Melanie Cao

Option Market Liquidity: Commonality and Other Characteristics

This study examines option market liquidity using Ivy DBs OptionMetrics data. We establish convincing evidence of commonality for various liquidity measures based on the bid-ask spread, volumes, and price impact. The commonality remains strong even after controlling for the underlying stock markets liquidity and other liquidity determinants such as volatility. Smaller firms and firms with a higher volatility exhibit stronger commonalities in option liquidity. Aside from commonality, we also uncover several other important properties of the option markets liquidity. First, information asymmetry plays a much more dominant role than inventory risk as a fundamental driving force of liquidity. Second, the market-wide option liquidity is closely linked to the underlying stock markets movements. Specifically, the options liquidity responds asymmetrically to upward and downward market movements, with calls reacting more in up markets and puts reacting more in down markets.

Weather Derivatives: A New Class of Financial Instruments

This paper is a concise introduction of the weather derivatives market. We present a brief survey of the market, describe the main products, and illustrate their usage in risk management. We also discuss the key issues in modeling and valuation. Finally, taking weather derivatives as an alternative asset class, we demonstrate their potentials in asset allocation and portfolio management.

Precipitation Modeling and Contract Valuation: A Frontier in Weather Derivatives

This article has two objectives. First, it describes the market for precipitation derivatives and provides examples of applications of such contracts. Second, it proposes, estimates, and compares several models for precipitation. Based on the data for Chicago Midway Airport (1950–2003), we find that a mixture of exponentials and kernel density provide a better fit than a gamma distribution. A valuation example is also presented.

Coordination, matching, and wages

We analyse the coordination problem in the labour market by endogenizing the matching function and the wage share. Each firm posts a wage to maximize the expected profit, anticipating how the wage affects the expected number of applicants. In equilibrium workers apply to firms with mixed strategies, which generate coordination failure and persistent unemployment. We show how the wage share, unemployment, and the welfare loss from the coordination failure depend on the market tightness and the market size. The welfare loss from the coordination failure is as high as 7.5 per cent of potential output.

Optimal CEO Compensation with Search: Theory and Empirical Evidence

We integrate an agency problem into search theory to study executive compensation in a market equilibrium. A CEO can choose to stay or quit and search after privately observing an idiosyncratic shock to the firm. The market equilibrium endogenizes CEOs’ and firms’ outside options and captures contracting externalities. We show that the optimal pay-to-performance ratio is less than one even when the CEO is risk neutral. Moreover, the equilibrium pay-toperformance sensitivity depends positively on a firm’s idiosyncratic risk, and negatively on the systematic risk. Our empirical tests using executive compensation data confirm these results.

Systematic jump risks in a small open economy: simultaneous equilibrium valuation of options on the market portfolio and the exchange rate

Abstract The valuation of stock options and currency options has witnessed an explosion of new development in the past 20 years. These models, set up either in a partial equilibrium or a general equilibrium framework, have certainly enriched our understanding of option valuation in one way or the other. However, the main drawback of these models is that stock options and currency options are analyzed in separate contexts. The co-movement of the stock market and the currency market is absent from the option valuation analysis. Such co-movement is extremely important and is best illustrated by the Southeast Asian financial crisis. To overcome this drawback, this paper uses an equilibrium model to investigate the joint dynamics of the exchange rate and the market portfolio in a small open monetary economy with jump-diffusion money supplies and aggregate dividends. It is shown that the exchange rate and the market portfolio are strongly correlated since both are driven by the same economic fundamentals. Furthermore, options on the exchange rate and the market portfolio are evaluated in the same equilibrium context. The analysis shows that parameters describing the same economic fundamentals have very different effects on currency and stock options

