Contingent Claims Analysis Research Articles

Employing real options methodology in agricultural investments: the case of greenhouse construction

The latest developments in investment analysis offer a number of valuable insights into how to evaluate investment opportunities encountering the weaknesses of net present value criterion. More specifically, irreversibility, uncertainty and the choice of timing are conditions that net present value does not include but they alter the investment decision in a determinant way. By employing contingent claims analysis in tangible investments better assessment results can be derived. In this work, an attempt is made to modify the NPV criterion by incorporating the real options approach, and its application is demonstrated in a greenhouse construction investment plan. A discounted cash flow approach indicates that the adoption of a new technology project under uncertainty is feasible while the real options approach differentiates the results. The corollary is that the real options approach can be proved useful when assessing projects with uncertainty and irreversibility and it can provide a new way of examining agricultural investment decisions.

Borrowing cost reduction by interest rate swaps––an option pricing analysis

Interest rate swaps generally involve two firms with different credit ratings. A quality spread differential (QSD) is observed to exist at different maturities for firm debts with different credit ratings. The quality spread differential allows two firms with different credit ratings to decrease their borrowing costs through interest rate swaps by utilising their comparative advantage in borrowing in different markets. The credit ratings of firms are determined by credit risk factors such as leverage and volatility of earnings asset value. This paper investigates the effect of the leverage and the volatility on the behaviour of risk premia between firm debts with different credit ratings by using the contingent claim analysis. Our results show that the quality spread differential can be explained by the differences in leverage and volatility. Thus two firms with different leverage and volatility of earnings asset value will benefit from interest rate swaps. However, it is found that the duration within which the QSD exists is limited by the values of the leverage and the volatility of two firms. In conclusion, this paper shows that interest rate swaps can help the firms to lower borrowing costs without necessarily relying on the arbitrage argument asserted by existing literature.

Financial e-commerce under capital regulation and deposit insurance

We use a two-stage contingent claim analysis model to study how capital regulation, deposit insurance, involvement in financial electronic commerce (e-commerce), and the optimal bank interest margin relate to one another under an uncertain loan loss source. Under strategic substitutes, both capital regulation and deposit insurance provide incentives for developing financial e-commerce, which helps the bank's growth. Our findings provide alternative explanations for the bank interest margin, which integrates the risk considerations of pricing equity with the bank's involvement in financial e-commerce, and for the asset–liability management rate-setting behavioral modes under capital regulation and deposit insurance.

On validity of the asymptotic expansion approach in contingent claim analysis

Kunitomo and Takahashi (1995, 2001) have proposed a new methodology, called small disturbance asymptotics, for the valuation problem of financial contingent claims when the underlying asset prices follow a general class of continuous Itô processes. It can be applicable to a wide range of valuation problems, including complicated contingent claims associated with the Black--Scholes model and the term structure model of interest rates in the Heath--Jarrow--Morton framework. Our approach can be rigorously justified by an infinite-dimensional analysis called the Watanabe--Yoshida theory on the Malliavin calculus recently developed in stochastic analysis.

Credit Enhancement and Loan Default Risk Premiums

AbstractUsing contingent claims analysis, we study the impact of private guarantees on the default risk premiums or credit spreads of discount loans. Specifically, we analyze the reduction of the default risk premium on a new junior loan by obtaining the numerical estimates under a stochastic interest rate. We demonstrate how the value of credit enhancement relates to the profitability and size of the new junior loan, as well as the leverage, asset risk, and debt seniority of the borrowing firm and the private insurer. The main results show that (a) for the new junior loan, although the benefits of financial insurance are substantial with an AAA‐rated private insurer, in general, default risk premiums can only be reduced to a minute amount; and (b) even with complete insurance coverage from an AAA‐rated private insurer, loan issues command default risk premiums that reflect not only the intrinsic values and risks of the insured and the insurer, but also their covariance.RésuméNous examinons l'impact des garanties financières privées sur la structure de risque des taux d'intérêt des prêts escomptés en utilisant l'approche d'évaluation de Brennan (1979) et de Stapleton et Subrahmanyam (1984) qui n'impose pas la condition de perte et de gain nul sur les créanciers. Nous étudions également la réduction (ou augmentation) des primes de risque de défaut des dettes sous le régime de taux d'intérêt stochastique. Pour obtenir des résultats de statique comparée, des simulations numériques ont été entreprises. Les résultats confirment les évidences empiriques provenant du marché d'assurance (et de rehaussement de crédit) des obligations. Nous trouvons que les primes de défaut ne peuvent être éliminées complètement par des endosseurs privés donc vulnérables.

