Menachem Brenner

Altering the Terms of Executive Stock Options

This paper examines the practice of resetting of the terms of previously-issued executive stock options. We identify the properties of the typical reset option, characterize the firms that have reset options, and develop a model to value options that may be reset. In our sample of 396 executives whose options had terms reset in 1992-95 period, a large majority had exercise prices reset to the market price. This resulted in a reduction of the typical options exercise price by about 40%. Slightly less than half of these options also had their maturities extended, generally receiving a new expiration of 10 years. We find that resetting has a strong negative relationship with firm performance even after correcting for industry performance. Resetting is also significantly more common among small firms than among large firms. However, few other industry- or firm-specific factors appear to matter. Finally, we find that the possibility of resetting does not have a large impact on the ex-ante value of an option award, but the ex-post gain can be substantial.

The Price of Options Illiquidity

The purpose of this paper is to examine the effect of illiquidity on the value of currency options. We use a unique data set which allows us to explore this issue in special circumstances where options are issued by a central bank and are not traded prior to maturity. The value of these options is compared to similar options traded on the exchange. We find that the non-tradable options are priced about 21% less than the exchange traded options. It is an anomaly that cannot be explained by non-hedgeable risks like jumps in the prices of the liquid options which we use in replicating the payoffs of the illiquid options.

On the Volatility and Comovement of U.S. Financial Markets Around Macroeconomic News Announcements

The objective of this paper is to provide a deeper insight into the links between financial markets and the real economy. To that end, we study the short-term anticipation and response of U.S. stock, Treasury, and corporate bond markets to the first release of surprise U.S. macroeconomic information. Specifically, we focus on the impact of these announcements not only on the level, but also on the volatility and comovement of those assets’ returns. We do so by estimating several extensions of the parsimonious multivariate GARCH-DCC model of Engle (2002) for the excess holding-period returns on seven portfolios of these asset classes. We find that both the process of price formation in each of those financial markets and their interaction appear to be driven by fundamentals. Yet our analysis reveals a statistically and economically significant dichotomy between the reaction of the stock and bond markets to the arrival of unexpected fundamental information. We also show that the conditional mean, volatility, and comovement among stock, Treasury, and corporate bond returns react asymmetrically to the information content of these surprise announcements. Overall, the above results shed new light on the mechanisms by which new information is incorporated into prices within and across U.S. financial markets.

The behavior of prices in the Nikkei spot and futures market

Abstract We examine the relation between the prices of Japanese stocks traded on the Tokyo Stock Exchange (TSE) as reflected in the Nikkei Stock Average (NSA) stock index and the prices of the NSA futures contract traded on the Singapore International Monetary Exchange (SIMEX). Since the inception of trading in September 1986, the NSA futures contract has generally sold at a discount relative to its theoretical value. Trading restrictions and transaction costs may explain some of this mispricing, which has been declining over time, as in the U.S. markets.

Information Effects and Stock Market Response to Signs of Firm Deterioration

A recent issue of the Journal of Financial Economics (June/September 1978) is devoted to reporting anomalous evidence regarding market efficiency. This study may qualify under the same heading. Here we examine the market response to information about firms whose future is assessed as being extremely problematic.

Hedging Volatility in Foreign Currencies

Wide jluctuations in exchange rates are o f continual concern to traders and investors in foreign currencies. One o f the main issues not addressed by current risk management techniques is the phenomenon that volatility itsey gyrates widely. These changes in volatility may have an adverse efect on risk management strategies, which typically assume that volatility is constant. In this article we propose the creation o f new derivative instruments, namely, options (and futures) on volatility, designed to help in the management of unexpected volatility jluctuations. We describe the construction o f a volatility index to refrct the volatility o f a spec& exchange rate. The index, based on implied volatilities3om currency options, will serve as an underlying instrument on which derivative products can be written. We discuss a variety ofissues in valuing such options, and present a simple binomial example.

Informed Options Trading Prior to M&A Announcements: Insider Trading?

We document pervasive informed trading activity in equity options before M&A announcements. About 25% of takeovers have positive abnormal volumes. These volume patterns indicate that informed traders are likely using bullish directional strategies for the target and volatility strategies for the acquirer. We show that this abnormal activity cannot be explained by deal predictability, speculation, news and rumors, trading of corporate insiders, or leakage in the stock market. While the SEC litigates only about 7% of deals in our sample, the characteristics of illegal option trades before M&A announcements they prosecute closely resemble the documented patterns of unusual options activity.

On Measuring the Risk of Common Stocks Implied by Options Prices: A Note

This paper examines the implied standard deviation (ISD) estimated from transactons data on options, using the Black-Scholes pricing model. It was found that the distribution of the ISD is symmetric, though not normal. Also, the ISD based on the last daily observation deviates significantly from the daily average ISD. It is suggested that the daily average is a more reliable estimate of the standard deviation.

Inflation Uncertainties and Returns on Bonds

The new wave of research on the effect of inflation on interest rates revolves around the incorporation of inflation uncertainty into the analysis.1 In a recent paper, Liviatan and Levhari (1977) examine in a single-period model the market risk premium on nominal bonds awarded as compensation for inflation-related uncertainty, where this premium is determined by attitudes of investors towards risk and the risk of inflation. The hypothesis that nominal bonds carry an inflation uncertainty premium could be extended to multi-period bonds. This is also consistent with Hicks (1946) liquidity premium, which was estimated by Kessel (1965) and McCullough (1975), who found systematic premia on the average returns of multi-period bonds.2 This study too is concerned with the possible relationships between inflation uncertainties and the returns on multi-period bonds. We are examining the hypotheses using ex ante data and measures of inflation uncertainty based on these data. The two sources of inflation uncertainty that may be associated with the returns on multi-period bonds are the uncertainty about the rate of inflation in the next period, and the uncertainty about expectations of inflation in future periods. For a bond with two periods to maturity, the holding period return is

Stock index futures arbitrage in the Japanese markets

Abstract This study examines the behavior of the prices of the first two futures contracts on Japanese stock price indices to be traded, the Nikkei Stock Average (NSA) contract on the Singapore International Monetary Exchange (SIMEX), and the Osaka Stock Futures 50 (OSF50) contract on the Osaka Securities Exchange (OSE). We find significant departures between the actual prices of the contracts and their ‘fair’ prices in the early months of trading from June 1987 to June 1988. The NSA contract was dominated by discounts of the actual prices in relation to the ‘fair’ price while the OSF50 contract was characterized by both premiums and discounts during this period. This suggests the viability of ‘cross-spreading’ strategies which were analyzed and found to be profitable during much of the period under study.