Outstanding risky debt provides risk-shifting incentives for managers fully aligned with stockholders. Earlier research shows that the risk-shifting incentive can be eliminated by using a stock-based compensation design to align managers' and stockholders' interests. I show that stock options as well as compensation designs that align managers' and bondholders' interests eliminate the risk-shifting incentive. Although a stock-based compensation design is not a unique mechanism to eliminate the pure risk-shifting incentive, it is essential where managers of levered firms are known to consume a portion of the investment outlay as perquisites.
This study extends the microstructure literature by examining the offering prices in the United States Initial Public Offering (IPO) market for the presence of clusters. It is found that the use of whole prices is more frequent in the IPO market than in secondary stock markets. Offering prices in the IPO market exhibit a dominant clustering at whole fives and tens (5s and 0s) that cannot be adequately explained by existing hypotheses. Unlike other studies on IPO underpricing, this study examines the impact of offering price clusters on the degree of underpricing. It is documented that whole-priced IPOs are underpriced more relative to fractional-priced IPOs. It is found that the negotiations hypothesis and the implicit collusion hypothesis are not adequate explanations and leave this puzzle to be resolved by future research.
The intrinsic value approach amortizes over the life of the option, the difference between the stock price on the date of the grant and the exercise price of the option. The fair market value approach amortizes over the life of the option, the market value of stock options on the date of the grant. These approaches do not reflect the changes in the option–based compensation cost after the grant date. This paper proposes an economic cost approach that not only adjusts for the changes in the value of the options during its life but also records the issuance of the stock at fair market value on the exercise date.
Abstract. This paper empirically examines the performance of Black-Scholes and Garch-M call option pricing models using call options data for British Pounds, Swiss Francs and Japanese Yen. The daily exchange rates exhibit an overwhelming presence of volatility clustering, suggesting that a richer model with ARCH/GARCH effects might have a better fit with actual prices. We perform dominant tests and calculate average percent mean squared errors of model prices. Our findings indicate that the Black-Scholes model outperforms the GARCH models. An implication of this result is that participants in the currency call options market do not seem to price volatility clusters in the underlying process.Key words: GARCH, currency options, Black-Scholes JEL Classification: G12, G13, G15Option pricing has its origins in the seminal works of Black-Scholes (1973) and Merton (1973). Empirical testing of these models did not become possible until Feigner and Jacquillat (1979) first proposed a market for currency options. In December of 1982, American Currency Options began trading in the Philadelphia Stock Exchange (PHLX). Today, this exchange lists six dollar-based standardized currency option contracts, which settle in the actual physical currency. These are Australian dollar, British Pound, Canadian Dollar, Euro, Japanese Yen and Swiss Franc.The Black and Scholes (1973) option-pricing model was the first to be used in pricing currency options; but, overtime and in practice, researchers have found that the prices estimated by the Black-Scholes model suffer from many biases. mentions that the Black-Scholes model exhibits under pricing of out-of-the money options, under pricing of options on low volatility securities and under pricing of short-maturity options and results in a U-shaped implied volatility curve. * We are grateful to Dr. Jin-Chuan Duan, Dr. Stewart Mayhew and the participants of the 2003 FMA International Meetings for valuable comments. We also thank Dr. Leigh Murray, New Mexico State University for statistical help and Dr. Jayashree Harikumar, Los Alamos National Laboratories, New Mexico for help with MATLAB. HARIKUMAR, DE BOYRIE AND PAKIn addressing these issues, some researchers have made refinements to the Black-Scholes model. Amin and Jarrow (1991) introduce a stochastic interest rate model in which the assumption of constant interest rates, both domestic and foreign, is relaxed. Hilliard, Madura and Tucker (1991) develop a currency option-pricing model under stochastic interest rates when interest rate parity holds. Their model assumes that domestic and foreign bond prices have local variances that depend only on time and not on other state variables such as the level of short-term interest rates. The authors test their option model and find that the stochastic interest rate model with domestic and foreign short term rates, driven by Arithmetic Brownian motion, exhibit greater pricing accuracy than the constant interest rate alternative. While modeling stochastic volatility, Heston and Nandi (2000) observe ...
The manager of a depository institution is shown to exhibit risk-taking behavior under the current insurance arrangement. Perfect monitoring or risk-based deposit insurance would eliminate this incentive if information were symmetric between bank managers and the insuring agency. Absent symmetric information, it is shown that a recently suggested scheme, where insurers collect insurance premiums based on projected and actual risk levels, does not control the risk-taking incentive. The only way to control this incentive through insurance rates is to levy a relatively high premium, which is not actuarially fair.
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