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We study capital management and investment decisions of a value-maximizing insurance firm with a broad ownership base in a discrete-time setting. We highlight that the valuation measure used to determine the value of the cash flows to shareholders should reflect two economically sound requirements: market-consistency and indifference to idiosyncratic risk. We provide a rigorous construction of this economic valuation measure and use it to derive the optimal capital-management and investment strategies that realize the economic value of the firm. Our objective is to shed light on the controversial question of whether insurers should invest in liquidly-traded risky assets. Decomposing firm value into net tangible value, default option value, and franchise value, we find that whether to take investment risk is optimal or not essentially depends on the tradeoff between the impact of investment risk on the owner’s option to default and on the firm’s franchise value. A variety of numerical examples illustrate how changes in the regulatory and financial environment can result in materially different optimal investment strategies.

Hypothetical Bias (HB) is an ongoing concern for welfare estimates generated from stated preference approaches. Employing a default option has been shown to affect decision-making and outcomes in a...

Regulation of natural monopolies implies strict adherence to the legislation that does not take into account the variety of circumstances of activities and the possible transactions organization options. The litigation between the "Rosneft" and "Sakhalin Energy" companies about the access to the gas pipeline, which connects the gas field in the North of the Sakhalin Island with the liquefied natural gas (LNG) plant in the Southern part of the Island, is analyzed. It is shown that consideration of a broader range of institutional alternatives of the gas transportation organization through an insulated pipeline is necessary. The basis of the regulator decisions is the existence of market for gas transportation services, which in fact is not (and should not be) the default option. An approach to such situations analysis is proposed, it allows covering a wide range of institutional alternatives that could provide a higher level of social welfare. The Grossman-Hart model of incomplete contracts and its verification on real data is used for the demonstration that a simple decision to allow an isolated pipeline access, when the participants of the transaction are independent, can lead to a decrease of the public welfare, compared with alternatives involving integration.

With the ubiquity and prevalence of advanced technologies in society, transactions have become increasingly digital, requiring new user identity verification mechanisms. Electronic identification (eID) enables user identity authorization in online environments. Although eID plays a central role in government initiatives worldwide to digitalize citizen transactions, eID adoption remains surprisingly low. Drawing on digital nudging theory and e-government literature, we examine how eID adoption can be increased by changing the decision environment in which users choose eID. In a controlled experiment with 161 participants, we investigate the effect of default options (eID vs. offline ID as default) and popularity signals (presence vs. absence of social proof) on users’ eID adoption behavior. Both nudges increase eID adoption, but default options are a double-edged sword as they simultaneously fuel privacy concerns towards the government, attenuating the effect of default option on eID adoption. These concerns can be mitigated by adding social proof cues.

This article evaluates the impact of two nudges on stimulating the use of doggy bags in restaurants. We run a field experiment at 14 restaurants in the province of Turin (Italy). In the first group of restaurants, we manipulated the descriptive social norm. In a second group we changed the default option - whereby customers asked for the doggy bag - by instead directing the waiter to automatically deliver the doggy bag unless told not to. A third group of restaurants was used as a control with no intervention. We find that the social norm intervention led to a sizeable increase in the use of doggy bags, while the default manipulation had a non-statistically significant impact.

Digital firms attract consumers and collect their data by offering service enhancements and data security. These require separate types of investment. In light of the GDPR, data collection now requires explicit consumer consent, i.e. opt-in. This changes the consumer default option and the data provision decision when consumers are loss averse. We examine the consequences for investment. We set out the conditions under which opt-in increases both types of investment and when security comes at the expense of service quality. We further find that most consumer types gain, even when service quality falls.

We study whether default options are mispriced in equity prices by employing a structural equity valuation model that explicitly takes into account the value of the option to default (or abandon the firm) and uses firm-specific accounting inputs. We implement our model on the entire cross-section of stocks and identify both over- and underpriced equity. An investment strategy that buys stocks that are classified as undervalued by our model and shorts overvalued stocks generates an annual 4-factor alpha of about 11% for U.S. stocks. The model’s performance is stronger for stocks with higher value of default option, such as distressed or highly volatile stocks. We find similar results in a sample of nine most highly capitalized developed markets.

