Underlying Cash Flows Research Articles

Bond pricing with a surface of zero coupon yields

AbstractWe present a new method for consistent cross‐sectional pricing of all traded bonds in the fixed income market. By applying thin plate regression splines (Wood, 2003) to bootstrapped zero coupon bond yields (Hagan and West, 2006), the method decomposes traded yields into a risk‐free component plus premia for credit and liquidity risks, where the decomposition is consistent with the market valuations and underlying cash flows of the bonds. We apply the framework to end of quarter yield data from 2008 to 2011 on Australian dollar denominated semi‐government, supranational and agency (SSA) bonds, and find that the surface provides an excellent fit to the underlying zero coupon yield curves. Further, the decomposition of selected yield time series and cross‐sections demonstrates how credit premia increased for Australian SSA bonds through the Global Financial Crisis (GFC), but were counterbalanced by liquidity discounts as investors sought safe haven securities.

Threshold-Type Policies for Real Options Using Regime-Switching Models

To investigate the impact of macroeconomic conditions on irreversible investments under a regime-switching model, our main effort in this work is to rigorously justify the existence and uniqueness of optimal threshold-type policies. The underlying cash flow process is modeled as a geometric Brownian motion with return rate and volatility depending on a continuous-time Markov chain. The problem is similar to the American style of call options. When dealing either with American options in a financial market or with real options, a common practice in the literature is to postulate threshold-type strategies and to find the optimal threshold levels as solutions of systems of nonlinear algebraic equations. Although from a computational standpoint, this seems to be a reasonable approach, the issue of existence and uniqueness of solutions has never been addressed to date. Instead of assuming the threshold-type policies, this paper establishes that indeed the threshold-type policies are the right choice. Variation...

Fair Value Accounting

The paper provides a genesis of fair value accounting (FVA) and reviews some research and empirical evidence that are relevant to the debate surrounding its use. We also comment on FVA’s role in the financial crisis: was it just the messenger of bad news or was it “procyclical,” contributing to the sad state of the economy in addition to reporting on it? We briefly characterize FVA as comprising three levels of valuation: level 1 for assets/liabilities for which market values are directly observable, level 2 for assets/liabilities for which market-derived inputs, but not prices, are observable and level 3 for assets/liabilities which value is derived from models. We conclude that the use of FVA by regulators was probably procyclical for level 1 FVA assets, i.e., those assets which accounting values were based upon directly observable market prices. In contrast, accounting values for FVA assets that were not actively traded (levels 2 and 3) probably lagged market developments and were likely biased in their valuation. Our analysis also suggests that the appropriateness of FVA-derived valuation is conditional upon market conditions (efficiency and liquidity), and that fundamental valuation drivers such as an asset/ liability underlying cash flows are still relevant valuation inputs despite the existence of concurrent market prices. The paper concludes with some observations regarding the role of auditors, regulators, standard-setters and investors regarding FVA-derived information.

Modelling and economic evaluation of forest biome shifts under climate change in Southwest Germany

We evaluated the economic effects of a predicted shift from Norway spruce ( Picea abies (Karst) to European beech ( Fagus sylvatica (L) for a forest area of 1.3 million ha in southwest Germany. The shift was modelled with a generalised linear model (GLM) by using presence/absence data from the National Forest Inventory in Baden-Württemberg, a digital elevation model, and regionalised climate parameters from the period 1970 to 2000. Two scenarios from the International Panel on Climate Change (IPCC) (B1, A2) for three different time scales (2030, 2065, and 2100) were investigated. The GLM predicted a decrease of the suitable area for growing Norway spruce between 21% (B1, 2030) and 93% (A2, 2100) in comparison to 2000. This corresponds to a reduction in the potential area of Norway spruce from between 190,000 and 860,000 ha. The financial effect of this reduction in area was then evaluated by using a classical Faustmann approach, namely the land expectation value (LEV) as an economic parameter for forests of Norway spruce versus European beech. Underlying cash flows were derived from a distance dependent, single-tree growth simulator (SILVA) based on data for prices and costs of the year 2004. With an interest rate of r = 2%, the predicted loss in the potential area of Norway spruce is related to a decrease of the LEV between 690 million and 3.1 billion Euro. We discuss the sensitivity of these results to changing interest rates, risk levels, and rotation lengths. Results suggest that managing forestland for profitability will be increasingly difficult under both climate scenarios.

