Industry cost of equity capital: European evidence for multifactor models

We estimate the costs of equity capital for 117 industries from 16 European countries employing the CAPM and 8 multifactor asset pricing models as well as a variety of different econometric techniques. In doing so, we extend previous research on cost of equity estimation in mainly two ways. First, our study involves European instead of US or UK industries, which are investigated in previous research, and we find that cost of equity estimates obtained from the CAPM or multifactor asset pricing models are as imprecise for European industries as for US and UK industries. Second, in addition to the CAPM, the Fama and French [1993 Fama, Eugene F., and Kenneth R. French. 1993. “Common Risk Factors in the Returns on Stocks and Bonds.” Journal of Financial Economics 33: 3–56. doi: 10.1016/0304-405X(93)90023-5[Crossref], [Web of Science ®] , [Google Scholar]. “Common Risk Factors in the Returns on Stocks and Bonds.” Journal of Financial Economics 33: 3–56] three-factor model, and the Carhart [1997 Carhart, Mark M. 1997. “On Persistence in Mutual Fund Performance.” The Journal of Finance 52 (1): 57–82. doi: 10.1111/j.1540-6261.1997.tb03808.x[Crossref], [Web of Science ®] , [Google Scholar]. “On Persistence in Mutual Fund Performance.” The Journal of Finance 52 (1): 57–82] four-factor model, which are usually employed, our study includes six multifactor models that have not yet been examined on their ability to provide precise estimates of the costs of equity: the five-factor model of Fama and French [1993 Fama, Eugene F., and Kenneth R. French. 1993. “Common Risk Factors in the Returns on Stocks and Bonds.” Journal of Financial Economics 33: 3–56. doi: 10.1016/0304-405X(93)90023-5[Crossref], [Web of Science ®] , [Google Scholar]. “Common Risk Factors in the Returns on Stocks and Bonds.” Journal of Financial Economics 33: 3–56] as well as the multifactor models of Pástor and Stambaugh [2003 Pástor, Lubos, and Robert F. Stambaugh. 2003. “Liquidity Risk and Expected Stock Returns.” Journal of Political Economy 111 (3): 642–685. doi: 10.1086/374184[Crossref], [Web of Science ®] , [Google Scholar]. “Liquidity Risk and Expected Stock Returns.” Journal of Political Economy 111 (3): 642–685]; Campbell and Vuolteenaho [2004 Campbell, John Y., and Tuomo Vuolteenaho. 2004. “Bad Beta, Good Beta.” American Economic Review 94 (5): 1249–1275. doi: 10.1257/0002828043052240[Crossref], [Web of Science ®] , [Google Scholar]. “Bad Beta, Good Beta.” American Economic Review 94 (5): 1249–1275]; Hahn and Lee [2006 Hahn, Jaehoon, and Hangyong Lee. 2006. “Yield Spreads as Alternative Risk Factors for Size and Book-To-Market.” Journal of Financial &; Quantitative Analysis 41 (2): 245–269. doi: 10.1017/S0022109000002052[Crossref], [Web of Science ®] , [Google Scholar]. “Yield Spreads as Alternative Risk Factors for Size and Book-To-Market.” Journal of Financial &; Quantitative Analysis 41 (2): 245–269]; Petkova [2006 Petkova, Ralitsa. 2006. “Do the Fama–French Factors Proxy for Innovations in Predictive Variables?” The Journal of Finance 61 (2): 581–612. doi: 10.1111/j.1540-6261.2006.00849.x[Crossref], [Web of Science ®] , [Google Scholar]. “Do the Fama–French Factors Proxy for Innovations in Predictive Variables?” The Journal of Finance 61 (2): 581–612]; and Koijen, Lustig, and van Nieuwerburgh [2010 Koijen, Ralph S., Hanno N. Lustig, and Stijn G. van Nieuwerburgh. 2010. “The Cross-Section and Time-Series of Stock and Bond Returns.” Working Paper, University of Chicago, University of California at Los Angeles, New York University. [Google Scholar]. “The Cross-Section and Time-Series of Stock and Bond Returns.” Working Paper, University of Chicago, University of California at Los Angeles, New York University]. Our results suggest that these models provide even more imprecise cost of equity estimates. One main reason for these inaccurate estimates is the large temporal variation of the risk loadings on the non-traded factors in these models.     

