Pricing executive stock options under employment shocks

We obtain explicit expressions for the subjective, objective and market value of perpetual executive stock options (ESOs) under exogenous employment shocks driven by an independent Poisson process. Previously, we obtain the executive's optimal exercise policy from the subjective valuation that is necessary for the objective one, or fair value. The perpetual ESO is compared with the true finite maturity ESO finding that the approximation is reasonably good. To illustrate the usefulness of the objective valuation for accounting purposes, we analyze the statistical distribution of the fair value when there is uncertainty about the employment shock intensity. Finally, the role of ESOs in the design of executives’ incentives is also discussed.     

Backdating executive stock options—An ex ante valuation

When backdating executive stock options (ESOs), the exercise price is set in favor of the recipient executive. Relative to a non-backdated benchmark, we find an (ex ante) upper bound for the cost of backdating to shrink from 10% to about 3.7%, as a consequence of the regime change represented by the Sarbanes-Oxley act (SOX).We frame the backdating behavior as a (compound) exotic option, considering both simple and extended models of the underlying ESO—in the latter case we draw on the analytical ESO models of Sircar and Xiong (2007). Post-SOX, we use a Longstaff-Schwartz inspired least squares Monte Carlo approach.     

Optimal consumption and investment under partial information

We consider a stock market model where prices satisfy a stochastic differential equation with a stochastic drift process. The investor’s objective is to maximize the expected utility of consumption and terminal wealth under partial information; the latter meaning that investment decisions are based on the knowledge of the stock prices only. We derive explicit representations of optimal consumption and trading strategies using Malliavin calculus. The results apply to both classical models for the drift process, a mean reverting Ornstein-Uhlenbeck process and a continuous time Markov chain. The model can be transformed to a complete market model with full information. This allows to use results on optimization under convex constraints which are used in the numerical part for the implementation of more stable strategies. Supported by the Austrian Science Fund FWF, project P17947-N12. We thank two anonymous referees for their comments which led to a considerable improvement of the paper.     

Can a stochastic cusp catastrophe model explain housing market crashes?

Like stock market prices, housing prices often exhibit temporary booms and busts. A possible explanation for the observed abrupt changes is offered by the stochastic catastrophe model. This paper addresses the question whether the catastrophe model can describe and predict the dynamics of housing markets. We fit a stochastic cusp catastrophe model to empirical housing market data for six OECD countries, US, JP, UK, NL, SE and BE. Two different estimation approaches are considered – Cobb׳s method and Euler discretization. The analysis shows that while Cobb׳s approach describes the long-run stationary density better, Euler discretization is more tailored for time series, as it provides better one-step-ahead predictions. Proceeding using the Euler discretization method we discuss the dynamics of housing markets in terms of the multiple equilibria cusp catastrophe model. By considering the long-term interest rate as an exogenous variable we obtain new insights into the policy implications of interest rate levels, in particular concerning the stability of housing markets.     

Alternative estimation method of earnings growth rate for PEGR strategy

The ambiguous return pattern for the PEGR (the ratio of the stock’s price/earnings to its estimated earnings growth rate) strategy has been documented in literature for the US stock markets. As stock prices and earnings per share (EPS) are objective data, earnings growth rate, however, is estimated by analyst whose method partial explains the PEGR vague return pattern. The purpose of this study is not to deny or substitute analysts’ estimation, but rather, to provide a simple and popular method, log-linear regression model, to forecast the earnings growth rate (G), and examine whether the typical PEGR effect, such as PER (price/earnings ratio) or PBR (price/book ratio) effect, exists by using our alternative estimation method. Our evidence indeed shows that returns on the lowest PEGR portfolio not only dominate over all higher PEGR portfolios, but also beat the market with stochastic dominance (SD) analysis, which is consistent with our prediction. Our results, at least, imply that using the log-linear regression model to construct the PEGR-sorted portfolios can benefit investors and the model is also a good choice for analysts in their forecasting.     

The mean-variance investment problem in a constrained financial market

This paper extends the mean-variance analysis and the two-fund separation theorem to a market with some constraints, such as, the incompleteness, prohibition of short-selling, and partial information, with stochastic interest rate, and with stochastic volatility for risky assets. By maximizing a quadratic utility of terminal wealth, we show that the efficient frontier for the problem is a straight line in the mean-standard-deviation diagram. The quadratic utility function exhibits mean-variance efficiency. Our results apply to portfolios of claims in a single period, multiperiod, and continuous time.     