Risk assessment is a critical audit task, as auditors’ accuracy therein affects audit effectiveness and financial reporting quality, as well as audit efficiency. We propose that risk assessment accuracy for client risks that have changed from the prior year is affected by the manner in which auditors access prior year risk assessments, specifically whether they face a default option created by the prepopulation of current year workpapers with those assessments. We find that auditors with prepopulated (vs. blank) workpapers are less accurate for risks that have changed because they are more likely to stick with last year's assessments, and also to work fast. We then show that auditor characteristics reflecting a preference for accuracy reduce, but do not eliminate, these effects. Finally, we provide exploratory evidence that sticking and working fast are associated with, respectively, motivated reasoning and superficial processing. Collectively, these findings suggest the critical need for an intervention, and also have implications outside auditing.

A sovereign borrower is modelled as a rational calculator choosing levels of investment, consumption, and borrowing to maximize the expected level of a valuation function. The borrowing nation knows that it may opt to default on its debt. The lenders understand this and price their loans to fully compensate for the risk of default. A boundary defines a set of states below which the default option will be exercised. Close to that boundary both consumption and investment are suppressed. The influence of the cost of default is most clear via its effects on the marginal valuations of consumption and investment.

We provide evidence that security design reflects the interplay of capital supplier and security issuer preferences. While call provisions have historically been the default option in convertible security design, only a minority of post-2005 issues are callable. Because hedge funds dominate the market for new convertibles today and because convertible arbitrage is less risky without callability, the recent diminution in the frequency of call provisions in new convertible bond issues illustrates the importance of the preferences of the suppliers of capital in security design.

PurposeThis paper aims to analyse the corporate rent-vs-buy decision on real estate through the trade-off theory and default option in the framework of a corporation that aims to optimise its capital structure.Design/methodology/approachThe methodological core of this paper comprises the trade-off theory that approaches the optimal capital structure by counterbalancing debt tax savings with bankruptcy costs. Impacts on the default option and the default barrier are made explicit. The paper also explores the practical applicability of the renting scenarios in the European context by examining the regimes of real estate investment trusts in different countries from the demand-side of commercial renting.FindingsAnalytical relationships with tax savings, bankruptcy costs, default option and default barrier are identified for the renting-vs-buying real estate decisions.Research limitations/implicationsThe theoretical model assumes simplifications, such as constant debt, to make it operational. The paper centres exclusively on the trade-off capital structure theory.Practical implicationsThis paper is an analysis of corporate real estate decisions together with capital structure. Applications are not only quantitative but also conceptual and strategic.Originality/valueIdentifying the main variables that govern the impact of corporate real estate decisions on capital structure and interweaving different approaches generates a conceptual framework that enlightens strategic thinking in this field.

We study defaults in a novel setting where the optimal choice is clear: the decision to escape from fraud. A government lawsuit created a natural experiment whereby some consumers enrolled in a fraudulent subscription programme were cancelled by default, while others had to actively cancel. We find that cancelling subscriptions by default increased cancellations to 99.8%, 63.4 percentage points more than requiring active cancellation. We also find that consumers residing in poorer, less-educated Census blocks were more likely than average to cancel prior to the lawsuit, but were less likely to actively cancel when notified they could do so. The structure of choices can have a substantial effect on an individual’s behaviour. In particular, the default option, the outcome that occurs when an individual takes no action, can have important impacts. Standard economic theory says that, in absence of substantial transaction costs, the default should not matter, as agents will choose to switch away when the default is not appropriate for them. However, a long literature in behavioural economics and psychology has shown that consumers tend to take no action and stick with the default option. This finding has led to policies designed to guide consumers to better decisions by ∗Corresponding Author: Robert Letzler, Government Accountability Office, Washington DC, 20548, USA. Email: LetzlerR@gao.gov. We are grateful to the editor, two anonymous referees, Patrick McAlvanah, Chris Wheeler, Joelle Abramowitz, Keith Anderson, Alex Bell, Saurabh Bhargava, Rozi Bhimani, Tim Daniel, Pete Dykstra, Marc Elliot, Peter Fishman, Avi Goldfarb, Manoj Hastak, Dan Hosken, Courtney LaFountain, Jesse Leary, Michael LeGower, Janis Pappalardo, Devesh Raval, Brian Rowe, Geno Smolensky, Alex Tang, Joshua Tasoff and Erez Yoeli for helpful comments and support. Eric Schaeffer provided outstanding research assistance. Any opinions expressed in this paper are those of the authors and do not necessarily represent the views of the Federal Trade Commission or the Government Accountability Office.

