Contingent Claims Analysis and Life-Cycle Finance

Abstract

This paper explores the application of contingent claims analysis (CCA) to two "hot" issues in life-cycle finance: (1) investing for retirement and (2) deciding when, if ever, to switch careers.Participants in individual retirement accounts do not have the time or the knowledge to make their own investment decisions. Today they are defaulted into life-cycle mutual funds that pass all risk directly through to the participant. We use CCA to demonstrate how financial firms can design and produce guaranteed contingent benefit contracts that improve participant welfare at no additional cost to the system. In exploring the career-choice issue in the second part of the paper, we use CCA in a somewhat different way. The decision to switch careers is analogous to deciding when to exercise an American-style option to swap one asset for another. By applying the methods used to analyze the option-exercise decision to the career-switching problem, we gain some new insights beyond those derived from the traditional dynamic programming approaches.

Limits of Arbitrage

“…Conceived at the outset as a parallel development to Merton's joint research with Bodie, and completed in 1997, was a textbook on basic finance that applies the functional perspective and presents the subject as a set of principles much like first courses in economics and the physical sciences (Bodie, Merton & Cleeton 2010). Financial Economics was intended for use in its current form anywhere in the world.…”

Bankruptcy risk induced by career concerns of regulators

“…This implies that the strike price in (2.5), based on the value of the regulator's pre-career change compensation package, must be compared to the firm's debt firm debt (αD) which serves double duty as the strike price in Merton (1974) firm valuation formula in (2.7). This Margrabe (1978) style option pricing problem was solved by Treussard (2007) and Bodie et al (2008). So we take it as given in the sequential move setting above.…”

“…Relative to any given beta level that might hold in the case of a disinterested regulator, we argue there will be a beneficial impact on the firms beta when a regulator exercises her career option to join the firm 4 . Whereas Treussard (2007) and Bodie et al (2008) solve the problem of when to switch careers, our model's focus is on what happens once a regulator decides to switch career and take an executive level position with a firm she regulates. Here, she embeds her human capital beta 5 in the firm's capital structure and observes a valuation effect.…”

“…This problem was solved byTreussard (2007) andBodie et al (2008), and is not dispositive of our main results.18 See e.g.,Øksendal (2003, pg. 237) …”