Employee Reload Options: Pricing, Hedging, and Optimal Exercise

Reload options, call options granting new options on exercise,are popularly used in compensation. Although the compound optionfeature may seem complicated, there is a distribution-free dominantpolicy of exercising reload options whenever they are in themoney. The optimal policy implies general formulas for numericalvaluation. Simpler formulas for valuation and hedging followfrom Black–Scholes assumptions with or without continuousdividends. Time vesting affects the optimal policy, but numericalresults indicate that it is nearly optimal to exercise in themoney whenever feasible. The results suggest that reload optionsproduce similar incentives as employee stock options and sharegrants.     

Pricing Efficiency in a Thin Market with Competitive Market Makers: Box Spread Strategies in the Hang Seng Index Options Market

Using a box spread arbitrage strategy, we examine the pricing efficiency of the emerging, thinly traded Hang Seng Index options market in Hong Kong, where market makers operate under a competitive open outcry system. In 20 months of tick‐by‐tick bid‐ask and transaction quotes we find very few arbitrage opportunities. Our examination of the reporting time of quotes shows that in effect, all the apparent mispricings are deceptive and could be explained by stale quotes. The absence of real arbitrage opportunities supports the pricing rationality hypothesis in the Hong Kong options market.     

不同融资制度下的金融中介发展

在任何一种经济中都需要建立一种金融机构与证券市场能够共同发挥作用的、完善的金融体系。但是,考虑到各种经济制度建立基础和发展历史与传统上的差异,以及金融体系与企业部门之间的关系不同,各国金融体系的架构并不需要保持完全的一致。本文从不同融资制度中金融中介的作用,探讨经济中金融中介的发展。     

Pricing and Hedging Discount Bond Options in the Presence of Model Risk

This paper focuses on pricing and hedging options on a zero-couponbond in a Heath—Jarrow—Morton (1992) framework whenthe value and/or functional form of forward interest rates volatilityis unknown, but is assumed to lie between two fixed values.Due to the link existing between the drift and the diffusioncoefficients of the forward rates in the Heath, Jarrow and Mortonframework, this is equivalent to hedging and pricing the optionwhen the underlying interest rate model is unknown. We showthat a continuous range of option prices consistent with noarbitrage exist. This range is bounded by the smallest upper-hedgingstrategy and the largest lower-hedging strategy prices, whichare characterized as the solutions of two non—linear partialdifferential equations. We also discuss several pricing andhedging illustrations.     

Pricing and Hedging Discount Bond Options in the Presence of Model Risk

This paper focuses on pricing and hedging options on a zero-coupon bond in a Heath–Jarrow–Morton (1992) framework when the value and/or functional form of forward interest rates volatility is unknown, but is assumed to lie between two fixed values. Due to the link existing between the drift and the diffusion coefficients of the forward rates in the Heath, Jarrow and Morton framework, this is equivalent to hedging and pricing the option when the underlying interest rate model is unknown. We show that a continuous rangeof option prices consistent with no arbitrage exist. This range is bounded by the smallest upper-hedging strategy and the largest lower-hedging strategy prices, which are characterized as the solutions of two non-linear partial differential equations. We also discuss several pricing and hedging illustrations.     

An Empirical Comparison of Option‐Pricing Models in Hedging Exotic Options

This paper examines the empirical performance of various option‐pricing models in hedging exotic options, such as barrier options and compound options. A practical and relevant testing approach is adopted to capture the essence of model risk in option pricing and hedging. Our results indicate that the exotic feature of the option under consideration has a great impact on the relative performance of different option‐pricing models. In addition, for any given model, the more “exotic” the option, the poorer the hedging effectiveness.     

