Managerial Responses to Incentives: Control of Firm Risk, Derivative Pricing Implications, and Outside Wealth Management

We model a firm’s value process controlled by a manager maximizing expected utility from restricted shares and employee stock options. The manager also dynamically controls allocation of his outside wealth. We explore interactions between those controls as he partially hedges his exposure to firm risk. Conditioning on his optimal behavior, control of firm risk increases the expected time to exercise for his employee stock options. It also reduces the percentage gap between his certainty equivalent and the firm’s fair value for his compensation, but that gap remains substantial. Managerial control also causes traded options to exhibit an implied volatility smile.

Managerial Responses to Incentives: Control of Firm Risk, Derivative Pricing Implications, and Outside Wealth Management

We model a firm’s value process controlled by a manager maximizing expected utility from restricted shares and employee stock options. The manager also dynamically controls allocation of his outside wealth. We explore interactions between those controls as he partially hedges his exposure to firm risk. Conditioning on his optimal behavior, control of firm risk increases the expected time to exercise for his employee stock options. It also reduces the percentage gap between his certainty equivalent and the firm’s fair value for his compensation, but that gap remains substantial. Managerial control also causes traded options to exhibit an implied volatility smile.Risk; Wealth Management; Derivative

Hedging the exchange rate risk in international portfolio diversification : currency forwards versus currency options

As past research suggest, currency exposure risk is a main source of overall risk of international diversified portfolios. Thus, controlling the currency risk is an important instrument for controlling and improving investment performance of international investments. This study examines the effectiveness of controlling the currency risk for international diversified mixed asset portfolios via different hedge tools. Several hedging strategies, using currency forwards and currency options, were evaluated and compared with each other. Therefore, the stock and bond markets of the, United Kingdom, Germany, Japan, Switzerland, and the U.S, in the time period of January 1985 till December 2002, are considered. This is done form the point of view of a German investor. Due to highly skewed return distributions of options, the application of the traditional mean-variance framework for portfolio optimization is doubtful when options are considered. To account for this problem, a mean-LPM model is employed. Currency trends are also taken into account to check for the general dependence of time trends of currency movements and the relative potential gains of risk controlling strategies

Optimal hedging and parameter uncertainty

We explore the impact of drift parameter uncertainty in a basis risk model, an incomplete market in which a claim on a non-traded asset is optimally hedged using a correlated traded stock. Using analytic expansions for indifference prices and hedging strategies, we develop an efficient procedure to generate terminal hedging error distributions when the hedger has erroneous estimates of the drift parameters. These show that the effect of parameter uncertainty is occasionally benign, but often very destructive. In light of this, we develop a filtering approach in which the hedger updates her parameter estimates from observations of the asset prices, and we find an analytic soultion to the hedger's combined filtering and control problem in the case that the drift of the traded asset is known with certainty

The informational content of over-the-counter currency options

Financial decision makers often consider the information in currency option valuations when making assessments about future exchange rates. The purpose of this paper is to systematically assess the quality of option based volatility, interval and density forecasts. We use a unique dataset consisting of over 10 years of daily data on over-the-counter currency option prices. We find that the OTC implied volatilities explain a much larger share of the variation in realized volatility than previously found using market-traded options. Finally, we find that wide-range interval and density forecasts are often misspecified whereas narrow-range interval forecasts are well specified. JEL Classification: G13, G14, C22, C53Density, forecasting, FX, Interval, Volatility

Term Structure of Volatility and Price Jumps in Agricultural Markets - Evidence from Option Data

Empirical evidence suggests that agricultural futures price movements have fat-tailed distributions and exhibit sudden and unexpected price jumps. There is also evidence that the volatility of futures prices contains a term structure depending on both calendar-time and time to maturity. This paper extends Bates (1991) jump-diffusion option pricing model by including both seasonal and maturity effects in volatility. An in-sample fit to market option prices on wheat futures shows that our model outperforms previous models considered in the literature. A numerical example illustrates the economic significance of our results for option valuation.Option pricing, Futures, Term structure of volatility, Jump-diffusion, Agricultural markets, Demand and Price Analysis,

Nonparametric Estimation of Risk-Neutral Densities

This chapter deals with nonparametric estimation of the risk neutral density. We present three different approaches which do not require parametric functional assumptions on the underlying asset price dynamics nor on the distributional form of the risk neutral density. The first estimator is a kernel smoother of the second derivative of call prices, while the second procedure applies kernel type smoothing in the implied volatility domain. In the conceptually different third approach we assume the existence of a stochastic discount factor (pricing kernel) which establishes the risk neutral density conditional on the physical measure of the underlying asset. Via direct series type estimation of the pricing kernel we can derive an estimate of the risk neutral density by solving a constrained optimization problem. The methods are compared using European call option prices. The focus of the presentation is on practical aspects such as appropriate choice of smoothing parameters in order to facilitate the application of the techniques.Risk neutral density, Pricing kernel, Kernel smoothing, Local polynomials, Series methods