Don M. Chance

The `repricing’ of executive stock options

We examine the incidence of corporations lowering the exercise prices of their executive stock options. These options can be viewed as a combination of a down-and-out call option and a down-and-in call option with the exercise price equal to the barrier. Using barrier option pricing theory, we find that at a minimum this features adds 7-10 percent to the value of the options on the grant date. We also examine the market, industry and firm-specific performance of a sample of 37 firms and 53 reset events. The period covered was 250 days before and after the day on which the firm reset the exercise prices of its executive stock options. The evidence strongly supports the conclusion that resetting the exercise price follows a period of poor firm-specific performance. The magnitude of the reduction in the exercise price was positively related to the firms stock price performance and using a value- weighted market portfolio, it was negatively related to the markets performance. No evidence supports the contention that lowering the exercise price brings an end to the firms problems and leads to an increase in shareholder wealth. Though the direct dollar impact at the time of the reset is relatively small to the shareholders, it is not insignificant to management. Allowing for the possibility of resetting after a stock price decline can create a perverse incentive under certain circumstances for managers to deliberately drive the stock price down further. In addition management has a greater incentive to engage in high risk projects than it would have with ordinary non- esettable options. These incentives and our results that the resets are indeed done, sometimes repeatedly, following poor firm-specific performance suggest that resetting is not in the best interests of shareholders, who should certainly question this practice.

THE PERFORMANCE OF PROFESSIONAL MARKET TIMERS: DAILY EVIDENCE FROM EXECUTED STRATEGIES

We examine the performance of 30 professional market timers during 1986–1994. Prior studies have analyzed implicit recommendations from mutual fund returns or explicit recommendations from newsletters. We analyze explicit recommendations executed in customer accounts. Using four tests, three benchmark portfolios, and daily data, we find significant unconditional and conditional ability that is robust with respect to transaction costs and survivorship bias. Relative ability persists and varies with the frequency of recommendation changes. When recommendations of successful timers are observed monthly instead of daily, significant ability generally disappears. Hence, the frequency with which recommendations are observed can change inferences regarding ability.

Benefits and Limitations of Diversification Among Commodity Trading Advisors

DON M. CHANCE is First Union professor of financial risk management at Virginia Tech. he benefits of diversification have been wellestablished since the early work of Markowitz [1952] and the formal proofs of Samuelson T [1967]. Modern capital market theory demonstrates that the value of &versification is bounded by the systematic risk of the market as a whole. In recent years, however, pension and endowment funds are turning to futures markets, looking for reductions in systematic risk. Some strategies involve hedging with market index or other futures contracts. Others involve the establishment of managed futures programs, often employing numerous managers who are called commodity trading advisors or CTAs. In thls article, we examine the benefits and limitations of diversieing across commod~ty tradmg advisors. Do such programs benefit investors the way that adding more securities to a portfolio has a diversifjmg effect? The answer to this question has important implications for assessing the general effect of diversification on portfolio risk. Beyond that, however, it is important for a significant segment of the investment community. Exhibit 1 shows the growth of the managed futures industry in the U.S. since 1980 in billions of dollars under management. These figures represent funds placed with CTAs for speculative trading in futures, and do not reflect hedging or trading of overthe-counter derivatives. The estimated amount for 1994 is

Mutual fund distribution fees: An empirical analysis of the impact of deregulation

25.6 billion. Although 1994 and 1995 produced two highly publicized cases of institutions terminating their managed

Private Information and the Exercise of Executive Stock Options

The Securities and Exchange Commissions Rule 12b-1 ended a 40-year prohibition on the payment of distribution fees by mutual funds. The fees have the potential to create conflicts between fund managers and shareholders. This study examines the characteristics of funds implementing the plans, and assesses costs and benefits. Findings reveal that there is a growing tendency of funds, particularly load funds, to adopt the plans. The costs have begun to increase dramatically in recent years though some load funds with plans have begun reducing their loads. However, 12b-1 plans do not seem to contribute to the expense ratios of funds oriented toward capital gains. The plans offer the intangible benefit of spreading load charges across time, thus increasing a funds attractiveness to a broader range of investors.

Executive Equity Swaps and Corporate Insider Holdings

We find evidence that executives use private information in exercising stock options. The most informed executives tend to exercise early, exercise after the vest date rather than at the vest date, do not exercise in anticipation of dividends, exercise a high percentage of their options, sell a large proportion of acquired stock, and exercise and leave the firm. The most costly options to exercise are associated with the most private information, and the least costly are associated with the least private information. We also find that higher ranked executives show greater exploitation of private information than do lower ranked executives.

Market index depository liabilities: Analysis, interpretation, and performance

Executive equity swaps have significant benefits for corporate insiders who wish to enhance their current income and maintain voting rights while reducing exposure to equity holdings in their firms. Since swaps do not require the sale of shares, capital gains taxes are delayed. Swaps, however, can reintroduce agency costs. Furthermore, they are very difficult to detect, though disclosure requirements have improved. We provide an examination of the hidden benefits and risks of executive equity swaps. We also discuss the pricing of these instruments and provide a mini-case analysis of the highly publicized Autotote equity swap.

Pricing an Option on Revenue from an Innovation: An Application to Movie Box Office Revenue

This paper examines a new financial instrument, the market index CD. This deposit offers an interest rate equal to a specified fraction of the change in the stock market over the life of the CD with a guaranteed minimum. We present a pricing formula, an examination of the effects of underlying variables, an evaluation of the early redemption feature, empirical results on the historical performance, and a discussion of some issues suggested by the introduction of this product.

Put—call ratios and market timing effectiveness

We develop a model for valuing revenue streams from innovations. The stochastic properties of revenue from innovations create a more difficult environment in which to value options than when the underlying is a security. There is no initial revenue, and cumulative revenue cannot decrease. Revenues from innovations are characterized by different lives and different rates of the resolution of uncertainty. A common deterministic model for predicting revenue from an innovation is known as the Bass model. We embed the Bass model in a gamma process, resulting in a stochastic process with moments proportional to the mean of the Bass model. To illustrate this model we choose the valuation of options on movie box office revenue. These options enable film distributors to manage the risk of a movie, and they offer diversification opportunities for investors. We develop the econometric methodology for ex ante parameter estimation and a Bayesian updating scheme using Markov chain Monte Carlo simulation as data after release become available. Call prices obtained using the maximum likelihood (ML) parameter estimates from the full data set closely approximate the average discounted value of ex post call payouts that would have occurred at option maturity.

Comment: A Test of Stone's Two-Index Model of Returns

A lmost every week Barron’s column, “The Striking Price,” quotes a noted market analyst’s interpretation of recent put-call ratio (PCR) figures. The PCR is the ratio of the volume of puts traded to the volume of calls traded. The ratio is often calculated using daily or weekly volume figures for the S&P 100 Index Option (OEX) and for the Chicago Board Options Exchange (CBOE) equity options. While the PCR is popularly cited and used in market timing strategies, its effectiveness has yet to face systematic scientific scrutiny. We remedy this apparent oversight by using market data to evaluate whether PCRs are helpful indicators or simply a proverbial fly in the technician’s ointment.