Steven K. Todd

Compensation for managers with career concerns: the role of stock options in optimal contracts

We study the problem of compensating a manager whose career concerns affect his investment strategy. We consider contracts that include cash, shares, and call options, focusing on the role of options in aligning incentives. We find that managers are optimally paid in cash, supplemented by a small amount of call options; shares are excluded. The options are struck at-the-money, consistent with the near uniform practice of compensation committees. The convexity of option payoffs helps to overcome managerial conservatism, though a non-trivial under-investment problem persists. Our model yields several testable implications regarding cross-sectional variation in the size of option grants and pay-for-performance sensitivity.

Forecasting Volatility in the Presence of Limits to Arbitrage

In this article, we develop a novel model to forecast the volatility of S&P 500 futures returns by considering measures of limits to arbitrage. When arbitrageurs face constraints on their trading strategies, option prices can become disconnected from fundamentals, resulting in a distortion that reflects the limits to arbitrage. The corresponding market based implied volatility will therefore also contain these distortions. Our contributions are both conceptual and empirical. Conceptually, the limits to arbitrage framework can shed light on relative asset prices as exemplified by this particular study. Empirically, our volatility forecasting model explains 71% of the variation in realized volatility, a substantial improvement over a naive forecast based only on lagged realized volatility, which produces an R-super-2 of 53%.

Price manipulation at the NYSE and the 1899 battle for Brooklyn Rapid Transit shares

In 1899, James Keene, a prominent bear, and Roswell Flower, a well-known bull, both attempted to manipulate the share price of Brooklyn Rapid Transit (BRT), a young commuter railway company. Flower and Keene were stock ‘operators’, who used pools of cash from like-minded investors to push share prices higher or lower. In their efforts to garner profits, BRT operators claimed insider status, planted rumors in the press, used leverage to accumulate large positions, manipulated borrowing costs and camouflaged trades. The events of 1899 can shed light on current market dynamics, and we draw parallels between the predatory trading strategies used in 1899 and those of today.