contingent capital tail risk and debt induced collapse we study the design and incentive effects of contingent convertible debt with contingent convertibles the endogenous bankruptcy boundary can be at either of two levels one with lower default risk or one at which default precedes conversion an increase in debt moves the firm from the first regime to the second a phenomenon we call debt induced collapse setting the conversion trigger sufficiently high avoids this hazard given this condition we investigate the effect of contingent capital and debt maturity on optimal capital structure debt overhang and asset substitution we calibrate the model to large banks during the financial crisis received april 10 2015 editorial decision march 20 2017 by editor leonid kogan

dynamic jump intensities and risk premiums evidence from s p500 returns and options we build a new class of discrete time models that are relatively easy to estimate using returns and or options the distribution of returns is driven by two factors dynamic volatility and dynamic jump intensity each factor has its own risk premium the models significantly outperform standard models without jumps when estimated on s p500 returns we find very strong support for time varying jump intensities compared to the risk premium on dynamic volatility the risk premium on the dynamic jump intensity has a much larger impact on option prices we confirm these findings using joint estimation on returns and large option samples

50th anniversary article option pricing valuation models and applications this paper surveys the literature on option pricing from its origins to the present an extensive review of valuation methods for european and american style claims is provided applications to complex securities and numerical methods are surveyed emphasis is placed on recent trends and developments in methodology and modeling

a tale of two regimes theory and empirical evidence for a markov modulated jump diffusion model of equity returns and derivative pricing implications abstract we provide closed form solutions for a continuous time markov modulated jump diffusion model in a general equilibrium framework for options prices under a variety of jump diffusion specifications we further demonstrate that the two state model provides the leptokurtic return features volatility smile and volatility clustering observed empirically for the dow jones industrial average djia and its component stocks using 10 years of stock return data we confirm the existence of jump intensity switching and clustering illustrate transition probabilities and verify superior empirical fit over competing poisson style models

factorization of european and american option prices under complete and incomplete markets abstract in a standard option pricing model with continuous trading and diffusion processes this paper shows that the price of one european style option can be factorized into two intuitive components one robust x 0 which is priced by arbitrage and a second 0 which depends on a risk orthogonal to the traded securities this result implies the following 1 in an incomplete market these parts represent the price of a hedging portfolio which is unique and a premium which depends only on the risk premiums associated with the residual risk respectively 2 in a complete market it allows factoring the contribution of the different sources of risk to the final option price for example in a stochastic volatility model we can quantify the impact on the option price of volatility risk relative to market risk 0 and x 0 respectively hence certain misspricings in option markets can be directly related to the premium 0 3 moreover these results extend to american securities which have a third component an additional early exercise premium

stochastic optimization applied to self financing portfolio does bequest matter the article studies stochastic optimization of an intertemporal consumption model to allocate financial assets between risky and risk free assets we use a stochastic optimization technique in which utility is maximized subject to a self financing portfolio constraint the papers in literature have estimated the errors of euler equations using data from financial markets it has been shown that it is sufficient to test the first order euler equation implied by the model however they all assume a constant consumption wealth ratio that constrains the boundary conditions hence influencing the coefficient of the risk premium the main contribution of our article is that we drop the assumption of a constant consumption wealth ratio we have an analytical solution using a utility maximization model with a stochastic self financing portfolio we introduce a terminal condition of wealth with and without bequests we also simulate the stochastic optimization with a self financing portfolio distinguishing risk

the role of market forces in assuring contractual performance the conditions under which transactors can use the market repeat purchase mechanism of contract enforcement are examined increased price is shown to be a means of assuring contractual performance a necessary and sufficient condition for performance is the existence of price sufficiently above salvageable production costs so that the nonperforming firm loses a discounted steam of rents on future sales which is greater than the wealth increase from nonperformance this will generally imply a market price greater than the perfectly competitive price and rationalize investments in firm specific assets advertising investments thereby become a positive indicator of likely performance

option valuation with systematic stochastic volatility we use an extension of the equilibrium framework of rubinstein 1976 and brennan 1979 to derive an option valuation formula when the stock return volatility is both stochastic and systematic our formula incorporates a stochastic volatility process as well as a stochastic interest rate process in the valuation of options if the mean volatility and covariance processes for the stock return and the consumption growth are predictable our option valuation formula can be written in preference free form further many popular option valuation formulae in the literature can be written as special cases of our general formula in this paper we investigate the valuation of individual stock options when the volatility of the underlying stock return is stochastic and has a systematic component which is related to the stochastic volatility of the consumption growth or the market return such an investigation is timely and of significant interest because there is now a considerable amount of evidence that the volatility of stock prices is not only stochastic but that it is also highly correlated with the volatility of the market as a whole for example see black 1975 conrad kaul and gultekin 1991 jarrow and rosenfeld 1984 jorion 1988 and ng engle and rothschild 1992 furthermore empirical work by black and scholes 1972 gultekin rogalski and tinic 1982 and whaley 1982 has shown that the empirical biases inherent in the black scholes option prices are different for options on high and low risk stocks because low risk stocks are mainly large firm stocks with stochastic return volatilities that are highly correlated with the return volatility of the market and high risk stocks are mainly small firm stocks with a lessimportant systematic volatility component incorporating systematic volatility effects in option valuation models has the potential to reduce the empirical biases exhibited by prices computed from the black scholes formula we use equilibrium arguments that extend the consumption based representative agent framework of rubinstein 1976 brennan 1979 and stapleton and subrahmanyam 1984 to allow individual asset returns and the consumption growth to exhibit stochastic volatility in particular we permit the volatility of individual asset returns to consist of a systematic component that is related to the consumption or market volatility in addi

