Robert G. Schwebach

Insurance Futures and Hedging Insurance Price Risk

This article discusses the Chicago Board of Trades proposal to establish a market for futures contracts (and options on futures) written on insurance business. A European call option on an insurance future is equivalent to a stop-loss reinsurance contract on the portfolio of insurance policies underlying the futures contract. Put options correspond to the discounted expected value of retained losses. After a credible experience record is developed, an insurer can determine the correlation of its own portfolio of policies with the market portfolio and use the futures options market as a partial substitute for traditional stop-loss reinsurance. The advantages of such a market are that it provides a tool for hedging business risk, it allows an entity to participate in the market portfolios profitability without being a licensed insurer, it may have lower transactions costs than traditional reinsurance, and it provides a mechanism for price discovery. But, despite the advantages of an insurance futures market, there are serious barriers to its success, which are discussed briefly.

WEBS, SPDRs, and country funds: an analysis of international cointegration

Prior empirical studies analyzing linkages between international equity markets have suffered because suitable real-world financial instruments representing national equity markets were not available for trading. In March 1996, World Equity Benchmark Shares (WEBS) began trading on the American Stock Exchange. WEBS are open-end index funds that trade like closed-end index funds; they are designed to closely track the international indices developed by Morgan Stanley Capital International. This study utilizes WEBS along with Standard & Poor’s Depository Receipts (SPDRs) to avoid the previously encountered problems associated with nonsynchronous trading, fluctuating foreign exchange rates, non-liquidity, trading restrictions, and index replication. Results indicate that substantial pairwise cointegration exists among the 18 market indices as well as between individual closed-end country funds and their own-country WEBS. In addition, Granger causality tests indicate the existence of short-term causal relationships, suggesting market inefficiencies and the possibility of short-run arbitrage opportunities.

Comparing Mean Reverting Versus Pure Diffusion Interest Rate Processes in Valuing Postponement Options

Using a simulation approach, we analyze the effect of mean reversion on the value of capital budgeting postponement options. Two interest rate processes are compared: a pure diffusion process and a stochastic mean reversion process. The mean reverting process generates interest rate paths that are consistent with historically observed rates. Because option values depend not only on the variance of rates but also on the pattern of rate diffusion across time, a pure diffusion process may lead to significant mispricing of options if the true process is mean reverting. We analyze mispricing for different yield curve scenarios and as a function of the differencing interval used to measure volatility.

Original‐Issue Systematic and Default Risk Pricing Efficiency of Speculative‐Grade Bonds

We investigate whether primary market, original-issue risk premiums on speculative-grade debt are justified solely by expected defaults or whether these risk premiums also include other orthogonal risk components. Studies of secondary-market holding period risk and return have hypothesized that risk premiums on speculative-grade debt may be explained by bond-and equity-related systematic risk and possibly other types of risk. Using an actuarial approach that considers contemporaneous correlation between default frequency and severity and first-order serial correlation, we cannot reject the hypothesis that the entire original-issue risk premium can be explained by expected default losses. This suggests that speculative-grade bond primary markets efficiently price default risk and that other types of risk are priced as coincident as opposed to orthogonal risks.

Comparative Value-Relevance of GAAP, IBES, S&P Core, Cash Earnings and Cash Flows

This study examines the impact the global financial crisis had on the value relevance of GAAP and non-GAAP earnings. We adopt the Ohlson (1995) valuation and CAR models to test the value relevance and information content of alternative earnings measures. We use six different earnings measures comprising IBES earnings, Standard & Poor’s (S&P) core earnings, cash earnings, cash flows from operations, earnings from operations adjusted to exclude special items under GAAP and income before extraordinary items under GAAP. We draw our sample from US publicly traded firms between 2002 and 2010. Our sample is partitioned into Financial and non-Financial firms, and S&P 500 and non-S&P 500 firms. The results show that investors place greater value relevance on GAAP earnings during the GFC period relative to the pre-GFC period.

Low-Cost Multinational Acquisition Financing UsingCollateralized Corporate Obligations

This article proposes an innovative financial transaction that employs a whole business securitization structure to create low-cost sources of acquisition financing. The transaction structure provides U.S. acquirers with a unique form of levered financing by creating a debt–equity hybrid security with option-like characteristics. The security, termed here a collateralized corporate obligation (CCO), creates low-cost capital that can be applied to finance the acquisition of operating assets from which payments on the securities are derived. The proposed transaction enables both public and private companies to structure leveraged transactions at lower rates than available through traditional forms of debt financing. Acquirer returns are enhanced through capital structure changes combined with mitigation of bankruptcy and agency costs. Similar transactions have been effected in the U.K. The feasibility of a CCO transaction is dependent on the ability to enhance creditor rights by shifting the administration of insolvency proceedings to creditor-friendly jurisdictions, such as the U.K. This article examines the financial, legal, accounting, and tax implications of the proposed transaction from a U.S. perspective.

The Informational Relevance of Strategic Corporate Social Responsibility

Proponents of corporate social responsibility (CSR) argue that CSR activities allow firms to improve relationships with key stakeholder groups and gain a competitive advantage over industry rivals. This study examines the impact of additions and deletions in the Domini Social 400 Index due to stakeholder-related CSR activities on the share prices for both announcing firms and rival companies. Results from the event study analysis indicate that CSR additions (deletions) are associated with positive (negative) abnormal returns for the announcement firm. Furthermore, evidence from the intra-industry share price response is consistent with a competitive effect where good (bad) news for the announcement firms is simultaneously perceived as bad (good) news for rival firms. The study highlights the central role of information in linking CSR with financial performance, and provides strategic implications for firm managers.

PER UNIT COST ALLOCATION OF INVESTED CAPITAL WITH ANTICIPATED NON-LEVEL PRODUCTION: THE CASE OF EXTRACTIVE INDUSTRIES

Abstract The concept of equivalent annual annuity (EAA) has long been used as a method of costing recovery of invested capital and the required return on invested capital over the productive life of a capital project. Academic texts almost universally use EAA methodology with level payment streams (annuities) to allocate capital costs. We develop a methodology for allocating capital costs evenly over each unit of production for projects with anticipated non-level production. This methodology uses a modified EAA approach that allows non-level annuity payment streams. Capital cost allocation is an important component in computing the value of extracted minerals for severance tax purposes; however, many firms and state and federal agencies use ad hocdepreciation schedules to allocate these costs. Ad hocdepreciation methods such as modified accelerated cost recovery system (MACRS) may be appropriate for income tax purposes but are inconsistent with commonly found requirements that severance taxes “shall be as...