PRICING CURRENCY OPTIONS UNDER STOCHASTIC INTEREST RATES AND JUMP‐DIFFUSION PROCESSES

We investigate the effects of stochastic interest rates and jumps in the spot exchange rate on the pricing of currency futures, forwards, and futures options. The proposed model extends Bates's model by allowing both the domestic and foreign interest rates to move around randomly, in a generalized Vasicek term‐structure framework. Numerical examples show that the model prices of European currency futures options are similar to those given by Bates's and Black's models in the absence of jumps and when the volatilities of the domestic and foreign interest rates and futures price are negligible. Changes in these volatilities affect the futures options prices. Bates's and Black's models underprice the European currency futures options in both the presence and the absence of jumps. The mispricing increases with the volatilities of interest rates and futures prices. JEL classification: G13     

EVIDENCE ON DELTA HEDGING AND IMPLIED VOLATILITIES FOR THE BLACK‐SCHOLES,GAMMA, AND WEIBULL OPTION PRICING MODELS

Modifying the distributional assumptions of the Black‐Scholes model is one way to accommodate the skewness of underlying asset returns. Simple models based on the compensated gamma and Weibull distributions of asset prices are shown to produce some improvements in option pricing. To evaluate these assertions, I construct and compare delta hedges of all S&P 500 options traded on the Chicago Board Options Exchange between September 2001 and October 2003 for the Weibull, Black‐Scholes, and gamma models. I also compare implied volatilities and their smiles (i.e., nonlinearities) among the three models. None of the three models improves over the others as far as delta hedging is concerned. Volatilities implied by all three models exhibit statistically significant smiles.     

LIQUIDITY AND ASSET PRICING UNDER THE THREE‐MOMENT CAPM PARADIGM

We examine whether the use of the three‐moment capital asset pricing model can account for liquidity risk. We also make a comparative analysis of a four‐factor model based on Fama–French and Pástor–Stambaugh factors versus a model based solely on stock characteristics. Our findings suggest that neither of the models captures the liquidity premium nor do stock characteristics serve as proxies for liquidity. We also find that sensitivities of stock return to fluctuations in market liquidity do not subsume the effect of characteristic liquidity. Furthermore, our empirical findings are robust to differences in market microstructure or trading protocols between NYSE/AMEX and NASDAQ.     

EXACT FORMULAS FOR PRICING BONDS AND OPTIONS WHEN INTEREST RATE DIFFUSIONS CONTAIN JUMPS

I develop Heath‐Jarrow‐Morton extensions of the Vasicek and Jamshidian pure‐diffusion models, extend these models to incorporate Poisson‐Gaussian interest rate jumps, and obtain closed‐form models for valuing default‐free, zero‐coupon bonds and European call and put options on default‐free, zero‐coupon bonds in a market where interest rates can experience discontinuous information shocks. The jump‐diffusion pricing models value the instrument as the probability‐weighted average of the pure‐diffusion model prices, each conditional on a specific number of jumps occurring during the life of the instrument. I extend the models to coupon‐bearing instruments by applying Jamshidian's serial‐decomposition technique.     

SHORT‐MATURITY OPTIONS AND JUMP MEMORY

We investigate jump memory using an extensive database of short‐term S&P 500 index options. Jump memory refers to the attenuation of the implied jump intensity and magnitude parameters following a crash event. We use a genetic algorithm to obtain a time series of implied parameter estimates and posit behavioral and rational explanations for parameter attenuation following a crash event. We find that a nested form of the jump‐diffusion model sharpens the remaining parameter estimates and has a negligible effect on pricing accuracy.     

THE PRICING OF EQUITY CARVE‐OUTS DURING THE 1990s

We examine the level of underpricing and characteristics of equity carveouts (ECOs) from 1990 to 1998 (the 1990s) and from 1999 to 2000 (the bubble period). For a sample of 458 ECOs, we find a mean initial return of 8.75% for the 1990s and 47.76% for the bubble period. The results suggest that, similar to other initial public offerings (IPOs), ECOs have been more willing to accept underpricing through time because of an increased importance in analyst coverage and the increased use of spinning, the practice where investment bankers allocate IPOs to high‐profile customers to garner potential future business.     