was there a peso problem in the u s term structure of interest rates 1979 1982 during the period following october 1979 through 1982 the u s federal reserve allowed interest rates to fluctuate widely in contrast to its previous policy of targeting these rates in the 1970s the policy was abandoned in 1982 in favor of an operating procedure that reduced the variation in interest rates this paper implements an estimation method to identify from the term structure of eurodollar returns the market s beliefs that the federal reserve may revert to interest rate targeting the model is not rejected and gives plausible estimates of the probability of a switch in monetary regimes copyright 1991 by economics department of the university of pennsylvania and the osaka university institute of social and economic research association

the term structure of euro interest rates and rational expectations abstract this paper analyzes the short end of the maturity spectrum of euro interest rates using recent monthly data the data for the euro franc and euro dm interest rates support the rational expectations hypothesis whereas those true for euro dollar interest rates do not this result is explained by the different approaches used to conduct monetary policy in the usa switzerland and west germany

jump risks and the intertemporal capital asset pricing model the specification of the stochastic process for stock prices is an important assumption underlying most equilibrium and option pricing models in modern finance this is particularly true of the continuous time capital asset pricing models where it is assumed that asset prices follow diffusion processes with continuous sample paths see merton 1973a breeden 1979 grossman and shiller 1982 the extent to which the implications of these models generalize to discontinuous sample paths is an unanswered question in theoretical finance however the answer to this question is of more than just theoretical interest since accumulated empirical evidence appears to be inconsistent with the continuous sample path assumption see rosenberg 1972 oldfield rogalski and jarrow 1977 rosenfeld 1982 one purpose of this paper is to provide some answers to this question we do this by extending merton s 1973a intertemporal asset pricing model in the special case of a constant investment opportunity set to include discontinuous sample paths for asset prices the constant investment opportunity set assumption is imposed because we are interested in obtaining sufficient conditions under which an instantaneous capital asset pricing model capm results the extension of our model to a stochastic opportunity set is discussed briefly in the text this paper investigates an economy where stock prices follow a jump diffusion process the first part of the analysis derives a sufficient condition under which an instantaneous capm will characterize equilibrium expected returns the sufficient condition is that the jump component of a stock s return must be unsystematic and diversifiable in the market portfolio the second part of the paper is an empirical investigation of the satisfaction of this condition the evidence is seen to be inconsistent with the satisfaction of this hypothesis that is the market portfolio appears to contain a jump component

tail risk and robust portfolio decisions this paper formulates a portfolio choice problem in a multiasset incomplete market characterized by ambiguous jumps and arbitrary tail assumptions we derive the optimal portfolio in closed form th

price barriers and the dynamics of asset prices in equilibrium a price barrier is a price level at which a large number of investors either buy or sell securities we analyze the dynamics of asset prices in an economy in which price barriers exist our analysis suggests that asset prices and volatility can exhibit jumps when the price barrier is reached interestingly the market s anticipation of future trades can influence prices in the opposite direction from what one might expect for example when multiple barriers exist stock prices can be inflated rather than depressed in the proximity of an anticipated stock sale

valuation of insurers contingent capital with counterparty risk and price endogeneity this study develops a structural framework to value insurers contingent capital with counterparty risk cr and overcomes the problem of price endogeneity pe in the valuation model our results on the focal contingent capital instrument catastrophe equity put option cateput indicate that prices can be significantly overestimated without considering cr and be significantly underestimated without considering pe this study also examines how cateputs affect the buyer s probability of default pd our results show that buying a cateput lowers the pd for high risk insurers but not necessarily so for low risk insurers however without taking cr and pe into account one may significantly overestimate the credit enhancement provided by the cateputs

information time option pricing theory and empirical evidence abstract with a stochastic time change from calendar time to information time we derive a parsimonious option pricing formula with stochastic volatility as a risk neutral poisson sum of merton s 1973 prices over the option s information time maturity domain the formula contains two unobservable parameters information arrival intensity and information time asset volatility with stochastic volatility induced by random information arrival when the information arrival rate intensifies the option price increases and vice versa we test the formula in pricing hedging and excess profits capture empirically using currency and the s p 500 futures options transaction data

on jumps in common stock prices and their impact on call option pricing the black scholes call option pricing model exhibits systematic empirical biases the merton call option pricing model which explicitly admits jumps in the underlying security return process may potentially eliminate these biases we provide statistical evidence consistent with the existence of lognormally distributed jumps in a majority of the daily returns of a sample of nyse listed common stocks however we find no operationally significant differences between the black scholes and merton model prices of the call options written on the sampled common stocks

systematic jump risks in a small open economy simultaneous equilibrium valuation of options on the market portfolio and the exchange rate abstract the valuation of stock options and currency options has witnessed an explosion of new development in the past 20 years these models set up either in a partial equilibrium or a general equilibrium framework have certainly enriched our understanding of option valuation in one way or the other however the main drawback of these models is that stock options and currency options are analyzed in separate contexts the co movement of the stock market and the currency market is absent from the option valuation analysis such co movement is extremely important and is best illustrated by the southeast asian financial crisis to overcome this drawback this paper uses an equilibrium model to investigate the joint dynamics of the exchange rate and the market portfolio in a small open monetary economy with jump diffusion money supplies and aggregate dividends it is shown that the exchange rate and the market portfolio are strongly correlated since both are driven by the same economic fundamentals furthermore options on the exchange rate and the market portfolio are evaluated in the same equilibrium context the analysis shows that parameters describing the same economic fundamentals have very different effects on currency and stock options