Nonlinear dynamics in economics and finance and unit root testing

The recent financial crisis exposed the inability of traditional theoretical and empirical models to parsimoniously capture the rich dynamics of the economic environment. This has stimulated the interest of both academics and practitioners in the development and application of more sophisticated models. By allowing for the presence of nonlinearities, complex dynamics, multiple equilibria, structural breaks and spurious trends, these latter models resemble more closely the properties of economic and financial time series. In this article, we illustrate the flexibility of a family of econometric models, namely the exponential smooth transition autoregressive (ESTAR), to encompass several of the above characteristics. We then re-assess the power of the ESTAR unit root test developed by Kapetanios, Shin and Snell ((2003) Kapetanios, G., Shin, Y. and Snell, A. 2003. Testing for a unit root in the nonlinear STAR framework. Journal of Econometrics, 112(2): 359–79. (doi:10.1016/S0304-4076(02)00202-6)[Crossref], [Web of Science ®] , [Google Scholar]) in the presence of nuisance parameters typically encountered in the literature and compare its performance with that of the augmented Dickey-Fuller and the Enders and Granger ((1998) Enders, W. and Granger, C. W.J. 1998. Unit-root tests and asymmetric adjustment with an example using the term structure of interest rates. Journal of Business & Economic Statistics, 16(3): 304–11. [Taylor & Francis Online], [Web of Science ®] , [Google Scholar]) tests. Our results show the lack of dominance of any particular test and that the power is not independent to priors about the nuisance parameters. Finally, we examine several asset price deviations from fundamentals and one hyper-inflation series and find contradictory results between the nonlinear fitted models and unit root tests. The findings highlight that new testing procedures with higher power are desirable in order to shed light on the behavior of financial and economic series.     

Quango reform: the next steps?

The coalition government elected in 2010 in the UK pursued a programme of quango reform focused on reducing the number and expenditure of arm’s-length bodies, increasing transparency, improving accountability and maximizing efficiency and effectiveness. This paper revisits Flinders and Skelcher’s 2012 Flinders, M. and Skelcher, C. (2012), Shrinking the quango state: five challenges in reforming quangos. Public Money &; Management, 32, 5, pp. 327–334.[Taylor &; Francis Online], [Web of Science ®] , [Google Scholar] PMM paper ‘Shrinking the quango state: five challenges in reforming quangos’ to assess progress to date and consider future challenges. Drawing insights from the UK programme of quango reform, as well as similar developments in Ireland, the authors identify five new challenges for governments: regulating, managing, reconciling, co-ordinating and reflecting.     

International accounting books: Publishers' dream,authors' nightmare and educators' reality

Abstract

The emergence of International Financial Reporting Standards (IFRS) as the required convention for reporting to stock exchanges in the European Union (EU) and other important markets, together with the convergence programmes of major standard setters, has accelerated the reduction in differences in financial reporting between countries. The education of potential accountants would be expected to respond to these changes and, indeed, there is evidence that the teaching of accounting techniques now frequently draws on both IFRS and local GAAP. Perhaps a greater shift has been in the discipline of International Accounting (IA), which has moved from being an optional subject to being core to most programmes and an increasingly popular choice for more specialised degrees at both undergraduate and Master's levels. This article surveys the books that are available to support educators and learners in IA building on the analysis and classification of Laidler and Pallett (1998) Laidler, J. and Pallett, S. 1998. International accounting: a review of books available to support UK courses: a teaching note. Accounting Education: an International Journal, 7(1): 75–86. [Taylor &; Francis Online] , [Google Scholar] Accounting Education: an international journal, 7(1), pp. 75–86. A range of IA textbooks is examined in detail, along with a more general review of reference works. The analysis finds that there has been a growth in the number, breadth and depth of texts serving the IA market. Authors have fallen upon a number of devices in their battle to keep their materials up to date in this dynamic environment. Some of Laidler and Pallett's (1998) Laidler, J. and Pallett, S. 1998. International accounting: a review of books available to support UK courses: a teaching note. Accounting Education: an International Journal, 7(1): 75–86. [Taylor &; Francis Online] , [Google Scholar] criticisms of the writing and coverage of IA texts have been addressed, although not necessarily in the way that they envisaged. In spite of the growth of this section of publishers' catalogues, there remain a number of areas given scant coverage, notably enforcement and audit, and countries outside of the EU and US. The article concludes with recommendations for publishers, authors and educators to enhance the teaching of IA and the resources needed to support it.     

