Management Insights

Valuing the Treasury's Capital Assistance Program (p. 1195)

Paul Glasserman, Zhenyu Wang

The Capital Assistance Program (CAP) was created by the U.S. government in February 2009 to provide backup capital to large financial institutions unable to raise sufficient capital from private investors. Under the terms of the CAP, a participating bank receives contingent capital by issuing preferred shares to the Treasury combined with embedded options for both parties: The bank gets the option to redeem the shares or convert them to common equity, with conversion mandatory after seven years, and the Treasury earns dividends on the preferred shares and gets warrants on the bank's common equity. An important question: What is the value of these CAP securities? Based on the 18 publicly held bank holding companies that participated in the Supervisory Capital Assessment Program, the authors estimate that, compared to a market transaction, the CAP securities carry a net value of approximately 30% of the capital invested for a bank participating to the maximum extent allowed under the terms of the program. The insight for management: Despite lack of participation from industry, it appears the CAP program was favorable to participants.

Mixed Source (p. 1212)

Ramon Casadesus-Masanell, Gastón Llanes

At one time, Microsoft touted the public position that open-source software was the bane of the industry. Today, Microsoft has softened its position, allowing, for example, modifications to .Net software for use with Linux. Proprietary software companies benefit from intellectual capital rights, resulting in continued investment and improvement in code. However, open source has multitudes of possible user-developers to continue its enhancement. Does “mixed source”—both proprietary and open code in combination—capture the best of both worlds? When would a profit-maximizing software company engage in a hybrid model? The firm can leverage armies of potential coders but must make open modules available for others to use free of charge. The authors show that when the firm's modules are of high quality, the firm is more open under competitor open-source incompatibility than under compatibility, but the opposite is true if modules are of low quality. The authors also find that firms are more likely to open substitute, rather than complementary, modules to existing open-source projects. The insight for management: Open-source and proprietary software companies are exploring mixed-source forms of “coopetition” in software markets.

Market Timing with Option-Implied Distributions: A Forward-Looking Approach (p. 1231)

Alexandros Kostakis, Nikolaos Panigirtzoglou, George Skiadopoulos

Typical portfolio mix optimization gauges the risk of an asset by its historical valuation variance. The authors develop “risk-adjusted implied distributions”—forward-looking estimates of asset valuation variance based on market option prices. They form optimal portfolios and evaluate their out-of-sample performance and find that the use of their risk estimate makes the investor better off than if she uses historical returns' distributions to calculate her optimal strategy. The insight for management: Historical risk is not an indicator of future risk; better asset allocation strategies can be devised by using future risk estimates from options markets.

Exclusive Territories and Manufacturers' Collusion (p. 1250)

Salvatore Piccolo, Markus Reisinger

Does granting exclusive territory rights to franchises encourage tacit price collusion among manufacturers? Having exclusive territories might soften price pressures on retailers by limiting same-product sales in an area and, in the short run, increase profits. However, retailers might deviate from agreed-upon prices in order to increase retailer profits. If two competing manufacturers both follow exclusive territory rights strategies, are such exclusive territory assignments conducive for creating tacit price collusion between competing supply chains? The authors show that exclusive territories are a more suitable organizational mode for tacit price collusion; however, if the retailer offers substantial demand-enhancing services, it tends to undermine collusive opportunities. The insight for management: Dedicated territories can support tacit collusions in supply chains if retailers do not offer extensive demand-enhancing services.

Modeling the Loss Distribution (p. 1267)

Sudheer Chava, Catalina Stefanescu, Stuart Turnbull

The predicted loss distribution is a basic input for calculating the loan loss reserves and the economic capital and for computing portfolio risk metrics such as value-at-risk and expected shortfall. For an individual asset such as a bond or loan, the loss distribution depends on the probability of default and on the recovery rate given default. The authors develop a new model based on the analysis of a default and recovery data set over the horizon 1980–2008. They show that the specification of the default model has a major impact on the predicted loss distribution but that the specification of the recovery model is less important. They find evidence that industry factors and regime dynamics affect the performance of default models, implying that the appropriate choice of default models for loss prediction will depend on the credit cycle and on portfolio characteristics. The insight for management: Default probabilities and recovery rates are negatively correlated, and the magnitude of the correlation varies with seniority class, industry, and credit cycle.

When Acquisition Spoils Retention: Direct Selling vs. Delegation Under CRM (p. 1288)

Yan Dong, Yuliang Yao, Tony Haitao Cui

“Offer not available to existing customers” is a disclaimer often seen in ads from phone, cable, and banking companies seeking to acquire new customers. But how does this make existing customers feel? Despite the synergies between acquisition and retention of customers, should the same organization conduct both acquisition and retention activities? Designing the appropriate incentives to do both may be difficult; efforts toward acquisition of new customers might spoil existing ones. The authors develop incentive mechanisms that simultaneously address acquisition and retention of customers with an emphasis on the interactions between them. The authors find that when customer acquisition and retention are independent pursuits, the firm's profit is higher under direct selling than under delegation; however, when acquisition spoils retention, the firm's profit may be higher under delegation. The insight for management: Despite synergies between the activities, responsibility for acquisition and retention should be combined only when new acquisition does not come at the cost of customer churn due to inattention or other existing customer ill will.

Centralized vs. Decentralized Ambulance Diversion: A Network Perspective (p. 1300)

Sarang Deo, Itai Gurvich

One of the most important operational challenges faced by emergency departments (EDs) in the United States is patient overcrowding. In periods of overcrowding, an ED can ask the emergency medical services (EMS) agency to divert incoming ambulances to neighboring hospitals, a phenomenon known as “ambulance diversion.” The EMS agency may accept this request provided that at least one of the neighboring EDs is not on diversion. From an operations perspective, properly executed ambulance diversion should result in resource pooling and reduce overcrowding and delays in a network of EDs. The authors explain that this potential benefit is not always realized because of decentralized diversion decisions. They show that in some cases EDs act “defensively” and do not accept diverted ambulances from the other ED. The insight for management: Cooperation between emergency rooms might be more effective if centrally planned.

Preference Reversals for Ambiguity Aversion (p. 1320)

Stefan T. Trautmann, Ferdinand M. Vieider, Peter P. Wakker

Research has shown that irrelevant details in problem framing reverse the decisions of otherwise rational agents. The authors find that preference reversals depend on ambiguity aversion, that is, the distaste for unknown probabilities of future outcomes. However, the reversals are not a function of context-dependent weightings of attributes. The insight for management: Measurements of ambiguity aversion that use willingness to pay are confounded by loss aversion and hence overestimate ambiguity aversion.

Testing for Prudence and Skewness Seeking (p. 1334)

Sebastian Ebert, Daniel Wiesen

A prudent decision maker avoids downside risk and exercises precautionary savings in anticipation of negative outcomes. The aversion to risk—measured as symmetric variance around expected outcomes—is well known and understood, but skewness—the asymmetry of outcomes—is less studied. Prudence—or anticipatory saving—might be used to offset the risk of negative outcomes. The authors test for prudence and skewness preference in a laboratory setting. The authors find that prudence is observed on the aggregate and individual level and that prudence does not boil down to skewness seeking. The insight for management: Risk-mitigating precautionary saving behaviors are different from other risk-avoidance behaviors and may be more commonly used than other risk strategies.