Duration dependence testing for speculative bubbles

Prior research has employed a number of methods to test for speculative bubbles in asset prices, including a method based on the concept of duration dependence. This study explores whether duration dependence tests for speculative bubbles are sensitive to specification decisions. Our results question the efficacy of using measures of duration dependence to test for speculative bubbles. In particular, we find that evidence of duration dependence is sensitive to the method of correcting for discrete observation of continuous duration, the use of value-weighted versus equally weighted portfolios, and the use of monthly versus weekly runs of abnormal returns. (JEL C41, G12)     

Catastrophe equity put options with floating strike prices

In this study, we extend the results in Cox et al. (2004) by considering floating strike prices, which are affected by accumulated losses. We employ a compound Poisson process to describe catastrophe losses and adopt a mean-reverting square root process to capture the volatility of the underlying stock. In the numerical section, we first compare the differences in the prices of the options with fixed and floating strike prices. In addition, we illustrate the variance of the portfolios consisting of the stock and options with alternative kinds of strike prices by holding the total cost of the options constant. Variance-optimal portfolios are also investigated. Interestingly, numerical results show that the portfolios consisting of the stock and options with floating strike prices have lower variances in all cases, even when we hold the total option costs constant.     

Supply chain management executives in corporate upper echelons

Supply chain strategies and their implementation have been recognized as a source of competitive advantage. According to the principle “structure follows strategy”, we expect the number of firms having supply chain management (SCM) functions represented on their top management team (TMT) to have increased in the past years. However, little is known about the degree to which executives responsible for SCM functions (i.e., Chief Supply Chain Officers) are present or absent in TMTs and if their presence is related to firm performance. Therefore, we study the TMTs of large US corporations and show that SCM is present in upper echelons, either through executives whose responsibilities explicitly include SCM or indirectly by executives, especially CEOs, who had acquired SCM experience in their previous positions. However, firms׳ operating margins are lower when a Chief Supply Chain Officer is present in the TMT.     

Lasso-based index tracking and statistical arbitrage long-short strategies

In this paper, we apply the lasso-type regression to solve the index tracking (IT) and the long-short investing strategies. In both cases, our objective is to exploit the mean-reverting properties of prices as reported in the literature. This method is an interesting technique for portfolio selection due to its capacity to perform variable selection in linear regression and to solve high-dimensional problems (which is the case if we consider broader indexes such as the S&P 500 or the Russell 1000). We use lasso to solve IT and long-short with three market benchmarks (S&P 100 and Russell 1000 – US stock market; and Ibovespa – Brazilian market), comprising data from 2010 to 2017. Also, we formed IT portfolios using cointegration (a method widely used for index tracking) to have a basis for comparison of the results using lasso. The findings for IT showed similar overall performance between portfolios using lasso and cointegration, with a slight advantage to cointegration in some cases. Nonetheless, lasso-based IT portfolios presented average monthly turnover at least 40% smaller, indicating that lasso generated portfolios that had not only a consistent tracking performance but also a considerable advantage in terms of transaction costs (represented by the average turnover).     

A fair go? The gender pay gap among corporate executives in Australian firms

In virtually all economies, executive positions are highly male dominated. This study examines the pay gap between male executives and female executives in large Australian firms from 2011 to 2014 to evaluate whether female executives are paid equitably compared with male executives. The mean pay comparison shows that female executives earn 80.7% of the total pay earned by male executives. A large part of the gender pay gap is explained by differences in positions held; female executives are particularly underrepresented in highly paid executive positions. After controlling for executive position and other relevant individual and firm characteristics, there remains a 15.1% gender gap in total pay. Our findings suggest that to achieve the goal of gender equity, both the proportion of women at executive level and the executive-level gender pay gap need to be monitored.     

Pricing perpetual options with stochastic discount interest rates

The aim of this study is to investigate the prices and optimal exercise strategies of certain perpetual American options on the asset under stochastic discount interest model. This is different from Gerber and Shiu (N Am Actuar J 2(3):101–112, 1998), in which the interest force was a constant; here we suppose that the accumulated interest function is perturbed by the standard Brownian motion and Poisson process. We obtain an explicit expression of optimal option-exercise boundary in the case of perpetual put option. Moreover, we get a corresponding result when the individual claim is described by an exponential distribution. Finally, we analyze the influence of certain coefficients in stochastic interest model on the optimal option-exercise boundary.     

The shadow costs of repos and bank liability structure

Making use of a structural model that allows for optimal liquidity management, we study the role that repos play in a bank׳s financing structure. In our model the bank׳s assets consist of illiquid loans and liquid reserves and are financed by a combination of repos, long-term debt, deposits and equity. Repos are a cheap source of funding, but they are subject to an exogenous rollover risk. We show that the use of repos inflicts two types of indirect (“shadow”) costs on the bank׳s shareholders: first, it induces the bank to maintain higher liquid reserves in order to alleviate the additional default risk; second, it adds to the cost of long-term debt financing. These shadow costs limit the bank׳s appetite for cheap but unstable repo funding. This effect is, however, weakened under poor returns on risky assets, access to deposit funding and the depositor preference rule. We also analyze the impact of a liquidity coverage ratio, payout restrictions and a leverage ratio on the bank׳s financing choices and show that all these tools are able to curb the bank׳s reliance on repos.     

