nep-cta New Economics Papers
on Contract Theory and Applications
Issue of 2016‒11‒06
five papers chosen by
Guillem Roig
University of Melbourne

  1. Multidimensional Private Information, Market Structure and Insurance Markets By Hanming Fang; Zenan Wu
  2. Dynamic Contracting with Long-Term Consequences: Optimal CEO Compensation and Turnover By Suvi Vasama; ;
  3. The Pros and Cons of Workplace Tournaments By Sheremeta, Roman
  4. Loading Pricing of Catastrophe Bonds and Other Long-Dated, Insurance-Type Contracts By Eckhard Platen; David Taylor
  5. Carbon pricing, forward risk premiums and pass-through rates in Australian electricity futures markets By Pawel Maryniak; Stefan Trueck; Rafal Weron

  1. By: Hanming Fang; Zenan Wu
    Abstract: A large empirical literature found that the correlation between insurance purchase and ex post realization of risk is often statistically insignificant or negative. This is inconsistent with the predictions from the classic models of insurance a la Akerlof (1970), Pauly (1974) and Rothschild and Stiglitz (1976) where consumers have one-dimensional heterogeneity in their risk types. It is suggested that selection based on multidimensional private information, e.g., risk and risk preference types, may be able to explain the empirical findings. In this paper, we systematically investigate whether selection based on multidimensional private information in risk and risk preferences, can, under different market structures, result in a negative correlation in equilibrium between insurance coverage and ex post realization of risk. We show that if the insurance market is perfectly competitive, selection based on multidimensional private information does not result in negative correlation property in equilibrium, unless there is a sufficiently high loading factor. If the insurance market is monopolistic or imperfectly competitive, however, we show that it is possible to generate negative correlation property in equilibrium when risk and risk preference types are sufficiently negative dependent, a notion we formalize using the concept of copula. We also clarify the connections between some of the important concepts such as adverse/advantageous selection and positive/negative correlation property.
    JEL: D82 G22 H11
    Date: 2016–10
  2. By: Suvi Vasama; ;
    Abstract: We examine optimal managerial compensation and turnover policy in a principal-agent model in which the firm output is serially correlated over time. The model captures a learning-by-doing feature: higher effort by the manager increases the quality of the match between the firm and the manager in the future. The optimal incentive scheme entails an inefficiently high turnover rate in the early stages of the employment relationship. The optimal turnover probability depends on the past performance and the likelihood of turnover decreases gradually with superior performance. With good enough past performance, the turnover policy reaches efficiency; the manager is never retained if it is inefficient to do so. The manager’s compensation depends on the firm value and the optimal performance-compensation relation increases with past performance.
    JEL: C73 D82 D86
    Date: 2016–10
  3. By: Sheremeta, Roman
    Abstract: Tournaments are commonly used in the workplace to determine promotion, assign bonuses, and motivate personal development. Tournament-based contracts can be very effective in eliciting high effort, often outperforming other compensation contracts, but they can also have negative consequences for both managers and workers. The benefits and disadvantages of workplace tournaments have been identified in theoretical, empirical, and experimental research over the past several decades. Based on these findings, I provide suggestions and guidelines for when it might be beneficial to use tournaments in the workplace.
    Keywords: tournaments, contests, competition, contracts, workplace
    JEL: C7 C8 C9 J4 J7 L1 L2 M1 M5
    Date: 2016–11–01
  4. By: Eckhard Platen; David Taylor
    Abstract: Catastrophe risk is a major threat faced by individuals, companies, and entire economies. Catastrophe (CAT) bonds have emerged as a method to offset this risk and a corresponding literature has developed that attempts to provide a market-consistent pricing methodology for these and other long-dated, insurance-type contracts. This paper aims to unify and generalize several of the widely-used pricing approaches for long-dated contracts with a focus on stylized CAT bonds and market-consistent valuation. It proposes a loading pricing concept that combines the theoretically possible minimal price of a contract with its formally obtained risk neutral price, without creating economically meaningful arbitrage. A loading degree controls how much influence the formally obtained risk neutral price has on the market price. A key finding is that this loading degree has to be constant for a minimally fluctuating contract, and is an important, measurable characteristic for prices of long-dated contracts. Loading pricing allows long-dated, insurance-type contracts to be priced less expensively and with higher return on investment than under classical pricing approaches. Loading pricing enables insurance companies to accumulate systematically reserves needed to manage its risk of ruin in a market consistent manner.
    Date: 2016–10
  5. By: Pawel Maryniak; Stefan Trueck; Rafal Weron
    Abstract: We investigate the impacts of the carbon tax (effective July 2012 to July 2014) on wholesale electricity prices in the Australian National Electricity Market (NEM). Analyzing spot and futures contracts in four major regional markets, we first compute ex-ante forward risk premiums in the pre-tax period, then use them to derive market-implied carbon premiums and pass-through rates in the carbon tax and post-tax periods. We find that carbon premiums and pass-through rates became increasingly higher, once the Clean Energy Bill had been introduced and subsequently passed in 2011. We also find strong evidence for a quick reaction of the extracted carbon premiums to changes in opinion polls for the Australian federal election in 2013 and the decision to repeal the tax. On the other hand, during periods where market participants could be relatively certain that the tax would be effective, we find expected carbon pass-through rates between 65% and 140%, which seem to be inversely related to emission intensities.
    Keywords: Carbon tax; Carbon pass-through rate; Forward risk premium; Electricity market; Spot and futures prices
    JEL: C51 C53 G13 Q41 Q58
    Date: 2016–11–02

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