Carl F. Luft

Corporate risk management: Costs and benefits

Abstract This paper establishes a framework within which the costs and the benefits of corporate risk management decisions can be analyzed. The most important conclusion is that risk management strategies should be pursued to enhance shareholder value. Although systematic hedging of all variation in the net cashflows may be in the best interest of the management, such behavior is inconsistent with maximizing firm and shareholder value. The extant empirical evidence cited is supportive of the notion that the strongest motive for risk management behavior is the avoidance of financial distress. However, there are offsetting costs to consider as well. The existence of these costs makes it imperative that shareholders understand the risk management process.

Over the Counter Bulletin Board Exchange: Market Structure, Risk, and Return

Unknown or little researched equity investment forms a central part of several hedge fund strategies. However, knowledge of the Over the Counter Bulletin Board (OTC-BB) Exchange is widely lacking. This research is an initial attempt to provide some empirical insights and analysis about the OTC-BB market.

Over the Counter Bulletin Board Exchange: The Impact of Liquidity and Size to Return, Volatility, and Bid/Ask Spread

This study was motivated by the lack of empirical research performed on securities traded on the over the counter bulletin board exchange (“OTC-BB” or the “Exchange”). It extends prior research on this market by studying the impact of market capitalization and liquidity to return, volatility and components of the bid-ask spread. The time period analyzed runs from January 1, 1996 through December 31, 2000. The authors calculate return, volatility, Sharpe ratio, spread, and turnover for 10 equal-size deciles exclusively using OTC-BB traded securities. They find that an investment strategy that focuses on the largest OTC-BB firms provides relatively the highest risk-return trade-off in this market during the period January 1996? December 2000. These findings are consistent with an earlier article by the authors that suggests that a trading strategy of OTC-BB securities will not yield an appropriate risk-return trade-off as measured by the Sharpe ratio. In addition, they find that competition appears to be increasing as the relative bid/ask spread for OTC-BB securities declines. Finally, they observe that the behavior of the market participants trading OTC-BB securities (“traders”) is consistent with the behavior exhibited by New York Stock Exchange (“NYSE”) specialists.

Stock Option Expensing: The Role of Corporate Governance

Analysis of the corporate stock option expensing decision (before the practice became mandatory in 2006) continues to be of interest because it provides insight into the underlying factors affecting not only expense recognition, but the overall corporate decision-making process. Using a sample of 207 companies that volunteered to expense options and more than 1,000 non-expensing firms, the authors found that companies that provide more disclosure and appeared to have a stronger alignment of managerial and shareholder interests were also more likely to expense stock options-a finding that the authors view as indirect evidence that voluntary expensing was more likely to occur in companies that practiced effective corporate governance. And consistent with the prediction of efficient market theorists, the study also found no significant market reaction to announcements of these decisions to expense options. Copyright (c) 2008 Morgan Stanley.

Hedging individual mortgage risk

Abstract This paper investigates the feasibility of an individual hedging the interest rate risk involved in planning to take out a mortgage at a future point in time. Simulation using market data indicates that a simple futures hedge reduces the variation in mortgage capacity by about one half. Expected mortgage capacity is very close to 100% of the original capacity at a very low cost. Hedging the individual mortgage with a put futures option is less effective in reducing downside risk and has a higher expected cost.

Commodity Exchange-Traded Funds: Observations on Risk Exposure and Performance

This paper compares returns of ETFs holding physical commodities and ETFs holding derivative products to their respective spot commodity returns to identify significant performance differences based on the ETF assets. We regress ETF returns on spot commodity returns to estimate beta and R2 values. We use these Beta and R2 values to evaluate the relationship between the ETFs and their spot prices. We found that the physical ETFs perform more consistently with their spot commodities; these products are more likely to provide the expected risk exposure investors desire. Also this paper performs two mean comparison tests: the first compares the returns of the ETFs with their spot commodities; while the second compares the Sharpe Ratios of the ETFs with the Sharpe Ratios generated by their spot commodities. Our analysis of the Sharpe Ratios found that futures based ETFs have considerable performance divergence from the physical commodity depending on if the futures market is in backwardation or contango. Finally this paper evaluates the performance of the stack and strip methods used by WTI Crude Oil based ETFs. We found that the use of a strip method improved the performance of the WTI Crude Oil ETF when the contango in the futures market became more severe, and eroded performance as the market became flat or backwardated.

Practical Applications of Exchange-Traded Funds: Sector Performance and Diversification

Practical Applications Summary ETFs continue to be valuable asset allocation tools, especially for investors looking for specific sector exposures. But how confident can investors be that ETF returns will replicate their chosen sectors? And how broad should the benchmark be? In an interview with Institutional Investor Journals, Carl Luft of DePaul University explains that correlations are actually closer with sector indices that match the S&P 1500 index, versus the more frequently used S&P 500 index.