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Risk Management

Brent Ambrose, Smeal Professor of Real Estate and Director of the Institute for Real Estate Studies

Ambrose and his colleague Sumit Agarwal, a financial economist at the Federal Reserve Bank of Chicago, examine the effect of financial institution direct mail (commonly referred to as junk mail) advertising on consumer choice of debt contracts—in particular the choice between fixed-rate versus adjustable-rate home equity loans. Their results indicate that financial advertising can lead to suboptimal financial choices by some borrowers. An example of a "suboptimal choice" is when a borrower selects the advertised line of credit when the economic environment (interest rates and yield curve) and other demographic variables indicate that a fixed-rate loan is best (and vice versa). Their analysis indicates that customers who have the characteristics of being more financially sophisticated (higher incomes and higher credit scores) are more likely to ignore the bank's advertisement and select the optimal loan. They also find that younger customers are more likely to ignore the bank's ad and select the optimal loan. For example, a 56-year old customer is 33 percent less likely to select the alternate loan (i.e., the one not advertised) than a 46-year old customer. Thus, it appears that older customers are more likely to follow the bank's advertising cue than younger customers. From a policy perspective, their study points to the importance of consumer education and greater information disclosure—topics that are especially relevant today given the events in the sub-prime market where some borrowers were misled or confused about the risks of alternative mortgage products.

Gary Bolton, Professor of Business Economics

Bolton is studying how groups make inventory decisions in light of varying levels of experience and access to information that is relevant to the task. Procurement managers and students were asked in a laboratory experiment to order inventory of a perishable item under conditions of uncertain demand and profitability. Decision-making is highly prone to cognitive errors and behavioral biases under these conditions. Procurement managers and students were introduced to more information about demand and profitability as the experiment progressed as well as to strategies for optimal performance. Although the performance of both groups improved, students improved faster than procurement managers because the latter tended to cling to their errors and biases longer than did students. Bolton contends that managers' experience may interfere with their ability to process and learn new information as quickly as students do.

Daniel Cahoy, Associate Professor of Business Law

Cahoy is studying how laws that permit government incursions on patents impact the incentives to create new medicines in the pharmaceutical industry. Many countries—including most recently Brazil, Rwanda, and Thailand—have relaxed pharmaceutical patent rights through compulsory licenses in times of emergency, or simply to save money. Cahoy is investigating whether the presumed protections afforded to patent owners under national and international law actually function to preserve the innovation incentives while increasing access among impoverished nations. He has discovered that the lack of any standard for compulsory license payments poses a serious threat to the entire drug discovery system, but that reasonable means exist for repairing the problem before a crisis occurs. Cahoy and an associate are also investigating the most important future legal disputes in this area by modeling the likely strategies of developed and developing countries in response to compulsory license rules.

Keith Crocker, William Elliott Chaired Professor of Insurance and Risk Management

Crocker’s current research concerns the impact of higher insurance deductibles on consumption of health care services. When deductibles are small, health care consumers tend to "overconsume" these services because they are cheap; but this also raises health insurance premiums. This dilemma can be addressed by rationing health care services, which would be unpopular, or by raising deductibles, which should motivate consumers to choose services more carefully because they are more exposed to the costs of their treatment decisions. Insurance coverage can still provide for catastrophic outcomes. Crocker's research also examines the use of Health Savings Accounts—who would enroll in these plans, how high-risk consumers would fare, and what is the impact of high-deductible plans on the health status of enrollees.

Anthony Kwasnica, Associate Professor of Business Economics

Kwasnica has examined the application of market-based techniques to internal firm forecasting. It is well known that financial markets somehow synthesize individual opinions in order to provide a consensus opinion (e.g., the stock price of a company is the market’s opinion of the future profitability of the company). Decision markets are an attempt to use this same feature to gather information, such as for sales forecasts within a firm. While the prospects for these techniques are exciting, they also require careful and critical examination. Kwasnica’s research examines whether employees can manipulate the markets. Specifically, do the markets provide incentives for employees to provide information that is not honest or results in suboptimal outcomes for the firm? Finally, his research examines how decision markets may be designed to alleviate some of these potential problems. In related research, Kwasnica examined whether similar market-based techniques can be applied to meteorological forecasting.

Anthony Kwasnica, Associate Professor of Business Economics

Kwasnica and Jim Shortle of Penn State’s College of Agricultural Sciences are designing auctions that will encourage bidders to reduce nitrogen run-offs by farmers into tributaries of the Chesapeake Bay. Auctions have been used successfully to reduce sulfur dioxide emissions and are now being used to reduce nitrogen from wastewater treatment plants and from hundreds of small farmers who use fertilizers. The latter are easier to regulate by marketplace techniques than by on-site monitoring. Consequently, the EPA oversees auctions in which wastewater treatment plants can buy certified nitrogen reduction credits from farmers who agree to reduce their level of nitrogen runoffs. Current auctions take only the pledged level of nitrogen into account.  Kwasnica and Shortle believe that project risk ought to be considered in the price also. Otherwise, farmers may choose only simple or less risky projects for the same price—higher prices should encourage greater nitrogen abatement. They are also applying their ideas to the auction of land for grazing by endangered species. Contiguous land is more valuable than isolated parcels of land, and therefore should sell for a higher price.