pricing hang seng index options around the asian financial crisis a garch approach abstract this paper investigates how well the hang seng index options the most important class of option contracts traded in hong kong are priced using the garch approach we calibrated the garch parameters using the call and put option data and used them to price options in the subsequent weeks we found the garch model performs very well in comparison with the black scholes model even after allowing for a smile smirk adjustment its superior performance was also evident both before and during the recent asian financial turmoil

the role of the variance premium in jump garch option pricing models abstract we develop a discrete time option pricing model incorporating a variance dependent pricing kernel of christoffersen et al 2013 under an economic framework allowing for dynamic volatility and jump intensity based on the model we examine the role of the variance premium and jump risk premium in explaining s p 500 index option prices and returns according to the results the variance premium is equally important as the jump risk premium in explaining the empirical option data whereas the incorporation of the jump risk premium improves the model fit on option prices the incorporation of the variance premium improves the fit on option returns in particular the variance premium can explain both 1 month holding period returns of 2 month maturity straddles which are significantly negative and call returns which decrease according to moneyness the model incorporating the jump risk premium only has a limitation in explaining the above two stylized returns the outperformance of the model incorporating the variance premium on option returns stems from its ability to capture the wedge between physical and risk neutral volatilities

expected returns risk premia and volatility surfaces implicit in option market prices abstract this article presents a pure exchange economy that extends rubinstein 1976 to show how the jump diffusion option pricing model of merton 1976 is altered when jumps are correlated with diffusive risks a non zero correlation between jumps and diffusive risks is necessary in order to resolve the positively sloped implied volatility term structure inherent in traditional jump diffusion models our evidence is consistent with a negative covariance producing a non monotonic term structure for the proposed market structure we present a closed form asset pricing model that depends on the factors of the traditional jump diffusion models and on both the covariance of the diffusive pricing kernel with price jumps and the covariance of the jumps of the pricing kernel with the diffusive price we present statistical evidence that these covariances are positive for our model the expected stock return jump and diffusive risk premiums are non linear functions of time

jump diffusion option valuation in discrete time we develop a simple discrete time model to value options when the underlying process follows a jump diffusion process multivariate jumps are superimposed on the binomial model of cox ross and rubinstein 1979 to obtain a model with a limiting jump diffusion process this model incorporates the early exercise feature of american options as well as arbitrary jump distributions it yields an efficient computational procedure that can be implemented in practice as an application of the model we illustrate some characteristics of the early exercise boundary of american options with certain types of jump distributions jump diffusion processes are popular in option valuation models these processes were incorporated by merton 1976 into the theory of option valuation and constitute an important alternative to the lognormal diffusion process assumed in the black and scholes 1973 model in this paper we develop a tractable discrete time model for valuing options with these processes many authors have suggested that incorporating jumps in option valuation models may explain some of the large empirical biases exhibited by the black scholes model 1 however in many cases closed form solutions for valuing options are not available for example this is true when there is a positive probability of early exercise when the jump distribution is neither lognormal nor discrete or when the option is based on the term structure of interest rates see ahn and thompson 1988 and jarrow and madan 1991 in these important cases the model developed in this paper can be used to value options another aim of this paper is to provide a model which relies on only simple mathematics to price options with jump diffusion processes it is hoped that the key economic relationships underlying jump diffusion models are transparent in this model we provide enough details to make the procedure readily accessible

new insights into smile mispricing and value at risk the hyperbolic model the authors investigate a new basic model for asset pricing the hyperbolic model which allows an almost perfect statistical fit of stock return data after a detailed introduction into the theory they use secondary market data to compare the hyperbolic model to the classical black scholes model the authors study implicit volatilities the smile effect and pricing performance exploiting the full power of the hyperbolic model they construct an option value process from a statistical point of view by estimating the implicit risk neutral density function from option data finally the authors present some new value at risk calculations leading to new perspectives to cope with model risk copyright 1998 by university of chicago press

two part pricing for experience goods in the presence of adverse selection abstract because customers learn something when they purchase an experience good for the first time a firm selling experience goods may face different demand curves from new and repeat customers the firm can exploit these differences by using a two part pricing strategy to price discriminate between new and repeat customers the firm may also use a two part pricing strategy to mitigate the information problems of adverse selection when its quality is uncertain the analysis is particularly applicable to service markets where customers and firms seek long term relationships and firms maintain customer records which facilitate price discrimination

protecting buyers from fine print buyers typically do not read the fine print in contracts providing an incentive for a monopolist to draft terms which are unfavorable to buyers we model this problem proving that trade must then be inefficient we show that regulation which mandates efficient terms raises welfare more interestingly regulations which prohibit the least efficient terms may reduce welfare by inducing the monopolist not to offer favorable terms we extend these results to markets in which some buyers are naive showing that prohibiting the least efficient terms may also harm the naive buyers

option valuation and hedging strategies with jumps in the volatility of asset returns we develop a model in which the volatility of risky assets is subject to random and discontinuous shifts over time we derive prices of claims contingent on such assets and analyze options based trading strategies to hedge against the risk of jumps in the return volatility unsystematic and systematic events such as takeovers major changes in business plans or shifts in economic policy regimes may drastically alter firms risk profiles our model captures the effect of such events on options markets lumpy arrival of information has long been recognized as a phenomenon of considerable importance in financial markets following merton 1976 1 much of the literature on contingent claims valuation under discontinuous information arrival has studied the case where jumps occur in asset values in this article we model the discontinuous resolution of uncertainty in a new way we allow for the volatility of an asset s return to change randomly and discretely we then derive and analyze valuation equations for claims contingent on such an asset we also show how certain traded options together with the underlying stock and a riskless bond can be used to insure against jumps in the volatility of an asset s returns stock price movements in our model fluctuate randomly between low and high volatility regimes discontinuous changes in the volatility of stock prices may be a result of significant changes in a firm s operating and financial structure its competitive environment or its corporate plan reorganizations caused by takeovers and mergers may also occasion such volatility shifts changes in uncertainty in our model could also be systematic and a result of aggregate supply shocks or shifts in economic policies and political regimes our model can also be interpreted as a model of a market where from time to time firms face the release of an important piece of information that may affect their stock prices significantly the market participants may be aware

