Ephraim A. Clark

Valuing political risk

In this paper, I develop a model that measures the effects of political risk on the outcome of a foreign direct investment project as the value of an insurance policy that reimburses all losses resulting from the political event or events in question. The evolutionary process of political risk is explicitly defined and includes a stochastic element as well as the timing of the political events that trigger losses. All parameters can be estimated from current data which eliminates the difficulty of forecasting political events far into the future. Valued in this way, political risk enters the capital budgeting process directly as a cost. Finally, I simulate the models use for the case of expropriation and the case of a series of losses.

The Determinants of Foreign Currency Hedging: Does Foreign Currency Debt Induce a Bias?

In this paper we use UK data to present strong empirical evidence that explains the mixed results in previous studies with respect to the effect of financial distress on the demand for corporate hedging. We build on recent studies that have identified a strong link between foreign currency (FC) debt use and leverage. Given this relationship, we show that using leverage variables as proxies for financial distress and the failure to distinguish between FC debt users and non-users causes misleading inference. More specifically, when we partition our sample of FC hedgers into firms that use and do not use foreign debt, we show that leverage variables are significantly related to the FC hedging decision for firms that use FC debt either in isolation or in combination with FC derivatives but not for firms that only use FC derivatives. This suggests that FC debt users are influencing these results. However, we also find that other financial distress cost proxies with no obvious link to FC debt use are significant determinants in the corporate demand for FC hedging, including derivatives use.

Foreign Currency Derivatives versus Foreign Currency Debt and the Hedging Premium

This paper compares the effect on firm value of different foreign currency (FC) financial hedging strategies identified by type of exposure (short or long term) and type of instrument (forwards, options, swaps and foreign currency debt). We find that hedging instruments depend on the type of exposure. Short term instruments such as FC forwards and/or options are used to hedge short term exposure generated from export activity while FC debt and FC swaps into foreign currency (but not into domestic currency) are used to hedge long term exposure arising from assets located in foreign locations. Our results relating to the value effects of foreign currency hedging indicate that foreign currency derivatives use increases firm value but there is no hedging premium associated with foreign currency debt hedging, except when combined with foreign currency derivatives. Taken individually, FC swaps generate more value than short term derivatives.

Optimal access pricing for natural monopoly networks when costs are sunk and revenues are uncertain

This paper studies optimal access pricing for natural monopoly networks with large sunk costs and uncertain revenues. Using techniques from the option pricing literature, we show that the optimal access price corresponds to a risk-free form of the Efficiency Component Pricing Rule (ECPR), that is, where the opportunity cost is based on the risk free rate of return. We also show that at levels of revenue above the optimal level that triggers entry, the entrant should pay a premium above risk-free ECPR that rewards the incumbent for relinquishing his rights to the risky cash flows at the higher revenue level.

Pricing the Cost of Expropriation Risk

The paper examines a firms cost of expropriation risk in a framework that links it to the governments incentive to expropriate. The author develops a pricing model for the firms cost of expropriation risk that includes the positions of both government and firm. The governments decision to expropriate is modeled as an American-style call option. The cost of expropriation risk is modeled as the value of an insurance policy that pays off all losses resulting from expropriation. The firms cost of expropriation risk is determined by the government acting to optimize the value of its option to expropriate. The author identifies the parameters that link the governments option to expropriate to the firms cost of expropriation risk, and shows how the model can be used in capital budgeting decisions and the ongoing management of expropriation risk.

Making inefficient market indices efficient

The concept of efficient portfolios plays an important role in modern financial theory and practice. Although there is an extensive and growing literature that focuses on testing portfolio efficiency, outside of mean-variance optimization, which has several serious shortcomings, no systematic methodology for building efficient portfolios from inefficient indices has been developed. This paper addresses this issue. It uses the concept of Marginal Conditional Stochastic Dominance and a generalization of the 50% Portfolio Rule to develop a tractable and parsimonious methodology for constructing an efficient portfolio from a given, inefficient index. Because the Stochastic Dominance (SD) approach considers the entire probability distributions of asset returns, the resulting portfolios are efficient with respect to all risk-averse, non-satiable investors regardless of the form of their utility functions or the distributions of asset returns.

Motives for Corporate Hedging: Evidence from the UK

In this paper, we use survey data and data from annual reports to identify the determinants of hedging activity of United Kingdom (UK) firms in the context of an overall program of risk management. Comparing the two sets of data makes it possible to identify misclassified firms, that is, firms whose hedging claims are not consistent across the two data sets. Our results on the consistent data show that the likelihood of hedging is related to growth options, foreign currency exposure, liquidity and economies of scale in hedging costs. Contrary to many previous US studies, we also find strong evidence linking the decision to hedge and the expected costs of financial distress. Results for the misclassified firms suggest that they are actually hedgers that hedge less extensively than the correctly classified (CC) hedgers.

Asymmetric Foreign Currency Exposures and Derivatives Use: Evidence from France

This paper provides evidence on the asymmetric sensitivity of stock returns of French firms to exchange rate risk and the effect of foreign currency (FC) derivative use in alleviating this risk. The results show that FC exposure is frequently asymmetric and differs with respect to the US dollar (USD) and non-USD currencies. Cross sectional analysis provides evidence that FC derivatives use has a significant effect on reducing FC exposure to appreciations and depreciations of non-USD currencies and depreciations of the USD, but not to appreciations of the USD.

Quantification of political risk with multiple dependent sources

In this paper, we develop a model using a conditional Poisson process for measuring the effect of a countable number of mutually dependant political risks on the outcome of foreign direct investment. We also apply a Bayesian updating process that makes it possible to re-estimate the models parameters as new information becomes available. We then show how the model can be operationalized and provide a comparative example related to foreign direct investment. (JEL G31, D81, F21).

Resource Management and The Mayor's Guarantee In French Water Allocation

This paper uses standard methods in stochastic calculus tomeasure the cost of the agency conflict that pits electedofficials of French municipalities against the communities theyrepresent in the management of the water supply. Under the Frenchlegal code, the municipalities are responsible for the watersupply and the elected officials are personally liable for anydamage due to negligence on their part. Uncertainty regardingexactly how negligence will be defined by the courts puts theelected officials in a precarious position. By delegatingauthority to an oligopoly of private firms, however, electedofficials can eliminate their personal liability, which istransferred to the delegated firm. Many studies argue thatdelegation locks communities into long-term contracts that areagainst their better interests. Thus, the agency conflict mayaffect the delegation decision to the detriment of the community.To determine whether or not this is true it is necessary to knowthe economic cost of the mayors personal liability.