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Applications of Contingent Claims Theory to Microeconomic Problems

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  • Hennessy, David A.

Abstract

In this thesis contingent claims techniques have been applied to various specifications of the economic problem of optimizing the expected value of a welfare function. In paper I we consider the relationship between financial market completeness, corn production, and the corn target price program. Using the observation that the program is similar to a government issued put option, we found that the per acre program benefit, at around 20/acre was quite large, that the program encourages producers to trade options, and that the existence of contingent markets facilitates the policy maker in decoupling agricultural support. In paper II we proposed a method for estimating the expected cost to the government of the corn target price program. The model is rational expectations in orientation. It allows the government to understand the implications for output and budget control of different program parameter choices. This model may be adapted to other economic problems, such as the effects of wage or rent control laws on production and factor use. In paper III we suggest that there is an inconsistency between the structure of existing contingent claims markets and how economists would seem to prefer to approximate demand functions. We propose an alternative structure that is consistent with the preferred approach to demand function approximation, and with the moment based foundations of Statistics and Probability; In the final paper we propose an alternative perspective on problems involving the maximization of the expected value of a welfare function. We reformulate the objective function in terms of options. We then show that existing techniques from economics, statistics, and finance theory may be applied to better understand the economic effects of uncertainty. Three standard economic problems are considered; valuation of a risky investment, production under price uncertainty, and the effects of price uncertainty on expected profit.
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Suggested Citation

  • Hennessy, David A., 1995. "Applications of Contingent Claims Theory to Microeconomic Problems," Staff General Research Papers Archive 870, Iowa State University, Department of Economics.
    • Handle: RePEc:isu:genres:870
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