Creating Value Through Best‐In‐Class Capital Allocation1

With the economy showing signs of recovery, companies are shifting their focus from liquidity and balance sheet concerns back towards capital allocation and value creation. This article provides a comprehensive framework to examine shareholder value creation through capital allocation, and discusses important capital allocation lessons that have re‐emerged over the last few years. Notable among the key lessons are the following:

• ? Growth alone does not guarantee value creation, which suggests that companies should allocate capital based on the economic value of each investment opportunity.
• ? The limits of diversification in a financial crisis should be considered when allocating capital and managing liquidity.
• ? Companies should be conservative with base‐case cash flow projections and incorporate the possibility of downside scenarios into their projections.
• ? It is important to incorporate all forms of capital when managing liquidity.
• ? Whether using a long‐term or current‐market approach, companies should be consistent throughout the cycle in their cost of capital methodology.
• ? Companies should continually rethink investments and allocate capital in an attempt to maintain a competitive advantage.
• ? Evaluate returns relative to risk and cost of capital, and not against the company's average ROIC.
• ? Comparing the IRR of share repurchases to new investments is not an apples‐to‐apples comparison.

Finally, companies should concentrate on the strategic uses and value of particular assets and not allow their decisions to be driven by the value they might receive relative to their initial cost.     

How to make Dupire’s local volatility work with jumps

There are several (mathematical) reasons why Dupire’s formula fails in the non-diffusion setting. And yet, in practice, ad-hoc preconditioning of the option data works reasonably well. In this note, we attempt to explain why. In particular, we propose a regularization procedure of the option data so that Dupire’s local vol diffusion process recreates the correct option prices, even in manifest presence of jumps.     

The Evolution of Private Equity Fund Terms Beyond 2 and 20

With the remarkable increases in the assets under management of private equity firms, the standard compensation arrangement of a 2% management fee plus 20% carried interest has raised concerns of a misalignment of interests between limited partners (LPs) and general partners (GPs). Using a proprietary data set that includes detailed fund terms of 210 PE buyout funds with vintage years between 1989 and 2012, the authors summarize the findings of their recent study of the evolution of fund terms. The authors report that PE fund terms have been remarkable mainly for their resistance to change, and that the only important force for bringing about reductions in percentage management fees has been the recent increase in fund sizes. But the modest cuts in management fees that have accompanied the increase in fund sizes have done little to address what appears to be a conflict of interest between LPs and GPs over the optimal PE fund size. As one possible solution to this conflict, the authors analyze a recent innovation by Bain Capital that involves considerably smaller management fees (say, 1%) and larger carried interest (as high as 30%). According to the authors, such terms have a good chance of becoming the new industry standard for two reasons: First, LPs have become increasingly “professionalized,” which has led to greater focus on GP compensation and ways of realigning their interests with LPs'. Second, the “signaling” benefits for those GPs willing to distinguish themselves by offering terms like “1 and 30” could encourage more GPs to move in this direction. In the authors' words, “For all but the most reputable and established PE firms, those GPs that do not offer the new terms may well be seen as signaling little confidence in their ability to do what they're being paid to do: namely, produce above‐market returns.”     

Bridging the Gap between Interest Rates and Investments

The links between interest rates, cost of capital, hurdle rates, and capital allocation have been remarkably weak during the last few years. For instance, whereas the current yield on the World Government Bond Index is a paltry 1.2%, survey evidence suggests that the median reported investment hurdle rate of S&P 100 companies is as high as 18%. In this report, members of J.P Morgan's corporate finance advisory group explain why the cost of capital for most companies is unlikely to increase materially even if interest rates rise as projected. This suggests that companies have room to lower their hurdle rates. Moreover, as the authors argue, a reduction in hurdle rates is likely to be beneficial since excessively high hurdle rates can have the effect of reducing value by sacrificing profitable growth opportunities and increasing the firm's risk profile. The report concludes with a framework for corporate hurdle rates and capital allocation strategies designed to help companies make better investment decisions.     

From risk analysis in Europe to European risk analysis: the first ten years of SRA-E (1987-97)

Risk analysis has both a long past and a short history. This latter is written in the past 30 years. Technology's potential to create sometimes irreversible damage, as well as unprecedented improvement in standard of living, prompted the need for risk analysis. The Society for Risk Analysis (SRA) was created in the United States at the end of the 1970s. Its purpose was and is to bring together scientists and professionals concerned by issues of risk to health, safety and the environment, on an international and interdisciplinary basis. This article traces European participation in the SRA and recounts the founding of the chapter Society for Risk Analysis- Europe (SRA-E) in 1987. The composition of founding, Advisory and Executive Committees is given, as are themes and Directors of the seven Conferences held by SRA-E to date. SRA in 1987 counted 69 Europe-based members in 13 countries; in 1997, 25 countries are represented in SRA-Europe by 317 members. A trend is seen from a mainly geographic extension of SRA towards a more specific identity springing from risk research and management as practised today in Europe. The multicultural and multilingual experience of members, and their capacity for collaboration across national and disciplinary lines, are among European risk analysis' strongest assets. The present Journal of Risk Research can provide a forum for reinforcing new currents in risk analysis. The creation of a European university cursus in risk studies is recommended, as is a stronger role for SRA-E as a body of expertise. A call is made for risk analysis sustainable in national and cultural contexts removed from those that have developed today's art and practice: needed are appropriate conceptualizations of risk, management methods, and indicators of success. The Mediterranean basin and North Africa are targeted as areas for development and new learning for risk analysts, communicators, managers and researchers in the 21st century.     

A transform approach to compute prices and Greeks of barrier options driven by a class of Lévy processes

In this paper we propose a transform method to compute the prices and Greeks of barrier options driven by a class of Lévy processes. We derive analytical expressions for the Laplace transforms in time of the prices and sensitivities of single barrier options in an exponential Lévy model with hyper-exponential jumps. Inversion of these single Laplace transforms yields rapid, accurate results. These results are employed to construct an approximation of the prices and sensitivities of barrier options in exponential generalized hyper-exponential Lévy models. The latter class includes many of the Lévy models employed in quantitative finance such as the variance gamma (VG), KoBoL, generalized hyperbolic, and the normal inverse Gaussian (NIG) models. Convergence of the approximating prices and sensitivities is proved. To provide a numerical illustration, this transform approach is compared with Monte Carlo simulation in cases where the driving process is a VG and a NIG Lévy process. Parameters are calibrated to Stoxx50E call options.     

Accuracy of Premium Calculation Models for CAT Bonds—An Empirical Analysis

CAT bonds are of significant importance in the field of alternative risk transfer. Because the market of CAT bonds is not complete, the application of an appropriate pricing model is of high relevance. We apply different premium calculation models to compare them with regard to their predictive power. Without taking the financial crisis into account, a version of the Wang transformation model and the linear model are the most accurate ones. In contrast, under consideration of the financial crisis, all analyzed models are approximately equivalent. Furthermore, we find that CAT bond specific information does not improve out‐of‐sample results.