Thursday, October 18, 2007

Moral Hazard, Bond Girls, and the "Anderson put"

For some student responses to the post below, see here.

I wound up canceling my midterms in both corporate finance and international business transactions - idiotic problems getting the relevant book in the bookstore and other silly stuff. In lieu of the midterm, however, I informed the two classes that I wanted them to post to the class discussion board a response to one of the following questions:

1. By canceling the midterm, have I created moral hazard or not? Explain, in relation to this class, future classes, and the final exam.

2. I have occasionally expressed the view, after seeing the last Bond movie, Casino Royale, that "Moral Hazard" would be a great name for a Bond Girl. Regardless of what you think of that idea, can you construct a Bond plot in which Moral Hazard is not just cute flirtation, but becomes a true pun by also having a financial meaning within the story? Tell me the proposed Bond movie plot.

3. We have discussed in class the so-called Greenspan put and the so called Bernanke put - the moral hazard situation created by figuring out that the Fed will take away your risks at the last moment and insure you against losses - you are able to "put" your risks to the Fed. Very well. My midterm has a very special grading mechanism - it is graded, but with the following conditions.

Because it is a finance terminology midterm, using multiple choice questions to test finance vocabulary questions taken from the finance dictionary and basic business concepts taken from the Hamilton Business Basics book, designed to induce students who didn't study business or economics to learn about these subjects in a "safe space," performance on the midterm can help you but cannot hurt you in the final grade. However, it only helps you at the lower end of the grade scale - it will raise your C to a B- or even a B, but it will not raise your B+ to an A- or an A. It is an insurance policy to give you confidence that you won't clobber your GPA in a class in which you are not on an even playing field with students who studied this subject as undergrads.

(This is hugely important given grade compression/inflation at law school - a single B+ may be enough to knock you out of the top 15%, for example, and so induces extraordinarily risk averse behavior among law students. Separate topic of discussion, but quite important in understanding law student behavior these days.)

Query: given that I have canceled the midterm but, out of consideration for those students who might actually have studied for it by now, I am giving full credit to everyone for it - ie, giving the benefit of this insurance policy. Could this be described, on analogy to the Fed, as the "Anderson put"? Why or why not?

(Update, October 22. Two thoughts from the responses my students have so far given me. The first is that the students tend to think of moral hazard as resulting in irrational behavior - they don't seem to understand that the point of moral hazard is that it shifts the margin for rational behavior outwards to encompass stuff that otherwise would have been irrational but now is not. The second is that the best response anyone has given to the question of whether my canceling the midterm has resulted in moral hazard - and given that I said that posting to the discussion board was mandatory in lieu of the midterm - was the student who said, Professor Anderson likely won't know whether he has created moral hazard or not, because the best evidence that he has created moral hazard will be the students who, notwithstanding that he said posting was mandatory, figure it's really not and don't bother to post at all. The proof of moral hazard will be the students who figure that there are no mandatory midterm requirements anymore and hence little disincentive to not posting. Hmm.)