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Abstract:
This paper demonstrates that preferred stock may arise as an optimal security in a tax-induced equilibrium. This result is driven by graduated tax schedules and by uncertainty. In a more general sense, our results can be interpreted as a template for including any security with a different tax treatment in a firm's capital structure. The first part of the paper demonstrates that the Miller (1977) equilibrium framework can accommodate more than two securities if different investor classes are taxed differently on each security and the tax schedule for each investor group is upward sloping. We then simplify the tax schedule, but introduce uncertainty, which implies the possibility of bankruptcy and the possible loss of tax shelters. The interaction of tax rates and seniority now affects the contribution of each security to after-tax firm value, as in some states the firm may not be able to pay either interest (or dividends) or even principal to its various claimholders. It is shown why and how these features, i.e. the various tax rates and seniority, determine the financing equilibrium, which is obtained by equating the expected marginal tax benefit of all securities. We demonstrate that non-profitable firms will tend to issue preferred shares whereas profitable firms will not find preferred stock advantageous in our framework. Comparative statics with respect to various tax rates are derived as well. These predictions are tested using a large sample of firms for the last twenty-five years. The empirical testing broadly confirms the theoretical predictions.

Abstract:
In this paper, we analyze the investment patterns of a large number of clients of a major Israeli brokerage house during 1994. We compare the behavior of clients making independent investment decisions to that of investors whose accounts were managed by brokerage professionals. Our main objective is to investigate whether the disposition effect (i.e., the tendency to sell winners quicker than losers), demonstrated in the US only for individual investors, also holds for professional investors. This analysis is important, as accepted financial theory predicts that prices are determined mainly by decisions made by professionals. We show that both professional and independent investors exhibit the disposition effect, although the effect is stronger for independent investors. The second objective of our study is the comparison of trade frequency, volume and profitability between independent and professionally managed accounts. We believe that these comparisons not only provide insights of their own, but also help to put the differences in the disposition effect in a wider perspective. We demonstrate that professionally managed accounts were more diversified and that round trips were both less correlated with the market and slightly more profitable than those of independent accounts.

Investor behavior, Disposition effect, Professional vs. amateur investment decisions, Churning

Abstract:
One of the most intriguing questions in insurance is the preference of consumers to buy low or no deductible insurance policies. This stands in sharp contrast to the theorem, proved by Mossin, 1968, that when the price of insurance is higher than its actuarial value, then under quite reasonable assumptions full coverage is not optimal. We show in a set of experiments that amateur subjects tend to underestimate the value of a policy with a deductible and that the degree of underestimation depends on the level of the deductible. This implies that a policy with a deductible priced according to the true expected payments may seem "overpriced" to the insured and therefore may not be purchased. Since the values of full coverage policies are not underestimated, the insured may find them as relatively better "deals".

Abstract:
This paper evaluates the common practice of setting the strike prices of executive option plans at-the-money. Hall and Murphy, 2000, claim this practice to be optimal since it maximizes the sensitivity of compensation to firm performance. However, they do not incorporate effort and the possibility that managers are effort averse into their model. We revisit this question while explicitly introducing these factors and allowing the reward package to include fixed wages and options or stock grants. We simulate the firm's decisions and the manager's effort choice under alternative compensation schemes and identify schemes that are optimal. Our simulations indicate that when abstracting from tax considerations, it is optimal to establish the strike price in-the-money. However, when issuing in the money options creates tax related disadvantages, it may be optimal to issue at-the-money options. We show that the above result holds both in the case when the strike price is linked to an economy-wide benchmark and when it is not benchmarked. Our simulations also indicate that issuing options with benchmarked strike prices usually dominates issuing options with non-benchmarked strike prices.