Understanding accounting as a career: an immersion work experience for students making career decisions

This paper reports on a project which is designed to increase the participation of high school students in accounting work experience placements. The focus of the paper is on an Australian-based project which overcomes the identified barriers to offering high school accounting work experience placements with a resultant increase in the number and quality of placements offered. The research project responds to a decline in both the number and quality of students enrolling in accounting degree programmes in Australia. The paper draws on the work experience, social psychology, careers, and accounting education literatures to design a ‘connective’ model (Guile &; Griffiths, 2001 Guile, D., &; Griffiths, T. (2001). Learning through work experience. Journal of Education and Work, 14(1), 113–131. doi: 10.1080/13639080020028738[Taylor &; Francis Online] , [Google Scholar]) of accounting work experience for high school students. The project adopts an action research methodology which engages professional accounting practice, high school career advisors, and the university sector to deliver a structured work experience programme which addresses barriers to participation in accounting work experience and improves the quality of the work experience ‘experience’ for both employers and students.     

Investor relations,information asymmetry and market value

Evidence to date on the market value of investor relations (IR) strategies is limited. We test the market relevance of IR activity directly employing a proprietary database measuring IR quality across all firms listed on NYSE, Amex and NASDAQ. Although, in theory, ‘repackaging’ and communicating existing information should have no market impact, we find that firms with higher quality IR strategies are rewarded with significantly higher valuation multiples. In addition, increase in IR quality is associated with increases in analyst following and liquidity. Overall, our findings are generally stronger for small firms which are more likely to be ‘neglected’. Our evidence is consistent with effective IR successfully raising firm visibility leading to enhanced recognition and reduced information asymmetry in line with Merton (1987 Merton, R., 1987. A simple model of capital market equilibrium with incomplete information. Journal of Finance, 42 (3), 483–510. doi: 10.1111/j.1540-6261.1987.tb04565.x[Crossref], [Web of Science ®] , [Google Scholar]) and thus ‘fairer’ firm valuation as argued by IR professionals.     

Comment on ‘earnings management around UK open offers’

This note discusses the result of Iqbal, A., S. Espenlaub, and N. Strong. 2008 Iqbal, A., Espenlaub, S. and Strong, N. 2008. Earnings management around UK open offers. European Journal of Finance, this issue [Google Scholar]. Earnings management around UK open offers. European Journal of Finance, this issue, regarding long-run abnormal returns following open offers and announcement abnormal returns, compared with differing results in two previous studies based on similar samples. A survivorship bias explains some of the differences in the reported long-run abnormal returns. The difference in the announcement abnormal returns could be due to use of different data sources.     

There's more to volatility than volume

It is widely believed that fluctuations in transaction volume, as reflected in the number of transactions and to a lesser extent their size, are the main cause of clustered volatility. Under this view bursts of rapid or slow price diffusion reflect bursts of frequent or less frequent trading, which cause both clustered volatility and heavy tails in price returns. We investigate this hypothesis using tick by tick data from the New York and London Stock Exchanges and show that only a small fraction of volatility fluctuations are explained in this manner. Clustered volatility is still very strong even if price changes are recorded on intervals in which the total transaction volume or number of transactions is held constant. In addition the distribution of price returns conditioned on volume or transaction frequency being held constant is similar to that in real time, making it clear that neither of these are the principal cause of heavy tails in price returns. We analyse recent results of Ane and Geman (2000 Ane, T and Geman, H. 2000. Order flow, transaction clock, and normality of asset returns. J. Finance, 55(5): 2259–2284. [Crossref], [Web of Science ®] , [Google Scholar]: J. Finance, 55, 2259–2284) and Gabaix et al. (2003 Gabaix, X, Gopikrishnan, P, Plerou, V and Stanley, H.E. 2003. A theory of power-law distributions in financial market fluctuations. Nature, 423: 267–270. [Crossref], [PubMed], [Web of Science ®] , [Google Scholar]: Nature, 423, 267–270), and discuss the reasons why their conclusions differ from ours. Based on a cross-sectional analysis we show that the long-memory of volatility is dominated by factors other than transaction frequency or total trading volume.     

