Applying Game Theory to Finance

I can calculate the motions of heavenly bodies, but not the madness of people
- Isaac Newton, upon losing 20,000 in the South Sea Bubble in 1720

Game Plan

Hostile Takeovers Bubbles

David McAdams

Hostile Takeovers
Robert Campeau is considered by many as the best example of a fool.
- Dale Oesterle, Cato Review of Business & Government, 1996

The biggest, looniest deal ever."

- Fortune Magazine, July 1988, on Campeaus acquisition of Federated Stores.

Hostile Takeover Plan

Robert Campeau vs. Macys for Federated

Conditional vs. unconditional offers Flat vs. tiered offers

Qwest Bond Swap

Coercive offers Staggered offers

Poison Pills, Saturday Night Specials, etc.

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Macys vs. Campeau

You are shareholders of Federated, whose share price is $100. Macys offers you $105 per share conditional on getting at least 50% Campeau offers an unconditional tiered offer
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Macys vs. Campeau

If less than 50% tender to him, then each gets $110 per share. If X% > 50% tender to him, then each gets a blended price of

50% * $110 ( X 50)% * $80

Campeau pays $80 extra per share beyond 50% If everyone tenders, Campeau pays $95 per share If Campeau wins and you have not tendered, then Campeau will be able to buy you out at $80

David McAdams

Macys vs. Campeau

Do you: Tender to Macys OR Tender to Campeau?

David McAdams

Qwest Bond Swap

Today a federal judge will decide whether Qwest can proceed with an exchange offer in which institutional investors (in a $1.5B issue) are being asked to exchange each $1,000 bond for a new one with face value $545. The offer is a coercive one that will leave bondholders who do not accept it in the back of line for repayment if Qwest goes broke
David Big Players, NY Times, December 18, - A Bond Swap Available Only toMcAdams 8

Qwest Bond Swap

If Judge Chin allows the offer to go ahead, institutional investors who own bonds will find themselves in a position with some resemblance to the classic prisoners dilemma... If no one tendered, then Qwest would be in the same position as before the offer, and any bondholder would be no worse off. But if a lot of holders tender, those who refuse will be worse off than they were.
- A Bond Swap Available Only to Big Players, NY Times, December 18,
2002.
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Qwest Coercive Bond Swap

How is / is not the game played among bondholders similar to the Prisoners Dilemma? Why exclude non-institutional investors from the offer?
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Qwest: Some Simple Cases

Qwest owes $1.5B w/ $600M assets.

Given success (everyone tenders) Qwest still goes bankrupt Is it a dominant strategy to tender?

Qwest owes $1.5B w/ $1B assets

Given success, Qwest avoids bankruptcy Is it a dominant strategy to tender?

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Qwest: Less Simple Cases

Qwest owes $1.5B w/ assets that are worth either $600M or $1B.
Given success, it avoids bankruptcy w/ Prob($1B)=45% Is tender a dominant strategy here? for higher or lower Prob($1B)?

Same as above but $300M worth of bondholders are excluded from the deal
Tender becomes a dominant strategy for the $1.2B who remain
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Qwest Continued: When All Bonds arent Created Equal

In reality, Qwest had many different bond issues it wanted to retire through these swaps, with different repayment priority. Qwest also didnt issue its swap offers for all of its issues at once but rather staggered the offers
Does the order matter?

Should Qwest swap high-priority bonds first or low-priority ones?

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Zwest Game

Fictional firm Zwest has three bondholders A,B,C each owed $3M.
There is some uncertainty about Zwests future assets: Zwest will have $5 million with 66.7% and $8 million with 33.3%. Absent any tendering, A gets repaid first followed by B, then C.
Since assets are always less than $9 million, Zwest always goes bankrupt and has equity value of $0.

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Zwest Game

Zwest will offer A,B,C each to exchange their $3M bond for a priority $2M bond.
Those who tender will have higher priority than those who dont, but priority rankings are preserved between those that tender and those that dont.
Example: if only B tenders, then B is paid $2M first then A is paid $3M then C is paid either $0M or $3M, depending on whether asset value is $5M or $8M.