A THEORY OF UNWINDING OF CROSS‐SHAREHOLDING UNDER MANAGERIAL ENTRENCHMENT

In this article I examine corporate strategies regarding cross‐shareholding and the unwinding of cross‐shareholding, and I present a rationale for corporate managers to unwind cross‐shareholding from the perspective of managerial entrenchment. Although cross‐shareholding enhances managerial entrenchment, the increased agency costs associated with managerial opportunism increase the incentives for a hostile takeover. To avoid a takeover, managers have to unwind cross‐shareholdings. The unwinding of cross‐shareholdings implies that managers will relinquish their entrenchment and thus will act to increase shareholders' wealth in the future. The model proposed here explains why cross‐shareholdings among Japanese firms declined during the 1990s, a decade during which the cost of takeovers decreased because of financial market deregulation.     

END‐OF‐DAY PRICING IN THE U.S. TREASURY MARKET: A COMPARISON OF GovPX AND THE FEDERAL RESERVE BANK OF NEW YORK

We compare end‐of‐day indicative U.S. Treasury prices from GovPX and the Federal Reserve Bank of New York (FRBNY). We find that the two sources rarely quote identical prices, and differences are not simply due to noise or rounding. The average bid price differential is 2 cents for notes and bonds, but it is only ¹/₁₀ of 1 cent for bills. Bid‐ask spreads in both sources appear to be largely artificial and contain limited information. Finally, we find that the end‐of‐day indicative FRBNY bid prices are closer to true intraday GovPX market quotes than end‐of‐day indicative quotes provided by GovPX itself.     

VALUATION OF EVENT‐CONTINGENT OPTIONS

I study a new class of investment options, event‐contingent options. These are options to invest and divest in projects that are dependent on other projects of the same firm or that are conditioned by projects of other firms in its value chain. I construct payoff functions and derive closed‐form solutions for the value of options to invest contingent on investment (OICI), options to invest contingent on divestment (OICD), options to divest contingent on divestment (ODCD), and options to divest contingent on investment (ODCI). I also derive analytical comparative statics for these option valuation equations and examine their implications on the firm's wealth. I offer examples of event‐contingent options in a global context.     

DYNAMIC HEDGE FUND STYLE ANALYSIS WITH ERRORS‐IN‐VARIABLES

We revisit the traditional return‐based style analysis in the presence of time‐varying exposures and errors‐in‐variables (EIV). We apply a benchmark selection algorithm using the Kalman filter and compute the estimated EIV of the selected benchmarks. We adjust them by subtracting their EIV from the initial return series to obtain an estimate of the true uncontaminated benchmarks. Finally, we run the Kalman filter on these adjusted regressors. Analyzing EDHEC alternative index styles, we show that this technique improves the factor loadings and allows more precise identification of the return sources of the considered hedge fund strategy.     

Managerial Social Capital and Financial Development: A Cross‐Country Analysis

This study examines the issue of whether managerial social capital, defined as aggregate benefits of social obligations and informal contacts formed through social networks, has an impact on financial development. Utilizing a large cross‐country sample for the period 1999–2012, we provide evidence that higher levels of social capital have a positive effect on financial development. We are able to examine different types of social connections for our sample firms and find that informal and nonprofessional relationships matter the most for financial market development. These findings are robust to alternative model specifications, variable measurement, and estimation techniques.     

ON THE ROBUSTNESS OF RANGE‐BASED VOLATILITY ESTIMATORS

We empirically examine Parkinson's range‐based volatility estimate in the federal funds market, which is unique because institutional regulations create a predictable pattern in interday volatility. We find that range‐based volatility estimates and standard deviations produce the expected volatility pattern. We also find that at trading pressure points where microstructure noise should be greatest, range‐based estimates are less than the standard deviations. Thus, we support the argument that range‐based volatility estimates remove the upward bias created by microstructure noise. We find that the Parkinson method is the most efficient range‐based volatility measure among a set of alternates in this market.     

LIQUIDITY AND QUOTE CLUSTERING IN A MARKET WITH MULTIPLE TICK SIZES

We analyze market liquidity (i.e., spreads and depths) and quote clustering using data from the Kuala Lumpur Stock Exchange (KLSE), where the tick size increases with share price in a stepwise fashion. We find that stocks that are subject to larger mandatory tick sizes have wider spreads and less quote clustering. We also find that liquidity providers on the KLSE do not always quote larger depths for stocks with larger tick sizes. Overall, our results suggest that larger tick sizes for higher priced stocks are detrimental to market liquidity, although the adverse effect of larger tick sizes is mitigated by lower negotiation costs (i.e., less quote clustering).     

