Richard J. Rendleman

The Pricing of Options on Debt Securities

In this paper we present a method for valuing American and European put and call options on debt securities. Although no exhange-traded options of this type currently exist in the United States, the Chicago Board Options Exchange plans to introduce option contracts on several government bonds, and the Chicago Board of Trade petitioned the Commodities Futures Trading Commission to allow the trading of options on the Ginny Mae futures contract. In addition to pricing put and call options, the model developed here can be applied to the valuation of other securities such as callable bonds and bank loan commitments.

Skill, Luck, and Streaky Play on the PGA Tour

In this study, we implement a random-effects model that estimates cubic spline-based time-dependent skill functions for 253 active PGA Tour golfers over the 1998–2001 period. Our model controls for the first-order autocorrelation of residual 18-hole scores and adjusts for round–course and player–course random effects. Using the model, we are able to estimate time-varying measures of skill and luck for each player in the sample. Estimates of spline-based player-specific skill functions provide strong evidence that the skill levels of PGA Tour players change through time. Using the model, we are able to rank golfers at the end of 2001 on the basis of their estimated mean skill levels and identify the players who experienced the most improvement and deterioration in their skill levels over the 1998–2001 period. We find that some luck is required to win PGA Tour events, even for the most highly skilled players. Player–course interactions contribute very little to variability in golfer performance, but the particular course rotations to which players are assigned can have a significant effect on the outcomes of the few tournaments played on more than one course. We also find evidence that a small number of PGA Tour participants experience statistically significant streaky play.

Fee-Based Pricing of Fixed Rate Bank Loan Commitments

Fixed rate bank loan commitments are contingent claim liabilities that commercial banks issue to provide their customers with a right to borrow a limited amount of funds at a specified interest rate within a specified time period. These prearranged credit agreements are often referred to as credit lines. Although there are many types of loan commitments in use, we restrict our attention to fixed rate commitments which are paid for by cash fees. Hong and Greenbaum [7] have pointed out that a loan commitment can be viewed as a put option that banks sell to corporate customers giving them the right to sell debt to the bank at a specified price (interest rate) within a specified time period. Although there is a great body of literature covering the pricing of put and call options on common stock, the existing theory must be modified to incorporate the interactions among stochastic interest rates, loan values, and the prices of loan commitments. A theory of loan commitment pricing focusing on the relationship between the commitments value and the uncertainty surrounding future interest rates is developed in detail

Covered Call Writing from an Expected Utility Perspective

“Writing covered calls is one of the most popular investment strategies involving options. It is often recommended by investment analysts, not infrequently with extravagant claims about high expected returns and low risk. By contrast, among the firmly established principles of finance are that there is no free lunch, and that a strategy that reduces risk exposure (for example, by writing calls that partially offset the market exposure of a long position in the underlying) should lead to lower expected returns. Rendleman addresses the following question: what assumptions about expected return and option (mis)pricing are required in order for an investor with constant proportional risk aversion to prefer writing covered calls to simply holding the underlying, the riskless asset, or a long call? Moreover, is it better to write long- or short-dated contracts? The results indicate that unless calls are significantly overpriced, the strategy is much less attractive in general than its promoters assert.”

Earnings announcements: Pre- and -post responses

hy does there appear to be such a welldocumented lag in the adjustment of stock returns to earnings announcements? If the market is efficient, returns should quickly reflect information that is publicly available, including its unexpected component, so that no abnormal returns are achievable after earnings announcements. Does the market adjust returns substantially before the earnings announcement date for anticipated extreme earnings surprises, and, if so, by how much? Or does most of the adjustment follow the announcement? Support for the latter possibility would be particularly troublesome for the concept of market efficiency. The purpose of this article is to document precisely the cumulative movement of stock returns relative to the announcement date of quarterly earnings, separated by both the size and the sign ofl the unexpected earnings. We perform this separation, by using a two-way classification relating the unexpected earnings in any given quarter to the unexpected earnings in the preceding quarter. Such a classification provides more detail about the overall relationship between unexpected earnings and stock returns than would be possible using a one-way classification. Our tests employ a large sample of stocks and cover almost the entire decade of the 1970s, providing extensive documentation for the adjustment of stock

Optimal Long-Run Option Investment Strategies

Recent theories of option pricing, such as the Black and Scholes (BS) option pricing model [1] and the work of Merton [12], have been based to a large extent on the idea that equilibrium option prices cannot provide investors with the ability to earn riskless arbitrage profits.1 If the no-arbitrage conditions underlying the models are violated in practice, it may be possible for a trader who faces low trading costs to earn riskless excess returns.2

Option Investing from a Risk-Return Perspective

Here the author derives the binomial option model via the CAPM. The derivation makes it clear that the expected returns from options should be consistent with their risks. Thus, call options, with very positive betas, should have very high expected returns, and put options, with very negative betas, should have expected returns significantly lower than the risk-free interest rate. Using both the CAPM and standard binomial pricing frameworks, the author illustrates the evolution of expected returns for various option-related investment strategies, and provides an analysis of expected and most likely returns for call and put options.

Ranking Errors in CAPM Capital Budgeting Applications

* The Sharpe-Lintner-Mossin Capital Asset Pricing Model (CAPM) provides a framework for valuing certain types of financial assets in a perfect and efficient capital market. Rubinstein [6], Weston [8], and others have applied the model to the firms capital expansion decision to determine the equilibrium value of the financial claims that are used to finance a particular asset under consideration. If this value is

What It Takes to Win on the PGA TOUR (If Your Name Is “Tiger” or If It Isn't)

In this study, we show what it takes to win on the PGA TOUR for Tiger Woods and other professional golfers as a function of individual player skill, random variation in scoring, strength of field, and depth of field. When Woods wins, he wins by scoring an average of 0.71 strokes per round less than other winning players. This difference reflects (1) that Woods may play better than other winning players when he wins and (2) that Woods tends to play in tournaments with the strongest fields, which require lower scores to win. To make this assessment, we develop a novel simulation-based estimate of relative tournament difficulty—the mean score per round that it takes to win a PGA TOUR event. We also explore the extent to which players could have won tournaments on the PGA TOUR by playing their normal game, with no favorable random variation in scoring. We estimate that Woods is the only player who could have won events on the PGA TOUR over the 2003–2009 seasons by simply playing his normal game.

Duration–Based Hedging with Treasury Bond Futures

A survey of derivatives textbooks and other documents shows at east four different treatments of duration-based hedging with Treasury bond futures. Most hedging methods also employ an incorrect definition of futures duration, and, in some cases, apply the accrued interest pricing method incorrectly This article develops an alternative model that is mathematically identical to the most frequently advocated hedging formula and helps to reconcile the various approaches to hedging. It also demonstrates a potential maturity mismatch problem that can represent 10% or more of a typical hedging quantity.