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The arbitrage-free binomial model has been applied to value bonds with embedded options. This article extends the binomial model to incorporate the risk of payment default. The basic solution procedure is modified by adjusting the expected cash flows for the likelihood of a payment default and the expected cash recovery when a payment default occurs. The default probabilities can be estimated from the historical default experience of similarly rated bonds. The expected cash recoveries can be estimated by calibrating to the yield curve for par value bonds with the same rating. The model is applied to value paymentin-kind debentures, which are rich in embedded options.

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Statement of Financial Accounting Standards (SFAS) standardizes the accounting treatment for derivative instruments by requiring all entities to report their derivatives as assets and liabilities on the balance sheet and to measure them at fair value. Reporting changes in the fair value of a derivative in earnings each quarter could create a matching problem. This article examines the test choices that firms must make. The hedger must select the methodology, such as regression analysis, choose the measurement period, and specify an appropriate test statistic like adjusted RI along with the critical value to distinguish a highly effective hedge from one that is not. 4 existing methods of testing hedge effectiveness are described.

This paper analyzes USUs. The analysis is based on the proposed terms of the exchange offers as outlined in the preliminary prospectuses filed with the Securities and Exchange Commission on December 5, 1988. This paper shows that an USU is equivalent to (1) one share of the underlying common stock stripped of its voting rights plus (2) a 30-year guarantee of the current dividend rate plus (3) a deep-in-the-money European put option. This paper identifies transfer-of-wealth effects and negative tax effects that might result from common-for-USU exchanges. It also finds that the stock market's reaction to the announcement of the proposed USU exchange offers was positive but not statistically significant.

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An option conveys to the buyer a right without an obligation. A put option involves the right to sell, and a call option the right to buy. A credit spread option is an option on a particular borrower's credit spread. The credit spread is the difference between the yield on the borrower's debt and the yield on Treasury debt of the same maturity. Credit spread options enable investors to separate credit risk from market risk and other types of risk in a number of situations. The major advantage of credit spread options over credit swaps is that a defined credit event does not have to be specified at the start of the transaction. The payoff is governed solely by measurement of the credit spread rather than a specific credit event. A significant drawback is that credit spread options are difficult to price and hedge.

Often simply referred to as credit swaps, their purpose is to provide protection against deterioration in the credit quality or financial condition of a reference asset or entity. The reference asset or entity is usually a corporation, a government, or some other debt issuer or borrower to which the credit protection buyer has some credit exposure. In a credit swap the protection seller makes payment only if a specified credit event occurs. The protection buyer makes an upfront payment, or series of payments to the seller for the protection afforded by the credit swap. Credit swaps are broadly used for risk management and for investment purposes.

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Yield to maturity (YTM) has well-recognized limitations when interpreted as a measure of relative value among fixed-income securities with embedded options. Option-adjusted spread (OAS) is superior to YTM because it adjusts for the value of any embedded options. However, OAS is not as robust a measure of relative value as many fixed-income professionals apparently believe it to be. Moreover, different broker-dealers may use different computational procedures to arrive at an OAS. An alternative rich-cheap index, called the arbitrage-free spread (AFS), is shown to be a consistent measure of relative value. The arbitrage-free return (AFR) counterpart to AFS is also described. AFR and AFS can be applied to any fixed-income security or derivative thereof for which there is a specified debt service stream. In a reply, Hayre points out that, with the traditional method of discounting cash flows by today's zero-coupon curve, a spread added to the discount rates can be interpreted as a parallel shift of today's curve. With the OAS method of a large number of randomly generated discount rate paths that simulate future interest behavior, such an interpretation cannot be made.

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Glasgo, Landes, and Thompson (GLT) attempted in 1982 to demonstrate that formulas used to calculate the coupon equivalent yield of a short-term discounted note contain a theoretical inconsistency and a serious bias. They propose the use of a compound yield formula instead. Finnerty counters that the flaws lie not within the long-accepted formulas for calculating coupon equivalent yield, but within GLT's interpretation of those formulas. It is demonstrated, following GLT's notation, that GLT's recommended alternative is not clearly superior; it is simply designed to handle a different problem. GLT's formula is more appropriate for comparing the yields of 2 discounted notes of different maturities. The customary formulas are more appropriate for comparing the yields of a discounted note and a coupon-bearing instrument that mature the same day. Whichever formula is used, any yield comparison must be based on yields that have been calculated on a consistent basis.

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The procedure described leads to the maximum amount of bonds an issuer can refund immediately at a profit. However, it does not state how much the issuer should actually call for immediate redemption. The decomposition approach permits the application of the methodology described by Boyce and Kalotay (1979). While there are a number of possible situations where refunding an entire issue would be less than optimal, there are at least 2 situations where a partial refunding could be more beneficial to a firm's shareholders than refunding the entire issue immediately. When a company tenders for an outstanding high-coupon issue, it may not be best to set the price as high as would be required in order to reacquire the whole issue. Also, due to the uncertainty of future interest rates, the reacquisition of only a part of a non-sinking fund issue might lead to greater expected utility of refunding savings than refunding the whole issue immediately when the issuer is risk averse because of the hedging implicit in a partial refunding.

I develop Heath-Jarrow-Morton extensions of the Vasicek and Jamshidian pure-diffusion models, extend these models to incorporate Poisson-Gaussian interest rate jumps, and obtain closed-form models for valuing default-free, zero-coupon bonds and European call and put options on default-free, zero-coupon bonds in a market where interest rates can experience discontinuous information shocks. The jump-diffusion pricing models value the instrument as the probability-weighted average of the pure-diffusion model prices, each conditional on a specific number of jumps occurring during the life of the instrument. I extend the models to coupon-bearing instruments by applying Jamshidian's serial-decomposition technique.