How a portfolio manager allocates own investment in a target date fund (TDF) series is informative about managerial commitment to the TDF investment principle. We find that TDFs whose managers choose to have zero ownership are associated with more idiosyncratic risk taking. In addition, TDFs with managers investing in remote funds and diversifying across TDFs exhibit high idiosyncratic risk taking. Overall, managerial commitment helps explain TDF heterogeneity; the impact of managerial discretion on fund investment strategies demonstrates externalities to 401(k) participants using TDFs as their default option.

To shed light on the effects of individual choice on pension wealth, we study a policy change to the management fees of pension funds implemented by Peru's government in 2013. The reform established a new balance fee as a default option; this fee is calculated as a percentage of the pension balance. Each individual had the initial option of keeping the previous management fee, a load factor fee calculated as a percentage of the individual's salary. We use administrative data to simulate pension balances based on the individual's choice of fee and the corresponding counterfactual. Our results indicate that the reform has been potentially adverse to 63.1 percent of individuals, of whom 41.4 percent were assigned to the default option and 21.7 percent voluntarily chose the load fee. These results reflect both the potentially negative unintended effects of the policy and an alarming lack of financial literacy among citizens. We also detect heterogeneity in the intensity of the losses and gains due to the reform, which caused greater losses than gains. In particular, younger and poorer individuals, as well as those automatically assigned to the balance fee, experienced higher losses. Moreover, the new fee scheme is also associated with increasing inequality between individuals' pension wealth.

This paper presents a model of choice with limited attention. The decision-maker forms a consideration set, from which she chooses her most preferred alternative. Both preferences and consideration sets are stochastic. While we present axiomatisations for this model, our focus is on the following identification question: to what extent can an observer retrieve probabilities of preferences and consideration sets from observed choices? Our first conclusion is a negative one: if the observed data are choice probabilities, then probabilities of preferences and consideration sets cannot be retrieved from choice probabilities. We solve the identification problem by assuming that an “enriched” dataset is observed, which includes choice probabilities under two frames. Given this dataset, the model is “fully identified”, in the sense that we can recover from observed choices (i) the probabilities of preferences (to the same extent as in models with full attention) and (ii) the probabilities of consideration sets. While a number of recent papers have developed models of limited attention that are, in a similar sense, “fully identified”, they obtain this result not by using an enriched dataset but rather by making a restrictive assumption about the default option, which our paper avoids.

This paper studies the welfare effects of behavioural policies that change a consumer's default option or their cost of optimizing. I find that such policies, though increasingly popular, lead not just to changes in the welfare of optimizers or default-takers in the population—the payoff effect—but also to the membership of those groups—the composition effect. This can lead to costly and potentially counterintuitive effects: improving defaults may actually lower welfare, unlike decision simplification, which is unambiguously positive. Such approaches present a useful policy tool but are not always appropriate, and considerable knowledge of preferences is necessary for effective implementation.

How does setting a donation option as the default in a charitable appeal affect people's decisions? In eight studies, comprising 11,508 participants making 2,423 donation decisions in both experimental settings and a large-scale natural field experiment, the authors investigate the effect of “choice-option” defaults on the donation rate, average donation amount, and the resulting revenue. They find (1) a “scale-back” effect, in which low defaults reduce average donation amounts; (2) a “lower-bar” effect, in which defaulting a low amount increases donation rate; and (3) a “default-distraction” effect, in which introducing any defaults reduces the effect of other cues, such as positive charity information. Contrary to the view that setting defaults will backfire, defaults increased revenue in the field study. However, the findings suggest that defaults can sometimes be a “self-canceling” intervention, with countervailing effects of default option magnitude on decisions and resulting in no net effect on revenue. The authors discuss the implications of the findings for research on fundraising specifically, for choice architecture and behavioral interventions more generally, and for the use of “nudges” in policy decisions.

Motivated by experimental and empirical evidence, I study a framework where reference-points – such as a status quo, endowment, or default option – can distort the way an individual responds to ambiguity. I characterize a model of reference-dependent maxmin expected utility, and provide behavioral foundations for comparing reference-dependent ambiguity attitudes. I also illustrate some implications of reference-dependent ambiguity for trade in an asset market, including underdiversification, no-trade, and the potential for a market collapse.