Valuing Corporate Liabilities When the Default Threshold is not an Absorbing Barrier

When a default payment occurs, many bankruptcy codes favour firm continuation against claims reimbursement i.e. immediate liquidation of the firm assets. Hence, safety covenants (allowing bondholders to bankrupt the firm) are violated. Default and liquidation cannot be considered as equivalent events anymore. And the absorbing barrier, first introduced by Black-Cox (1976) and used as an immediate liquidation threshold in structural models (Leland (1994), Longstaff-Schwartz (1995), Leland-Toft (1996)) largely over-estimates creditors rights. This paper aims at reconciling the classical contingent claims analysis with this observed deviation from net-worth covenants. The assets value is now allowed to pass through the default threshold without causing the usual immediate liquidation. While some procedures based on excursion and occupation times may be designed, it is shown that only the latter sufficiently accounts for past financial distresses. Complex corporate securities (including subordinated and convertible debt) are then priced within an extended framework a la Black-Cox-Scholes-Merton. Depending on the retained liquidation procedure, analytical formulae of Chesney-Jeanblanc-Picque-Yor (1995) for valuing parisian options must be extended or not.

An Analysis of Private Loan Guarantee Portfolios

We use contingent claims analysis to evaluate portfolios of vulnerable private loan guarantees and to investigate their risk diversification properties. We find that for plausible baseline values of the parameters, the diversifiable credit risk can be eliminated in a portfolio of ten insured firms. We also show that further diversification can be achieved by an appropriate choice of insured firms' risk postures and of correlations between them and the guarantor. Our results suggest that, for high leverage cases, guarantors can do better through size portfolio diversification than by seeking cross-sector diversification.

Staging of Venture Capital Investment: A Real Options Analysis

This paper uses contingent claims analysis to investigate the staging decision of a venture capitalist in a principal-agent framework. Venture capital investment opportunities are modeled as real options with multiple volatilities, and the entrepreneur's incentive is assumed to maximize the probability of getting funded in the next financing round. The formulae of Black and Scholes (1973) and Geske (1979) are generalized to evaluate these real options. We find that staging not only gives the venture capitalist a waiting option but also mitigates the agency problem of the entrepreneur undertaking too conservative activities. Moreover, we find that the venture capitalist tends to stage her investment when the expected growth rate of the venture's market value is lower, when more capital is needed in future financing rounds, or when the venture is younger. However, the risk-free interest rate is not an important factor in the staging decision. Our model also provides a good explanation for existing empirical evidence on the staging of venture capital investment.

Partially Irreversible Investment Decisions and Taxation under Uncertainty: A Real Option Approach

Abstract The paper applies contingent claims analysis in a real option investment model in order to investigate taxation's influence on investor's decisions under uncertainty. The results show the distortion from realistic-type tax systems, allow to identify a tax-induced paradox in option valuation for specific settings and acknowledge the property of investment neutrality of well-known `ideal' tax systems in the context of different degrees of irreversibility. Furthermore, it is clarified that the idea of risk-neutral valuation cannot be adopted by the real option approach in general.

Taxation Under Uncertainty - Problems of Dynamic Programming and Contingent Claims Analysis in Real Option Theory

This article deals with the integration of taxes into real option-based investment models under risk neutrality and risk aversion. It compares two possible approaches -- dynamic programming and contingent claims analysis -- to analyze their effects on the optimal investment rules before and after taxes. It can be shown that despite their different assumptions, dynamic programming and contingent claims analysis yield identical investment thresholds under risk neutrality. In contrast, under risk aversion, there are severe problems in determining an adequate risk-adjusted discount rate. The application of contingent claims analysis is restricted to cases with a dividend rate unaffected by risk. Therefore, only dynamic programming permits an explicit investment threshold without taxation. After taxes, both approaches fail to reach general solutions. Nevertheless, using a sufficient condition, it is possible to derive neutral tax systems under risk aversion as is demonstrated by using dynamic programming.

