Many common types of financial contracts incorporates options with extendible maturities. This paper derives closed-form expressions for options that can be extended by the optionholder and presents a number of applications including the valuation of American options with stochastic dividends, junk bonds, and shared-equity mortgages. We also derive closed-form expressions for writer-extendible options and discuss the writer's economic incentives for extending an out-of-the-money option. We apply these results to show that corporate debtholders have a strong incentive to extend the maturity of defaulting debt if there are liquidation costs. We model and solve the debtholders' optimal extension problem and show that the possibility of an extension can induce shareholders in highly levered firms to accept negative NPV projects.

Many common types of financial contracts incorporate options with extendible maturities. This paper derives closed-form expressions for options that can be extended by the optionholder and presents a number of applications including the valuation of American options with stochastic dividends, junk bonds, and shared-equity mortgages. We also derive closed-form expressions for writer-extendible options and discuss the writer's economic incentives for extending an out-of-the-money option. We apply these results to show that corporate debtholders have a strong incentive to extend the maturity of defaulting debt if there are liquidation costs. We model and solve the debtholders' optimal extension problem and show that the possibility of an extension can induce shareholders in highly levered firms to accept negative NPV projects.

ABSTRACT We examine how the empirical implications of the Capital Asset Pricing Model (CAPM) are affected by the length of the period over which returns are measured. We show that the continuous‐time CAPM becomes a multifactor model when the asset pricing relation is aggregated temporally. We use Hansen's Generalized Method of Moments (GMM) approach to test the continuous‐time CAPM at an unconditional level using size portfolio returns. The results indicate that the continuous‐time CAPM cannot be rejected. In contrast, the discrete‐time CAPM is easily rejected by the tests. These results have a number of important implications for the interpretation of tests of the CAPM which have appeared in the literature.

We find that Treasury floating rate notes (FRNs) trade at a significant premium relative to the prices of Treasury bills and notes. This premium is directly related to the near-constant nature of FRN prices and is correlated with measures reflecting investor demand for safe assets. Money market funds are often the primary investors in FRNs, and the FRN premium is related to flows into funds with fixed net asset values, but not to flows into funds with variable net asset values. These results provide strong evidence that the FRN premium represents a convenience yield for the mark-to-market stability feature of FRNs.

Corporate cash flows are highly volatile and strongly procyclical. We examine the asset-pricing implications of the sensitivity of corporate cash flows to economic shocks within a continuous-time model in which dividends are a stochastic fraction of aggregate consumption. We provide closed-form solutions for stock values and show that the equity premium can be represented as the sum of three components which we call the consumption-risk, event-risk, and corporate-risk premia. Calibrated to historical data, the model implies a total equity premium many times larger than in the standard model. The model also generates levels of equity volatility consistent with those experienced in the stock market.

Abstract We study the valuation of state-issued tax-exempt municipal bonds and find that there are significant convenience premia in their prices. These premia parallel those identified in Treasury markets. We find evidence that these premia are tax related. Specifically, the premia are related to measures of tax and fiscal uncertainty, forecast flows into state municipal bond funds, and are directly linked to outmigration from high-tax to low-tax states and to other measures of tax aversion such as IRA and retirement plan contributions. These results suggest that investors are willing to pay a substantial premium to avoid taxes.

Abstract We use the prices of credit card asset-backed securities to study the market risk premium associated with unsecured consumer credit risk. We find that the market incorporates a substantial credit risk premium into the prices of these securities. Furthermore, there has been a major repricing of unsecured consumer credit risk since the 2007–2009 financial crisis. We find evidence that this increase is linked to balance-sheet costs imposed by postcrisis changes in regulations that have placed credit card securitizations back onto issuer balance sheets. These regulatory changes may have added more than 100 basis points to the cost of unsecured household credit.

Abstract A long-standing asset pricing puzzle is that the funding rates in derivatives contracts often differ from those in cash markets. We propose that the cost of renting intermediary balance sheet space may help resolve this puzzle. We study a persistent basis in what is arguably the largest derivatives market, namely, the interest rate futures market. This basis is strongly related to exogenous measures of intermediary balance sheet usage and proxies for the balance sheet costs imposed by debt overhang problems and capital regulation. These results extend to the cash derivatives bases documented in many of the other largest financial markets.

[This article studies the central role of the credit market. We show that the credit market facilitates optimal risk sharing by allowing less risk-averse investors to take on levered positions and consume more risk. The equilibrium amount behaves procyclically when aggregate consumption is low but countercyclically when it is high. The varying size of the credit market modifies the amount of risk sharing, which in turn influences asset prices such as expected stock returns, stock return volatility, and the term structure of interest rates. Our article provides a frictionless benchmark for the role and the behavior of the credit market.]