Research in Finance: Volume 26

The current volume in the Research in Finance series features an international set of contributors. The overall theme of the volume is a timely topic capturing one of the leading issues of the year: coping with “systemic” risk.

As global economic systems become increasingly more complex and dynamic and the universal language of historical accounting is being profoundly altered, the theory and tools we use in neo-classical economics, traditional finance, and valuation are beginning to prove inadequate to the tasks being required of them. Hence, there is a need to consider new avenues of thought and new tools. In this conceptual chapter, I explore the use of real options “in” engineering systems design as a means to achieve more rigorous and insightful results in the design and valuation of economic systems, particularly that of the firm. In the process, I gain further insight into the causes and cures for systemic disturbances generated by the presence and selection of real options in economic systems.

The authors are a finance professor and an administrator in a major suburban independent school district who minored in finance while working toward his doctorate in education. We have used the case of shell space to discover the different incentives non-profit administrators have in the acquisition, recognition, and rational exercise of real options by their organizations (compared with managers of for-profit businesses). Shell space is space within a new building that has been enclosed against the elements, but not yet finished for its intended future use. The shell space can be viewed as a set of complex options (along the lines of the Stulz–Johnson options to choose among a group of several possible finished outcomes with different costs of exercise). A business executive could be expected to make the acquisition decision based on the value drivers know to impact such options. In the not-for-profit arena, though, decisions about the acquisition and use of options are driven by incentives that arise from within the organization or emanate from the politically elected (or appointed) board of trustees.

We examine explicitly priced financial distress risk in post-1990 equity markets. We add a financial distress risk factor to Fama and French's (1993) three-factor model, based on Griffin and Lemmon's (2002) findings that financial distress is not fully captured by the book-to-market factor. We test three-factor and four-factor capital asset pricing models using both annual buy-and-hold analysis and monthly time series analysis across portfolios adjusted for common book-to-market, size, and financial distress factors. We find empirical support for an Ohlson (1980) O-score-based financial distress risk four-factor asset pricing model in the U.S. and Japanese markets.

In this chapter, we apply an efficient subset of vector error correction model (VECM) using the forgetting factor to examine the cointegration under climate change of the time series of the gross domestic product (GDP) and the industrial production and that of the utilization and consumption of important metals such as copper and steel in some important OECD countries as well as some selected newly industrialized Asian and Latin American countries. Both the long-term and the short-term dynamic relations among these variables are examined and the implications are discussed.

This study presents evidence of a statistically significant negative correlation between crude oil and equities over the past 20 years. Including proper proportions of negatively correlated assets in a diversified portfolio can improve the ratio of reward relative to risk, and therefore, adding crude oil with equities into a diversified portfolio can provide superior portfolio performance, compared with equities alone. Because crude oil prices held stable for nearly a century before the oil crisis of 1973, and oil derivatives did not begin trading actively on public markets until the 1980s, the diversification value of oil is a relatively new phenomenon. Also contributing to the phenomenon, the majority of oil reserves and the majority of crude oil production capacity worldwide are held by entities that are not traded in public equity markets, and therefore, the diversification benefits of oil cannot be fully realized by holding a portion of the global market portfolio of equities.

When a stock is added into the S&P 500 Index, it in effect becomes cross-listed in the Index derivative markets. When index-based trading strategies such as index arbitrage are executed, the component stocks are directly affected by such trading. We find increased volatility of daily returns, plus increased trading volume for the underlying stocks. Utilizing a list of S&P 500 Index composition changes over the period September 1976 to December 2005, we study the market-adjusted volume turnover and return variance of the stocks added to and deleted from the Index. The results indicate that after the introduction of the S&P 500 Index futures and options contracts, stocks added to the S&P 500 experience statistically significant increase in both trading volume and return volatility. Both daily and monthly return variances increase following index inclusion. When stocks are removed from the index, though, neither volatility of returns nor trading volume experiences any significant change. So, we have new evidence showing that Index inclusion changes a firm's return volatility, and supporting the destabilization hypothesis.

The dynamics between five-year US Treasury bonds and interest rate swaps are examined using bivariate threshold autoregressive (BTAR) models to determine the drivers of spread changes and the nature of the lead–lag relation between the two instruments. This model is able to identify the economic – or threshold – value that market participants consider significant before realigning their portfolios. Specifically, three different regimes are identified: when the swap spread in the previous week is either high or low, the Treasury bond market leads the swap market. However, when the swap spread is low, none of the markets leads each other. Thus, yield movements are shown to be governed by the direction and magnitude of the change in the swap spread, which in turn provides an economic insight into the rebalancing between swap and bond portfolios.

A variety of equity-linked insurance contracts such as variable annuities (VA) and equity-indexed annuities (EIA) have gained their attractiveness in the past decade because of the bullish equity market and low interest rates. Due to the complexity of their inherent nature, pricing and risk management of these products are quantitatively challenging and therefore have become sources of concern to many insurance companies. From a financial engineer's perspective, the options in VA and those embedded in EIA can be modeled as puts and calls, respectively, and enable the use of numerical option pricing techniques. Additionally, values of VA and EIA move in opposite directions in response to changes in the underlying equity value. Therefore, for insurers who offer both businesses, there are natural offsets or diversification benefits in terms of economic capital (EC) usage. In this chapter, we consider two specific products: the guaranteed minimal account benefit (GMAB) and the point-to-point (PTP) EIA contract, which belong to the VA and EIA classes respectively. Taking into account mortality risk and suboptimal dynamic lapse behavior, we build a framework that quantifies the value of each product and the natural hedging benefits based on risk-neutral option pricing theory. With Monte Carlo simulation and finite difference methods being implemented, an optimum product mixture of those two contracts is achieved that deploys capital the most efficiently.