You are on page 1of 47

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 2
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 Campeau’s acquisition of Federated Stores.
Hostile Takeover Plan

 Robert Campeau vs. Macy’s for Federated

• Conditional vs. unconditional offers
• Flat vs. tiered offers

 Qwest Bond Swap

• Coercive offers
• Staggered offers

 Poison Pills, Saturday Night Specials, etc.

David McAdams 4
Macy’s vs. Campeau
 You are shareholders of Federated,
whose share price is $100.

 Macy’s offers you $105 per share

conditional on getting at least 50%

 Campeau offers an unconditional

tiered offer …

David McAdams 5
Macy’s 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 6
Macy’s vs. Campeau

Do you:
Tender to Macy’s
Tender to Campeau?

David McAdams 7
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
- “A Bond Swap Available Only to Big Players”, NY Times, December 18, 2002.

David McAdams 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.

David McAdams 9
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?

David McAdams 10
Qwest: Some Simple Cases

 Qwest owes $1.5B w/ $600M assets.

• Given success (everyone tenders) Qwest still goes
• 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?

David McAdams 11
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

David McAdams 12
Qwest Continued: When All
Bonds aren’t Created Equal
 In reality, Qwest had many different bond
issues it wanted to retire through these
swaps, with different repayment priority.
 Qwest also didn’t 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?

David McAdams 13
Zwest Game
 Fictional firm Zwest has three
bondholders A,B,C each owed $3M.
 There is some uncertainty about Zwest’s
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.

David McAdams 14
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 don’t, but priority
rankings are preserved between those
that tender and those that don’t.
• 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.

David McAdams 15
Zwest Game #1 (A first)

 Zwest makes A decide first whether

or not to tender, then B, then C

David McAdams 16
Zwest Game #2 (C first)

 Zwest makes C decide first whether

or not to tender, then B, then A

David McAdams 17
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 18
Play Zwest Games!

 I’ll inform you which game your

group will be playing

 Record the progress and the results

on the sheet given to you

David McAdams 19

“The Power to Constrain an

Adversary Depends Upon the
Power to Bind Oneself.”
- Thomas Schelling
Commitment in the
Examples We’ve 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

David McAdams 21
Game within a Game
 So far, we have examined hostile
takeovers as a voting game played
among the target’s 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 …

David McAdams 22
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”

David McAdams 23
Saturday Night Specials
“From the hostile bidder’s 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
- Source, Gibson and Black (1995), “The Law and Finance of Corporate

David McAdams 24
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
management’s 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

David McAdams 25
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
• 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.

David McAdams 26

“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 won’t play”,

and they carried him out feet first.
Druckenmiller said, ‘This is irrational and I’ll
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…

2. Should you sell when you know

you are in a bubble?

3. Bubble Game

4. Lessons learned: Bubble Game

David McAdams 28
Newspapers, academics, and
crystal balls …

 Spotting trends

 The January Effect

David McAdams 29
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”

David McAdams 30
Spotting Trends

Mark Twain, in Pudd’nhead 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: Jan, June, July, Dec
 Bad: 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 naïve analyst will identify
(with 95% false confidence!) a day of the month
on which the markets have historically
performed better than average.

David McAdams 32
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

David McAdams 33
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

David McAdams 34
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.

David McAdams 35
What Should You Do?
 Careful research has shown that
there was a January effect from

 Should you go buy small-caps this


David McAdams 36
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.”

David McAdams 37
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

David McAdams 38
 What is a bubble?

 How do bubbles start?

 How do bubbles persist?

 How do bubbles burst?

David McAdams 39
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)

David McAdams 40
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 naïve realize
their error and the bubble bursts.
David McAdams 41
How Do Bubbles Start?
 You are an investor in the early
 The masses believe that the South
Seas Company’s 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?!

David McAdams 42
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

David McAdams 43
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 don’t know if you were the first to
learn, the second, … or the last!

David McAdams 44
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 45
How Do Bubbles Persist and
 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 46
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.

David McAdams 47