Vulnerable Options, Risky Corporate Bond, and Credit Spread

In the current literature, the focus of credit‐risk analysis has been either on the valuation of risky corporate bond and credit spread or on the valuation of vulnerable options, but never both in the same context. There are two main concerns with existing studies. First, corporate bonds and credit spreads are generally analyzed in a context where corporate debt is the only liability of the firm and a firm’s value follows a continuous stochastic process. This setup implies a zero short‐term spread, which is strongly rejected by empirical observations. The failure of generating non‐zero short‐term credit spreads may be attributed to the simplified assumption on corporate liabilities. Because a corporation generally has more than one type of liability, modeling multiple liabilities may help to incorporate discontinuity in a firm’s value and thereby lead to realistic credit term structures. Second, vulnerable options are generally valued under the assumption that a firm can fully pay off the option if the firm’s value is above the default barrier at the option’s maturity. Such an assumption is not realistic because a corporation can find itself in a solvent position at option’s maturity but with assets insufficient to pay off the option. The main contribution of this study is to address these concerns. The proposed framework extends the existing equity‐bond capital structure to an equity‐bond‐derivative setting and encompasses many existing models as special cases. The firm under study has two types of liabilities: a corporate bond and a short position in a call option. The risky corporate bond, credit spreads, and vulnerable options are analyzed and compared with their counterparts from previous models. Numerical results show that adding a derivative type of liability can lead to positive short‐term credit spreads and various shapes of credit‐spread term structures that were not possible in previous models. In addition, we found that vulnerable options need not always be worth less than their default‐free counterparts.

Incentive stocks and options with trading restrictions: not as restricted as we thought

Stock ownership and incentive options are used by companies to retain and motivate employees and managers. These grants usually come with vesting features which require grantees to hold the assets for certain periods. This vesting requirement makes the grantees total wealth highly undiversified. As a result, as shown by previous researchers, grantees tend to value these incentive securities below market. In this case, grantees will have a strong desire to hedge away the firm-specific risk. Facing the restrictions of direct hedges such as shorting the firms stock, employees may implement a partial hedge by taking positions in an asset highly correlated with the firms stock, such as an industry index. In this chapter, we investigate the effects of such a partial hedge. Using the continuous-time, consumption-portfolio framework as a backdrop, we demonstrate that the hedging index can enhance the employees optimal portfolio holding and increase his intertemporal utility. Consequently, his private valuations of these grants are higher than that without the partial hedging. However, because the partial hedge makes the employees total wealth less sensitive to the firms stock price, it will also undermine the incentive effects. Therefore, the presumed incentive effects of these restricted assets should not be taken for granted.

AN EXPANDED STUDY ON THE STOCK MARKET TEMPERATURE ANOMALY

This is a companion paper to our previous study in Cao and Wei (2005) on stock market temperature anomaly for eight international stock markets. The temperature anomaly is characterized by a negative relationship between stock market returns and temperature. This line of work relies on the impact of environmental variables, such as temperature, on mood and behavior changes. In this paper, we expand the sample in Cao and Wei (2005) to include 19 additional financial markets. Our evidence confirms the identified negative relationship for the expanded sample. More importantly, our nonparametric tests, as opposite to the parametric or semi-parametric approaches used by previous related studies, demonstrate that this negative relationship is robust to distributional assumptions. Based on the sub-sample analysis, we find that this negative relationship is stable over time. Furthermore, we consider temperature deviation and demonstrate that this negative relationship is not just a level effect.

Stock or options? An economical justification for using stocks as a compensation tool

Starting from 2003, Microsoft and many other companies have either gradually reduced or completely replaced stock options with restricted stocks in their compensation plans. This raises an interesting question: which form of compensation is better, stock or options? This chapter makes an economic comparison between the two compensation vehicles and concludes that stock is preferred to options. The backdrop of the study is dynamic asset allocation within a utility maximization framework whereby the company may go bankrupt. The incorporation of bankruptcy risk into the analysis is motivated by the recent downfalls of companies such as Enron and WorldCom. We demonstrate that vesting requirements and bankruptcy risk can lead to significant value discounts. When the restricted stock and options have a vesting period of 5 years, and account for 50% of the total wealth, the total discount is more than 60%, out of which 20% is due to bankruptcy risk. More importantly, we find that stock is a better compensation tool than options. For a given dollar amount of grant, the higher the stock proportion, the higher the expected utility. In fact, replacing options by stock can lead to a substantial amount of cost savings for the firm, while maintaining the same level of utility for the employee. For example, when options account for 50% of the total wealth and are subsequently replaced by stock, the granting cost is reduced by about 60%. Our findings therefore provide a theoretical support for the move to stock-only style of performance compensations.