your terms or mine the duty to read the fine print in contracts this article examines the legal rules that govern the interpretation of standardized form contracts different legal rules induce different bargaining games between buyers and sellers and they can influence the efficiency of exchange when communication is costly the traditional common law rule which binds an assenting recipient of a form contract to fine print terms he has not read has little effect in encouraging parties to read contracts contrary to the conventional wisdom among lawyers instead there is little practical difference between a rule that nominally holds the drafter of a form contract responsible for communicating its terms and one that holds the receiving party responsible moreover the traditional rule may be pareto inferior to a rule providing presumptive warranties when negotiation is costly

a continuous time arbitrage pricing model with stochastic volatility and jumps we formulate and test a continuous time asset pricing model using u s equity market data we assume that stock returns are driven by common factors including random jump size poisson processes and brownian motions with stochastic volatility the model places overidentifying restrictions on the mean returns allowing one to identify risk neutral probability distributions useful in pricing derivative securities we test for the restrictions and decompose moments of the asset returns into the contributions made by different factors our econometric methods take full account of time aggregation

sources of regime switching in short term interest rates for canada the purpose of this study is to identify sources of regime switching in short term interest rates for canada the choice of information variables is based on three well known hypotheses about interest rates the expectations hypothesis the fisher relationship and the condition for uncovered interest parity the empirical framework consists of an autoregressive distributive lag adl model in error correction form with information spreads and a markov regime switching estimation methodology the models choose interest rate regimes that are similar in many respects to those found for the usa the different regimes in canada are driven by movements in the monetary policy rate the us short term rate and the long term yield the monetary policy rate is found to trigger very large changes in the short term rate responding one for one in the high variance regime and slightly less in the more normal interest rate regime both the us short rate and long term yield are also found to trigger relatively large

do stationary risk premia explain it all evidence from the term structure abstract predictable variations in excess returns have often been attributed to the presence of time varying risk premia in this paper we use an insight based upon new techniques from time series analysis to test whether stationary risk premia can alone explain the behavior of excess returns to long bonds relative to rolling over short rates surprisingly we reject this hypothesis using u s t bill returns we then show that either permanent shocks to the risk premia and or rationally anticipated shifts in the interest rate process could produce anomalous results

markov switching models rational expectations and the term structure of interest rates in order to evaluate the efficiency of the monetary transmission mechanism we develop the formulas for testing rational expectations theory in the term structure of interest rates with var models of stochastically switching regimes in which all the parameters are regime dependent these formulas are obtained for the strict version of rational expectations as well as for the case where measurement errors are assumed in the expectations relationship they are extensible to other contexts that involve variables linked by rational expectations behaviours the testing procedure is implemented on interest rates of the spanish inter bank money market measurement errors must be assumed to find signs favourable to the theory

dynamic asset pricing theory with uncertain time horizon abstract this paper addresses the problem of pricing and hedging a random cash flow received at a random date in a general setup with a random time that is not a stopping time of the filtration generated by asset prices we first provide an explicit characterization of the set of equivalent martingale measures we also present price bounds consistent with perfect replication in the absence of arbitrage as is often the case such bounds are too wide to be of any practical use and we consider several choices for narrowing down to one the number of equivalent martingale measures

spatial temporal model of insect growth diffusion and derivative pricing insect derivatives represent an important innovation in specialty crop risk management an active over the counter market in insect derivatives will require a transparent pricing method this paper develops an econometric model of the spatio temporal process underlying a particular insect population and develops a pricing model based on this process we show that insect derivatives can play an important risk management role in mitigating b tabaci whitefly damage in cotton beyond developing a new risk management instrument the key methodological contribution of this paper lies in pricing derivatives with stochastic properties in both space and time dimensions copyright 2008 oxford university press

pricing and hedging in incomplete markets abstract we present a new approach for positioning pricing and hedging in incomplete markets that bridges standard arbitrage pricing and expected utility maximization our approach for determining whether an investor should undertake a particular position involves specifying a set of probability measures and associated floors which expected payoffs must exceed in order for the investor to consider the hedged and financed investment to be acceptable by assuming that the liquid assets are priced so that each portfolio of assets has negative expected return under at least one measure we derive a counterpart to the first fundamental theorem of asset pricing we also derive a counterpart to the second fundamental theorem which leads to unique derivative security pricing and hedging even though markets are incomplete for products that are not spanned by the liquid assets of the economy we show how our methodology provides more realistic bid ask spreads

