Interim Losses Research Articles

Long-term option pricing with a lower reflecting barrier

AbstractThis paper considers the pricing of long-term options on assets such as housing, where either government intervention or the economic nature of the asset limits large falls in prices. The observed asset price is modelled by a geometric Brownian motion (“the notional price”) reflected at a lower barrier. The resulting observed price has standard dynamics but with localised intervention at the barrier, which allows arbitrage with interim losses; this is funded by the government’s unlimited powers of intervention, and its exploitation is subject to credit constraints. Despite the lack of an equivalent martingale measure for the observed price, options on this price can be expressed as compound options on the arbitrage-free notional price, to which standard risk-neutral arguments can be applied. Because option deltas tend to zero when the observed price approaches the barrier, hedging with the observed price gives the same results as hedging with the notional price and so exactly replicates option payoffs. Hedging schemes are not unique, with the cheapest scheme for any derivative being the one which best exploits the interventions at the barrier. The price of a put is clear: direct replication has a lower initial cost than synthetic replication, and the replication portfolio always has positive value. The price of a call is ambiguous: synthetic replication has a lower initial cost than direct replication, but the replication portfolio may give interim losses. So the preferred replication strategy (and hence price) of a call depends on what margin payments need to be made on these losses.

Transient Alterations in Streamwater Quality Induced by Pollution Incidents: Interim Losses Calculations and Compensation Alternatives Based on Habitat Equivalency Analysis.

Pollution incidents cause transient water quality alterations during the passage of contaminants' plume along watercourses, with plume passage period and contaminants' concentrations modelled by advection-dispersion equations. Despite being transient, water quality alterations can impose many impacts on the streamwater ecosystem services. This study proposes two frameworks based on Habitat Equivalency Analysis to be applied during assessments of streamwaters' pollution incidents and respective compensation panoramas: (1) Streamwater interim loss framework, to calculate interim loss debits caused by transient alterations in the streamwater quality; (2) Total credit framework, to calculate streamwater credits generated by improvements in selected watercourse's streamwater quality, produced by wastewater treatment plants in this study. The amount of credits calculated in the selected watercourses assists in the proposal of suitable compensatory remediation projects to offset interim losses. Frameworks' calculations are founded on IVA, a water quality index for protection of aquatic life and aquatic communities. Frameworks' calculations depend on three parameters: IVA, watercourses fluxes and the present value multiplier. The frameworks were calculated in ΔIVAxL, unit defined by multiplying sensed alterations in streamwater quality (as ΔIVA) and streamwater flux, in liters (L). The frameworks were applied to two major streamwater pollution incidents in Brazil, caused by the dam collapses of Mariana and Brumadinho, suggesting suitable compensatory remediations' projects for the respective streamwater interim losses. Depending on the selected project, Brumadinho compensation period varied from 2 to 5 years, with estimated costs in the 2020 Int.$ 5.7-18.7M range; Mariana compensation period varied from 8 to 20 years, with estimated costs in the 2020 Int.$ 16.7-58.1M range. Based on Brumadinho compensatory remediation projects, an average water pollution environmental damage value per interim loss was calculated, 1.17E-4 2020 Int.$/ΔIVAxL, which might be useful in comparing streamwater pollution evaluations around the world.

Habitat Equivalency Analysis, a framework for forensic cost evaluation of environmental damage

When environmental damage takes place, forensic experts investigate and undertake initial damage assessments. Determining damage costs can be challenging in terms of remedial action and of assigning monetary value to losses. We develop a Habitat Equivalency Analysis (HEA) framework to assess environmental damage costs and apply it to three case studies from the Brazilian Atlantic Rainforest (BAR). Remediation costs have been used previously as proxies for valuing ecosystem services (ES). In this approach, interim losses, those ES not supplied till the damage is restored, are accounted as compensatory remediation costs, the costs of resource enhancement or creation that compensates for the loss in ES provision. We compared values derived here to those using an alternative valuation, based on a tropical forest’s average annual value (Int.$/ha/year), as described in the literature. Findings demonstrate the potential of the framework to account for interim losses, perpetual damages and the cost of remediation. Although the three study areas varied in the extent of damage and the remediation procedures, the damage cost per hectare was of the same order of magnitude and within a narrow range: 13,216; 28,024; and 19,681 (in 2017 Int.$/ha) for the Citrus; Sand Mining and Eucalyptus study areas respectively. The environmental damage costs per hectare appraised by the alternative valuation were higher and showed greater variation: 32,692; 139,389; and 38,260 (in 2017 Int.$/ha) respectively. The experimental data were shown to be within the range of theoretical results derived. As HEA valuation is solely based on ecosystem damage remediation principles, its application will provide a more robust platform for the evaluation of the total economic value of tropical forests, even in the early stages of damage assessments.

