Unyong Pyo

Real Option Pricing and Bounds in Incomplete Markets

This article prices a real option and constructs narrow bounds around the value of real options embedded in capital budgeting decisions by applying the minimax deviations approach to real options in incomplete markets. While it is straightforward to obtain the unique value of a real option with hyperbolic absolute risk aversion (HARA) utility functions, the parameters of risk aversion are often subject to misspecification and raise concerns for practical uses. Recognizing that investors allow deviation from parameter values related to a benchmark pricing kernel, we derive narrow bounds on a real option price. Comparison with the approaches in the literature clarifies advantages of the minimax bounds: simple, consistent, and efficient.

Reducing Agency Conflicts with Target Debt Ratios

We show how target debt ratios in book value terms applied to new investment can improve alignment of investment incentives in firms when they have risky debt outstanding and asymmetric information. While wealth transfer from both agency conflicts can reduce the value of existing equity, new debt offsets the value loss to old shareholders. New debt set by the target debt ratio naturally reflects key factors such as the NPV and size of the new project and offsets wealth transfers. Numerical examples show that both agency conflicts can be eliminated both in structural models and in binomial models.

Equity-Based Compensation for Firm Performance

The paper finds evidence that the equity-based compensation is positively related to firm performance and risk-taking. Both stock price and operating performance as well as firms risk-taking increase with incentives provided by CEO stock options and stock holdings. The pay-performance sensitivity can explain stock returns better as an additional factor to the Fama-French 3-factor model. When CEOs are compensated with the higher PPS, firms experiences the higher return on asset. The higher pay-volatility sensitivity also leads to the higher risk-taking. While CEO incentive compensation has been perceived mixed on its effectiveness, this study provides support to the equity-based CEO compensation in reducing agency conflicts between CEOs and shareholders.

Liquidity Hedging with Futures and Forward Contracts

We present a model for developing hedging strategies using both futures and forward contracts and issuing risky debt. A financially constrained firm with limited cash balance must hedge its liquidity with both futures and forward contracts and issue risky debt to support its long-term operations. The firm can issue a minimal amount of risky debt by adding forward contracts into hedging and increase its value higher than that when hedging with only futures contracts. We show numerically that hedging with both futures and forward contracts allows the firm to issue minimal risky debt in increasing its firm value.