price quality and reputation evidence from an online field experiment we examine the link between price quality seller claims and seller reputation in internet auctions after purchasing actual baseball cards and having them professionally graded we find that some buyers in the online graded market are misled by incredible claims of quality they pay higher prices but do not receive better quality and in fact are defrauded more often online seller reputation is effective for identifying good faith sellers but conditional on completed auctions reputable sellers do not provide better quality evidence also suggests that high claim sellers target less experienced buyers we attribute these patterns to two loopholes in the ebay rating system we benefited from the comments of austan goolsbee raphael thomadsen john shea dan vincent david reiley larry ausubel peter cramton v joseph hotz jeff smith jimmy chan vincent crawford mark duggan and attendees at numerous seminars and conferences we are particularly grateful to seth sanders and john list for their constructive advice at the early stage of the research to timothy bresnahan rachel kranton and thomas hubbard for their detailed suggestions in reshaping earlier versions and to editor ariel pakes and two anonymous referees for their careful readings special thanks to eight friends who acted as our agents in purchasing baseball cards in retail markets and to numerous sports card store owners who shared their insights on the sportscard industry excellent research assistance from randy alexander moore and krzysztof fizyta is gratefully acknowledged any remaining errors are ours

the crash of ʼ87 was it expected the evidence from options markets transactions prices of s p 500 futures options over 1985 1987 are examined for evidence of expectations prior to october 1987 of an impending stock market crash first it is shown that out of the money puts became unusually expensive during the year preceding the crash second a model is derived for pricing american options on jump diffusion processes with systematic jump risk the jump diffusion parameters implicit in options prices indicate that a crash was expected and that implicit distributions were negatively skewed during october 1986 to august 1987 both approaches indicate no strong crash fears during the 2 months immediately preceding the crash attempts to explain what caused the stock market crashes around the world in october 1987 have suffered from the paucity of major economic developments occurring around that time that could have triggered the crashes shifting expectations regarding monetary policy foreign investors fears of a dollar decline increasing riskiness of assets none of these appeared major enough if present at all to explain the magnitude of the crashes and although portfolio insurance strategies could conceivably magnify the effects of a jump in fundamentals the initiating jump in fundamentals appears to be lacking

pricing weather derivatives this article presents a general method for pricing weather derivatives specification tests find that a temperature series for fresno ca follows a mean reverting brownian motion process with discrete jumps and autoregressive conditional heteroscedastic errors based on this process we define an equilibrium pricing model for cooling degree day weather options comparing option prices estimated with three methods a traditional burn rate approach a black scholes merton approximation and an equilibrium monte carlo simulation reveals significant differences equilibrium prices are preferred on theoretical grounds so are used to demonstrate the usefulness of weather derivatives as risk management tools for california specialty crop growers

understanding index option returns this paper studies the returns from investing in index options previous research documents significant average option returns large capm alphas and high sharpe ratios and concludes that put options are mispriced we propose an alternative approach to evaluate the significance of option returns and obtain different conclusions instead of using these statistical metrics we compare historical option returns to those generated by commonly used option pricing models we find that the most puzzling finding in the existing literature the large returns to writing out of themoney puts is not even inconsistent with the black scholes model moreover simple stochastic volatility models with no risk premia generate put returns across all strikes that are not inconsistent with the observed data at the money straddle returns are more challenging to understand and we find that these returns are not inconsistent with explanations such as jump risk premia peso problems and estimation risk

prices as signals of product quality this paper is concerned with the provision of quality in markets in which consumers have only imperfect information the analysis focuses on a market for a product that can be produced at different quality levels all consumers prefer higher to lower quality but they may differ in their willingness to pay for quality producers can produce any quality they like but higher qualities are more costly to produce the information in this market is imperfect in the sense that the exact quality chosen by a firm is known only to the firm itself some information about the quality of a firm s product will however reach its potential customers even if they do not make any special effort to acquire it within the framework suggested here two conclusions are drawn first prices may serve as signals which exactly differentiate the available quality levels that is there exists a fulfilledexpectations equilibrium at which each price signals a unique quality level second the pricesignals are not arbitrary each price signal exceeds the marginal cost of producing the quality it signals such a mark up depends on the nature of the product specific information received by consumers the poorer the information the higher the mark up

the equilibrium allocation of diffusive and jump risks with heterogeneous agents abstract we study a two agent pure exchange equilibrium subject to both nondiversifiable diffusive and jump risks agents can trade in a financial market consisting of a stock market a money market and an insurance market for jump risk heterogeneity is introduced through different levels of relative risk aversion in the framework of standard expected utility we find the surprising result that the less risk averse agent purchases insurance contracts against jump risk from the more risk averse agent this equilibrium allocation is linked to the non linear wealth sharing rule in such an economy and preserves the wealth effects studied by dumas rev financ stud 2 1989 157 in the case of pure diffusive risk since the benchmark economy with homogeneous agents generates no excess uncertainty in the stock market we study the effect on excess volatility and excess jump size solely due to different levels of relative risk aversion we observe 3 excess uncertainty in jump sizes for a reasonable specification of economic fundamentals

option pricing with stochastic volatility information time vs calendar time empirical evidence has shown that subordinated processes represent well the price changes of stocks and futures using either transaction counts or trading volume as a proxy for information arrival it supports the contention that volatility is stochastic in calendar time because of random information arrival and thus becomes stationary in information time this contention has also been supported later in theoretical models in this paper we investigate the implication of this contention to option pricing first we price the option in calendar time where the return of the underlying asset follows a jump subordinated process we extend rubinstein s rubinstein m 1976 the valuation of uncertain income streams and the valuation of options bell j econom management sci 7 407 425 and ross s ross s 1989a information and volatility the no arbitrage martingale approach to timing and resolution irrelevancy finance44 1 17 martingale valuation methodology to incorporate the pricing of volatility risk the resulting equilibrium formula requires estimating seven parameters upon implementation we then make a stochastic time change from calendar time to information time in order to obtain a stationary underlying asset return process to price the option we find that the isomorphic option has random maturity because the number of information arrivals prior to the option s calendar time expiration date is random we value the option using dynkin s dynkin e b 1965 markov processes vols i and ii springer verlag berlin and new york version of the feynman kac formula that allows for a random terminal date the resulting information time formula requires estimating only one additional parameter compared to the black scholes s in practical application in this regard the time change has reduced the computational complexity of the option pricing problem simulations show that the formula may outperform the black scholes black f m scholes 1973 the pricing of options and corporate liabilities political econom 81 637 659 and merton merton robert c 1976a option pricing when underlying stock returns are discontinuous financial econom 3 125 143 models in pricing currency options as a first attempt to derive valuation relationships in the information time economy this investigation may suggest that the information time approach is a functional alternative to the current calendar time norm it is especially suitable for deriving volatility free portfolio insurance strategies