Pricing Commodity Spread Options with Stochastic Term Structure of Convenience Yields and Interest Rates

The purpose of this research is to provide a valuation formula for commodity spread options. Commodity spread options are options written on the difference of the prices (spread) of two commodities. From the aspect of commodity contingent claims, it is considered that commodity spread options are difficult to evaluate with accuracy because of the existence of the convenience yield. Hence, the model of the convenience yield is the key factor to price commodity spread options. We use the concept of future convenience yields to develop the model that enriches the stochastic behavior of convenience yield. We also introduce Heath-Jarrow-Morton interest rate model to the valuation framework. This general model not only captures the mean reverting feature of the convenience yield, but also allows us to handle a very wide range of shape that the term structure of convenience yield can take. Therefore our model provides various types of models. The numerical analysis presented in this paper provides some unique features of commodity spread options in contrast to normal options. These characteristics have never been addressed in previous studies. Moreover, it suggests that the existing model overprice commodity spread options through neglecting the effect of interest rates.     

A Pricing and Hedging Comparison of Parametric and Nonparametric Approaches for American Index Options

This article investigates the extent to which options on theAustralian Stock Price Index can be explained by parametricand nonparametric option pricing techniques. In particular,comparisons are made of out-of-sample option pricing performanceand hedging performance. The dataset differs from many of thoseused previously in the empirical options pricing literaturein that it consists of American options. In addition, a broaderspectrum of techniques are considered: a spline-based nonparametrictechnique is considered in addition to the standard kernel techniques,while the performance of a Heston stochastic volatility modelis also considered. Although some evidence is found of superiorperformance by nonparametric techniques for in-sample pricing,the parametric methods exhibit a markedly better ability toexplain future prices and show superior hedging performance.     

Static Hedging of Exotic Options

This paper develops static hedges for several exotic options using standard options. The method relies on a relationship between European puts and calls with different strike prices. The analysis allows for constant volatility or for volatility smiles or frowns.     

Trading Mechanisms and the Components of the Bid-Ask Spread

We compare the relative magnitudes of the components of the bid-ask spread for New York Stock Exchange (NYSE)/American Stock Exchange (AMEX) stocks to those of National Association of Securities Dealers Automated Quotations (NASDAQ)/National Market System (NMS) stocks. We find that the order-processing cost component is smaller, and the adverse selection component is greater on the NYSE/AMEX trading systems than on the NASDAQ/NMS system. The inventory holding component is also greater for exchange-traded stocks than for NASDAQ/NMS stocks, but this may be attributable to differences in the characteristics of the firms whose stocks trade on the respective systems.     

Detecting Abnormal Bid-Ask Spread: A Comparison of Event Study Methods

This study examines empirical issues associated with the use of bid-ask spreads in event studies. The simulation results indicate that the distribution of average standardized abnormal spread shows little deviation from normality. Simulation results also indicate that the widely used percent spread metric results in test statistics with low power. In contrast, use of a standardized raw spread metric and a simple mean-adjusted expectation model results in well specified and reasonably powerful Patell and Brown-Warner type test statistics. As the abnormal spread series is characterized by high first order serial correlation, it is important to adjust for this serial correlation when using multi-day event windows.     

Earnings Announcements and the Components of the Bid-Ask Spread

This study investigates the behavior of the components of the bid-ask spread around earnings announcements. We find that the adverse selection cost component significantly increases surrounding the announcements, while the inventory holding and order processing components significantly decline during the same periods. Our results suggest that the directional change in the total bid-ask spread depends on the relative magnitudes of the changes in these three components. Specifically, the decreases in inventory holding costs and order processing costs imply that earnings announcements may have an insignificant impact on the total bid-ask spread, even when they result in increased information asymmetry.     

Inferring the Components of the Bid-Ask Spread: Theory and Empirical Tests

The relation between the square of the quoted bid-ask spread and two serial covariances—the serial covariance of transaction returns and the serial covariance of quoted returns—is modeled as a function of the probability of a price reversal, π, and the magnitude of a price change, ?, where ? is stated as a fraction of the quoted spread. Different models of the spread are contrasted in terms of the parameters, π and ?. Using data on the transaction prices and price quotations for NASDAQ/NMS stocks, π and ? are estimated and the relative importance of the components of the quoted spread—adverse information costs, order processing costs, and inventory holding costs—is determined.     