We test whether people's tendency to stick with the default option can help save resources. In a natural field experiment we switch printers’ default settings, from simplex to duplex printing, at a large Swedish university. The results confirm that roughly one third of all printing is determined by the default alternative, and hence daily paper consumption drops by 15 percent due to the change. The effect is immediate, lasts throughout the experimental period, and remains intact after six months. We also investigate how the more conventional method of encouraging people to save resources performs, and find it has no impact. Recent theoretical and empirical contributions indicate that the default effect works through recommendation, depends positively on the number of alternatives in the choice set, and is reinforced for difficult decisions. We demonstrate that the default option matter in a simple, non-dynamic, decision task with only two alternatives, and where people have been explicitly informed about the recommended course of action.

Within five years of leaving school, 25% of student loan borrowers default on required minimum payments. These defaults are costly: they add to interest and penalties on loans and lower credit scores, which limits access to future credit and can adversely affect job prospects. We ask why so few student loan borrowers enroll in Income Driven Repayment (IDR) plans, which insure against default caused by low earnings. To do so we run an incentivized laboratory experiment using a facsimile of the government’s Student Loan Exit Counseling website. We test the roles information complexity, uncertainty about earnings, and the default option play. We find that switching the default option from the Standard plan with fixed minimum payments to an IDR with income-contingent minimum payments, and providing good information about earnings, can dramatically decrease choice of the risky Standard plan.

China's recently implemented New Rural Pension Scheme (NRPS), the largest social pension program in the world, was designed to provide financial protection for its rural population and reduce economic inequities. Yet the impact of this program is mitigated if those eligible fail to enroll. This paper examines the extent to which pension-eligible individuals, and their families, make optimal pension decisions. Families are involved in the NRPS decisions because, in most cases, adult children need to enroll as a prerequisite of their parents' receipt of benefits. We examine the decisions of both those eligible for pension benefits (i.e. over 60 years old) and their adult children. We use the rural sample of the 2012 China Family Panel Studies to study determinants of the decision to enroll in NRPS, premiums paid, and time taken to enroll.We find evidence of low and suboptimal pension enrollment by eligible individuals and their families. Suboptimal enrollment takes various forms including failure to switch from the dominated default pension program to NRPS and evidence that families do not make mutually beneficial intra-family decisions. For the older cohort, few individual and family characteristics are significant in enrollment decisions, but village characteristics play an important role. For the younger cohort, more individual-level characteristics are significant, including own and children's education. Village characteristics are important but not as much as for the older cohort. Our finding of suboptimal enrollment is important as it highlights the need for policies to improve enrollment. This paper provides needed information on the extent of the factors relating to suboptimal enrollment.

Economists increasingly appreciate the value of studying the time taken to make decisions in order to provide insights into decision makers' choices. This article shows that studying how time is allocated among individual options is also valuable in helping researchers to understand the impact default options have on decision makers' attention allocation, as approximated by how the time is allocated. The study of this impact generates new insights into the well-known choice phenomenon of status quo bias, which typically refers to decision makers' tendency to stick to a default option. By designing a series of novel experiments, I find that this bias arises even when the choice is among prizes of fixed monetary value expressed in arithmetic form. I also find asymmetric attention (i.e., more time devoted to default options) and strikingly asymmetric choice errors; specifically, decision makers fail to select an alternative better than the default 28% of the time, while they incorrectly select an alternative worse than the default only 11% of the time; and provide evidence supporting a causal relationship between asymmetric attention and asymmetric errors. (JEL D03, D12, D83)

We test the effect of advice on the well-known top trading cycles (TTC) matching algorithm. We compare three treatments involving third party advice [right advice (R), wrong advice (W), and both right and wrong advice (RW)] to a no-advice baseline (B). In line with previous literature the truth telling rate is higher than 70% in B, but it does not even reach 30% in W. Truth telling rates are also significantly lower in the other advice treatments when compared to B. This evidence suggests that the majority of participants in matching experiments fail to understand strategy-proofness, as they can be easily influenced by advice. High truth telling rates may just be the result of participants taking a default option.

