In this dissertation, I consider a range of topics in investment and risk management. I seek to understand several existing yet puzzling phenomena from a theoretical perspective.
In the first chapter, we study the optimal insurance demand of a risk- and ambiguity-averse consumer if contract nonperformance risk is perceived as ambiguous. Ambiguity lowers optimal insurance demand and the consumer's degree of ambiguity aversion is negatively associated with the optimal level of coverage. Biased beliefs and greater ambiguity may increase or decrease the optimal demand for insurance, and we determine sufficient conditions for a negative effect. We also discuss wealth effects and evaluate the robustness of our results by considering several alternative models of ambiguity aversion. Our findings show how ambiguous nonperformance risk can undermine the functioning of insurance markets, making it a concern for regulators. Caution is required though because, as we show, demand reactions are only imperfectly informative about the welfare effects of nonperformance risk.
In the second chapter, we address an ongoing debate on pension investment policy: should defined-benefit corporate pension plans invest aggressively in risky securities or completely de-risk their assets? In our model, firms maximize shareholder value subject to the participation constraint of employees, who are wealth-constrained and are partially exposed to pension investment risk via a corporate bankruptcy channel and a pension surplus sharing channel. For a reasonable set of parameter values, the model-suggested optimal pension allocation to risky assets exceeds 50%. The level of pension risk-taking predicted by the model, and its relation with a firm's bankruptcy probability and pension funding ratio, match with empirical observations. We show that due to limited sharing of the investment risk by employees. Defined-benefit pensions may take on even more risk than what employees choose in the defined contribution plans. Further, firms may substantially reduce their overall pension funding costs under an alternative arrangement in which employees bear all the systematic pension investment risk. This is consistent with the secular trend of firms switching from defined benefit plans to defined contribution plans.
In the third chapter, I model the shadow banking mechanism and discusses its functionality of risk sharing and its impact on financial instability. In equilibrium, the shadow banking becomes more active when investors perceive higher expected returns from the capital market. The shadow banking yield arises when the capital market gets more volatile. Lower interest rates from regulated banks encourage the shadow banking and the magnitude of impacts depends on investors' aggregate risk preference. Overactive shadow banking activities can “cool down” themselves. The shadow banking's influence over the economy is twofold: it improves the overall welfare of heterogeneous agents by risk sharing, but it spreads the risk through the financing channel, which makes the savers more vulnerable to the negative shocks in financial markets.