An Associative Approach to Risk Perception: Measuring the Effects of Risk Communications Directly and Indirectly<1?tpb=-6pt?>

Risk perception is often measured by a direct method, e.g., a questionnaire. This mainly reveals the deliberate evaluation of a risk (a so‐called secondary evaluative process), whereas risk perception can also be based on a first, spontaneous reaction (a primary evaluative process). An indirect test such as the Extrinsic Affective Simon Task (EAST, De Houwer, 2003 De Houwer, J. 2003. The Extrinsic Affective Simon Task. Experimental Psychology, 50: 77–85. [Crossref], [PubMed], [Web of Science ®] , [Google Scholar]) may be needed to reveal this first, spontaneous reaction. In this study, a questionnaire and an EAST measured the effects of varying risk communications (high risk, low risk or control article), about high‐voltage power lines. The results of the EAST showed that the respondents associated power lines stronger with unhealthy than with healthy. However, the questionnaire results did not seem to indicate that the respondents considered power lines as risky. The EAST did not reveal an effect of article variation on the associations of power lines with (un)healthy. Conversely, the questionnaire results showed that article variation influenced the secondary evaluative process. Further, our findings demonstrated that the direct and indirect measures were unrelated. An indirect test may complement a direct test to get an overall picture of how people evaluate risks.     

A modified Corrado test for assessing abnormal security returns

Event studies typically use the methodology developed by Fama et al. [1969 Fama, E., Fisher, L., Jensen, M. and Roll, R. 1969. The adjustment of stock prices to new information. International Economic Review, 10(1): 1–21. [Crossref] , [Google Scholar]. The adjustment of stock prices to new information. International Economic Review 10, no. 1: 1–21] to segregate a stock's return into expected and unexpected components. Moreover, conventional practice assumes that abnormal returns evolve in terms of a normal distribution. There is, however, an increasing tendency for event studies to employ non-parametric testing procedures due to the mounting empirical evidence which shows that stock returns are incompatible with the normal distribution. This paper focuses on the widely used non-parametric ranking procedure developed by Corrado [1989 Corrado, C. 1989. A nonparametric test for abnormal security price performance in event studies. Journal of Financial Economics, 23(2): 385–95. [Crossref], [Web of Science ®] , [Google Scholar]. A nonparametric test for abnormal security price performance in event studies. Journal of Financial Economics 23, no. 2: 385–95] for assessing the significance of abnormal security returns. In particular, we develop a consistent estimator for the variance of the sum of ranks of the abnormal returns, and show how this leads to a more efficient test statistic (as well as to less cumbersome computational procedures) than the test originally proposed by Corrado (1989 Corrado, C. 1989. A nonparametric test for abnormal security price performance in event studies. Journal of Financial Economics, 23(2): 385–95. [Crossref], [Web of Science ®] , [Google Scholar]). We also use the theorem of Berry [1941 Berry, A. 1941. The accuracy of the Gaussian approximation to the sum of independent variates. Transactions of the American Mathematical Society, 49(1): 122–36. [Crossref] , [Google Scholar]. The accuracy of the Gaussian approximation to the sum of independent variates. Transactions of the American Mathematical Society 49, no. 1: 122–36] and Esseen [1945 Esseen, C. 1945. Fourier analysis of distribution functions: A mathematical study of the Laplace–Gaussian law. Acta Mathematica, 77(1): 1–125. [Crossref], [Web of Science ®] , [Google Scholar]. Fourier analysis of distribution functions: A mathematical study of the Laplace–Gaussian law. Acta Mathematica 77, no. 1: 1–125] to demonstrate how the distribution of the modified Corrado test statistic developed here asymptotically converges towards the normal distribution. This shows that describing the distributional properties of the sum of the ranks in terms of the normal distribution is highly problematic for small sample sizes and small event windows. In these circumstances, we show that a second-order Edgeworth expansion provides a good approximation to the actual probability distribution of the modified Corrado test statistic. The application of the modified Corrado test developed here is illustrated using data for the purchase and sale by UK directors of shares in their own companies.     

Enhanced policy iteration for American options via scenario selection

Kolodko and Schoenmakers (2006 Kolodko, A and Schoenmakers, J. 2006. Iterative construction of the optimal Bermudan stopping time. Finan. Stochast., 10: 27–49. [Crossref], [Web of Science ®] , [Google Scholar]) and Bender and Schoenmakers (2006 Bender, C, Kolodko, A and Schoenmakers, J. 2006. Iterating cancelable snowballs and related exotics in a many-factor Libor model. Risk, September: 126–130.  [Google Scholar]) introduced a policy iteration that allows the achievement of a tight lower approximations of the price for early exercise options via a nested Monte Carlo simulation in a Markovian setting. In this paper we enhance the algorithm by a scenario selection method. It is demonstrated by numerical examples that the scenario selection can significantly reduce the number of inner simulations actually performed, and thus can greatly speed up the method (by up to a factor of 15 in some examples). Moreover, it is shown that the modified algorithm retains the desirable properties of the original, such as the monotone improvement property, termination after a finite number of iteration steps, and numerical stability.     