Non-Regression Clauses in Times of Ecological Restoration Law: Article 6(2) of the EU Habitats Directive as an unusual ally to restore Natura 2000?

Recently, the concept of ecological restoration has risen to the fore in international and regional biodiversity policies as a newly coined tool for the intentional recovery of degraded ecosystems. The EU Biodiversity Strategy to 2020 has also embraced ecological restoration and translated it into an ambitious target to restore 15% of the degraded ecosystems in the EU. Although the concrete delineation of these recent policies remains uncertain, to say the least, it is obvious that the EU Nature Directives will play a crucial role in achieving these restoration targets. In recent years, the relevance of the non-regression or standstill clause contained in Article 6(2) of the Habitats Directive – which does not seem to focus on recovery but rather on avoiding additional losses in Natura 2000 sites – to achieving these objectives has gained considerable traction. This paper argues that taking into account recent CJEU case-law developments and the lack of proper enforcement of conservation duties during the past two decades, Article 6(2) of the Habitats Directive will be a major catalyst for the implementation of more robust recovery policies, especially in cases of previous non-compliance with the conservation duties that EU Member States have regarding the Natura 2000 Network. Its legal teeth allow it to bolster recovery and remediation programmes across the EU, tackling past, interim and ongoing biodiversity losses in the context of the Natura 2000 Network, and to remove bothersome obstacles that stand in the way of further restoration.

The role of ecosystem services in USA natural resource liability litigation

This paper examines how the United States has valued harm to public resources in natural resource liability laws and practice, an early legal application of the ecosystem-services conceptual framework. Our primary focus is on valuing harm to the difficult-to-value resources and ecological services that provide indirect or passive human uses, for which revealed preference valuation methods (based on observable behavior) are not applicable. We concentrate on the past 25years of U.S. experience with the innovative, restoration-based framework established in regulations implementing the Oil Pollution Act of 1990. By reframing the damage claims as the cost of both “primary” restoration (to promote recovery of injured resources) and “compensatory” restoration (to account for interim losses pending recovery), the regulations deflected some of the controversy surrounding valuation methods.The restoration-based compensation framework provides two basic approaches for calculating the scale of compensatory restoration projects. A service-to-service approach, which does not require valuation, applies to projects that provide resources and ecosystem services of the same type, quality, and comparable value as those harmed. A valuation approach, intended for a broader range of applications, relies on survey-based methods.For injuries to ecological services, we found trustees have relied almost exclusively on habitat equivalency analysis (HEA), a service-to-service approach, adapting its use to applications where restoration projects make resource and/or ecosystem services substitutions. We explore how the trustees address the challenge of characterizing the equivalency between injury and restoration resources and ecosystem services through the choice of restoration projects and the choice of the ecosystem service metrics. Widely used in the U.S. and EU, the restoration-based measure of damages and the associated HEA methodology may be useful for other countries.

Valuing environmental damage remediation and liability using value estimates for ecosystem services

The European Environmental Liability Directive aims to ensure that damaged habitats are restored where possible, but allows for complementary remediation with replacement habitat where restoration is not possible within a reasonable time. It also allows for compensatory remediation of the resource based on an assessment of environmental values in cases where there are interim social losses. This paper concurs with the argument that physical remediation without consideration of social values can fail to be equivalent to the resource that has been lost. Using, as a case study, a river in Ireland, it demonstrates that estimating social value can be challenging in practice, noting also differences between the value of environmental gains and losses. The paper argues that estimates of final ecosystem service values, including wastewater treatment costs, can provide a measure of social value and makes a case for the systematic collection of these data to inform decision-making.