Characteristics of Risk and Return in Risk Arbitrage

ABSTRACTThis paper analyzes 4,750 mergers from 1963 to 1998 to characterize the risk and return in risk arbitrage. Results indicate that risk arbitrage returns are positively correlated with market returns in severely depreciating markets but uncorrelated with market returns in flat and appreciating markets. This suggests that returns to risk arbitrage are similar to those obtained from selling uncovered index put options. Using a contingent claims analysis that controls for the nonlinear relationship with market returns, and after controlling for transaction costs, we find that risk arbitrage generates excess returns of four percent per year.

A contingent claim analysis of closed-end fund premia

We estimate contingent claims that replicate monthly net asset value (NAV) payoffs from closed-end funds. A claim's theoretical value is obtained by martingale pricing methods. The resulting net present value (NPVS) sequence is the theoretical premia sequence that is compared to the actual market premia sequence. The theoretical premia, like actual premia, are uncorrelated with NAV returns and are positively autocorrelated due to autocorrelation in the pricing information. However, there is poor correspondence between the theoretical and actual premia that seems due to the market's systematic errors in estimating a fund's management value. Risky arbitrage may be available to insiders.

An Economic Model for Evaluating Mining and Manufacturing Ventures with Output Yield Uncertainty

This paper develops an operational risk management model for evaluating production efforts in manufacturing and mining industries where the resource to be exploited is nonhomogenous. Using a contingent claims methodology now commonly encountered in financial applications, we formulate a production control model in an environment characterized by market and process uncertainty. In our analysis, market risk is depicted by the output price while process uncertainty is captured by the random variability inherent in the output's yield. In this light, adjustments to the rate of production are viewed as a sequence of (nested) real options affording operating flexibility. We account for an optimal sequence of production adjustments, over a preestablished production horizon, by taking the production rate as an adapted positive real-valued process. Accordingly, techniques of stochastic control theory and contingent claims analysis (CCA) are employed to ensure value maximizing production policies are rendered in a manner consistent with an equilibrium price structure.

Reducing Asset Substitution with Warrant and Convertible Debt Issue

The conflict between shareholders and bondholders in a levered firm over the choice of the risk level for firm assets is well-known. The original contingent claims approach to this issue had the firm reaching a critical point at the bond maturity date, similar to what happens at expiration of an option. In that model, equity is shown to be like a call option on the value of the firm. But the reality is that firms are continuously monitored by investors, customers and employees, and may potentially experience financial distress if the value of its assets Falls too low at any point in time. In this article, Chesney and Gibson present an alternative contingent claims analysis, in which equity is modeled as a down and out call, with an outstrike equal to the asset level that would precipitate distress. In this revised framework, they are able to study how the use of convertible debt, or debt with attached warrants, in place of straight debt affects the problem of volatility choice, and may perhaps eliminate the conflict of interest entirely.

Comments on the Investment-Uncertainty Relationship in a Real Option Model

The paper considers the problem of evaluating the probability of investing in a capital-investment project as a measure of the uncertainty-investment relationship in a real option model. By the use of the contingent claims analysis the opportunity to invest is modelled as an American call option with expiring time. We show that an increase in uncertainty of the project may actually have positive or negative effects on the probability of investing depending on which market parameters are called to restore the asset price equilibrium condition.