on pricing and hedging options in regime switching models with feedback effect abstract we study the pricing and hedging of european style derivative securities in a markov regime switching model with a feedback effect depending on the economic condition we adopt a pricing kernel which prices both financial and economic risks explicitly in a dynamically incomplete market and we provide an equilibrium analysis a martingale representation for a european style index option s price is established based on the price kernel the martingale representation is then used to construct the local risk minimizing strategy explicitly and to characterize the corresponding pricing measure

on jump processes in the foreign exchange and stock markets exchange rates exhibit systematic discontinuities even after allowingfor conditional heteroskedasticity in the diffusion process the results are much more significant in theforeign exchange market than in the stock market which suggests differences in the structure of these markets finally this jump component is shown to explain some of the empirically observed mispricings in the currency options market the objective of this article is to analyze and compare the empirical distribution of returns in the stock market and in the foreign exchange market there are a number of reasons why a better understanding of the stochastic processes driving prices in these markets would be useful many financial models rely heavily on the assumption of a particular stochastic process while relatively little attention is paid to the empirical fit of the postulated distribution as a result models like option pricing models are applied indiscriminately to various markets such as the stock market and the foreign exchange market when the underlying processes may be fundamentally different the foreign exchange market for instance is characterized by active exchange rate man

a jump diffusion model for option pricing brownian motion and normal distribution have been widely used in the black scholes option pricing framework to model the return of assets however two puzzles emerge from many empirical investigations the leptokurtic feature that the return distribution of assets may have a higher peak and two asymmetric heavier tails than those of the normal distribution and an empirical phenomenon called volatility smile in option markets to incorporate both of them and to strike a balance between reality and tractability this paper proposes for the purpose of option pricing a double exponential jump diffusion model in particular the model is simple enough to produce analytical solutions for a variety of option pricing problems including call and put options interest rate derivatives and path dependent options equilibrium analysis and a psychological interpretation of the model are also presented

a jump diffusion model for the european monetary system abstract we propose a general continuous time bivariate jump diffusion representation for the exchange rates of european currencies our model captures key features of the exchange rate mechanism fluctuation within bilateral limits is modeled by appropriate diffusion dynamics while discontinuous variation in the level of the fluctuation band is posited to have a jump structure under specific assumptions the probability distribution of the exchange rate process is derived analytically we also perform an empirical investigation of these exchange rates comparing the fit of alternative models we find some evidence of mean reversion inside the bands for these exchange rates jel f33 c51

equilibrium with new investment opportunities abstract we develop a general equilibrium model where there are opportunities to abandon existing technologies and adopt new technologies we study how technologies change endogenously in an equilibrium and the effect of technological changes on the equilibrium we find that locally the equilibrium resembles that from cox et al 1985 econometrica 53 363 384 globally the equilibrium can be viewed as the equilibria from cir economies pasted together we also find that while the equilibrium consumption and security price processes are continuous the equilibrium return processes experience jumps at the time of technological changes

rational expectations econometric analysis of changes in regime an investigation of the term structure of interest rates abstract this paper is of interest both for its methodological contribution of new tools for analyzing rational expectations models and for its substantive conclusions concerning the term structure of interest rates during the monetary experiment of october 1979 the paper studies systems subject to changes in regime interpreted here as occasional discrete shifts in the parameters governing the time series behavior of exogenous economic variables the specification is shown to be quite tractable both theoretically and empirically the technique is used to analyze yields on three month treasury bills and ten year treasury bonds during 1962 to 1987 a constant parameter linear model for short term rates is shown to be inconsistent both with the univariate time series properties of short rates and with the observed bivariate relation between long and short rates under the expectations hypothesis of the term structure an alternative nonlinear model that admits the possibility of changes in regime affords a much better description of the univariate process for short rates moreover the cross equation restrictions implied by the expectations hypothesis of the term structure are consistent with the nonlinear specification indeed the residuals of the restricted relation have a standard error of only 0 8 basis points this is a third less than that of a completely unrestricted linear regression of long rates on short rates and compares with an unconditional standard deviation of long rates of 142 basis points i conclude that once the recognition by bond traders of changes in regime is taken into account the expectations hypothesis of the term structure of interest rates holds up fairly well for these data

marital division of labor with risk of divorce the role of voice enforcement of contracts it is assumed that emotional ties can be relied on to enforce implicit marital contracts by voice therefore in the present model divorce has economic consequences not only because the economies of scale from living together are destroyed but also because the scope for such voice enforcement is weakened moreover perhaps surprisingly i find that it is ambiguous how an increase in the probability of divorce influences predivorce allocation of time even when preferences are assumed to be homothetic