Neural systems for choice and valuation with counterfactual learning signals

The purpose of this experiment was to test a computational model of reinforcement learning with and without fictive prediction error (FPE) signals to investigate how counterfactual consequences contribute to acquired representations of action-specific expected value, and to determine the functional neuroanatomy and neuromodulator systems that are involved. 80 male participants underwent dietary depletion of either tryptophan or tyrosine/phenylalanine to manipulate serotonin (5HT) and dopamine (DA), respectively. They completed 80 rounds (240 trials) of a strategic sequential investment task that required accepting interim losses in order to access a lucrative state and maximize long-term gains, while being scanned. We extended the standard Q-learning model by incorporating both counterfactual gains and losses into separate error signals. The FPE model explained the participants' data significantly better than a model that did not include counterfactual learning signals. Expected value from the FPE model was significantly correlated with BOLD signal change in the ventromedial prefrontal cortex (vmPFC) and posterior orbitofrontal cortex (OFC), whereas expected value from the standard model did not predict changes in neural activity. The depletion procedure revealed significantly different neural responses to expected value in the vmPFC, caudate, and dopaminergic midbrain in the vicinity of the substantia nigra (SN). Differences in neural activity were not evident in the standard Q-learning computational model. These findings demonstrate that FPE signals are an important component of valuation for decision making, and that the neural representation of expected value incorporates cortical and subcortical structures via interactions among serotonergic and dopaminergic modulator systems.

Environmental rejuvenation of the Gulf by compensation and restoration

The Gulf is considered to be a young sea in decline, with poor prognosis for continuing production of abundant natural resources. We compare and contrast ‘monetary’ and ‘environmental’ compensation as mechanisms for addressing ecosystem damage in the Gulf. The 1992 International Oil Pollution Compensation Conventions settle claims financially, but only for certain categories of oil spills. For example, aside from inherent difficulties of valuing ecosystem services and their losses, ecological damage from the time of injury to recovery (interim losses) is not compensated. Another approach involves reimbursement for environmental action/projects to restore affected resources and offset impacts until recovery. In habitat equivalency analysis, mitigation requirements are calculated from the type(s), severity, duration and extent of resource impacts. This approach was utilized to resolve several claims for damage from the 1991 Gulf War oil spill. Various compensatory projects resulted, including direct oil spill remediation and other environmental projects such as the establishment of ≥1 protected area (x ha for y years). Besides compensation, in this paper we advocate setting threshold levels for the protection of different coastal and marine ecosystems. This could be achieved by a proportion (c. 30%) of every major ecosystem becoming fully protected, through an expanded regional protected area network.

Medida de la compensación del daño ambiental en la Directiva de Responsabilidad Ambiental: lecciones aprendidas del caso Aznalcóllar-Doñana

The Aznalcóllar mine tailings spill near the Doñana Park (Spain), taking place in 1998, is analyzed in the context of the Environmental Liability Directive (ELD). The ELD imposes liability on operators of risky activities for environmental damage, including the compensation for interim losses. The aim of this study is to analyze the role of economic valuation in the measurement of the compensation in the context of the ELD and derive some lessons for future applications. The results show that the measures carried out after the accident (Green Corridor) did not compensate for the damage at Doñana. This study points out the need of a deeper analysis of non-use values, the control of protest answers and the set up of valuation scenarios specific to the interim losses.

LIQUIDITY RISK AND CORPORATE HEDGING WITH FUTURES

This paper examines the hedging behaviour of a value-maximizing firm that exists for two periods. The firm faces uncertain income and is subject to tax asymmetries with no loss-offset provisions. The firm has access to unbiased futures contracts in each period for hedging purposes. We impose a liquidity constraint on the firm. Specifically, whenever the net interim loss due to its first-period futures position exceeds a predetermined threshold level, the firm is forced to terminate its risk management program and, therefore, is prohibited from trading the futures contracts in the second period. We show that the liquidity-constrained firm optimally adopts a full-hedge via its second-period futures position to minimize the extent of the income risk and an under-hedge via its first-period futures position to limit the degree of the liquidity risk.

Multinationals and futures hedging: An optimal stopping approach

This paper examines the optimal design of a futures hedge program for a risk-averse multinational firm (MNF) under exchange rate uncertainty. All currency futures contracts are marked to market and require interim cash settlement of gains and losses. The MNF commits to prematurely liquidating its futures position on which the interim loss incurred exceeds a threshold level (i.e., the liquidation threshold). When the liquidation threshold is exogenously given, we show that the MNF optimally opts for an under-hedge (an over-hedge) should the futures exchange rates be not too (sufficiently) positively autocorrelated. When the liquidation threshold is endogenously determined, we show that the MNF voluntarily chooses to prematurely liquidate its futures position only if the futures exchange rates are positively autocorrelated. In the case that the futures exchange rates are uncorrelated or negatively autocorrelated, the MNF prefers not to commit to any finite liquidation thresholds.

