Option-based Risk Research Articles

Bear Beta or Speculative Beta?—Reconciling the Evidence on Downside Risk Premium

Abstract This article develops a new approach to explain why risk factors constructed from index option returns are priced in the stock market. We decompose an option-based factor into three main components and identify the one responsible for the beta–return relationship. Applying this method to the bear risk factor proposed by Lu and Murray reveals that the negative correlation between bear betas and stock returns does not reflect systematic risk premia. Instead, it represents an anomaly closely related to the betting-against-beta puzzle. We trace the root of this anomaly to disagreement concerning the aggregate stock market. Our work reconciles the conflicting evidence concerning downside risk by showing that neither ex-post nor ex-ante downside risk is priced in the cross-section of stocks while making a methodological contribution that facilitates more accurate interpretation of option-based risk factors in future research.

Option-Based Risk Incentives, Prior Losses, and Firm Performance

Option-Based Risk Incentives, Prior Losses, and Firm Performance

Corporate governance and firm-level jump and volatility risks

ABSTRACT Corporate governance plays a significant role in monitoring managerial behaviour, and thus in reducing firm-level risks and increasing firm value. Using a global unbalanced panel of 6,241 firm-year observations over the period of 1996–2016, we investigate the impact of internal and external governance attributes on firm risk. We address the endogeneity problem inherent in governance studies using option-based risk measures for jump and volatility risks. We use a multiple theoretical perspective to explain the relationship between governance mechanisms and firm risk. Our results indicate that board structure and entrenchment factors have a differential impact on firms’ jump and volatility risks. Our evidence reveals that firms with higher entrenchment provisions tend to increase volatility risk and that a higher proportion of outside directors increases firms’ volatility risk. Board size and CEO salary reduce volatility risk yet increase jump risk. We also find that the proportion of outside directors is negatively associated with firms’ jump risk. Overall, our results reveal interesting evidence and provide implications for future governance studies.

Index Option Trading Activity and Market Returns

Do order flows in index derivatives play an informational role? Weekly index put order flow on the International Securities Exchange positively and robustly predicts weekly S&P 500 index returns. This result obtains mainly for net put buying and is stronger in high VIX periods and in periods following macroeconomic announcements. We explore rationales for our findings, which include investor sentiment, the notion that market makers trade on information in options markets, and option-based risk protection strategies used by retail investors. The last explanation accords best with our analysis. This paper was accepted by Tyler Shumway, finance.

Managing financial risk in Chinese stock markets: Option pricing and modeling under a multivariate threshold autoregression

The Shanghai Stock Exchange and the Shenzhen Stock Exchange have grown remarkably since their inception 20years ago. Many of the investors in these two markets are asset management firms or pension funds, some of which may offer guaranteed returns to their clients. To these investors, modeling and managing the risk associated with their equity investments are highly important. In this paper, we use a multivariate threshold autoregressive (TAR) process to model the non-linear relationship between the two markets. This model may help fund managers better plan or execute their risk management decisions, as it captures the difference in investment return behavior when one market significantly out- or under-performs the other. We also contribute a risk-neutral version of the multivariate TAR model to the literature. This contribution permits one to price exotic options written on multiple stock indexes, and consequently helps fund managers calculate the cost of an option-based risk management strategy for funds involving the two Chinese markets.

Real option theory for risk mitigation in transport PPPs

Purpose – Public-private partnerships (PPPs) require the analysis and allocation of a broad spectrum of risks which are considered more complex than in traditional construction contracts. Traditional risk management techniques tend to ignore the manager's ability to recognize and exploit opportunities, which arise as uncertainties are resolved over time and which could potentially increase the project's value. Therefore it is necessary that the risk management process takes account of the managerial flexibility (e.g. real options). The objective of this paper is to explore the possibilities and rationale for implementing real options strategies in the risk management process. Design/methodology/approach – The approach is based on a literature analysis aimed at identifying key risks and related mitigation strategies and on real option theory in order to model these strategies as managerial flexibilities that naturally exist or are built “artificially” in contractual conditions and clauses, guarantees, etc. Findings – The paper develops an option-based risk management framework that associates to each risk the related mitigation strategies, which are expressed in terms of real options. The latter is expressed over the project phases conditioned to the natural evolution of risks over time. Originality/value – This paper proposes a new “dynamic” risk management approach for PPP projects based on real options that improves the traditional risk management techniques by supporting the decision makers in finding a cost-effective combination of real options (or forms of flexibility) to embed in a PPP investment in order to optimally control risk and maximize investment value.

Volatility and the Cross-Sectional Performance of Emerging Market Hedge Funds

Using an augmented Treynor and Mazuy model, the authors analyze the cross-sectional performance of a large sample of hedge funds operating in different regions of emerging markets. The performances of these funds are benchmarked on the relevant regional capital market indices and optionbased risk factors. They find that the realized volatility of emerging market stock indices generally has a negative impact on fund performance. For some of these funds, they find evidence of an ability to generate alpha and time the market. Furthermore, they provide information on how certain fund characteristics are related to the performance and ability of the fund managers.

Option-based risk management of a bond portfolio under regime switching interest rates

In the present paper, we assume an economy with regime switching short rates and show how the Value at Risk of a financial position on zero-coupon bonds, hedged by buying protective put options under budget constraints, can be minimized by selecting optimal (regime-dependent) strike prices.

A risk management framework and model for pension investment funds

Risk management in finance is an increasingly important area, which has been highlighted in the midst of the global credit crisis. In this paper, we propose a new risk management model for pension investment funds: a risk management framework and risk measure based on modelling the pension fund value as an option. We review risk management, discussing risk management frameworks and risk management measures. We discuss the advantages of our option-based risk management model and framework and conduct numerical experiments on our pension fund portfolio. We show that our risk management framework and model provides advantageous insight into managing pension funds.

Real options in information technology risk management

Recently, an option-based risk management (OBRiM) framework has been proposed to control risk and maximize value in information technology investment decisions. While the framework is prescriptive ...

Concave Payoff Patterns in Equity Fund Holdings and Transactions

Recent results from the hedge fund literature provide evidence that option-based risk factors may be a significant factor in managed fund returns. By examining a unique database of high-frequency holdings and transactions from a representative sample of forty Australian equity funds we find that exposure to these option-based risk factors may well arise from trading activity rather than from derivative positions that generate similar payouts. While the resulting concave payout patterns are associated with large and significant alphas in our sample, these alphas may be more a compensation for a modest increase in tail risk exposure than they are a reward for information-based trading.

Real Options in Information Technology Risk Management: An Empirical Validation of Risk-Option Relationships

Recently, an option-based risk management (OBRiM) framework has been proposed to control risk and maximize value in information technology investment decisions. While the framework is prescriptive in nature, its core logic rests on a set of normative risk-option mappings for choosing which particular real options to embed in an investment in order to control specific risks. This study tests empirically whether these mappings are observed in practice. The research site is a large Irish financial services organization with well established IT risk management practices not tied to any real options framework. Our analysis of the risk management plans developed for a broad portfolio of 50 IT investments finds ample empirical support for OBRiM's risk-option mappings. This shows that IT managers follow the logic of option-based risk management, although purely based on intuition. Unfortunately, reliance on this logic based on intuition alone could lead to suboptimal or counterproductive risk management practices. We therefore argue that managerial intuition ought to be supplemented with the use of formal real option models, which allow for better quantitative insights into which risk mitigations to pursue and combine in order to effectively address the risks most worth controlling.