jump processes in commodity futures prices and options pricing empirical evidence shows that log return relatives on commodity futures prices are not normally distributed this departure from normality seems to be caused by large price changes occurring in the commodity markets with the arrival of important new information this suggests that a jump diffusion model may be a plausible choice for modeling the stochastic process underlying commodity option prices merton 1976a develops a jump diffusion option pricing model assuming that jump risk is unsystematic however the jump diffusion model developed by bates 1991 is more appropriate for commodity option pricing since it allows jump risk to be systematic in this article recent transactions data on futures and futures options are used to test out of sample options using american versions of black s diffusion and bates s jump diffusion models the results show that bates s model performs considerably better than black s model jump diffusion asian option prices are also shown to differ considerably from geometric brownian motion asian option prices

new hope for the expectations hypothesis of the term structure of interest rates survey data on interest rate expectations permit separate testing of the two alternative hypotheses in traditional term structure tests that the expectations hypothesis fails and that expected future interest rates are ex post inefficient forecasts we find that the source of the spread s poor predictions of future interest rates varies with maturity at short maturities the expectations hypothesis fails at long maturities however changes in the yield curve reflect changes in expected future rates one for one an implication of the expectations hypothesis this result confirms earlier findings that long rates underreact to short rates but now it cannot be attributed to term premia if the attractiveness of an economic hypothesis is measured by the number of papers which statistically reject it the expectations theory of the term structure is a knockout most tests beginning with macaulay 1938 find no evidence supporting the expectations hypothesis 1 many cannot even reject statistically the alternative hypothesis that the spread between long and short rates contains no information about future interest rate changes 2 to make matters worse in u s postwar data future long rates tend to rise when short rates are above long rates since the expectations hypothesis would predict that long rates tend to fall the theory often does worse than even the naive model that future interest

learning and asset price jumps w e develop a general equilibrium model in which income and dividends are smooth but asset prices contain large moves jumps these large price jumps are triggered by optimal decisions of investors to learn the unobserved state we show that learning choice is determined by preference parameters and the conditional volatility of income process an important model prediction is that income volatility predicts future jump periods while income growth does not consistent with the model large moves in returns in the data are predicted by consumption volatility but not by consumption growth the model quantitatively captures these novel features of the data jel g00 g12 g14 d83 a prominent feature of financial markets is infrequent but large price movements jumps 1 in this article we develop a model in which income and dividends have smooth gaussian dynamics however asset prices are subject to large infrequent jumps in our model large moves in asset prices obtain from the actions of the representative agent to acquire more information about the unobserved state of the economy for a cost we show that the optimal decision to incur a cost and learn the true economic state is directly related to the level of uncertainty in the economy this implies that aggregate economic volatility as well as market volatility should predict jumps in returns we show that indeed in the data consistent with the model return jumps are predicted by consumption volatility market volatility further the implied asset price implications from our model are consistent with the key findings from parametric models about frequency and predictability of jumps as well as nonparametric jump detection analysis of barndorff nielsen and shephard 2006 based on

an empirical note on the term structure and interest rate stabilization policies the expectations theory of the term structure of interest rates supplemented by the rational expectations and time invariant risk premium assumption implies that the spread between the long and the short rate has in general predictive power for the short rate this implication was consistently rejected in recent studies shiller campbell and schoenholtz 1983 fama 1984 mankiw and summers 1984 with data at the short end of the maturity spectrum threeand six month treasury bills time variations of the risk premium which are probably important for the behavior of the yield on long term bonds are not an entirely satisfactory explanation for these findings in a more recent article of mankiw and miron 1986 who analyzed quarterly data for threeand six month interest rates over the period 1890 1979 an interesting new explanation for the failure of the expectations theory emerged they showed that the spread had substantial predictive power for changes in the short rate in the period before the founding of the federal reserve 1890 1914 whereas for all other periods considered 1915 1933 1934 1951 1951 1958 and 1959 1979 the spread did not help to predict the short rate thus mankiw and miron suggested that the rejection of the expectations theory with recent data is a consequence of the commitment of the federal reserve to stabilize interest rates resulting in random walk behavior of the short rate under these circumstances expected future short rates are equal to the actual short rate and variations of the spread are only brought about by changes in the risk premium in this note the short term interest rate stabilization explanation for the failure of the predictive implications of the expectations theory of the term structure is subjected to an additional empirical test using recent monthly data thereby the short end of the term structure of swiss german and u s interest rates is analyzed for the years 1974 1986 these three cases are of great interest in our context the swiss national bank and the german federal bank used the opportunity offered by the flexible exchange rate system to implement money supply targets and did not attempt to stabilize short term interest rates whereas the federal reserve was at

the antecedents and performance implications of cooperative exchange norms our study investigates the antecedents and performance implications of cooperative exchange norms we argue that in early relationships the level of expected cooperative norms in an exchange is the result of a calculative process facilitated by transaction attributes joint transaction specific investments and observability the greater the level of these two exchange attributes the greater the level of cooperative exchange norms all else being equal we further argue that the realized level of cooperative exchange norms can deviate from the expected level because the development of such norms is the result of social processes that management cannot directly and fully control this gap between realized and expected norms affects exchange performance performance suffers when the realized level of cooperative exchange norms falls below the expected level but overshooting expectations lays a critical groundwork for repeat transactions the analysis of a survey of 182 collaborative r d alliances provides initial support for our theory