Companies often encourage consumers to engage in sustainable behaviors using their services in a more environmentally friendly or green way, such as reusing the towels in a hotel or replacing paper bank statements by electronic statements. Sometimes, the option of green service is implied as the default and consumers can opt-out, while in other cases consumers need to explicitly ask (opt-in) for switching to a green service. This research examines the effectiveness of choice architecture and particularly the different default policies—i.e., the alternative the consumer receives if he/she does not explicitly request otherwise—in engaging consumer green behavior. In four experiments, we show that the opt-out default policy is more effective than the opt-in, because it increases anticipated guilt. This effect is stronger for consumers who are less conscious for the environment (Study 1).We also show that a forced choice policy, in which the consumer is not automatically assigned to any condition and is forced to choose between the green and the non-green service option, is more effective than the opt-in policy and not significantly more effective than the opt-out policy (Study 2). Finally, we show that the role of defaults is weakened (enhanced), if a negotiated (reciprocal) cooperation strategy is used (Study 3). The article contributes to the literature of defaults and provides managerial and public policy implications for the design of green services.

In a large number of decisions, the option that does not require a specific action such as filling in a form is chosen frequently. It is a stylized fact that opt-in or opt-out designs for otherwise identical choices lead to vastly different outcomes. Choice options are chosen more frequently simply because they are the no-action alternative or default option. However, direct empirical evidence on the reasons for the popularity of defaults is scarce. We devised a special survey module for the Dutch DNB Household Survey to study potential explanations for default choices. We find that the popularity of the default option is related to different personal traits in economic and non-economic decisions. Financially literate individuals are more likely to take action and opt out the default option in economic decision-making. In non-economic decisions, procrastination increases the popularity of the default while individuals who care much about the opinion of others are more inclined to deviate from the default.

Defaults can influence behaviour in many contexts, from savings to organ donations registrations, but can also reduce an individual’s perception of control if they don’t take into account individual preferences. This paper examines defaults in a charitable giving setting where a preference for control might limit the role of the default option. We run a field experiment with an NGO hosting an online peer-to-peer micro-lending platform. Lenders, who had their microloans fully repaid but had taken no action for over one year, were invited to use their money in one of four ways: withdraw, lend to a new borrower, donate to the NGO, or leave idle. In the control condition, there was no default. In the ‘default loan’ and ‘default donation’ treatments, lenders were told that if they did not take any action their money would automatically be re-lent to a new borrower or donated to the NGO respectively. We find that both defaults increase the proportion of individuals giving and the amount given, compared to the control, and that the increase was largest in the ‘default loan’ treatment. This suggests that aligning defaults with past behavior can increase their effectiveness.

The objective of this article is to examine how default and investment triggers change under different levels of tax asymmetry when firms face nonlinear tax schedules. Under a convex tax schedule, profits are taxed at a higher rate, while losses are taxed (or rebated) at a lower rate, thus reducing the risk shared by the government. This article presents a dynamic model based on the contingent-claims framework to explore the impacts of tax convexity on the triggers, and we find that the impacts vary significantly depending on several countervailing forces. Tax convexity has a nonmonotonic relationship with both the default and investment triggers, because of the government’s risk-sharing role. The default trigger is higher when tax convexity increases, while the growth option exerts a counteracting effect that lowers this trigger, creating an ambiguity in the investment trigger when changing the level of tax asymmetry.

We develop a framework to quantify credit risks of non-traditional mortgage products (NMPs). Ex ante probabilities of default are caused by willingness-to-pay and ability-to-pay problems and the high default rates for NMPs confirm that payment shock is a critical default risk indicator. Monte Carlo simulations are conducted using three correlated stochastic variables (mortgage interest rate, home price, and household income) under normal and stressed economies. Results confirm that the default risk of 2/28 and option ARM contracts requiring a minimum monthly interest payment have a greater probability of default than other mortgage products in all economic scenarios. Additionally, the credit risk of NMPs is primarily systematic risk, suggesting that these products should require higher risk-based capital. Due to the non-linear distribution of credit risk, even the advanced internal-based rating approach of the Basle II framework can understate the risk involved in these NMPs.

