Knowledge that Transforms

We introduce a model that captures the main properties that characterize employee stock options (ESO). We discuss the likelihood of early voluntary ESO exercise, and the obligation to exercise immediately if the employee leaves the firm, except if this happens before options are vested, in which case the options are forfeited. We derive an analytic formula for the price of the ESO and in a case study compare it to alternative methods. Since the mid-1980s, stock options have been a substantial component of com-pensation packages for employees. For example, in 1999, 94 % of companies in the S&P 500 offered stock options to their top employees (see Murphy, 1999; Hall and Murphy, 2002). In 1995, the Financial Accounting Standards Board (FASB) (with FAS 123) set a standard that required firms to expend stock-based compensation at the moment the compensation was granted (see FASB, 1995). Firms were encour-aged to use the “fair value ” of the stock option to compute the value of the compensation, but were allowed to use the “intrinsic value”—market price of the stock minus strike price. Since employee stock options (ESOs) are typically granted at the money, the intrinsic value is zero, which results in no expense recorded at the time of the grant, and this is probably one of the reasons that helped their popularity.

Microstructure researchers have long understood that information quality has an effect on price formation in the underlying asset market. However, option researchers have largely ignored the fact that information quality might also impact the options market. This article characterizes the nature of the impact by showing how option prices and implied volatility levels are related to the forward looking information quality path. This result follows from a noisy rational expectations model that abandons the normal distribution in favor of the gamma distribution, but maintains the standard assumption of exponential utility. Thus the new model bridges the gap between the microstructure literature that relies so heavily on the normal-exponential framework, and the options literature that relies exclusively on models that are consistent with the limited liability of stock prices. The model's tractability allows for a robustness check against the standard framework and provides a viable setting for analyzing the empirical implications of information quality for the options market. The Author 2007. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please email: [email protected]., Oxford University Press.

We analyze an intertemporal portfolio problem with both taxable and tax-deferred retirement accounts. Using a tax-arbitrage argument, we identify conditions under which the optimal location decision (where to place an asset) is separable from the allocation decision (how much to allocate to each asset). Investors place highly taxed assets in the tax-deferred account to maximize the tax benefit and adjust their taxable portfolios to achieve the optimal risk exposure. We show that the two-account problem can be reduced to a taxable-account-only problem. The results are robust to capital gains tax deferrals, consumption and contribution decisions, and stochastic tax rates. The Author 2008. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For permissions, please e-mail: [email protected], Oxford University Press.

The Review of Financial Studies has among its missions the facilitation and promotion of a vigorous academic debate across unsettled questions in finance. This issue represents a cross section of views regarding one such debate: Can ourempirical models accurately forecast the equity premium any better than the historical mean? Or, is the forecast our empirical models give us any more accurate than what we would get by simply using the historical mean? The Author 2008. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please email: [email protected]., Oxford University Press.

We theoretically and empirically investigate the role of information on the cross section of stock returns and firms' cost of capital when investors face estimation risk and learn from noisy signals of uncertain quality. The resultant equilibrium is an information-dependent conditional CAPM. We find strong empirical support for the model. Innovations in market volatility, oil prices, exchange rates, and dispersion of analysts' forecasts not only help explain the cross section of stock returns, but their influence depends on the stock's systematic estimation risk. Moreover, dividend and share repurchase initiations have significant downward announcement effects on estimated betas and their standard errors.

We use a movie industry project-by-project dataset to analyze the choice of financing a project internally versus financing it through outside alliances. The results indicate that project risk is positively correlated with alliance formation. Movie studios produce a variety of films and tend to develop their safest projects internally. Our findings are consistent with internal capital market explanations. We find mixed evidence regarding resource pooling, i.e., sharing the cost of large projects. Finally, the evidence shows that projects developed internally perform similarly to projects developed through outside alliances.

Regulation Conference at the Bank of Portugal, and two anonymous referees for useful comments. All errors remain our own.

A growing number of studies in finance decompose multiperiod portfolio returns into a series of single-period returns, using these to test asset pricing models or market efficiency or to evaluate the returns to investment strategies such as those based on momentum, size, and value–growth. We provide a formal analysis of the decomposition method. Crucially, we argue and present empirical evidence that some methods researchers use involve portfolios that nobody would seriously consider ex ante, that transactions costs associated with such portfolios make them poor investment vehicles, and that they can lead to spurious statistical inferences.

We consider the choice between stocks and options to provide effort incentives to a risk-averse manager. We show that stocks can dominate options as a means of motivation only if nonviability risk is substantial, as in financially distressed firms or start-ups. Options dominate stocks for other firms. These results hold regardless of the existing portfolio of the manager. We provide empirical evidence that higher bankruptcy risk is indeed correlated with more use of stock. The Author 2007. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please email: [email protected], Oxford University Press.

We provide evidence of two variants of a dating game that entails picking a grant date ex post, that is, after the board's compensation decision is made: back-dating (picking a date before the board decision date), and forward-dating (waiting after the board decision date to observe the stock price behavior). Consistent with back-dating, we find stock return behavior around the grant date to be positively related to reporting lag. In the promptly reported sample, we find stock return behavior and the pattern of reporting lags consistent with forward-dating. Our calculations show that managers can obtain economically significant benefits by playing the dating game. , Oxford University Press.