Cash Flow, Consumption Risk, and the Cross‐section of Stock Returns

ABSTRACTI link an asset's risk premium to two characteristics of its underlying cash flow: covariance and duration. Using empirically novel estimates of both cash flow characteristics based exclusively on accounting earnings and aggregate consumption data, I examine their dynamic interaction in a two‐factor cash flow model and find that they are able to explain up to 82% of the cross‐sectional variation in the average returns on size, book‐to‐market, and long‐term reversal‐sorted portfolios for the period 1964 to 2002. This finding highlights the importance of fundamental cash flow characteristics in determining the risk exposure of an asset.

Trading imbalances, predictable reversals, and cross-stock price pressure

We test the implications of a multi-asset equilibrium model in which a finite number of risk-averse liquidity providers accommodate non-informational trading imbalances. These imbalances generate predictable reversals in stock returns. An imbalance in one stock also affects the prices of other stocks. The magnitude of the cross-stock price pressure depends on the correlations of the stocks’ underlying cash flows. The model implies that non-informational trading increases the volatility of stock returns. We confirm the model's implications using data from the Taiwan Stock Exchange.

Does Dividend Stability Provide a Promising Stock Return? Evidence from Bursa Malaysia

This paper examines whether there is any significant impact between a stable dividend policy and firm performance. More recent empirical studies have looked at the association of dividend stability with risk factor. Stable dividend signals the stability of the underlying cash flow as this translates into lower level of uncertainty and business risk, while variable dividend stream will increase fluctuation of cash flows in the hands of shareholders. Thus they will require a higher rate of return in order to compensate them for the uncertainty of cash flows that they have to endure. Using 120 stocks from seven different industries in Malaysia covering over a period of six years from 2001 to 2005, our results suggest that there is no significant impact of dividend stability on stock market return. The results further reveal that dividend stability does differs significantly across different industry sectors.

Learning, Structural Instability, and Present Value Calculations

Present value calculations require predictions of cash flows both at near and distant future points in time. Such predictions are generally surrounded by considerable uncertainty and may critically depend on assumptions about parameter values as well as the form and stability of the data generating process underlying the cash flows. This paper presents new theoretical results for the existence of the infinite sum of discounted expected future values under uncertainty about the parameters characterizing the growth rate of the cash flow process. Furthermore, we explore the consequences for present values of relaxing the stability assumption in a way that allows for past and future breaks to the underlying cash flow process. We find that such breaks can lead to considerable changes in present values.

Evaluating Liquidity Measures

We propose to numerical solve for the equilibrium in a dynamic limit order market with a market maker and a large trader. Using the simulated data, we will evaluate commonly used measures of transaction costs and liquidity, such as the Amihud illiquidity measure, Kyle's, the PIN measure and spread measures. Varying the structural parameters of the model, such as the gains to trade, the degree of asymmetric information, the arrival rate of traders and the volatility of the underlying cash flows we can determine how each of these measures changes with changes in the economic fundamentals. As all these measures have been used to explain asset returns, this exercise will allow us to determine which economic fundamentals are priced. We propose to solve a model with risk-neutral agents who arrive randomly at the market for an asset that has both common and private components to its value. Agents will have different information about the common value, i.e., the present value of the future cash flows on the asset. Thus, there will be adverse selection: prior to his first entry in to the market, each agent chooses whether to buy information about the fundamental value of the asset. An informed agent views the current expected value of the cash flows on each entry, where as an uninformed agent forms an estimate of this value based on market observables. On arrival, each agent chooses either to buy or sell one share. If his order does not execute, here visits the market and can revise his order. Thus, agents face a dynamic problem: the actions they take at any point in time incorporate the possibility of future reentry. We will incorporate a market maker into this framework. Specifically, there will be an uninformed agent who is always in the market who bears a cost of holding inventories. In addition, we will introduce a large trader who submits market orders within a short time period. The out put of the model will be a time series of limit order books, including cancellations and transactions. In addition, we will observe market maker participation rates and inventories, and how the large trader splits his orders. Using this time series, we will construct standard transaction cost proxies. We will then vary the underlying parameters in the model to measure the changes in these proxies.

