Steve B. Wyatt

Strategic Default, Workout, and Commercial Mortgage Valuation

This paper extends existing equilibrium commercial mortgage pricing models by endogenizing negotiated workout into the usual noncooperative lending game. Workout is a feasible subgame strategy for the lender to play whenever foreclosure transaction costs exist for either party to a loan transaction. In particular, negotiated workout solutions Pareto dominate the foreclosure alternative when default occurs. To obtain our results, we embed a cooperative bargaining game within a noncooperative mortgage loan/default game. We also address the valuation “wedge” problem that occurs when foreclosure transaction costs are introduced. Through the notion of replacement game equilibrium, we find symmetric mortgage pricing solutions that eliminate the valuation wedge and thus suggest that lending will occur in commercial real estate mortgage markets even when foreclosure transaction costs exist.

Wimp or Tough Guy: Sequential Default Risk and Signaling with Mortgages

When analyzing what to do with a currently defaulted loan, the lender must consider the impact of his foreclosure versus workout decision on the expected payoff of subsequent loans as well as on the payoff of the current loan. This is because borrowers with future loan payoff dates can observe the lenders actions and update prior information regarding the lenders toughness or wimpiness when dealing with defaulted loans. In this paper we consider the strategic interaction between a lender and multiple borrowers, where borrowers have distinct, sequentially maturing mortgage loans and where the lender has private information regarding the magnitude of his foreclosure costs. We find that a variety of strategic outcomes can occur that explain the co-existence of workout and foreclosure in the mortgage marketplace. In general, the lenders workout/foreclosure response depends on the cost of bluffing (e.g., foreclosing when workout is cheaper) versus the value of reducing expected defaults and workout concession losses on future loans (e.g., imperfect foreclosure cost information leads future borrowers to payoff the mortgage when default would have been optimal under perfect information). Given recently revised expectations regarding the depth of the real estate recession, our results may explain the move by many lenders away from granting workout concessions and toward taking a harder line when dealing with defaulting borrowers.

Integrating Auction and Search Markets: The Slow Dutch Auction

The issue of choosing to sell property by auction or by traditional negotiated search markets is addressed in this article. A general selling institution called the slow Dutch auction is introduced. This general selling mechanism reduces to either a conventional auction, a posted offer, or some time dependent mix of these selling institutions depending on the pricing rule chosen by the seller. We model search by having potential buyers whose private valuation for the property is unknown to the seller arrive randomly over time. With this general framework the sellers problem is to choose a selling mechanism that maximizes expected wealth. Surprisingly, we find that the optimal selling institution is always a posted offer market. The seller chooses an optimal posted price and waits until a buyer arrives who is willing to pay this price. Auctions are never optimal.

Biases in option prices: Evidence from the foreign currency option market

Abstract This paper examines a European call model of option pricing over a data set which does not suffer from the early exercise problems that have plagued earlier studies of call options on common stocks. We specifically examine a data set of American call prices on spot foreign exchange for which it is plausible to apply an adjusted version of the Garman-Kohlhagen (1983) and Grabbe (1983) European call option model. We make adjustments for interest rate risk and find that the model is nearly unbiased in the valuation of foreign currency options. We conclude that the Geske-Roll (1984) conjecture about dividend uncertainty creating biases in stock option prices holds analogously in the foreign currency option market. Interest rate differential risk (analogous to risky dividends) thus appears to be an important element in the valuation of foreign currency options.

Preferencing, Internalization of Order Flow, and Tacit Collusion: Evidence from Experiments

This paper examines preferencing arrangements and tacit collusion in laboratory asset markets. In the experiments, dealers may internalize by matching the best quote or by passing orders to the dealer posting the best quote. Although some markets were highly competitive, several markets reached a collusive equilibrium with wide spreads and near complete internalization of order flow. The paper further examines the role of market transparency and passed order flow on quote-setting behavior and suggests that these affect the mechanism leading to tacitly collusive equilibria.

On the pricing of European and American foreign currency call options

Abstract This study uses Cox-Ross analysis and dynamic programming techniques to price foreign currency call options. We show that, under certain conditions, the American call price will exceed its European counterpart, while under other conditions the two prices will be identical. We find that the American premium is a complex function of the degree to which an option is in or out of the money, and that this premium is greatest when an option is near in or out. We present empirical evidence which shows that the American model significantly improves upon a European model; however, significant pricing errors associated with the American model remain.

A Contingent Claims Analysis of Trade Credit

We investigate trade credit decisions using a framework which reflects capital market equilibrium via contingent claims analysis. We approach the valuation of trade credit from the perspective of straightforward evaluation of risky debt. By modeling the trade credit limit decision in this way, optimal decisions on the part of the seller and buyer are assumed. This paper has two purposes. First, to develop a theoretically plausible credit-valuation framework. Second, to illustrate the proper use of this framework for effectively setting credit limits.

On the pricing of European and American foreign currency options: a clarification

Abstract This paper amends misprints in Adams-Watt (1987) of simulated American foreign currency call prices and, for purposes of completeness, provides simulation results for corresponding European calls and European and American puts on spot foreign exchange.

Discussion: The Theory of Housing and Interest Rates

Professors Kau and Keenen (K & K) explore in this paper the microeconomic foundations of the demand and supply of housing. In order to investigate these foundations, K & K adopt the standard neoclassical framework: the demand for housing arises from solution of a multiperiod consumption problem; and, the supply of new housing is derived from a one–period profit maximization problem. Within this general framework, K & K argue that owner–occupied housing is distinguished from other consumption goods by its durability. As a consequence of this durability, the stock of housing held enters into each periods budget constraint. The utility, on the other hand, from housing enters only as a flow of services in each time period. Because of the stock/flow nature of housing, the comparative statics of the model become interesting. K & K investigate the comparative statics of the model with special attention focused on the impact of changes in the real rate of interest. K & K show, by use of fairly elegant duality theory, that if consumers of owner–occupied housing are net debtors, then an increase in the real rate of interest leads to a fall in the immediate demand for housing. This result is as it should be, since an increase in the real rate of interest reduces the wealth of net borrowers for any given level of future income and, consequently, demand for normal goods falls. K & K argue that a similar net debtor condition must hold to produce the same result in the rental market. I am sure this is a stronger condition than is necessary since an increase in the real rate of interest lowers the price of future consumption and to the extent that current consumptions of rental housing are a substitute for future consumption, it would be expected that current demand for rental housing would fall.