Option pricing and replication with transaction costs and dividends

This paper derives optimal perfect hedging portfolios in the presence of transaction costs within the binomial model of stock returns, for a market maker that establishes bid and ask prices for American call options on stocks paying dividends prior to expiration. It is shown that, while the option holder's optimal exercise policy at the ex-dividend date varies according to the stock price, there are intervals of values for such a price where the optimal policy would depend on the holder's preferences. Nonetheless, the perfect hedging assumption still allows the derivation of optimal hedging portfolios for both long and short positions of a market maker on the option.     

Executive compensation and firm risk after successful mergers and acquisitions in Africa

This paper examines the impact of various executive compensation types on the postmerger risk taking by firm's executives. We find that executive pay influences firm risk differently depending on compensation type and risk measure. Specifically, we find that rewarding executives with cash compensation reduces the total postmerger risk of acquirers. However, managers are motivated to increase systematic risk when they are rewarded with stock‐based incentives. Besides, based on the argument that managerial compensation portfolio might impact systematic and unsystematic risks differently, our findings show no evidence of the impact of executive pay on unsystematic risk.     

Monetary policy trade-offs in an estimated open-economy DSGE model

This paper studies the trade-offs between stabilizing CPI inflation and alternative measures of the output gap in Ramses, the Riksbank׳s estimated dynamic stochastic general equilibrium (DSGE) model of a small open economy. Our main finding is that the trade-off between stabilizing CPI inflation and the output gap strongly depends on which concept of potential output in the output gap between output and potential output is used in the loss function. If potential output is defined as a smooth trend this trade-off is much more pronounced compared to the case when potential output is defined as the output level that would prevail if prices and wages were flexible.     

Joint dynamic modeling and option pricing in incomplete derivative-security market

In this study, we evaluate the option prices on two assets under stochastic interest rates when the stochastic process that underlying asset prices follow is depending on a correlated bivariate Markov-modulated geometric Brownian motion model with jump risks. More specifically, we conduct the joint dynamic modeling by identifying two independent compound Poisson processes with the log-normal jump sizes to describe both individual jumps and systematic cojumps. Facilitating the cojumping behavior this way with the time-inhomogeneity of the volatility, option pricing expressions are readily obtainable since the Gerber–Siu’s approach is employed to determine a pricing kernel. The empirical results and numerical illustrations are provided to show the impact of cojumps and stochastic volatilities on option prices.     

The reputation costs of executive misconduct accusations: Evidence from the #MeToo movement

In this study, we examine how sexual harassment accusations against executives affect the stock returns of the affiliated organization. Taking a reputation cost perspective, we identify 98 sexual harassment accusations during 2016–2019, of which 25 directly target organizational executives. We employ an event study methodology to detect abnormal stock reactions for the affiliated organization. The results indicate that #MeToo accusations substantially harmed the stock returns of the organization despite the accusation relating to an individual’s misconduct. We discover significant results only for executives who are employed at the parent organization. Therefore, we first provide evidence that misconduct by individuals matters for organizations. We demonstrate that executive misconduct becomes particularly relevant when the executive assumes a leading position at the parent organization. This finding has important implications for future research and practitioners.     

Pricing vulnerable options with stochastic liquidity risk

In this paper, we consider vulnerable options with stochastic liquidity risk. We employ liquidity-adjusted pricing models to describe the underlying stock price and option issuer’s assets. In addition, the correlation between these assets is stochastic, depending on the market liquidity measures. In the proposed framework, we derive closed forms of vulnerable European options with stochastic liquidity risk and then use them to illustrate the effects of stochastic liquidity risk on vulnerable option prices. Numerical results show that the effects of liquidity risk on the prices of out-of-the-money options or the options with a short maturity are not negligible.     

An options pricing approach to ramping rate restrictions at hydro power plants

This paper investigates the impact of ramping rate restrictions imposed on hydro operations to protect aquatic ecosystems. The optimal ramping decision is specified as an optimal control problem which results in a Hamilton Jacobi Bellman (HJB) equation. Electricity prices are modelled as a regime switching stochastic process. The optimal control is determined by solving the HJB equation numerically using a fully implicit finite difference approach with semi-Lagrangian time stepping. The paper focuses on the effect of ramping restrictions on a hydro plant׳s value and optimal operations, and provides an analysis of which factors cause ramping restrictions to have a greater or lesser impact on profitability. It is shown that hydro plant value is negatively affected by ramping restrictions, but the extent of the impact depends on key parameters which determine the desirability of frequent changes in water release rates. Interestingly for the case considered, value is not sensitive to ramping restrictions over a large range of restrictions. The results point to the importance of accurately modelling electricity prices in gauging the trade offs involved in imposing restrictions on hydro operators which may hinder their ability to respond to volatile electricity prices and meet peak demands.