A class of solvable stochastic dividend optimization problems: on the general impact of flexibility on valuation

We consider the determination of an optimal dividend policy in the presence of cash flow uncertainty and transaction costs. We state a set of weak conditions under which the optimal dividend policy can be explicitly characterized for a broad class of diffusions modelling the underlying cash flow dynamics and demonstrate that increased dividend policy flexibility does not only increase the maximal expected cumulative present value of the future dividends, it also increases the rate at which this value grows (i.e. Tobin’s marginal q). We also prove that increased transaction costs result into larger but less frequent dividend payments.

Feedback and the success of irrational investors

We provide a model in which irrational investors trade based upon considerations that have no inherent connection to fundamentals. However, trading activity affects market prices, and because of feedback from security prices to cash flows, the irrational trades influence underlying cash flows. As a result, irrational investors can, in some situations, earn abnormal (i.e., risk-adjusted) profits that can exceed the abnormal profits of rational informed investors. Although the trading of irrational investors cause prices to deviate from fundamental values, stock prices follow a random walk.

Learning, Structural Instability and Present Value Calculations

Present value calculations require predictions of cash flows both at near and distant future points in time. Such predictions are generally surrounded by considerable uncertainty and may critically depend on assumptions about parameter values as well as the form and stability of the data generating process underlying the cash flows. This paper presents new theoretical results for the existence of the infinite sum of discounted expected future values under uncertainty about the parameters characterizing the growth rate of the cash flow process. Furthermore, we explore the consequences for present values of relaxing the stability assumption in a way that allows for past and future breaks to the underlying cash flow process. We find that such breaks can lead to considerable changes in present values.

Learning, Structural Instability and Present Value Calculations

Present value calculations require predictions of cash flows both at near and distant future points in time. Such predictions are generally surrounded by considerable uncertainty and may critically depend on assumptions about parameter values as well as the form and stability of the data generating process underlying the cash flows. This paper presents new theoretical results for the existence of the infinite sum of discounted expected future values under uncertainty about the parameters characterizing the growth rate of the cash flow process. Furthermore, we explore the consequences for present values of relaxing the stability assumption in a way that allows for past and future breaks to the underlying cash flow process. We find that such breaks can lead to considerable changes in present values.

Cash Flow, Consumption Risk and Cross Section of Stock Returns

This paper directly links the risk premium on an asset to two characteristics of its underlying cash flow: cash flow covariance with aggregate consumption; and cash flow duration, which measures the temporal pattern of the cash flow. Their impact on the cross-sectional variation of risk premia can be largely captured by a two-factor cash flow model. While cash flow covariance is of first-order importance in explaining the cross-sectional variation of risk premia, cash flow duration still provides additional explanatory power through a second-order interaction term. Cash flow duration is particularly important in explaining the value premium given as value and growth stocks have significantly different durations. Empirically, I measure both cash flow characteristics using only consumption and accounting data. I show that the two-factor cash flow model is able to explain 82% of the cross-sectional variation in returns on size or book-to-market sorted stock portfolios.