Risk management with options and futures under liquidity risk

AbstractFutures hedging creates liquidity risk through marking to market. Liquidity risk matters if interim losses on a futures position have to be financed at a markup over the risk‐free rate. This study analyzes the optimal risk management and production decisions of a firm facing joint price and liquidity risk. It provides a rationale for the use of options on futures in imperfect capital markets. If liquidity risk materializes, the firm sells options on futures in order to partly cover this liquidity need. It is shown that liquidity risk reduces the optimal hedge ratio and that options are not normally used before a liquidity need actually arises. © 2009 Wiley Periodicals, Inc. Jrl Fut Mark 29:297–318, 2009

Production, liquidity, and futures price dynamics

AbstractThis study examines the optimal design of a futures hedge program for the competitive firm under output price uncertainty. All futures contracts are unbiased and marked to market in that they require interim cash settlement of gains and losses. The futures price dynamics follows a first‐order autoregression with a random walk serving as a special case. The firm's futures hedge program is constituted of an endogenous provision for premature termination, which depends on how the futures prices are autocorrelated. Succinctly, the firm voluntarily commits to premature liquidation of its futures position on which the interim loss incurred exceeds a predetermined threshold level if the futures prices are positively autocorrelated. In this case, the liquidity constrained firm optimally opts for an over‐hedge if its preferences exhibit either constant or increasing absolute risk aversion. If the futures prices are uncorrelated or negatively autocorrelated, the firm prefers to be liquidity unconstrained and thus adopts a full‐hedge to completely eliminate the output price risk. © 2008 Wiley Periodicals, Inc. Jrl Fut Mark 28:749–762, 2008

Risk Management with Options and Futures Under Liquidity Risk

Futures hedging creates liquidity risk through marking to market. Liquidity risk matters if interim losses on a futures position have to be financed at a markup over the risk-free rate. This paper analyzes the optimal risk management and production decisions of a firm facing joint price and liquidity risk. It provides a rationale for the use options on futures in imperfect capital markets. If liquidity risk materializes, the firm sells options on futures in order to partly cover this liquidity need. It is shown that liquidity risk reduces the optimal hedge ratio and that options are not normally used before a liquidity need actually arises.

Multinationals and futures hedging under liquidity constraints

This paper examines the behavior of a multinational firm (MNF) under exchange rate uncertainty. The MNF has operations domiciled in the home country and in a foreign country. Each of these two operations produces a single homogeneous good to be sold in the home and foreign markets. To hedge the exchange rate risk, the MNF has access to an intertemporally unbiased currency futures market. All currency futures contracts are marked-to-market and thus require interim cash settlement of gains and losses. We impose a liquidity constraint on the MNF in that the MNF is forced to prematurely liquidate its futures position from which the interim loss exceeds a predetermined threshold level. If the MNF's utility function satisfies decreasing absolute risk aversion, we show that the MNF optimally opts for a short under-hedge. Furthermore, the MNF sells less (more) and produces more (less) in the foreign (home) country in response to the imposition of the liquidity constraint.

Tax asymmetry and futures hedging under liquidity constraints

This paper examines the optimal futures hedging decision of a firm facing uncertain income that is subject to asymmetric taxation with no loss-offset provisions. All futures contracts are marked to market and require interim cash settlement of gains and losses. The firm is liquidity constrained in that it is forced to prematurely close its futures position on which the interim loss incurred exceeds a threshold level. The liquidity risk created by the interim funding requirement of a futures hedge is shown to proffer the firm perverse incentives, thereby making an under-hedge optimal. This under-hedging result holds irrespective of whether the firm is risk neutral or risk averse. Copyright © 2005 John Wiley & Sons, Ltd.

