Higher Idiosyncratic Risk Research Articles

The Subjective Valuation of Indexed Stock Options and Their Incentive Effects

AbstractWe analyze the potential role of indexed stock options in future pay‐for‐performance executive compensation contracts. We present a unified framework for index‐linked stock options, discuss their incentive effects, argue that indexation schemes based on the capital‐asset pricing model (CAPM) are the most suitable for executive compensation, and derive a subjective pricing model for the class of CAPM‐based indexed stock options. Contrary to earlier work, executives would not be motivated to take on investment projects with high idiosyncratic risk once their lack of wealth diversification and degree of risk aversion are factored into the analysis.

Hidden Orders, Trading Costs and Information

This paper explores the use of non-displayed (reserve) depth in Nasdaq market-maker quotes in SuperSOES. Non-displayed size represents 25 percent of the dollar-depth at the NBBO in the Nasdaq 100; this appears to be additional depth provided to the market, rather than a shift away from displayed depth to non-displayed depth. Market participants tend to use reserve size more for firms with high idiosyncratic risk and high volatility. While the presence of hidden depth at the inside has no effect on effective half-spreads, the information content of a trade (as measured by the midquote adjustment in the 30 minutes post-trade) is significantly lower when reserve size is quoted, suggesting reserve size is a signal of short-term price movements. Although this information impact is present at thirty second and five minute intervals post-trade for many classes of market participants, the presence of non-displayed depth by investment banks and wirehouses is predictive of price changes up to 30 minutes post-trade. Displayed depth does not predict daily returns, but the reserve size quotes of investment banks and wirehouses is indicative of which stocks will increase or decrease in price over the course of the day's trading. This effect is strongest at earnings releases, where only investment bank and wirehouse non-displayed depth predicts returns of individual stocks in the wake of an earnings announcement.