Contrasting two approaches in real options valuation: Contingent claims versus dynamic programming

This paper compares two well-known approaches for valuing a risky investment using real options theory: contingent claims (CC) with risk neutral valuation and dynamic programming (DP) using a constant risk adjusted discount rate. Both approaches have been used in valuing forest assets. A proof is presented which shows that, except under certain restrictive assumptions, DP using a constant discount rate and CC will not yield the same answers for investment value. A few special cases are considered for which CC and DP with a constant discount rate are consistent with each other. An optimal tree harvesting example is presented to illustrate that the values obtained using the two approaches can differ when we depart from these special cases to a more realistic scenario. We conclude that for real options problems the CC approach is preferred when data exists (such as futures prices) that allow the estimation of the market price of risk or convenience yield. Even when such data do not exist we argue that the CC approach is preferred as it has the advantage of allowing the individual specification of the prices of different sources of risk.     

Is China's P/E ratio too low? Examining the role of earnings volatility

We find that China's P/E ratio is comparable to that of the U.S. S&P 1500 index, a broad based index covering large, middle, and small capitalization firms. We provide an explanation as to why China's seemingly low P/E ratio is not surprising in light of the economic growth that it has experienced. Specifically, we show that (i) the P/E ratio is negatively associated with earnings volatility in both the Chinese and U.S. stock markets with an economically significant magnitude; and (ii) historical earnings volatility is considerably higher in China than in the U.S. Higher earnings volatility in China offsets higher growth prospect in setting the P/E ratio, making its P/E ratio much closer to what is observed empirically than otherwise implied by its growth rate.     

Testing the Stochastic Implications of the Permanent Income Hypothesis Using Canadian Provincial Data*

This paper utilizes relatively unexplored Canadian provincial‐level data to investigate an old but still relevant question in macroeconomics as to whether consumption responds to income innovations in a manner consistent with the stochastic implications of the permanent income hypothesis (PIH). The empirical results obtained do not appear to be in accord with the PIH. Instead, consumption's response to income innovations is found to be much weaker than that predicted by PIH; in particular, the response displays an asymmetric pattern in the sense that it is much stronger for negative than positive income innovations. We interpret this evidence of asymmetry as indicative of the presence of liquidity constraints in provincial households.     

Exploring consumption-based asset pricing model with stochastic-trend forcing processes

Using Canadian data, the consumption-based asset pricing model is studied, defined in terms of nondurable and durable goods consumption. A two-stage estimation procedure is used, which takes account of the presence of common stochastic trends in the forcing processes. This method yields more reasonable estimates of the preference parameters than the previous studies did, and the asset-pricing equation is not rejected by the data. Moreover, the preference specification adopted in this paper allows a number of useful economic information to be obtained. The additive separability assumption and the Cobb–Douglas functional form of the utility function are ruled complements in the sense of Edgeworth and Pareto.     

Intertemporal substitution, imports and the permanent income model

We examine the importance of intertemporal substitution in U.S. import consumption using a model of permanent income that allows for random preference shocks and additive separability. The latter feature allows us to take two estimation approaches. In the first approach, we show that there is a cointegrating restriction imposed by the first-order conditions of the model which allows us to estimate the intertemporal elasticity of imported and domestic goods consumption. In the second approach, we estimate the Euler equations using generalized method of moments. This approach, however, requires us to place some restrictive assumptions on the model that are not required for the first estimation approach. Thus, the two different approaches allow an assessment of the severity of these restrictive assumptions which are often imposed in the literature.     

Demography and Inflation: An International Study

Changes in the relative share of different age groups in the population may present inflationary, disinflationary, or even deflationary tendencies. We find evidence that increases in the share of the very old (age 80 and older) may be associated with deflation. The analysis is based on an international dataset over a long period. Classifying age groups into young, working, younger old, and older old, we find that the shares of the young and the younger old groups are inflationary, while those of the working group are disinflationary and those of the very old group seemingly deflationary.     

Role of IT executives in the firm's ability to achieve competitive advantage through IT capability

Contrary to prior studies that have tried to examine the role of IT capabilities (ITC) on firm performance in isolation from the role of senior IT executives, we propose that the two are linked. More specifically we argue that there is a positive relationship between the structural power of senior IT executives and the likelihood that the firm will develop superior ITC. Furthermore, the contribution of ITC to a firm's competitive advantage is much stronger in firms with powerful senior IT executives as they are the driving force that may ensure the continuous renewal of ITC. We develop a two-stage econometric model designed to test this chain hypothesis that the structural power of senior IT executives will affect a firm's ability to achieve superior ITC, in turn driving firm performance. Empirical evidence based on a sample of large US firms strongly supports both of our hypotheses.     

An Empirical Study of Dynamic Labor Demand with Integrated Forcing Processes

In this paper, we examine a version of the Sargent (1978) and Kennan (1979) labor demand model under the assumption that the forcing processes are nonstationary. We derive a simple model of dynamic labor demand and highlight the important econometric and time-series implications of the optimization problem. The empirical results are surprisingly favorable and consistent with the underlying dynamic theory. Specifically, we find estimates that imply adjustment costs are about fourfold more important than disequilibrium costs in determining the dynamic demand for labor.     

Empirical tests of the float-adjusted return model

This paper implements empirical tests of the recently proposed float-adjusted return model by using Chinese stock-market data. The results show that variation in free float can explain cross-sectional variation in asset returns by about 6.7% annually, after we control for market risk, size, and book-to-market equity. In addition, we also find that size and book-to-market equity help explain cross-sectional variations in returns even after controlling for free float.     

An analytic approximation formula for pricing zero-coupon bonds

This paper presents an analytic approximation formula for pricing zero-coupon bonds, when the dynamics of the short-term interest rate are driven by a one-factor mean-reverting process in which changes in the volatility of the interest rate are a function of the level of the interest rate.