APPLICABILITY OF THE FAMA‐FRENCH THREE‐FACTOR MODEL IN FORECASTING PORTFOLIO RETURNS

For the model‐based estimation of the equity cost of capital, evidence shows that the common practice of using the average historical factor premiums as the estimates of the next‐period factor premiums generates inaccurate estimates. I propose an alternative way to estimate factor premiums by using the structural variables that are important predictors of future asset returns. Based on the out‐of‐sample results from a trading strategy with four in‐sample model‐selection criteria, I find that my estimation procedure performs better than the common practice even when transaction costs are considered.     

KEIRETSU AFFILIATION AND STOCK‐MARKET‐DRIVEN ACQUISITIONS

We examine misvaluation as a driver of takeover activity in Japan. Mirroring empirical results from the United States, we find that overvaluation is an important factor affecting the dichotomy between acquirers and nonacquirers in Japan. Being affiliated to a keiretsu group appears to reduce the probability that an overvalued firm will decide to acquire another firm. Misvaluation is also an important determinant of the likelihood of a firm becoming a target; however, there is no significant difference between keiretsu and nonkeiretsu firms in this regard. Shareholders of keiretsu‐affiliated acquirers do not gain from acquisitions, whereas acquisitions by nonaffiliated firms do seem to be value enhancing.     

A Reduced‐Form Model for Warrant Valuation

This paper studies warrant valuation using a reduced‐form model. Analogous to the credit risk literature, structural models require complete information about the asset value process and the firm’s liabilities. In contrast, reduced‐form models require only information about the firm’s stock price process. We introduce a reduced‐form model where the warrant holder is a price taker, and we relate our model to structural models appearing in the literature.     

THE EFFECT OF THE TRADING SYSTEM ON IPO UNDERPRICING: EVIDENCE FROM THE 1997 ORDER‐HANDLING RULES

We use a natural experiment resulting from the 1997 Securities and Exchange Commission rule mandating a change in the order‐handling rules (OHR) for all NASDAQ stocks to test whether secondary market structure affects initial public offering (IPO) underpricing. We find that the increase in liquidity that the OHR represent led to a decrease in underpricing for cold NASDAQ IPOs, suggesting that when liquidity is lowest, changes in market liquidity display a negative relation to initial returns.     

CONVERTIBLE DEBT AND RISK‐SHIFTING INCENTIVES

I argue that convertible debt, in contrast to its perceived role, can produce shareholders’ risk‐shifting incentives. When a firm's capital structure includes convertible debt, every investment decision affects not only the distribution of the asset value but also the likelihood that the debt will be converted and thereby the distribution of the firm's leverage. This suggests that managers can engage in risk‐increasing projects if a higher asset risk generates a more favorable distribution of leverage. Empirical evidence using 30 years of data supports my argument.     

INSTITUTIONAL TRADING AND OPENING PRICE BEHAVIOR: EVIDENCE FROM A FAST‐EMERGING MARKET

Using daily and intraday data, we investigate the cross‐sectional relation between stock prices and institutional trading in the Taiwan stock market. Consistent with the investigative herding hypothesis, we find that institutional herding exists because of institutional positive feedback trading behavior rather than following trades made by other institutions, as suggested by the information cascade hypothesis. Moreover, the positive correlation between institutional trade imbalance and stock returns mainly comes from institutional positive feedback trading. The institutional trading decisions rely on returns measured not only over the lagged trading day but also over the opening session during the same day.     

INTANGIBLE ASSETS,BOOK‐TO‐MARKET,AND COMMON STOCK RETURNS

I examine two anomalies where the Fama and French three‐factor model fails to adequately explain monthly industry and index returns. Both anomalies are consistent with a bad model problem where the book‐to‐market factor introduces a negative bias in the intercepts. I propose the intangibles model as an alternative where the three‐factor model is known to have difficulty. This alternative model, which replaces the book‐to‐market factor with zero investment portfolio returns based on prior investments in intangible assets, is well specified in random samples, has comparable power, and fully explains both anomalies.