Abstract:
We study herding behavior of amateur and professional investors using a unique data-set consisting of all their daily transactions during a four-year period, and explore the factors that can explain such behavior and examine to what extent is herding information-driven. We distinguish between stock specific features such as systematic risk, idiosyncratic risk, and size, on the one hand, and market factors such as total stock market volume and returns on the other hand. We find herding a tendency among both types of investors and that this tendency is higher for amateurs. Herding is affected by both risk and size: it is a decreasing function of the size of the firm, and an increasing function of its risk. Idiosyncratic risk tends to positively affect herding but this effect is significantly lower for professionals. Systematic risk however positively influences only herding by professionals. Our data also reveal that herding behavior of the two groups is a persistent phenomenon, and that it is closely related to the volatility of market returns. In addition, amateurs' herding is weakly related to market returns. Most of the results are consistent in general with the theory that herding is information-based.

Herding, professional investors, amateur investors, behavioral finance

Abstract:
This paper explores the impacts of managerial overconfidence on the structure of executive compensation, managerial effort, and the welfare of stockholders and managers. Our findings help explain two puzzling corporate finance phenomena. The viability of managerial overconfidence is perplexing since it has been shown to lead managers to erroneous and costly decisions. Our simulations indicate that managerial overconfidence induces managers to exert higher effort levels, and thus helps mitigate a well known agency problem. We construct a measure of the combined welfare of managers and stockholders and show that it is directly related to managerial overconfidence. This provides partial support to the persistence of the overconfidence behavioral bias. The optimality, and hence the viability, of the common practice of providing executive stock options with strike prices at-the-money is another debated issue since it is not based on well founded theory and its main benefits are tax advantages that expired in 2006. We show that the optimal strike prices for overconfident managers are in-the-money as those for realistic managers, but they are higher for the former, and therefore closer to the at-the-money strike prices provided in practice. We show that this implies that the tradition of offering executives stock options with at-the-money exercise prices is less damaging than hitherto believed.

Overconfidence, Managerial Effort, Incentive Options, Strike Price

Abstract:
One of the most intriguing questions in insurance is the preference of consumers for low or zero deductible insurance policies. This stands in sharp contrast to a theorem proved by Mossin, 1968, that under quite common assumptions when the price of insurance is higher than its actuarial value, then full coverage is not optimal.

We show in a series of experiments that amateur subjects tend to underestimate the value of a policy with a deductible and that the degree of underestimation increases with the size of the deductible. We hypothesize that this tendency is caused by the anchoring heuristic. In particular, in pricing a policy with a deductible subjects first consider the price of a full coverage policy. Then they anchor on the size of the deductible and subtract it from the price of the full coverage policy. However, they do not adjust the price enough upward to take into account the fact that there is only a small chance that the deductible will be applied toward their payments. We also show that professionals in the field of insurance are less prone to such a bias. This implies that a policy with a deductible priced according to the true expected payments may seem "overpriced" to the insured and therefore may not be purchased. Since the values of full coverage policies are not underestimated the insured may find them as relatively better "deals".

Anchoring, discounting, insurance, decision making, premium

Abstract:
This paper compares the trading patterns of amateur and professional investors during the days following the weekend. The comparison is based on all the daily transactions of a sample of both amateurs and professionally managed investors in a major brokerage house in Israel from 1994 to1998. We find that weekends influence both amateurs and professional investors; however they affect them in opposite directions. Individuals increase both their buy and sell activities, and their propensity to sell rises more than their propensity to buy. Professionals on the other hand tend to perform fewer buy as well as sell trades after the weekend, but unlike individuals, the drop in their activity is almost the same for buy trades and for sell trades.

The results agree with previous hypotheses raised in the literature, but not directly tested, about the effects of the weekend on the predisposition to trade of individuals and institutions in other markets. We also find that returns on the Israeli Stock Market Index are correlated in general with the behavioral patterns exhibited by the investors in our sample. In particular the returns on the days following the weekend are lower than those in other weekdays in a manner consistent with the behavioral patterns we found.

Weekend effect, Professional and individual investors' behavior, Behavioral finance