Pricing catastrophe options with stochastic claim arrival intensity in claim time

We model claim arrival and loss uncertainties jointly in a doubly-binomial framework to price an Asian-style catastrophe (CAT) option with a non-traded underlying loss index using the no-arbitrage martingale pricing methodology. We span these uncertainties by benchmarking to the shadow price of a one-claim bond and the premium of a reinsurance contract. We implement a stochastic time change from calendar time to claim time to more efficiently price the CAT option as a random sum – a binomial sum of claim time binomial Asian option prices. This choice of the operational time dimension allows us to incorporate different patterns of catastrophe arrivals by adjusting the claim arrival probability. We demonstrate this versatility by incorporating a mean-reverting Ornstein-Uhlenbeck intensity arrival process. Simulation results verify our model predictions and demonstrate how the claim arrival probability varies with the expected claim arrival intensity.     

Regulatory competition and forbearance: Evidence from the life insurance industry

Regulatory separation theory indicates that a system with multiple regulators leads to less forbearance and limits producer gains while a model of banking regulation developed by Dell’Ariccia and Marquez (2006) predicts the opposite. Fragmented regulation of the US life insurance industry provides an especially rich environment for testing the effects of regulatory competition. We find positive relations between regulatory competition and profitability measures for this industry, which is consistent with the Dell’Ariccia and Marquez model. Our results have practical implications for the debate over federal versus state regulation of insurance and financial services in the US.     

Socially responsible investment fund performance: the impact of screening intensity

Perhaps the most common criticism of socially responsible investment funds is that imposing non‐financial screens restricts investment opportunities, reduces diversification efficiencies and thereby adversely impacts performance. In this study we investigate this proposition and test whether the number of screens employed has a linear or curvilinear relation with return. Moreover, we analyse the link between screening intensity and risk. Screening intensity has no effect on unadjusted (raw) returns or idiosyncratic risk. However, we find a significant reduction in α of 70 basis points per screen using the Carhart performance model. Increased screening results in lower systematic risk – in line with managers choosing lower β stocks to minimize overall risk.     

An analysis of the reasons for the asymmetries surrounding earnings benchmarks

Several studies report an asymmetry in the distribution of earnings around specified benchmarks. However, doubt has arisen over whether the observed ‘kink’ in the distribution of earnings is solely caused by earnings management. We use a ratio analysis approach to examine a range of specific accruals for evidence of earnings management. We find little evidence that firms immediately above the benchmark have abnormal receivables, inventories or provisions. However, they do increase cash‐from‐customers and reduce inventory. Thus, our results support the recent research that suggests that firms engage in real actions to meet earnings benchmarks.     

The appropriateness of default investment options in defined contribution plans: Australian evidence

For participants in defined contribution (DC) plans who refrain from exercising investment choice, plan contributions are invested following the default investment option of their respective plans. Since default investment options of different plans vary widely in terms of their benchmark asset allocation, the most important determinant of investment performance, participants enrolled in these options face significantly different wealth outcomes at retirement. This paper simulates the terminal wealth outcomes under different static asset allocation strategies to evaluate their relative appeal as default investment choice in DC plans. We find that strategies with low or moderate allocation to stocks are consistently outperformed in terms of upside potential of exceeding the participant's wealth accumulation target at retirement as well as downside risk of falling below that target outcome by aggressive strategies whose allocation to stocks approach 100%. The risk of extremely adverse wealth outcomes for plan participants also does not appear to be very sensitive to asset allocation. Our evidence suggests the appropriateness of strategies heavily tilted towards stocks to be nominated as default investment options in DC plans unless plan providers emphasize predictability of wealth outcomes over adequacy of retirement wealth.     

Predicting issuer credit ratings using a semiparametric method

This paper proposes a prediction method based on an ordered semiparametric probit model for credit risk forecast. The proposed prediction model is constructed by replacing the linear regression function in the usual ordered probit model with a semiparametric function, thus it allows for more flexible choice of regression function. The unknown parameters in the proposed prediction model are estimated by maximizing a local (weighted) log-likelihood function, and the resulting estimators are analyzed through their asymptotic biases and variances. A real data example for predicting issuer credit ratings is used to illustrate the proposed prediction method. The empirical result confirms that the new model compares favorably with the usual ordered probit model.     

Takeover risk and the correlation between stocks and bonds

Existing research suggests that, for a given firm, stock returns and bond prices are positively related, and this implies a negative relation between stock returns and bond spreads. In this paper, we show how takeover risk influences this relation. Bondholders of high-rated firms can suffer losses in a takeover, particularly if the takeover is largely funded with debt, resulting in a more positive (or less negative) correlation between stock returns and bond spread changes. Consistent with this notion and based on a large sample of data covering the period from 1980 to 2000, we find that high-rated firms which are likely to be taken over have a more positive correlation between stock returns and bond spread changes, while target firms with a poison put or an indebtedness covenant have a more negative correlation. Overall, our findings have implications for the pricing and hedging of bonds and default risk based financial products such as credit default swaps.     

Foreign issuers in the U.S. PIPE market

We document that the use of private investment in public equity (PIPE) by foreign firms listed on U.S. exchanges is growing even faster than its use by U.S. firms. On average, foreign firm PIPE stock deals represent a similar proportion of the firm's market capitalization to U.S. firm PIPEs, but suffer less of a share price discount than U.S. firm PIPE issuances, a relation that is robust to consideration of exchange, deal size, share turnover and return volatility. We document that hedge funds are only small investors in foreign firm PIPEs issued in the U.S., which tend to be purchased by pensions, government funds and corporations. PIPE, in combination with the reverse merger method of going public, provides a cost-effective means for foreign firms to raise capital in the U.S. capital market.     

Examining bank SEOs: Are offers made by undercapitalized banks different?

Despite extensive monitoring, banking operations are often considered opaque, and despite explicit capital adequacy regulation, banks may have substantial discretion in their financing. Both monitoring and capital regulation have changed substantially over time, with the adoption of FDICIA being one important breakpoint. This article empirically studies seasoned equity offerings (SEOs) by banks to understand how opacity and capital regulation interact to determine the timing of bank SEOs and their market valuation. SEOs both by banks that are undercapitalized relative to regulatory standards and also well-capitalized banks are fully discretionary when it comes to SEOs, even before FDICIA. Both undercapitalized and well-capitalized banks experience similar and significantly negative stock price reactions to SEO announcements, and also have similar prior patterns of insider trading and similar economic drivers of the issuance decision. Moreover, post-SEO abnormal stock returns are similar to benchmark returns for both types of issuers in the long run, suggesting that, contrary to the well-documented evidence for industrial SEOs, investors understand the value implications of bank SEOs upon announcement. The evidence implies that undercapitalized banks' SEOs are more discretionary and that all bank SEOs are less opaque than implied by earlier studies.