Accounting for Variation in the Explanatory Power of the Psychometric Paradigm: The Effects of Aggregation and Focus

Most psychometric studies of risk perception have used data that have been averaged over participants prior to analysis. Such aggregation obscures variation among participants and inflates the magnitude of relationships between psychometric dimensions and dependent variables such as overall riskiness. However, most studies that have not averaged data over participants have also shifted the focus of analysis from differences among hazards to differences among participants. Hence, it is unclear whether observed reductions in the explanatory power of psychometric dimensions result from the change in the level of analysis or from the change in the focus of analysis. Following Willis et al.'s (2005 Willis, H. H., DeKay, M. L., Fischhoff, B. and Morgan, M. G. 2005. Aggregate, disaggregate, and hybrid analyses of ecological risk perceptions. Risk Analysis, 25(2): 405–428. [Crossref], [PubMed], [Web of Science ®] , [Google Scholar]) analysis of ecological risk perceptions, we unconfound these two variables in a study of risk perceptions in Santiago, Chile, although we use more traditional hazards, attributes, and statistical procedures. Results confirm that psychometric dimensions explain less variation in judgments of riskiness and acceptability at the disaggregate level than at the aggregate level. However, they also explain less variation when the focus of analysis is differences among participants rather than differences among hazards. These two effects appear to be similar in magnitude. A simple hybrid analysis economically represents variation among participants' judgments of hazards' riskiness by relating those judgments to a common set of psychometric dimensions from a traditional aggregate‐level analysis.     

The non-linear market impact of large trades: evidence from buy-side order flow

We perform an empirical study of a set of large institutional orders executed in the US equity market. Our results validate the hidden order arbitrage theory proposed by Farmer et al. [How efficiency shapes market impact, 2013] of the market impact of large institutional orders. We find that large trades are drawn from a distribution with tail exponent of roughly 3/2 and that market impact approximately increases as the square root of trade duration. We examine price reversion after the completion of a trade, finding that permanent impact is also a square root function of trade duration and that its ratio to the total impact observed at the last fill is roughly 2/3. Additionally, we confirm empirically that the post-trade price reverts to a level consistent with a fair pricing condition of Farmer et al. (2013 Farmer, D., Gerig, A., Lillo, F. and Waelbroeck, H., How efficiency shapes market impact, 2013. Available online at: http://arxiv.org/abs/1102.5457 [Google Scholar]). We study the relaxation dynamics of market impact and find that impact decay is a multi-regime process, approximated by a power law in the first few minutes after order completion and subsequently by exponential decay.     

Do financial returns have finite or infinite variance? A paradox and an explanation

One of the major points of contention in studying and modelling financial returns is whether or not the variance of the returns is finite or infinite (sometimes referred to as the Bachelier–Samuelson Gaussian world versus the Mandelbrot stable world). A different formulation of the question asks how heavy the tails of the financial returns are. The available empirical evidence can be, and has been, interpreted in more than one way. The apparent paradox, which has puzzled many a researcher, is that the tails appear to become less heavy for less frequent (e.g. monthly) returns than for more frequent (e.g. daily) returns, a phenomenon not easily explainable by the standard models. Inspired by the prelimit theorems of Klebanov, Rachev and Szekely (1999 Klebanov, L, Rachev, S and Szekely, G. 1999. Pre-limit theorems and their applications. Acta Applicandae Mathematicae, 58: 159–174.  [Google Scholar]) and Klebanov, Rachev and Safarian (2000 Klebanov, L, Rachev, S and Safarian, M. 2000. Local prelimit theorems and their applications to finance. Appl. Math. Lett., 13: 73–78.  [Google Scholar]), we provide an explanation of this paradox. We show that, for financial returns, a natural family of models are those with tempered heavy tails. These models can generate observations that appear heavy tailed for a wide range of aggregation levels before becoming clearly light tailed at even larger aggregation scales. Important examples demonstrate the existence of a natural scale associated with the model at which such an apparent shift in the tails occurs.     

The effect of pseudo‐immediacy on intertemporal choices

An interesting phenomenon, which we dub the ‘pseudo‐immediacy effect’, was detected in intertemporal choices. The majority of our participants preferred the smaller but sooner (SS) outcome to the larger but later (LL) outcome when a pseudo‐immediacy reward was framed, but a higher proportion of participants preferred the LL outcome to the SS outcome when the pseudo‐immediate format was removed. Such a shift violated the invariance principle which requires that the preference order between options does not depend on the manner in which they are described. With reference to the pseudo‐certainty effect reported by Kahneman and Tversky in 1984 Kahneman, D. and Tversky, A. 1984. Choice, values, and frames. American Psychologist, 39: 341–50. [Crossref], [Web of Science ®] , [Google Scholar], our findings typically support the notion that risk and delay are psychologically equivalent and that the same psychological process underlies risk and intertemporal choice.     

