A game theory analysis of options. Contributions to the theory of financial intermediation in continuous time (Q1819261)

This monograph is an outgrowth of the author's doctoral dissertation. Its aim is, first, to present a novel method for analyzing problems involving uncertainty, as well as strategic interactions between economic agents, in a dynamic context; and, second, to use this method to analyze a variety of such problems arising in models whose primary distinguishing feature is that they incorporate financial intermediation, and gain some new insights thereby. The novel aspect of the method lies in the integration of two aspects of mathematical economics and the mathematics of finance, namely, the theory of games and the theory of option pricing devoted to the valuation of financial assets providing contingent claims. The central feature of the method, which is perhaps its most valuable aspect from the standpoint of rendering tractable complex problems of dynamic multi-person decision making in continuous time and under uncertainty, is that it separates the problem of valuation of uncertain payoffs from the analysis of strategic interactions. Specifically, it replaces the more abstract notion of maximization of expected utility of an uncertain stream of payoffs by the more operational notion of maximization of the value of an option which, obtained from option pricing theory, is the arbitrage-free values for the payoffs, and is considered as a proxy for expected utility. Typically, as a first step, the players' future uncertain payoffs are valued, using option pricing theory, as a closed form formula where all the players' possible actions enter the valuation formula as parameters. Once the valuation problem is finessed in this fashion, the strategic aspect of the problem is tackled by considering the players' optimal strategies, using backward induction or subgame perfection as a solution concept. lf there are more than one possible such solution, renogiciation proofness, which is considered as a sensible requirement from the standpoint of a dynamically stable solution which reduces negociation costs, is used as an added criterion, to obtain an unique solution. The first two chapters of the book provide a good explanation of the method with examples, in particular addressing two classical problems in financial contracting, the risk-shifting problem and the observability problem. The reader would gain a good feel for the essence of the treatise from these first two chapters. The remaining four chapters elaborate on the initial model of financial intermediation by introducing complicating features such as the possibility of endogenously determined bankruptcy, existence of junior debt together with senior debt, possibility of bank ruins and the existence of deposit insurance. The models are of the principal agent type and much of the focus is on the analysis of the incentive effects of some common contractual arrangements and on the design of incentive contracts as a means for the principal to elicit desired response or to resolve conflicts of interest. While these chapters provide a much richer context in which the basic method is applied and, sometimes, draw interesting conclusions in these problems of financial intermediation, they are not central as far as understanding the essence of the author's new method. A brief outline of the author's method follows. Throughout the book, the current value of an asset \(S\) is supposed to follow a geometric Brownian motion \(ds= \mu s dt+ \sigma S dz\), where \(\mu\) is the drift and \(\sigma\) the instantaneous standard deviation of the process. \(z\) denotes the increment of a standard Wiener process. Let \(t\) denote time, \(r\) denote the risk-free rate of return, \(a\) the payout to the holders of the asset per unit of time and \(b\) the payout to the holders of a contingent claim, based on this underlying asset, per unit of time. Let \(F(S,t)\) denote the value of the contingent claim. It is known that \(F\) must satisfy the linear partial differential equation \[ (1/2)\sigma^2 S^2 F_{ss}+ (rS- a)F_s+ F_t- rF+ b= 0, \tag \(*\) \] where subscripts denote partial derivatives. The value of any contingent claim written on \(S\) must satisfy \((*)\), different contingent claims differing only by their boundary conditions. These boundary conditions, together with the parameters of the equation, constitute the factors which may be influenced by the agents' strategies, i.e. these are the alternatives over which choices must be made. As mentioned earlier, a solution is that which may be obtained by backward induction or subgame perfection. As an example, consider a financial intermediary in a competitive market, selling a perpetual put option on an underlying asset \(S\), with an exercise price \(X\), to an investor. At initial time, the intermediary sells the option to the investor for \(a\), as yet undetermined, price \(P^\infty\). The investor holds the option until he decides to exercise it. Let \(S^*\) denote his optimal exercise strategy. At the time of exercise, the payoff to the investor is \(\text{Max} [0, X-S^*]\). Let \(P^\infty (S)\) denote the arbitrage free value of the perpetual put option given \(S^*\), which satisfies the equation \((*)\), where \(P^\infty (\cdot)\) is the function \(F\) which, here, depends only on \(S\) while the parameters \(a\) and \(b\) are 0, together with the boundary conditions \(P^\infty (\infty)= 0\) and \(P^\infty (S^*)= X- S^*\). The closed form solution is given by \[ P^\infty (S)= (X- S^*) (S/S^*)^{-\gamma}, \tag \(**\) \] where \(\gamma= (2r/ \sigma^2)\). It is supposed that the investor chooses his exercise strategy \(S^*\), the free boundary, so as to maximize the value of the option \(P^\infty (S)\). This yields \(S^*= \gamma X/(1+ \gamma)\). Under this anticipation (backward induction) that the investor exercises when it is optimal to do so, the optimal price asked for by the intermediary is the price given by \((**)\) where \(S\) takes the value \(S^*\). The book is clearly written and well worth reading by anyone interested in mathematical models of financial intermediation as well as someone who may be more generally interested in dynamic problems of strategic interaction under uncertainty. The author notes several directions for further research, in particular, that the analysis is carried out in continuous time, whereas modeling in discrete time is more realistic and is an open question.