Liquidity constraints and the hedging role of futures spreads

AbstractThis paper examines the behavior of the competitive firm under price uncertainty in general and the hedging role of futures spreads in particular. The firm has access to a commodity futures market where unbiased nearby and distant futures contracts are transacted. A liquidity constraint is imposed on the firm such that the firm is forced to prematurely close its distant futures position whenever the net interim loss due to its nearby and distant futures positions exceeds a threshold level. This paper shows that the liquidity constrained firm optimally opts for a long nearby futures position and a short distant futures position should the firm be prudent, thereby rendering the optimality of using futures spreads for hedging purposes. This paper further shows that the firm's production decision is adversely affected by the presence of the liquidity constraint. © 2004 Wiley Periodicals, Inc. Jrl Fut Mark 24:909–921, 2004

Hedging, liquidity, and the competitive firm under price uncertainty

AbstractIn this paper, the behavior of the competitive firm under price uncertainty when the firm has access to an intertemporally unbiased futures market is examined. Futures contracts are marked‐to‐market and thus require interim cash settlement of gains and losses. The firm is subject to a liquidity constraint in that it is forced to prematurely close its futures position on which the interim loss incurred exceeds a threshold level. It is shown that the liquidity constrained firm optimally opts for an under‐hedge should it be prudent. Furthermore, the prudent firm cuts down its optimal level of output in response to the presence of the liquidity constraint. As such, the liquidity risk created by the interim funding requirement of a futures hedge adversely affects the hedging and production decisions of the competitive firm under price uncertainty. © 2004 Wiley Periodicals, Inc. Jrl Fut Mark 24:697–706, 2004

The use of habitat equivalency analysis in natural resource damage assessments

Federal and state government agencies and Indian tribes, acting on behalf of the public as trustees, can recover damages to natural resources from companies responsible for oil spills or hazardous-substance releases. Habitat equivalency analysis (HEA) is a method for estimating the appropriate amount of compensation for interim losses resulting from such spills or releases. HEA has several restrictive assumptions that are not met in many situations and its input parameters often are not known with certainty, which can lead to substantial differences between HEA results and the “true” amount of compensation for losses resulting from oil spills or hazardous-substance releases. Critical assumptions of HEA include a preference for compensation with the same services as were injured, a fixed proportion of habitat services to habitat value, and a constant real value of services over time. HEA also requires that complex ecological services are expressed as a single metric and that the incremental effect of spills/releases are estimated reliably over time. Notwithstanding these important assumptions and limitations, HEA is frequently used to settle natural resource damage (NRD) claims and two HEA applications to NRD claims have been upheld by the courts. When properly structured and applied, HEA can produce relatively reliable results for most oil spills and simple cases involving hazardous-substance releases. Even when unmet assumptions and/or differences in professional judgment with respect to input parameters produce differences in HEA results, the method can be useful in achieving an NRD settlement in a variety of situations. However, HEA should only be viewed as a framework to provide a general approximation of any required restoration, and not as a substitute for a formal NRD assessment in cases involving complex hazardous-substance releases.

The NRDA Process can be Timely and Productive for All

ABSTRACT On August 24, 1998, there was an accidental hose failure at Tesoro Hawaii Corporation's (“Tesoro Hawaii” or “Tesoro”) single-point mooring (SPM) about a half mile off Barbers Point, near Honolulu, Oahu, Hawaii. The incident released approximately 117 barrels of bunker fuel. Immediate containment and clean up efforts were commenced, but on September 5, 1998, tarballs began to come ashore on Kauai. Shoreline impacts were observed between Kilauea Point to Makahuena Point on the eastern shore and between Makaha Point and Mana Point on the western shore of Kauai. To avoid the costs and delays associated with litigating resource damages that may have resulted from the release and any associated civil penalties, the Trustees and Tesoro Hawaii entered into a cooperative Natural Resource Damage Assessment (NRDA) protocol. The Trustees and Tesoro Hawaii conducted a phased approach focusing on injury determination and quantification using technical working groups (TWGs) composed of Trustee and Tesoro Hawaii representatives. Resource injuries considered were for seabirds, marine environment (opihi), marine mammals (Hawaiian monk seal), and human use. To expedite the process, it was agreed that time and money would best be spent identifying and scaling restoration projects. Coordination of effort was key to cost-effectiveness of the assessment and avoiding duplication of studies. The Final Restoration Plan and Environmental Assessment were accomplished within two years, including public participation. Restoration actions were undertaken promptly following execution of the Consent Decree. One of the initiatives developed by this collaborative effort was a derelict net removal project (the “Project”). The Project met the goals of the Trustees by compensating for interim losses to shoreline, intertidal and subtidal habitats and the biota in those habitats and by addressing potential injury to the endangered Hawaiian monk seal.