It is well documented that people are reluctant to switch from a default option. We experimentally test the robustness of this behavioral inertia in a collective decision-making setting by varying the default option type and the decision-making environment. We examine the impacts of automatic-participation and no-participation default options on subjects’ participation in a public goods provision and their contributions. Two variants of public goods game are employed: the linear and the threshold public goods games. The study shows the evidence of partial stickiness rather than complete stickiness of default options as indicated in empirical studies. Our experimental results square with the evidence of behavioral inertia only when the automatic-participation default is used. This default boosts contributions in the linear public goods game but not in the threshold public goods game. The evidence of partial stickiness is robust to the variation of the game employed, but the effect on contribution is sensitive to it. Published version

If forced to choose a supplementary pension fund, people will decide not to decide, accepting decisions made for them by others (default bias), reaching a status quo position. This study analyses whether the status quo position achieved via the default option in Italian occupational pension funds is later changed over the period studied (2007-2011), and the factors influencing any change.

Individual preferences for environmental policies can be influenced by the frame in which choices and decisions are presented. In this paper we present results of a field experiment on the contributions to carbon offsetting programs under two alternative treatments for the default option. The opt-in treatment asked subjects to pay for the policy proposal while the opt-out treatment asked subjects if they wanted to be excluded from payment for the policy proposal. The results show that the frame of the default option had a significant effect on the amount of money paid for the policy proposal. Subjects were more likely to accept the policy proposal if the default option was the opt-out treatment. The results have implications for the design of environmental policies. Refereed/Peer-reviewed

In this study the Taiwan Insurance Guaranty Fund (TIGF) is introduced to investigate the ex ante assessment insurance guaranty scheme. We study the bankruptcy cost when a financially troubled life insurer is taken over by TIGF. The pricing formula of the fair premium of TIGF incorporating the regulatory forbearance is derived. The embedded Parisian option due to regulatory forbearance on fair premiums is investigated. The numerical results show that leverage ratio, asset volatility, grace period, and intervention criterion influence the default costs. Asset volatility has a significant effect on the default option, while leverage ratio is shown to aggravate the negative influence from the volatility of risky asset. Furthermore, the numerical analysis concludes that the premium for the insurance guaranty fund is risk sensitive and that a risk-based premium scheme could be implemented, hence, to ease the moral hazard.

The objective of the present paper is to investigate the robustness of the well-known result that pre-set default options determine people's choices. We do so by conducting a field experiment among environmental economists attending a large international conference on environmental economics. The participants were, at the time of registration, randomly allocated to different treatments related to carbon offsetting. What differs from earlier default studies is that our subjects have good knowledge about the good at hand. We investigate whether the choices of these experienced individuals are affected by a pre-set default option, and we also study the effect of a treatment with no pre-set default option. Our results, together with previous findings, indicate that the effect of a default option attenuates with experience.

We quantify the effect of recourse on default and find that recourse affects default by lowering the borrower's sensitivity to negative equity. At the mean value of the default option for defaulted loans, borrowers are 30% more likely to default in non-recourse states. Furthermore, for homes appraised at $500,000 to $750,000, borrowers are twice as likely to default in non-recourse states. We also find that defaults are more likely to occur through a lender-friendly procedure, such as a deed in lieu, in states that allow deficiency judgments. We find no evidence that mortgage interest rates are lower in recourse states. The Author 2011. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oup.com., Oxford University Press.

This paper investigates the association between real estate demand and the volatility of population changes. In a financial liberalized housing market, the housing mortgage loan implies insurance function to homeowners through the default option. Larger expected volatilities in the population imply a higher value of the default option. When analyzing the impact of the long-term population development on housing prices, the traditional deterministic population forecasting employed by previous research provides limited credibility. By means of the newly developed stochastic population forecasting methodology and counterfactual numerical simulations, we found a huge volatility associated with long-term population forecasting. A positive correlation between the expected volatility of population changes and real estate demand is ascertained.

The presale contract is a popular property selling method that allows a buyer to default on the remaining payment and/or a developer to abandon a project. Using a simple two-period game theoretical model, we derive a closed-form pricing equation for a presale contract that explicitly accounts for a developer's abandonment option and a buyer's default option. Although a developer has an abandonment option under either a spot sale or a presale method, the option is more valuable under a presale contract because of an additional cash inflow from the presale downpayment. A presale also provides a buyer a default option, which is valuable in a real estate market with uncertain demand and price risk. We analyze the implications of the abandonment option on a developer's construction decision and choice of selling method, as well as the implications of the default option on a buyer's purchase decision. Furthermore, our model framework has implications to the pricing of futures contracts that involve both stochastic revenues and costs.