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Zwest Game #1 (A first)

Zwest makes A decide first whether or not to tender, then B, then C

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Zwest Game #2 (C first)

Zwest makes C decide first whether or not to tender, then B, then A

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Play Zwest Games!

Group into three pairs to play (you and a partner will play together)
Roll a die to see who is A, B, C

With your partner decide which game you would rather be playing (in your role), and write this down with your names and a brief explanation
Your choice will not affect which game you ultimately play

David McAdams

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Play Zwest Games!

Ill inform you which game your group will be playing Record the progress and the results on the sheet given to you

David McAdams

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Commitment

The Power to Constrain an Adversary Depends Upon the Power to Bind Oneself.
- Thomas Schelling

Commitment in the Examples Weve Seen

Campeau committed to paying the high price $110 even if he failed to gain control
This allowed him to avoid failure, since shareholders would all want to tender if he were going to fail

Qwest committed not to renegotiate later with the non-tenderers

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Game within a Game

So far, we have examined hostile takeovers as a voting game played among the targets stockholders
But actually the shareholder vote is a game within a game
Entrenched management, the raider, and other suitors strategize over influencing shareholders options and incentives in the forthcoming vote That in itself is a game
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Bitter Pills

Numerous ways for entrenched management to increase the cost of a takeover (Shark Repellant)
Poison Pills Macaroni Defense

and for raiders to fight back

Lady MacBeth Strategy Saturday Night Special

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Saturday Night Specials

From the hostile bidders perspective, the most critical element in contrast to substantive matters such as the price offered and the number of shares sought is speed If the hostile bidder can structure its offer so that target shareholders must decide to tender before a competitive bid can be arranged, a substantial advantage will be secured
- Source, Gibson and Black (1995), The Law and Finance of Corporate Acquisitions
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Game within a Game within a Game (within a Game)

Management needs shareholders to approve a Poison Pill. Thus, shareholders and management play a game long before raider arrives. Yet one layer deeper: Poison Pills remove managements incentive to take more drastic, self-destructive behavior
If management can commit to adopt such a Scorched-Earth Policy, then shareholders will be more willing to grant a Poison Pill
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Role of Regulation

Players may strategically commit to strategies that reduce overall gains from the game. Beneficial regulation shapes the options available to players so that the options they will likely choose lead to better outcomes.
Saturday Night Specials were made illegal by the Williams Act of 1968, which stipulated that any tender offer must be kept open for at least 20 days.
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Bubbles
We thought it was the 8th inning, and it was the 9th
- Stanley Druckenmiller, former manager of Soros Quantum Fund, April 2000.

Julian said, This is irrational and I wont play, and they carried him out feet first. Druckenmiller said, This is irrational and Ill play, and they carried him out feet first.
NYTimes April 29, 2000: Another Technology Victim; Soros Fund Manager Says He Overplayed Hand. (Julian Roberts managed Tiger Hedge Fund, dissolved in 1999.)

Bubbles: Game Plan

1.

Newspapers, academics, and crystal balls

Should you sell when you know you are in a bubble? Bubble Game Lessons learned: Bubble Game
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2.

3. 4.

Newspapers, academics, and crystal balls

Spotting trends

The January Effect

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Spotting trends

__ __ __ __
__ __ __ __

is typically a strong month for stocks tends to be a good month for stocks has historically been a strong month is usually a great month for stocks
is often a negative month for stocks. tends to be a bad month for stocks is traditionally a poor month for stocks is a scary month for stocks

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Spotting Trends
Mark Twain, in Puddnhead Wilson:

October. This is one of the peculiarly dangerous months to speculate in stocks in The others are July, January, September, April, November, May, March, June, December, August, and February.

Spotting trends
Sources: Motley Fool, CNN, USA Today, Dow Jones, Dean Inv. Ass.

Good: Bad:

Jan, June, July, Dec Mar, Aug, Sep, Oct

If each month is equally likely to go up or down, there is an 80% chance that some month will be bad three years in a row! 80% of the time, a nave analyst will identify (with 95% false confidence!) a day of the month on which the markets have historically performed better than average.
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January Effect

Tendency of the stock market to rise between December 31 and the end of the first week in January.
Well-documented by a spate of scholarly research in the 1980s

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Sampling of Research (USA data up to 80s)

In equally-weighted portfolio, average return 3.5% in January, only .5% in others

Excess returns not seen in DJIA, so effect limited to and more pronounced in small stocks Over half of excess return on small stocks in Jan.