Characteristics of Risk and Return in Risk Arbitrage

This paper uses a sample of 4,750 stock swap mergers, cash mergers, and cash tender offers during 1963 - 1998 to characterize the risk and return in risk arbitrage. For out-of-sample comparison, we also examine the risk/return profile for a sample of active risk arbitrage hedge funds during 1990 - 1998. Results from both samples indicate that risk arbitrage returns are positively correlated with market returns in severely depreciating markets but uncorrelated with market returns in flat and appreciating markets. This result suggests that returns to risk arbitrage are similar to those obtained from selling uncovered index put options. Although linear asset pricing models provide reasonable estimates of the excess returns in risk arbitrage, a contingent claims analysis that incorporates the non-linearity in returns provides a more accurate description of the risk/return relationship. After controlling for both the non-linear return profile and transaction costs, we find that risk arbitrage generates excess returns of 4% per year.

Takeover Bids, Price Offer and Investors Protection

In this paper, we develop a contingent claim analysis concerning both inside and outside shareholders' rights to sell their shares at the acquisition bid price. We will show that this regulation brings about wealth transfer towards inside shareholders (compared to a situation without any guarantee). A second question can be formulated as follows: why, in an apparently irrational way, do the outside shareholders, who may benefit from a price guarantee, not systematically sell their shares? That question emphasizes on the outside shareholders' behavior. In theory, it appears that equal treatment between inside and outside shareholders may lead outside ones to sell their shares. We put into evidence that an unconditional price guarantee for minor investors induces an apparent transfer of wealth which is equal to the put option they are given. This implicit put is evaluated as an abandon option. The improvement in the treatment of the outside investors can be a pure illusion because a rational buyer should take it into account in his economic setting of the takeover bid. This put is paid by the new controlling investor who is aware of that. What is also outlined is that, in fact, the price guarantee mechanism imply a disclosure of information because the buyer is led to evaluate wealth transfer implied by the financial regulation of some European countries. The buyer is not passive, he can play with the bid acquisition price and the target participation rate. Moreover, to minimize the cost of a given put option, the major shareholder can increase his participation rate. In doing that, he will tend to expel the minor investors by exercising their put option. We saw that, in this framework, a unique equilibrium exists between the two parties, each one maximizing its wealth in this new environment. It is quite possible that this equilibrium can be the same (or can be better) for the outside investors compared with a no protection case. We also noticed that a more general setting of the choices should also take into account the possibility of direct appropriation of the cash-flow by the controlling investor.

Capital Budgeting Under Uncertainty—An Integrated Approach Using Contingent Claims Analysis and Integer Programming

Recently the application of contingent claims analysis and dynamic programming to project evaluation has attracted a lot of attention. These techniques are required, for example, if the value of a project develops stochastically over time and the decision to invest into this project can be postponed. Yet, so far there are no considerations regarding how this perception of projects reflects on a capital budgeting situation. We propose two approaches that integrate these methods with traditional capital budgeting models. A simple capital budgeting model can be formulated as the problem of finding the portfolio of options that has maximal value and fulfils the capital expenditure constraint. However, this model has some shortcomings regarding its applicability in traditional budgeting situations. Therefore, we define an alternative optimisation model that uses scenarios to depict a set of possible future states. The optimal portfolio is then equivalent to a dynamic investment strategy that determines a number of state-dependent optimal portfolios.

Capital Budgeting Under Uncertainty---An Integrated Approach Using Contingent Claims Analysis and Integer Programming

Recently the application of contingent claims analysis and dynamic programming to project evaluation has attracted a lot of attention. These techniques are required, for example, if the value of a ...

A contingent claim analysis of a rate-setting financial intermediary

Realizing that a financial intermediary's lending, treated as an investment opportunity, is like a financial call option clarifies the role of uncertainty. We argue that the portfolio-theoretic approach and the firm-theoretic approach have important linkages that can be used to demonstrate the contingent claim analysis of a rate-setting financial intermediary. Borrower-intermediary-lender relationships between the portfolio-theoretic combined volatilities and the firm-theoretic rate-setting modes under the Black-Scholes valuation are investigated, and the conclusions depend upon the portfolio composition redistribution effect. The effect of changes in the open market security rates on the loan rate and deposit rate settings depend on the borrower-intermediary-lender relationship, portfolio risk, and management of rate-setting strategy. Moreover, movements in open market security rates are not necessarily transmitted to the loan lender and deposit absorber.