Feedback and the Success of Irrational Investors

We provide a model in which irrational investors trade based upon considerations that are not inherently related to fundamentals. However, because trading activity affects market prices, and because of feedback from security prices to cash flows, the irrational trades influence underlying cash flows. As a result, irrational investors can, in some situations, earn positive expected profits. These expected profits are not market compensation for bearing risk, and can exceed the expected profits of rational informed investors. The trades of irrational investors can distort real investment choices and lower ex ante firm values, even though stocks prices follow a random walk.

Risk and Valuation under an Intertemporal Capital Asset Pricing Model*

We analyze the risk characteristics and valuation of assets in an economy in which the investment opportunity set is described by the real interest rate and the maximum Sharpe ratio. We show that, holding constant the beta of the underlying cash flow, the beta of a security is a function of the cash flow maturity. For parameter values estimated from U.S. data, the security beta always increases with the maturity of the underlying cash flow, while discount rates for risky cash flows can be increasing, decreasing, or nonmonotone functions of that maturity.

Risk and Valuation Under an Intertemporal Capital Asset Pricing Model

We analyze the risk characteristics and the valuation of assets in an economy in which the investment opportunity set is described by the real interest rate and the maximum Sharpe ratio. It is shown that, holding constant the beta of the underlying cash flow, the beta of a security is a function of the maturity of the cash flow. For parameter values estimated from U. S. data, the security beta is always increasing with the maturity of the underlying cash flow, while the discount rates for risky cash flows can be increasing, decreasing or non-monotone functions of the maturity of the cash flow. The variation in discount rates and present value factors that is due to variation in the real interest rate and the Sharpe ratio is shown to be large for long maturity cash flows, and the component of the volatility that is due to variation in the Sharpe ratio is more important than that due to variation in the real interest rate.

Abandonment Options and Information System Design

We study a principal-agent model of moral hazard in which the principal has an abandonment option. The option to abandon a project midstream limits a firm's downside risk. From a consumption (production) perspective, the option is clearly beneficial. However, from an incentive perspective, the option can be costly. Removing the lower tail of the project's underlying cash flow distribution also eliminates the information it contains about an agent's (unobservable) productive input. In addition, there is also the issue that the option holder cannot always (ex ante) commit to the precise circumstances under which the option will be exercised. These concerns introduce an interaction in the valuation of the abandonment option and information system. In particular, the manner in which information is coarsened and the direction of the flow of information are critical design parameters that affect option value.

Layered Finance

The general objectives of subordinated debt in project finance transactions are to mitigate risk for senior lenders and to mobilize a higher aggregate level of project debt than is otherwise justified by the project9s underlying cash flows. This article focuses primarily on three purposes of debt subordination in project finance, 1) replacement by project sponsor or other “insider” of equity with debt, 2) provision by other “investors” of equity-like capital on a hybrid basis, and 3) promoting the participation of senior lenders by improving the margin of debt service coverage.

The Quality of Accruals and Earnings: The Role of Accrual Estimation Errors

This paper suggests a new measure of one aspect of the quality of accruals and earnings. The major benefit of accruals is to reduce timing and mismatching problems in the underlying cash flows. However, accruals accomplish this benefit at the cost of making assumptions and estimates about future cash flows, which implies that accruals include errors of estimation or noise. Since estimation noise reduces the beneficial role of accruals, this study suggests that the quality of accruals and earnings is decreasing in the magnitude of estimation noise in accruals. More specifically, we develop a simple model of working capital accruals where accruals correct the timing problems in cash flows at the cost of including errors in estimation. Based on the model, we derive an empirical measure of accrual quality as the residual from firm-specific regressions of changes in working capital on past, present, and future operating cash flow realizations. The study concludes with two empirical applications that illustrate the usefulness of our measure of accrual quality. First, we explore the relation of accrual quality to economic fundamentals. We find that accrual quality is negatively related to the magnitude of total accruals, length of the operating cycle, and the standard deviation of sales, cash flows, and earnings, while it is positively related to firm size. Second, we show a strong positive relation between accrual quality and earnings persistence.