Optimal time to sell a stock in the Black–Scholes model: comment on ‘Thou shalt buy and hold’, by A. Shiryaev,Z. Xu and X.Y. Zhou

We reconsider the problem of the optimal time to sell a stock studied by Shiryaev et al. (2008 Shiryaev, A, Xu, Z and Zhou, XY. 2008. Thou shalt buy and hold. Quant. Finan., 8: 765–776. [Taylor & Francis Online], [Web of Science ®] , [Google Scholar]) (following in this issue of Quantitative Finance) using path integral methods. These methods allow us to confirm the results obtained by these authors and extend them to the entire parameter region. We also obtain the full distribution of the time t_m at which the maximum of the price is reached for arbitrary values of the drift.     

Comparing Professions in UK and German-Speaking Management Accounting

This paper studies professional education in management accounting and the ways in which management accounting professions establish jurisdictional claims about management accounting work in the UK and German-speaking countries, respectively. We adopt a comparative approach drawing on the framework of systems of professions and the distinction between public, legal and workplace jurisdiction [Abbott, A. (1988 Abbott, A. (1988). The system of professions: An essay on the division of expert labor. Chicago, IL: University of Chicago Press.[Crossref] , [Google Scholar]). The system of professions: An essay on the division of expert labor. Chicago, IL: University of Chicago Press]. Our findings highlight some notable differences between the UK and German-speaking countries with respect to professional management accounting education, the jurisdictional claims that the professions make as well as the establishment and history of professional institutes for management accounting. Based on this analysis, the paper identifies a dilemma or at least a challenge for policy-makers with respect to balancing the need for a context-dependent model of professional education with a need for comparability and convergence.     

The Tourinho model: neglected nugget or a receding relic?

This article evaluates Tourinho's (1979b Tourinho, O. A.F. 1979b. “The valuation of reserves of natural resources: an option pricing approach”. Berkeley: University of California. PhD thesis [Google Scholar]) work as one of the earliest contributors to the real options literature. His model pioneered the application of risk neutrality to uncertain investments, but his originality of introducing an option-holding cost albeit to overcome the extraction paradox is rarely imitated. We claim that the combination of a convenience yield and an option-holding cost produces a more satisfying representation. Moreover, variations in the holding cost give rise to a host of investment decisions ranging from the standard real option solution for a zero-holding cost to a net present value solution for an infinite-holding cost. Not only does the holding cost mediate between these two poles, but it provides the option seller (usually a landowner or a government) with a policy instrument for influencing the extraction timing and thus the extraction profit of the option buyer. We derive the holding cost that optimizes the landowner's combined value of the option premium, holding costs and eventual royalties.     

Pricing and capital requirements for with profit contracts: modelling considerations

The aim of this paper is to provide an assessment of alternative frameworks for the fair valuation of life insurance contracts with a predominant financial component, in terms of impact on the market consistent price of the contracts, the embedded options, and the capital requirements for the insurer. In particular, we model the dynamics of the log-returns of the reference fund using the so-called Merton (1976 Merton, RC. 1976. Option pricing when underlying stock returns are discontinuous. J. Finan. Econ., : 125–144.  [Google Scholar]) process, which is given by the sum of an arithmetic Brownian motion and a compound Poisson process, and the Variance Gamma (VG) process introduced by Madan and Seneta (1990 Madan, DB and Seneta, E. 1990. The variance gamma (VG) model for share market returns. J. Bus., 63: 511–524. [Crossref], [Web of Science ®] , [Google Scholar]), and further refined by Madan and Milne (1991 Madan, DB and Milne, F. 1991. Option pricing with VG martingale components. Math. Finan., 1: 39–45. [Crossref] , [Google Scholar]) and Madan et al. (1998 Madan, DB, Carr, P and Chang, E. 1998. The variance gamma process and option pricing. Eur. Finan. Rev., 2: 79–105. [Crossref] , [Google Scholar]). We conclude that, although the choice of the market model does not affect significantly the market consistent price of the overall benefit due at maturity, the consequences of a model misspecification on the capital requirements are noticeable.