Excess returns greatest for small firms whose prices have declined previous year
Excess returns in first five days not observed for winners of previous year
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Sampling of Research (non-USA data up to 80s)

January returns exceptional in 15/16 countries studied.

In Belgium, Netherlands, Italy, January return exceeds the return for the whole year!

Taxes appear confirmed as part of story

Britain has April effect, Australia has July effect.

January itself seems significant

Effect in Japan (where no capital gains) as well as Britain and Australia.
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What Should You Do?

Careful research has shown that there was a January effect from 1900-1980.
Should you go buy small-caps this December?

David McAdams

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January Defect?
Source: The Independent Adviser for Vanguard Investors, December 10, 2002

In the past few years, the January effect has been more of a January defect as investors, trying to get an edge on their competitors, have jumped earlier and earlier. In some cases the January effect takes place in November or even December.
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Most Recent Research

The Declining January Effect: Evidences from the U.S. Equity Markets Source:Quarterly Review of Economics and Finance v43, n2 (Summer 2003): 395-404

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Bubbles

What is a bubble?
How do bubbles start? How do bubbles persist? How do bubbles burst?
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A Simple Model of Bubbles

A structural change leads unsophisticated investors to conclude there is a new economy with permanently higher growth (and permanently rising prices!).
South Sea bubble in 1700s Tech bubble in 1990s

BUT sophisticated investors know that the growth spurt is temporary and will return to normal levels
Still, no one knows how long high growth will last
This model is based on Abreu and Brunnermeier, Bubbles and Crashes, Econometrica (2003)
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A Simple Model of Bubbles

Sophisticated investors begin to realize that the growth spurt has ended after the fact and not all at the same time. As long as a majority of sophisticated investors stay invested, price continues to increase at a high rate. (This is an assumption.)
For our purposes, bubble = majority of sophisticated investors know that growth has stopped, but still a majority stays invested.

BUT once a majority of sophisticated investors have sold, the nave realize their error and the bubble bursts.
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How Do Bubbles Start?

You are an investor in the early 1700s. The masses believe that the South Seas Companys price is sure to rise at high rates permanently. To your surprise, you learn that South Seas trade is a dud! Should you sell immediately?!

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Bubble Game: Rules

5 players 10 periods. Decide Buy/Sell in each

After period 10, Price will revert to Value

Price process
Price = Value = $1 at start Price doubles each period until 3 or more sophisticates have sold

Player payoffs
Once you Sell, you are done and get current price. If you still own when 3 others have sold, you get current Value
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Bubble Game: Rules

Value process
Value doubles each period during the growth period.
I will flip a coin each period to determine whether growth has ended (beginning after round 1). Example: If growth stops after round 3, then value = price ($1, $2, $4) in periods 1,2,3 but value = $4 in all periods T > 3 whereas price keeps on doubling. When bubble bursts, price falls back to $4.

Information process
Once growth ends, one randomly chosen player will immediately learn that it has ended The next period, a second player will learn that it has ended, and so on Note: Upon learning, you dont know if you were the first to learn, the second, or the last!
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Sell Immediately Upon Learning: Nash Equilibrium?

Suppose that all others are following the strategy of selling immediately upon learning that growth has stopped (but not before)
Should you sell immediately upon learning yourself?

David McAdams

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How Do Bubbles Persist and Burst?

Play the Bubble Game to find out!! Form groups of four or five so that there are ten groups total
Select one from among you to represent your group. Discuss among yourselves how to play no discussion will be allowed once game begins Consult hand-out for more detailed info on game

We will play two iterations of the Bubble Game, then discuss for lessons learned

David McAdams

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News and Overreaction

We have seen that bubbles can exist even when there are numerous rational players BUT bubble can only persist when these players are relatively uncertain about when others are going to sell Even small news events can serve as coordinating devices that allow / force the rational investors all to escape the bubble The response is not an overreaction to the news but the bubble bursting
Note: This does not explain why the stock market moves a lot with every news story.
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