Pricing Options with Extendible Maturities: Analysis and Applications

Many common types of financial contracts incorporate options with extendible maturities. This paper derives closed-form expressions for options that can be extended by the optionholder and presents a number of applications including the valuation of American options with stochastic dividends, junk bonds, and shared-equity mortgages. We also derive closed-form expressions for writer-extendible options and discuss the writer's economic incentives for extending an out-of-the-money option. We apply these results to show that corporate debtholders have a strong incentive to extend the maturity of defaulting debt if there are liquidation costs. We model and solve the debtholders' optimal extension problem and show that the possibility of an extension can induce shareholders in highly levered firms to accept negative NPV projects.     

Temporal Aggregation and the Continuous-Time Capital Asset Pricing Model

We examine how the empirical implications of the Capital Asset Pricing Model (CAPM) are affected by the length of the period over which returns are measured. We show that the continuous-time CAPM becomes a multifactor model when the asset pricing relation is aggregated temporally. We use Hansen's Generalized Method of Moments (GMM) approach to test the continuous-time CAPM at an unconditional level using size portfolio returns. The results indicate that the continuous-time CAPM cannot be rejected. In contrast, the discrete-time CAPM is easily rejected by the tests. These results have a number of important implications for the interpretation of tests of the CAPM which have appeared in the literature.     

How Much Can Marketability Affect Security Values?

How marketability affects security prices is one of the most important issues in finance. We derive a simple analytical upper bound on the value of marketability using option-pricing theory. We show that discounts for lack of marketability can potentially be large even when the illiquidity period is very short. This analysis also provides a benchmark for assessing the potential costs of exchange rules and regulatory requirements restricting the ability of investors to trade when desired. Furthermore, these results provide new insights into the relation between discounts for lack of marketability and the length of the marketability restriction.     

Financial Globalization,Governance, and the Evolution of the Home Bias

We merge portfolio theories of home bias with corporate finance theories of insider ownership to create the optimal corporate ownership theory of the home bias. The theory has two components: (1) foreign portfolio investors exhibit a large home bias against countries with poor governance because their investment is limited by high optimal ownership by insiders (the “direct effect” of poor governance) and domestic monitoring shareholders (the “indirect effect”) in response to the governance and (2) foreign direct investors from “good governance” countries have a comparative advantage as insider monitors in “poor governance” countries, so that the relative importance of foreign direct investment is negatively related to the quality of governance. Using both country‐level data on U.S. investors' foreign investment allocations and Korean firm‐level data, we find empirical evidence supporting our optimal corporate ownership theory of the home bias.     

The TIPS‐Treasury Bond Puzzle

We show that the price of a Treasury bond and an inflation‐swapped Treasury Inflation‐Protected Securities (TIPS) issue exactly replicating the cash flows of the Treasury bond can differ by more than $20 per $100 notional. Treasury bonds are almost always overvalued relative to TIPS. Total TIPS‐Treasury mispricing has exceeded $56 billion, representing nearly 8% of the total amount of TIPS outstanding. We find direct evidence that the mispricing narrows as additional capital flows into the markets. This provides strong support for the slow‐moving‐capital explanation of arbitrage persistence.     

The High‐Frequency Responses of Australian Financial Futures to Unexpected Cash Rate Announcements*

This study examines the high‐frequency responses of Australian financial futures to monetary surprises using intra‐day futures data. Using the event window method with tick data to control for the endogeneity between market interest rates and the cash rate, our empirical findings support the following. First, monetary policy announcements significantly impact not only short‐term interest rate futures but also longer‐term treasury security future markets. Second, the most significant responses of these markets occur in the event window that contains the policy announcement. Third, we also find that the monetary policy is not well anticipated by market participants until the Reserve Bank of Australia’s policy release.     

Does Corporate Transparency Contribute to Efficient Resource Allocation?

This paper examines whether a country's corporate transparency environment, which includes the quality of accounting information, contributes to efficient resource allocation. Based on a cross-country study of 37 manufacturing industries in 37 countries, we provide three pieces of related evidence. First, we find the contemporaneous correlations in industry growth rates across country pairs are higher when there is a greater level of corporate transparency in the country pairs, after controlling for country-level economic and financial development. Second, we find the influence of transparency on these correlations is stronger when country pairs are at similar levels of economic development (GDP). Finally, when we control for the level of transparency explained by a country's institutions in place, we find that residual transparency (unexplained by country-level factors) is associated with industry-specific growth rates. Taken together, the results are consistent with corporate transparency facilitating the allocation of resources across industry sectors.