John D. Finnerty

An Average-Strike Put Option Model of the Marketability Discount

Liquidity is the ability to buy or sell a security quickly with relatively little impact on the price. The most extreme example of an illiquid asset is one that cannot be traded at all, such as restricted stock under SEC Rule 144. The ability to sell a stock is a valuable option, the loss of which should produce a “marketability discount” relative to the same stock without the restriction. Previous work on Rule 144 stock derived an upper bound on the value of the marketability option by modeling it as a put on the maximum stock price over the restriction period. But an investor would require perfect foresight to actually attain that upper bound. Finnerty argues that a better assumption is that the investor has no special timing ability, so the option to sell should be closer to a put on the average price. Using this model, he finds that it tends to understate the observed marketability discount, but the theoretical option value is highly significant in regressions on the discount in over 200 private placements.

The Behavior of Equity and Debt Risk Premiums

he most widely recognized source of risk premium data is the pioneering study by Ibbotson and Sinquefield [1982], updated T annually by Ibbotson Associates (see Siegel [1990]). Accordmg to Siegel [1990, p. 1031, the best forecast for a future-period risk premium is given by the arithmetic average of its associated values observed since 1926, which is the initial year in Ibbotson and Sinquefield’s study.’ Ibbotson and Sinquefield define four types of risk premiums equity, bond horizon, small stock, and default risk premiums. The equity risk premium is defined as the excess of the S&P 500 Index Rate of Return (denoted ROR) over the T-bill ROR. Similarly, the bond horizon risk premium (hereafter referred to simply as the “horizon risk premium”) is defined as the excess of the long-term T-bond ROR over the T-bill ROR. The s m a l l stock risk premium is defined as the excess of the composite ROR of the fifth quintile (by market capitalization) of NYSE-listed common stocks over the S&P 500 Index ROR; and the default risk premium is defined as the excess of the long-term corporate bond ROR over the long-term T-bond ROR. The Ibbotson Associates approach assumes that the random process generating each of the risk premiums is stationary.2 Because portfolio managers, investors, utility regulators, and corporate financial officers use these forecasted risk premiums as guides in decision-making and performance evaluation, it is

Arbitrage–free spread: A consistent measure of relative value

A veritable flood of new fixed-income securities have come along within the past decade. While these new securities afford potentially attractive investment opportunities, they present an imposing analytical challenge: They are often difficult to value because of complex embedded options or other difficult-to-assess features. How can a portfolio manager determine whether a complex security’s expected rate of return compensates adequately for the cost (in the case of a call option) or benefit (in the case of a put option) of the options embedded in the security? Yield to maturity (YTM) is usually of little help because YTM assumes deterministic cash flows. Many portfolio managers are tempted to rely instead on optionadjusted spread (OAS) in forming their investment judgments (see Hayre [1990]). OAS is clearly superior to YTM in one important respect It adjusts for the value of any embedded options. But do portfolio managers appreciate the underlying assumptions and understand OAS’s consequent limitations? Do they know how the broker-dealers they deal with calculate OAS? There is a troubling tendency for two broker-dealers to calculate different-sometimes significantly different -0AS values for the same security.’ OAS is not as robust a measure of relative value as many fixed-income analysts within the brokerage industry apparently believe it to be. When they are used to measure relative value, OAS and YTM share an important weakness: Neither measure can serve as a consistent indicator of relative value. But while YTM is calculated according to generally accepted securities industry standards (albeit different standards for different classes of debt securities), there is no current industry standard for calculating OAS. Even with general agreement on the basic definition, different broker-dealers use different computational procedures and make different assumptions about the interest rate process used to generate the future interest rate paths that underlie the OAS calculation. Also, there is remarkably little published by broker-dealers concerning how they calculate OAS, so it is virtually impossible in many cases either to verify OAS calculations furnished by a broker-dealer or to reconcile-differences between different calculations. OAS can turn out to be misleading for the portfolio manager who is looking for a reliable indicator of fixed-income investment value. This article examines the deficiencies of OAS and suggests an alternative richkheap index, called the arbitrage-free spread (AFS). We show that AFS is a consistent measure of relative value.

Fraud and Firm Performance: Evidence from Fraud on the Market and Securities Class Action Lawsuits

We investigate the argument that securities frauds are preceded by surprisingly good firm performance but are followed by rapid negative investor response by studying the long-term stock performance of a sample of 430 firms that disclosed securities fraud and experienced class action lawsuits filed between 1989 and 1999. Estimating Fama-French (F-F) three-factor model-based monthly abnormal returns for three events, alleged fraud commission (FC), fraud disclosure (FD), and initial class action filing (CA), we find significant upward price drift during the five-year pre-FC horizon and weak evidence of a negative drift for up to five years following CA. The observed pre- and post-event abnormal returns cannot be explained by changes in systematic risk (F-F factor loadings), suggesting that the effects of fraud are confined primarily to changes in expected cash flows rather than changes in discount rates. Further, we find positive abnormal trading volume and return volatility during the pre-FC horizon but a significant deterioration in market quality, as evidenced by a persistent negative abnormal drift in relative trading volume and a sustained increase in return volatility, for up to five years following CA.

