This paper presents a theory for pricing options on options, or compound options. The method can be generalized to value many corporate liabilities. The compound call option formula derived herein considers a call option on stock which is itself an option on the assets of the firm. This perspective incorporates leverage effects into option pricing and consequently the variance of the rate of return on the stock is not constant as Black-Scholes assumed, but is instead a function of the level of the stock price. The Black-Scholes formula is shown to be a special case of the compound option formula. This new model for puts and calls corrects some important biases of the Black-Scholes model.
This paper derives a single-beta asset pricing model in a multi-good, continuous-time model with uncertain consumption-goods prices and uncertain investment opportunities. When no riskless asset exists, a zero-beta pricing model is derived. Asset betas are measured relative to changes in the aggregate real consumption rate, rather than relative to the market. In a single-good model, an individual's asset portfolio results in an optimal consumption rate that has the maximum possible correlation with changes in aggregate consumption. If the capital markets are unconstrained Pareto-optimal, then changes in all individuals' optimal consumption rates are shown to be perfectly correlated.
This paper derives an after tax version of the Capital Asset Pricing Model. The model accounts for a progressive tax scheme and for wealth and income related constraints on borrowing. The equilibrium relationship indicates that before-tax expected rates of return are linearly related to systematic risk and to dividend yield. The sample estimates of the variances of observed betas are used to arrive at maximum likelihood estimators of the coefficients. The results indicate that, unlike prior studies, there is a strong positive relationship between dividend yield and expected return for NYSE stocks. Evidence is also presented for a clientele effect.
Mayers and Rice do not resolve the basic problem in portfolio performance evaluation with the securities market line, the ambiguity introduced by being obliged to choose a market index. Other performance evaluation techniques exist and possess some superior qualities. The Mayers-Rice discussion of my critique of the capital asset pricing model (CAPM) fails to recognize the CAPM's unusual testing implications and ignores the existence of alternative asset pricing theories. Residual analysis should give approximately correct estimates of the abnormal returns caused by specific events if it is conducted with the market model.
This paper presents a simple discrete-time model for valuing options. The fundamental economic principles of option pricing by arbitrage methods are particularly clear in this setting. Its development requires only elementary mathematics, yet it contains as a special limiting case the celebrated Black-Scholes model, which has previously been derived only by much more difficult methods. The basic model readily lends itself to generalization in many ways. Moreover, by its very construction, it gives rise to a simple and efficient numerical procedure for valuing options for which premature exercise may be optimal.
Whereas frictionless exchange markets provide a high degree of liquidity for financial assets, investments in real assets and productive capacity may be very costly to modify, and thus effectively irreversible in the short-run. This paper addresses the problem of an investor (individual or enterprise) who must allocate a limited resource to productive investments over time. Investment opportunities arrive in a random sequence and are irreversible in the short-run: thus investment decisions are made under uncertainty as to future opportunities (which may have to be foregone). The analysis demonstrates that a rational investor will demand a higher return on long-lasting opportunities than on those which are instantaneously reversible. The liquidity premium increases with the average duration of the non-liquid investments.
In addition to the recent interest of the Securities and Exchange Commission, executive forecasts of earnings have received a considerable amount of attention in the academic literature (Basi, Carey, and Twark [1976], Lorek, McDonald, and Patz [1976], McDonald [1973], Copeland and Marioni [1972], Kapnick [1972], Daily [1971]). Much of this attention has focused either on the absolute or relative accuracy of such forecasts or on the ethical, legal, and practical problems of publishing and reviewing executive forecasts of earnings in external accounting reports. One aspect that has not been adequately considered is investor reaction to executive long-range forecasts of earnings. The purpose of this study is to investigate the information content of voluntarily disclosed long-range earnings forecasts by executives by determining security return reactions to a sample of such forecasts that were reported in the Wall Street Journal. The inclusion of management estimates of future earnings in annual reports is advocated on the assumption that such forecasts contain information, of interest to investors or other persons outside the firm, not otherwise publicly available. Not only do executives have information about internal and external factors expected to affect future operations and earnings, but they also exert considerable effort evaluating these factors and their impact on prospective operations in the normal planning function. Consequently, executive forecasts of earnings might be of inter-
John G. Ramage, Abba M. Krieger, Leslie L. Spero, [Discussion of An Empirical Study of Error Characteristics in Audit Populations]: A Reply, Journal of Accounting Research, Vol. 17, Studies on Auditing-Selections from the "Research Opportunities in Auditing" Program (1979), pp. 111-113
William R. Kinney, Jr., The Predictive Power of Limited Information in Preliminary Analytical Review: An Empirical Study, Journal of Accounting Research, Vol. 17, Studies on Auditing-Selections from the "Research Opportunities in Auditing" Program (1979), pp. 148-165