Essays in multiperiod risk management with information updating

Essay I addresses an apparent paradox: risk managers try to avoid negative earnings surprises, yet they hedge risks uninformative of the value of the company. Using a game-theoretic model with informational asymmetry between insiders (managers) and outsiders (investors), this is shown to be a rational response consistent with shareholder value maximization. Investors derive information about company value from its net earnings, but the information revealed through earnings, and hence the stock price movement, depends on the risk management strategy pursued by managers. Fully revealing earnings information is in the investors' interest, so they design a compensation package to induce managers to make the earnings fully informative. Under plausible assumptions, managers will select the efficient hedge strategy if their compensation includes stock options. This result challenges the notion that options induce suboptimal hedging, and helps explain the rationality behind apparent overreactions of stock prices to earnings surprises. Essays 2 and 3 offer a new explanation for the thin private market for individual annuities. Individuals face a risk of health shocks which cause expenditures and simultaneously shorten life expectancy. After a health shock, a life annuity loses value at the same time as the need to liquidate it arises. When the risk of such shocks is substantial, it is not optimal for risk-averse agents with uncertain life span to hold all of their wealth in life annuity form, contrary to the classic result. An overlapping-generation economy is modeled in a dynamic programming computational model with emphasis on the demand for life annuities. The model is used to estimate the demand for life annuities, relative significance of the factors that affect the demand (bequest motives, premium loadings, Social Security and random health shocks), and the macroeconomic effects of the resulting savings and annuitization choices. Health shocks by themselves reduce the aggregate demand for annuities slightly, but they amplify the effects of premium loads and other factors, so that low levels of annuitization are consistent with rational choice for plausible values of preference parameters.