parameters were known with certainty). Output, therefore, increases and inputs per unit of output decrease as a function of time (and cumulative output), and a learning curve emerges. ‘Plateauing’ of the learning curve is discussed, as are the conditions sufficient for the existence of this phenomenon, for which the model presented herein is offered as a possible explanation.

Experimental Tests of Self-Selection and Screening in Insurance Decisions

A major characteristic of insurance markets is information asymmetry that may lead to phenomena such as adverse selection and moral hazard. Another aspect of markets with asymmetric information is self-selection, which refers to the pattern of choices that individuals with different personal characteristics make when facing a menu of contracts or options. To combat problems of asymmetric information, insurance firms can use screening. That is, they can offer the clients a menu of choices and infer their characteristics from their choices.This article reports the results of several studies that examined the degree to which people behave according to the notions of self-selection and screening. Subjects played the role of either insurance buyers or sellers. The results of these studies provide partial support for the hypothesis that subjects use self-selection and screening in insurance markets. Our study also points at the importance of learning in experimental studies. In one-stage experiments where subjects did not get feedback, screening was not detected. When multistage experiments were conducted, and the subjects learned from experience and were also taught the relevant theories, their decisions were more aligned with screening.

Exclusive vs. independent agents: a separating equilibrium approach

Abstract We provide a separating equilibrium explanation for the existence of the independent insurance agent system despite the potentially higher costs of this system compared to those of the exclusive agents system (or direct underwriting). A model is developed assuming asymmetric information between insurers and insureds; the former do not know the riskiness of the latter. We also assume that the claims service provided by the independent agent system to its clients is superior to that offered by direct underwriting system, that is, insureds using the independent agent system are more likely to receive reimbursement of their claims. Competition compels the insurers to provide within their own system the best contract to the insured. It is shown that in equilibrium the safer insureds choose direct underwriting, whereas the riskier ones choose independent agents. The predictions of the model agree with previous research demonstrating that the independent agent system is costlier than direct underwriting. The present model suggests that this does not result from inefficiency but rather from self-selection. The empirical implication of this analysis is that, ceteris paribus, the incidence of claims made by clients of the independent agents system is higher than that of clients of direct underwriting. Implications for the coexistence of different distribution systems due to unbundling of services in other industries such as brokerage houses and the health care industry are discussed.

On the theory of the competitive firm with a utility function defined on profits and regret

Abstract In this paper we analyze the optimal output determined by a competitive firm facing uncertain demand. We analyze the effect of introducing uncertainty and the effect of increasing uncertainty on the optimal output, under the assumption that the utility function of the firm depends both on profits and on regret. We show that if the firm is more risk averse to profits than to regret (in a sense described below), both effects tend to decrease the optimal output. Similar effects of introducing uncertainty and of increased uncertainty were previously shown by Sandmo (1971) to exist in the case where utility is defined on profits only. Thus, this paper provides conditions under which the above results hold true, even when utility is defined on regret and on profits.

Optional stopping on nonstationary series

Abstract Two experiments were run to investigate optional stopping behavior where the offers came from different types of series. Subjects attempted to choose the maximal offers by looking through stacks of seven cards in a situation of sampling without recall. In the first experiment subjects were provided with full information on the nature of the series regarding the form of the distribution, its variance and its trend (i.e., descending, constant, or ascending). In the second experiment subjects were presented with probabilistic information on the type of series. The results indicate that the trend of the series does not affect the proportion of optimal decisions. However, various kinds of series lead to different types of errors. Also, the proportion of optimal decisions is higher when subjects have full information rather than probabilistic information on the type of the series. The results are discussed in terms of normative search theory, heuristic information processing, and choice behavior.

On the Relationship between Accounting Risk and Return: Is There a (Bowman) Paradox?

Bowmans (1980, 1982, 1984) finding of a negative relationship between the means and variances of accounting returns (the Bowman Paradox) spurred a considerable literature analyzing this phenomenon. The sign of the relationship between the mean return on equity (ROE) and its standard deviation remains unresolved. Concerns were raised about ROE measurement and statistical techniques used in establishing the paradox. The papers critiquing (and supporting) it were mostly limited in scope, studied only short periods of time and provided limited robustness checks. In addition, no paper considered the effect of issuances and repurchase of stocks on the measurement of ROE. This study revisits the Paradox and addresses the above mentioned deficiencies in prior research. We use data from longer periods, control for size and leverage and provide additional robustness checks. We conclude that a positive relationship between mean ROE and its standard deviation is far more likely than a negative one.

Loan Commitments and the Management of Uncertain Credit Demand

We provide an explanation for loan commitments unrelated to borrower creditworthiness. In our model, banks can use loan commitments to reduce uncertainty regarding their own future funding needs. Given a cost advantage to banks that can acquire such information, there exists an equilibrium demand for commitments by riskneutral firms. The purchase of the loan commitment and the choice of contract terms reveals the buyers private information regarding future credit needs. In order to ensure the sorting of the a priori indistinguishable applicants according to their private information, we show that a usage fee applied to the commitment holders unused credit line is necessary.

The determinants of bond call premia: A signalling approach

A signalling model is presented that provides an additional explanation for the determination of call premia on corporate bonds. It is shown that firms may signal their exclusive information about their probability of default by the choice of their call premia. Stockholders of safer firms (i.e., those that have a lower probability of bankruptcy) have a higher incentive for providing a low call premium. This occurs because the call option will be valuable only if the firm survives by the first call date. This event, however, is more likely for the safer firm. The safer firm will therefore be more willing to sacrifice some current revenues (or equivalently, to provide a higher coupon than it would otherwise have to pay in order to sell the bond at par) by determining a lower call premium. The model therefore predicts a negative correlation between safety and call premia, a correlation that has been empirically confirmed by Fischer, Heinkel, and Zechner (1989). This correlation provides support to the signalling theory vis-à-vis the alternative explanation of taxes determining the call premia. Another contribution of this model is that it ties the call premium decision with expectations of future interest rates. Such expectations are considered important by practitioners, but were rarely considered in previous research.