dynamic hedging under jump diffusion with transaction costs if the price of an asset follows a jump diffusion process the market is in general incomplete in this case hedging a contingent claim written on the asset is not a trivial matter and other instruments besides the underlying must be used to hedge in order to provide adequate protection against jump risk we devise a dynamic hedging strategy that uses a hedge portfolio consisting of the underlying asset and liquidly traded options where transaction costs are assumed present due to a relative bid ask spread at each rebalance time the hedge weights are chosen to simultaneously i eliminate the instantaneous diffusion risk by imposing delta neutrality and ii minimize an objective that is a linear combination of a jump risk and transaction cost penalty function because reducing the jump risk is a competing goal vis a vis controlling for transaction cost the respective components in the objective must be appropriately weighted hedging simulations of this procedure are carried out and our results indicate that the proposed dynamic hedging strategy provides sufficient protection against the diffusion and jump risk while not incurring large transaction costs

the compound option approach to american options on jump diffusions abstract we derive analytical valuation formulas for compound options when the underlying asset follows a jump diffusion process we then apply these results to value extendible options american call options on stocks that pay discrete dividends and american options on assets that pay continuous proportional dividends numerical results are provided

dollar jump fears 1984 1992 distributional abnormalities implicit in currency futures options abstract deutsche mark and yen futures options over 1984 1992 and 1986 1992 respectively are examined for deviations from the lognormal assumption underlying standard option pricing models two methods are used an atheoretic skewness premium and daily estimates of moments using a model for pricing american foreign currency futures options under systematic exchange rate jump risk substantial variation over time is found in all moments including implicit skewness and kurtosis the implicit abnormalities predict future abnormalities in log differenced dm futures prices but not yen the peso problem implications do not explain standard rejections of uncovered interest parity

an extension of the black scholes model of security valuation abstract this paper provides a formula for the market value of a security whose dividends and liquidation value depend on securities with diffusion dividend and price processes the solution is in terms of the feynman kac formula solving the partial differential equation determining the derivative sucurity s unique arbitrage free value the interest rate process may be stochastic markets need not be dynamically complete

jumps in financial markets a new nonparametric test and jump dynamics this paper introduces a new nonparametric test to detect jump arrival times and realized jump sizes in asset prices up to the intra day level we demonstrate that the likelihood of misclassiflcation of jumps becomes negligible when we use high frequency returns using our test we examine jump dynamics and their distributions in the u s equity markets the results show that individual stock jumps are associated with prescheduled earnings announcements and other company speciflc news events additionally s p 500 index jumps are associated with general market news announcements this suggests difierent pricing models for individual equity options versus index op

general equilibrium pricing of options on the market portfolio with discontinuous returns when the price process for a long lived asset is of a mixed jump diffusion type pricing of options on that asset by arbitrage is not possible if trading is allowed only in the underlaying asset and a risk less bond using a general equilibrium framework we derive and analyze option prices when the underlying asset is the market portfolio with discontinuous returns the premium for the risk of jumps and the diffusion risks forms a significant part of the prices of the options in this economy an attempted replication of call and put options by the black scholes type of trading strategies may require substantial infusion of funds when jumps occur we study the cost and risk implications of such dynamic hedging plans article published by oxford university press on behalf of the society for financial studies in its journal the review of financial studies

the term structure of interest rates and regime shifts some empirical results abstract a test of the expectations theory of the term structure in the framework of a regime switching var model for a change in the short rate and the short long spread with euro us and euro swiss franc rate data points to the importance of uncertainty about the procedures of monetary policy for the rejection of the expectations theory in the us case whereas in the swiss case a time varying term premium also seems to be relevant

the expectation hypothesis in emerging financial markets the case of malaysia this article deals with the expectation hypothesis of the term structure of interest rates it is argued that the rapid progress and financial market liberalization that is occurring in emerging financial markets could provide additional evidence for testing the expectation hypothesis this article employs data from the malaysian government securities market which represents one of the examples of an emerging financial market cointegration and error correction analyses show significant empirical validity for the expectation hypothesis the long and short term interest rates are shown to be cointegrated and subject to a long run equilibrium path in addition to shedding some light on the experience of emerging financial market this article explicitly identifies the process of adjustment towards the long run equilibrium for the long run the results are in favour of the long to short version of expectation hypothesis with longer term interest rates playing a greater role as equilibrium attractor howeve

yield factor volatility models the term structure of interest rates is often summarized using a handful of yield factors that capture shifts in the shape of the yield curve in this paper we develop a comprehensive model for volatility dynamics in the level slope and curvature of the yield curve that simultaneously includes level and garch effects along with regime shifts we show that the level of the short rate is useful in modeling the volatility of the three yield factors and that there are significant garch effects present even after including a level effect further we find that allowing for regime shifts in the factor volatilities dramatically improves the model s fit and strengthens the level effect we also show that a regime switching model with level and garch effects provides the best out of sample forecasting performance of yield volatility we argue that the auxiliary models often used to estimate term structure models with simulation based estimation techniques should be consistent with the main features of the yield curve that are identified by our model

modelling implied volatility with ols and panel data models abstract the paper performs an empirical estimation of time varying volatility using ols regression error components and dummy variable models by regressing the implied volatility on time to maturity the strike price and a dummy both the daily ols equations and the panel data model provide more accurate estimates of black and scholes option prices than the bench mark standard deviation of log returns ft se 100 index european options are used for empirical analysis

term structure anomalies term premium or peso problem abstract the goal of this paper is to develop a test for the relative importance of the time varying term premium and the peso problem for rejection of the expectation hypothesis of the term structure ehts our reasoning is based on a term structure model that allows for both phenomena simultaneously if we assume that only one regime is observed ex post we can estimate all the information we need to evaluate distortions generated by both hypotheses we can also test the presence of a peso problem firstly we find that a peso problem might explain rejection of the ehts in germany and the united kingdom after the european exchange rate crisis secondly we show that this explanation appears inappropriate to explain the ehts failure in the united states