Maturity Effect on Bid-Ask Spreads of OTC Currency Options

The paper ascertains the relation between bid-ask spreads and the contract maturity of OTC currency options. Contrary to previous findings in the futures market, spreads of currency options are found to be negatively related to the contract's term-to-maturity. The negative relation persists even after controlling for the effects of price risks, competition, and trading activity. The pronounced differences in the term-to-maturity results are attributable to the market risk effect and differences in the market structure of options and futures markets.     

Piggy Banks: Financial Intermediaries as a Commitment to Save

Banks and other intermediaries may help savers commit to investment plans that savers could not stick to if they held assets directly. We illustrate this commitment function using a version of the Diamond and Dybvig (1983) model where savers’ short-run liquidity needs are correlated with shocks to investment opportunities. The investment securities are all freely tradeable, yet savers still do better if they delegate their investment decisions to an intermediary that overrides the savers’ liquidity demands when investment opportunities warrant. Bank CDs, insurance annuities, pensions, and even social security, by locking funds out of reach, may all constitute real world examples of this commitment role of financial intermediaries.     

Intraday Variation in the Bid-Ask Spread: Evidence after the Market Reform

In this article we show that intraday variation in spreads for Nasdaq‐listed stocks has converged to intraday variation in spreads for NYSE‐listed stocks after the implementation of the new order‐handling rules. We attribute this convergence to the Limit Order Display Rule, which requires that limit orders be displayed in Nasdaq best bid and offer when they are better than quotes posted by market makers. Our findings suggest that the different patterns of intraday spreads between NYSE and Nasdaq stocks reported in prior studies can largely be attributed to the different treatment of limit orders between the NYSE and Nasdaq before the market reform.     

Market Microstructure Empirical Regularities: Behavior of the Bid-Ask Spread and Closing Prices

A substantial number of last reported transactions for stocks trading on the New York Stock Exchange occur inside the quoted closing bid-ask spread. The tendency to close inside the spread results in price change magnitudes much smaller than those predicted from binomial models. Moreover, although the change magnitude is biased by the underlying trend of the market, the distribution of next day price change relatives is largely unaffected. The result is a systematic regularity between the location of today's close and tomorrow's close relative to the bid-ask spread.     

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.     

The Pricing of Options with Default Risk

This paper considers the pricing of options with default risk. The comparative statics of such options can differ from those of ordinary options, and early exercise of such American call options can be optimal. Several examples of options with default risk are considered.     

Financial Intermediaries and Interest Rate Risk: II

The current work extends and updates the previous survey ( Staikouras, 2003 ) by looking at other aspects of the financial institutions' yield sensitivity. The study starts with an extensive discussion of the origins of asset‐liability management and the subsequent work to identify effective ways of measuring and managing interest rate risk. The discussion implicates both regulatory and market‐based approaches along with any issues surrounding their applicability. The literature is enriched by recognizing that structural and regulatory shifts affect financial institutions in different ways depending on the size and nature of their activities. It is also noted that such shifts could change the bank's riskiness, and force banks to adjust their balance sheet size by altering their maturity intermediation function. Besides yield changes, market cycles are also held responsible for asymmetric effects on corporate values. Furthermore, nonstandard investigations are considered, where embedded options and basis risk are significant above and beyond the intermediary's rate sensitivity, while shocks to the slope of the yield curve is identified as a new variable. When the discount privilege is modeled as an option, it is shown that its value is incorporated in the equities of qualifying banks. Finally, volatility clustering is further established while constant relative risk aversion is not present in the U.S. market. Although some empirical findings may be quite mixed, there is a general consensus that all forms of systematic risk, risk premia, and the risk‐return trade‐off do exhibit some form of variability, not only over time but also across corporate sizes and segments.