Differentiated product models are predicated on the belief that a product’s utility can be derived from the summation of utilities for its individual attributes. In one framed field experiment and two natural field experiments, we test this assumption by experimentally manipulating the order of attribute presentation in the product customization process of custom‐made suits and automobiles. We find that order affects the design of a suit that people configure and the design and price of a car that people purchase by influencing the likelihood that they will accept the default option suggested by the firm.

We study multiline insurance companies with limited liability and limited capital, creating the possibility of insurer default. Insurance premiums are determined by no-arbitrage option pricing methods. The results are developed under the realistic assumption that the losses created by insurer default are allocated among policyholders following an ex post, pro rata, sharing rule. In general, the ratio of default costs to expected claims, and thus the ratios of premiums to expected claims vary across insurance lines. Moreover, capital and related costs are allocated across lines in proportion to each line’s share of a digital default option on the insurer. Our results differ from those derived elsewhere in the literature.

This paper presents a systematic framework for capturing the collateral-driven mortgage default risk. A forward-looking home price distribution model is developed that explicitly incorporates different sources of volatility in the market value of collateral houses. A consistent and computationally-efficient top-down approach of home price simulation is also introduced. We show that with the proper inclusion of all relevant sources of volatilities, the top-down approach provides close approximation to the results generated by a theoretically sound but computationally demanding bottom-up simulation approach. Using a numerical simulation, we demonstrate that a geographically-diversified mortgage pool entails a substantially lower level of systematic collateral driven mortgage default risk compared to a spatially-concentrated pool. However, the expected default risk is shown to remain unaffected, indicating that the benefit from geographic diversification is only realized through lower risk-based capital requirements, not in lower mortgage insurance premiums. Based on the US state level house price indices, the systematic risk of a state-concentrated mortgage pool is estimated to be about four times higher than that of a nationally-diversified mortgage pool. Our results also show that, among the different volatility components, omitting the cross-sectional dispersion of individual home prices would produce the largest bias in assessing home-price-based mortgage default risk.

This paper uses a real options approach to analyse the exercise of the default option embedded in mortgages. In particular, it examines a subprime household who borrows at a premium, but hopes to refinance at prime rates if their house appreciates. We show how these optimal default decisions can be used to calculate probabilities of default – an important input for risk management and pricing purposes. Numerical examples are provided, calibrated to US data. In a low interest rate environment, the credit-upgrade potential may discourage subprime borrowers from defaulting. However, default probabilities are highly sensitive to changes in interest rates and house prices. This provides a rational explanation for the prevalence of adjustable rate mortgages among subprime borrowers, and the subsequent large numbers of defaults, when interest rates rose and house prices declined.

In this study we introduce a new stochastic choice rule that categorizes objects in order to simplify the choice procedure. At any given trial, the decision maker deliberately randomizes over mental categories and chooses the best item according to her utility function within the realized consideration set formed by the intersection of the mental category and the menu of alternatives. If no alternative is present both within the considered mental category and within the menu the decision maker picks the default option. We provide the necessary and sufficient conditions that characterize this model in a complete stochastic choice dataset in the form of an acyclicicity restriction on a stochastic choice revealed preference and other regularity conditions. We recover the utility function uniquely up to a monotone transformation and the probability distribution over mental categories uniquely. This model is able to accommodate violations of IIA (independence of irrelevant alternatives), of stochastic transitivity, and of the Manzini-Mariotti menu independence notion (i-Independence). A generalization of the categorizing procedure accommodates violations of regularity and thus provides an alternative model to random utility.

We document changes in borrowers’ sensitivity to negative equity and show heightened borrower default propensity as a fundamental driver of crisis period mortgage defaults. Estimates of a time-varying coefficient competing risk hazard model reveal a marked run-up in the default option beta from 0.2 during 2003–06 to about 1.5 during 2012–13. Simulation of 2006 vintage loan performance shows that the marked upturn in the default option beta resulted in a doubling of mortgage default incidence. Panel data analysis indicates that much of the variation in default option exercise is associated with the local business cycle and consumer distress. Results also indicate elevated default propensities in sand states and among borrowers seeking a crisis-period Home Affordable Modification Program loan modification.

