Jennifer N. Carpenter

Does Option Compensation Increase Managerial Risk Appetite

This paper solves the dynamic investment problem of a risk averse manager compensated with a call option on the assets he controls. Under the managers optimal policy, the option ends up either deep in or deep out of money. As the asset value goes to zero, volatility goes to infinity. However, the option compensation does not strictly lead to greater risk-seeking. Sometimes, the managers optimal volatility is less with the option than it would be if he were trading his own account. Furthermore, giving the manager more options causes him to reduce volatility.

The exercise and valuation of executive stock options

In theory, hedging restrictions faced by managers make executive stock options more difficult to value than ordinary options, because they imply that exercise policies of managers depend on their preferences and endowments. Using data on option exercises from 40 firms, this paper shows that a simple extension of the ordinary American option model which introduces random, exogenous exercise and forfeiture predicts actual exercise times and payoffs just as well as an elaborate utility-maximizing model that explicitly accounts for the nontransferability of options. The simpler model could therefore be more useful than the preference-based model for valuing executive options in practice.

Survivorship Bias and Attrition Effects in Measures of Performance Persistence

We generate samples of fund returns calibrated to match the U.S. mutual fund industry and simulate standard tests of performance persistence. We consider a variety of alternative return generating processes, survival criteria, and test methodologies. When survival depends on performance over several periods, survivorship bias induces spurious reversals, despite the presence of cross-sectional heteroskedasticity in performance. In samples which are largely free of survivorship bias, look-ahead biased methodologies and missing returns still affect statistics. In samples with no true persistence, the spurious persistence caused by survivorship bias in the presence of single-period survival criteria never reaches the magnitude found in recent empirical studies. When fund returns are truly persistent, the simulations reveal an attrition effect, distinct from survivorship bias. The systematic disappearance of poor performers causes mean persistence measures to differ from those in a hypothetical sample in which funds never disappear, even in tests which incorporate all data on disappearing funds. The magnitude and direction of this effect depends on the return generating process. We also examine the specification and power of the persistence tests. The t-test for the difference between top and bottom portfolios ranked by past performance is the best specified under the null and among the most powerful against the alternatives we consider.

Executive Stock Option Exercises and Inside Information

This article examines whether insiders use private information to time the exercises of their executive stock options. Before May 1991, insiders had to hold the stock acquired through option exercise for 6 months. Exercises from that regime precede significantly positive abnormal stock performance, suggesting the use of inside information to time exercises. By contrast, we find little evidence of such timing since insiders have been able to sell acquired shares immediately. Now, such timing should show up as negative abnormal stock returns after option exercise. However, we find negative stock performance only after exercises by top managers at small firms.

Portfolio Performance and Agency

The literature traditionally assumes that a portfolio manager who expends costly effort to generate information makes an unrestricted portfolio choice and is paid according to a sharing rule. However, the revelation principle provides a more efficient institution. If credible communication of the signal is possible, then the optimal contract restricts portfolio choice and pays the manager a fraction of a benchmark plus a bonus proportional to performance relative to the benchmark. If credible communication is not possible, an additional incentive to report extreme signals may be required to remove a possible incentive to underprovide effort and feign a neutral signal.

The Real Value of China's Stock Market

China is the world’s largest investor and greatest contributor to global economic growth by wide margins, and will remain so for many years. The efficiency of its financial system in allocating capital to investment will be important to sustain this growth. This paper shows that China’s stock market has a crucial role to play. Since the reforms of the last decade, China’s stock market has become as informative about future corporate profits as in the US. Moreover, though it is a segmented market, Chinese investors price risk and other stock characteristics remarkably like investors in other large economies. They pay up for large stocks, growth stocks, and long shots, and they discount for illiquidity and market risk. China’s stock market no longer deserves its reputation as a casino. In addition, the trend of stock price informativeness over the last two decades is highly correlated with that of corporate investment efficiency. China’s stock market appears to be aggregating diffuse information and generating useful signals for managers. On the buy side, because of its low correlation with other stock markets and high average returns, China’s stock market offers high alpha to diversified global investors who can access it. Yet this high alpha amounts to an inflated cost of equity capital, constraining the investment of China’s smaller, more profitable enterprises. Further reforms that open this market to global investors and improve stock price informativeness will be important to increase China’s investment efficiency and fuel its continued economic growth. Finally, we interpret the stock market’s recent gyrations through the lens of this research, arguing that its post-crisis lag was a rational downward adjustment to competition from the rapidly expanding shadow banking sector, and its enormous rally last year is a cheer for the roll out of deposit insurance and other Third Plenum reforms. More than ever, China’s stock market is a crucial counterpart to its extraordinary, relationship-driven, but opaque banking sector. China’s stock market may now be the world’s most important crystal ball.

Current Issues in Accounting for Derivatives

Although the Financial Accounting Standards Board has been developing standards f o r reporting and disclosing derivatives activity for many years, current guidelines are still neither comprehensive nor widely accepted. With regard to recognition ofproJt or loss from these instruments, the dficulty arises from the fact that some balance sheet items are marked to market, while others are measured at cost. This means that ofsetting gains and losses in hedging relationships may be recognized in dgerent reporting periods. Both existing and newly proposed accounting rules address this problem by allowing firms to defer certain derivatives gains and losses until ofsetting gains and losses are realized. The problem remains that, because hedging relationships are o f t n complex and dynamic, this approach can be eflective only

Mutual Fund Survivorship

firms have jlexibility in deciding which gains and loises to defer. Yet that very flexibility makes financial statements d#cult to interpret and creates the potential for income manipulation. One way to resolve this conflict would be to recognize all gains and losses as they occur, but this solution has always generated controversy. Is it too costly, or just too radical? The problem with regard to disclosure is that the important information about derivatives positions is often not their size and market value, but rather their impact on the probability distribution o f future earnings, an aspect that is beyond the scope o f traditional accounting. Rulemakers defend the lack o f requirements for quantitative risk disclosure by citing the cost o f obtaining relevant risk measures and a lack ofagreement about them. Yet many derivatives dealers estimate and track quantitative measures ofrisk on a daily basis. Ifcorporate managers are unable to quant

Corporate Bond Valuation and Hedging with Stochastic Interest Rates and Endogenous Bankruptcy

y the risks associated with their derivatives positions, is it prudent f o r them to expose shareholders to those risks?