nep-fmk New Economics Papers
on Financial Markets
Issue of 2007‒06‒11
three papers chosen by
Kwang Soo Cheong
Johns Hopkins University

  1. A GARCH Option Pricing Model in Incomplete Markets By Giovanni Barone-Adesi; Robert F. Engle; Loriano Mancini
  2. A Monte Carlo approach to value exchange options using a single stochastic factor By Giovanni Villani
  3. Financing and Takeovers By Erwan Morellec; Alexei Zhdanov

  1. By: Giovanni Barone-Adesi (University of Lugano and Swiss Finance Institute); Robert F. Engle (New York University, Leonard Stern School of Business); Loriano Mancini (University of Zurich and Swiss Banking Institute)
    Abstract: We propose a new method for pricing options based on GARCH models with filtered historical innovations. In an incomplete market framework we allow for different distributions of the historical and the pricing return dynamics enhancing the model flexibility to fit market option prices. An extensive empirical analysis based on S&P 500 index options shows that our model outperforms other competing GARCH pricing models and ad hoc Black-Scholes models. Using our GARCH model and a nonparametric approach we obtain decreasing state price densities per unit probability as suggested by economic theory, validating our GARCH pricing model. Implied volatility smiles appear to be explained by the negative asymmetry of the filtered historical innovations. A new simplified delta hedging scheme is presented based on conditions usually found in option markets, namely the local homogeneity of the pricing function. We provide empirical evidence and we quantify the deterioration of the delta hedging in the presence of large volatility shocks.
    Date: 2004–10
  2. By: Giovanni Villani
    Abstract: Exchange options give the holder the right to exchange one risky asset V for another risky asset D. The asset V is referred to as the optioned (underlying) asset, while D is the delivery asset. So, when an exchange option is valued, we generally are exposed to two sources of uncertainity, namely we have two stochastic variables. Exchange options arise quite naturally in a number of signi¯cant ¯nancial arrangements including bond futures contracts, investment performance, options whose strike price is an average of the experienced underlying asset price during the life ot the option and so on. In this paper we propose some algorithms to estimate exchange options by Monte Carlo simulation reducing the bi-dimensionality of valuation problem to single stochastic factor.
    Keywords: Exchange Options; Monte Carlo Simulations.
    JEL: G13 C15
    Date: 2007–05
  3. By: Erwan Morellec (University of Lausanne, Swiss Finance Institute and CEPR); Alexei Zhdanov (School of Management, George Mason University)
    Abstract: This paper analyzes the interaction between financial leverage and takeover activity. We develop a dynamic model of takeovers in which the financing strategies of bidding firms and the timing and terms of takeovers are jointly determined. In the paper, capital structure plays the role of a commitment device, and determines the outcome of the acquisition contest. We demonstrate that there exists an asymmetric equilibrium in financing policies with endogenous leverage, bankruptcy, and takeover terms, in which the bidder with the lowest leverage wins the takeover contest. Based on the resulting equilibrium, the model generates a number of new predictions. In particular, the model predicts that the leverage of the winning bidder is below the industry average and that acquirers should lever up after the takeover consummation. The model also relates the dispersion in leverage ratios to various industry characteristics, such as the volatility of cash flows, effective tax rates, and bankruptcy costs.
    Keywords: takeovers, option games, real options, capital structure
    JEL: G13 G32 G34
    Date: 2006–10

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