This paper uses unique micro data from Swiss employer-based pension plans to study the annuitization decision at retirement. The administrative nature of our data, though limited with respect to individual background characteristics, allows us to analyze real choices over large retirement balances, rather than subjectively reported intentions to annuitize. We find a strong and robust impact of a utility-based measure of the annuity's value (computed within a life-cycle framework) on individual annuitization rates. Low accumulation of retirement assets is strongly associated with the choice of the lump sum, presumably due to the availability of means-tested social assistance. The sponsor's default option, in most cases the annuity, is also found to be highly influential in the decision to annuitize.

In this paper we focus on an adverse effect of extensive choice widely known as ‘choice overload’. We draw on the case of Swedish funded pensions for illustration and analyze the consequences of the design that allowed for maximizing the choice set. The analysis shows limitations of employing the rational choice approach to the real choice decisions biased with common psychological factors and demonstrates that government’s responsibility for the privatized pension system does not end with the design. We also emphasize the need for a decent default option, which would mitigate socially harmful results of adverse behavior effects like procrastination, status quo bias or abstaining from choice. After all, privatized pension systems still belong to the sphere of public policy.

The determination and allocation of economic capital is important for pricing, risk management, and related insurer financial decision making. This paper considers the allocation of economic capital to lines of business in insurance. We show how to derive closed-form results for the complete markets, arbitrage-free allocation of the insurer default option value, or insolvency exchange option, to lines of business for an insurer balance sheet. We assume that individual lines of business and the surplus ratio are joint log-normal although the method we adopt allows other assumptions. The allocation of the default option value is required for fair pricing in the multiline insurer. We discuss and illustrate other methods of capital allocation, including Myers-Read, and give numerical examples for the capital allocation of the default option value based on explicit payoffs by line.

Research on the effectiveness of credit counseling is surprisingly scarce given its widespread use and given that it has been around for at least three decades. This paper studies the effects of counseling on default by adopting an option-based approach to mortgage termination. Data come from a counseling program developed as result of the collaborative efforts of a large Midwest bank, Community Churches, and a local community development company implemented during the 1992–1996 period. We find some evidence that counseled borrowers defaulted less often than non-counseled borrowers and that counseling affects optimal exercise of the default option.

The purpose of the article is to apply contingent claim theory to the valuation of the type of participating life insurance policies commonly sold in the UK. The article extends the techniques developed by Haberman, Ballotta, and Wang (2003) to allow for the default option. The default option is a feature of the design of these policies, which recognizes that the insurance company's liability is limited by the market value of the reference portfolio of assets underlying the policies that have been sold. The valuation approach is based on the classical contingent claim pricing “machinery,” underpinned by Monte Carlo techniques for the computation of fair values. The article addresses in particular the issue of a fair contract design for a complex type of participating policy and analyzes in detail the feasible set of policy design parameters that would lead to a fair contract and the trade-offs between these parameters.

A default option is the choice alternative a consumer receives if he/she does not explicitly specify otherwise. In this article we argue that defaults can invoke a consumer's “marketplace metacognition,” his/her social intelligence about marketplace behavior. This metacognitive account of defaults leads to different predictions than accounts based on cognitive limitations or endowment: in particular, it predicts the possibility of negative or “backfire” default effects. In two experiments, we demonstrate that the size and direction of the default effect depend on whether this social intelligence is invoked and how it changes the interpretation of the default.

This paper is based on a presentation given at the IBC ‘Pensions Communication’ Conference on 29th April, 2003. It examines the legal issues for trustees of defined contribution occupational pension schemes when selecting a range of investment funds, including default funds and life-style options. The position of employers when selecting personal pensions or stakeholder pensions is contrasted. The paper also considers the implications for UK occupational pension schemes of the USA experience, particularly following the collapse of Enron.

This paper considers the valuation and default exercise policy of risky coupon debt that is secured by a lease-encumbered noisy real asset. For parameter values used in our analysis, asset value noise is shown to reduce the value of waiting to default. Moreover, the borrower is shown to delay default exercise until the noisy signal of asset value is far into-the-money. This latter finding provides an information-based explanation for the apparent under-exercise of the mortgage default option that has been observed in the literature. An implication of this finding is that, if the claimholder recognizes that noise exists, but the empiricist—who is trying to compare observed exercise policy with that predicted by a noiseless model of asset prices—does not, a “sub-optimal” exercise policy may be inferred when in fact the policy is rational given the information available. This explanation is consistent with evidence from mortgage default studies as to why the observed default exercise boundary is lower than that predicted by standard theoretical option-based models.