Fraud and firm performance: Keeping the good times (apparently) rolling

Purpose - – The purpose of this paper is to examine the hypothesis that a period of sustained supernormal firm performance (for up to five years before fraud commission) creates financial pressure on actors/agents so they have a propensity to behave fraudulently to keep the good times (apparently) rolling. Design/methodology/approach - – Applying the Fama and French (1993) three-factor model using a range of calendar time portfolio methodologies, the authors measure abnormal drifts in stock performance in periods up to five years before alleged fraud commission dates. The authors examine a sample of 561 US firms subject to enforcement actions initiated by the Securities and Exchange Commission (SEC) and the Department of Justice (DOJ) over 1968-2009. Findings - – The authors find that sustained firm-specific positive stock price performance for up to five years followed by the almost inevitable adverse shock, which eventually brings the good times to an end, generally precedes corporate fraud. Fraud occurs when firm managers engage in misconduct in a misguided attempt to keep the good times (apparently) rolling despite the negative shock. Research limitations/implications - – The sample is restricted to firms with trading histories on the stock market prior to the misconduct, and to firms contained in the Federal Securities Regulation database of US firms subject to enforcement actions initiated by the SEC and the DOJ over 1968-2009. Practical implications - – The desire to keep the good times rolling appears to be a very important driver of fraudulent behavior, even after controlling for the executive compensation incentive effects and business cycle effects emphasized in prior studies. The robust findings of positive abnormal returns for up to five years preceding initial fraud commission suggest that regulators and investors would be well-advised to scrutinize the behavior of firms that exhibit surprisingly persistent superior performance over an extended period. If the financial results appear too good to be true, a closer examination might just reveal that they indeed are. Social implications - – While most investors generally like to see the “good times keep rolling” this pressure can create ethical dilemmas for managers. Originality/value - – Unlike most other papers in this area of the literature, which concentrate on the pre-fraud disclosure, the authors investigate the firm’s performance in the pre-fraud commission period. The authors find that the commission of the alleged fraud is preceded by a sustained period of surprisingly good performance of up to five years in length. The authors believe that the paper provides empirical evidence that supports the hypothesis that a period of sustained supernormal firm performance (for up to five years before fraud commission) creates financial pressure on actors/agents so they have a propensity to behave fraudulently to keep the good times (apparently) rolling.

Regulatory Uncertainty and Financial Contagion: Evidence from the Hybrid Capital Securities Market

This paper examines the negative market impact that resulted from the insurance regulators potential reclassification of 140 hybrid capital securities in spring and summer 2006. It illustrates how financial contagion can spring from a regulatory policy change that lacks transparency. We investigate the impact of the uncertainty surrounding the regulators true classification criteria by measuring the effect of the reclassification announcements on hybrid new issue volume, cumulative average abnormal returns, bid-ask spreads, and yield spreads. The financial contagion adversely affected the entire hybrid capital securities market for six months. The effect was most pronounced among those hybrids that were eventually reclassified as common equity equivalents. It was greater for Yankee Tier 1 hybrids, which had been more popular with insurance firm investors prior to the reclassifications, than among non-Tier 1 hybrids.

Adjusting the Binomial Model for Default Risk

Th arbitrage-free binomial model has been applied to value bonds with embedded options. This article extends the binomial model to incorporate the risk of payment default. The basic solution procedure is modified by adjusting the expected cash flows for the likelihood of a payment default and the expected cash recovery when a payment default occurs. The default probabilities can be estimated from the historical default experience of similarly rated bonds. The expected cash recoveries can be estimated by calibrating to the yield curve for par value bonds with the same rating. The author applies the model to value payment-in-kind debentures, which are rich in embedded options.

Collars, Prepaid Forwards, and the DLOM: Volatility Is the Missing Link

The variable prepaid forward (VPF) model assumes that a marketability restriction only costs the asset owner the time value of money during the restriction period. It does not fit the definition of the marketability discount. A put-option model is better suited for the discount for lack of marketability (DLOM) calculation. The VPF model will usually significantly underestimate the DLOM, the more so the higher the assets price volatility.

Options in Structured Notes: Fix the Price or Fix the Spread?

We derive consistent contingent-claims models for valuing implicit options embedded in structured notes, and use them to compare the cost of fixing the spread with that of fixing the price in bond tender offers. We analyze 289 bond tender offers and find that the cost difference is economically significant in a substantial majority of cases. The cost difference and choice of method depend especially on whether the offer is for investment-grade or high-yield bonds. Other significant determinants of the choice of method include the percentage of issue sought, the inclusion of a consent solicitation, and a change-of-control.

Modifying the Black-Scholes-Merton model to calculate the cost of employee stock options

Purpose - – More than 80 percent of S&P 500 firms that issue ESOs use the Black-Scholes-Merton (BSM) model and substitute the estimated average term for the contractual expiration to calculate ESO expense. This simplification systematically overprices ESOs, which worsens as the stocks volatility increases. The purpose of this paper is to present a modification of the BSM model to explicitly incorporate the rates of forfeiture pre- and post-vesting and the rate of early exercise. Design/methodology/approach - – The paper demonstrates the models usefulness by employing historical exercise and forfeiture data for 127 separate ESO grants and 1.31 billion ESOs to calculate the exercise and forfeiture parameters and value ESOs for nine firms. Findings - – The modified BSM model is just as accurate but easier to use than the more computationally intensive utility maximization and trinomial lattice models, and it avoids the ASC 718 BSM models overpricing bias. Originality/value - – If firms prefer the BSM model over more mathematically elegant alternatives, they should at least use a BSM model that is free of overpricing bias.