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Financial engineering allows the creation of innovative financial instruments and processes and the formulation of creative solutions to complex financial problems. A new security is innovative only if it: 1. enables an investor to realize a higher aftertax-risk-adjusted rate of return without adversely affecting the issuer's aftertax cost of funds, and/or 2. lets an issuer realize a lower aftertax cost of funds without adversely affecting investors. The basic causal factors reflected in innovative financial processes are: 1. efforts to reduce transaction costs, 2. steps to reduce idle cash balances in response to higher interest rates, and 3. the availability of relatively inexpensive computer technology that facilitates quicker financial transactions. Creative solutions to corporate finance problems have concentrated on developing the most efficient strategy for calling high-coupon debt when interest rates decline.

We calculate the expected additional fire protection cost to a city implied by the 1974 amendments to the Fair Labor Standards Act. Under the amendments, if a city chooses not to pay its men who are on duty for more than 24 hours at a time for sleep and meal time, it may exclude up to eight hours of sleep time, but must compensate them at overtime rates for the entire sleep period if one or more alarms prevent them from obtaining at least five uninterrupted hours of sleep in that period. Interalarm times are modeled as a Poisson process, and both point and interval estimates of the additional annual overtime cost are computed for the city of Monterey by estimating the annual number of interrupted sleep periods. A model that permits the rate at which alarms are received and the length of the designated sleep period to be varied is developed for computing the proportion of nights in the year during which the firemen get five uninterrupted hours of sleep. A procedure for adjusting the model to allow for the time spent in response to an alarm is also described.

In July 1988, the Federal National Mortgage Association (FNMA) issued $500 million principal amount of 8.7% indexed sinking fund debentures (ISFD). Five additional issues of ISFDs totaling $3.175 billion followed over the next 14 months. ISFDs contain an interest-rate-contingent sinking fund. The contingency feature works to the issuer's advantage because sinking fund payments accelerate when market interest rates drop and decelerate when interest rates rise. A contingent claims model is developed to value the ISFDs for each trading day between July 30, 1990 and August 31, 1991. ISFDs and similar financial instruments with contingent sinking funds represent an effective tool for financial institution asset-liability management. Issuing such instruments permits a financial institution that invests in fixed-rate mortgages to match more closely the durations of its assets and liabilities.

On January 28, 1991, the Republic of Austria publicly offered $100 million principal amount of stock index growth notes (SIGN) in the US. SIGNs may be characterized as a package consisting of a 5.5-year zero coupon note, plus a 5.5-year European call option, or warrant, on the S&P 500 with a strike price of 336.69. The prospectus for the SIGNs suggests that they will be taxed as so-called contingent interest notes. The tax discussion of the prospectus suggests that tax arbitrage may be a possible motivation behind the creation of SIGNs. The creation of a new security can benefit investors if it reduces the impact of market imperfections or makes the capital markets more complete. The price behavior of the SIGNs in relation to the predicted price suggests that investors may have initially overvalued the SIGNs but that mispricing was eliminated within 2 months.

This paper generalizes the Chance-Morgan procedure for calculating the duration of a floatingrate non-sinking fund bond, developing a computational formula within a discrete time framework that incorporates the sensitivity of the coupon rate index to changes in market interest rates. The formula developed for the duration of a floating bond is expressed in terms of the duration of a fixed-rate but otherwise identical bond. The responsiveness to changes in market interest rates of the index to which the floating-rate bond's coupon rate is tied and the frequency of coupon rate adjustment have a significant impact on the duration of a floating-rate bond.

In a new issue dividend reinvestment plan (NIDRP), reinvested dividends are used to buy newly issued shares directly from the sponsoring firm. To a dividend-paying company, the NIDRP is a potentially important source of equity capital. The cost of equity capital raised by way of NIDRP is more than the cost of retention-financed equity capital but less than the cost of stock-financed equity capital when shares are sold through the NIDRP at their market value. A transfer of wealth from nonparticipants to participants results from selling shares through the NIDRP at a discount from market value. When the discount is large enough, the NIDRP-financed equity capital is even more expensive than stock-financed equity capital. In the absence of market imperfections, NIDRPs are not consistent with minimizing a firm's cost of equity capital, but when markets are imperfect, the NIDRP eases "homemade retentions" by shareholder clienteles that prefer a low-payout policy.

The subject of bond refunding has received extensive treatment in the finance literature. A recent study by Finnerty [3] summarizes the bond refunding literature and describes methods of analyzing the refunding of high-coupon debt and low-coupon debt both with and without a sinking fund that are all based on a unified analytical framework which preserves debt service parity.

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A production function incorporating real money balances can be used meaningfully in a model of a firm in which the firm's money capital requirements are to be taken explicitly into account, such as in the Vickers model of the firm. Such a production function cannot be obtained simply by incorporating real money balances in the physical production function; it is, instead, derived from the production function and the existing relations among real money balances, inputs, and output. Mathematical implementation indicates that attributing reasonable properties to the cash balance relation leads to a derived production function which exhibits the familiar properties. It is also mathematically demonstrated that, in general, a firm's expansion path will not be identical with and without cash balances as a factor input; this suggests that the inclusion of cash balances in the production function may be the more appropriate formulation.

This paper demonstrates that refunding discounted debt represents a form of tax arbitrage that is profitable to taxpaying corporations when the present value of the additional tax shields, created through the refunding, exceeds the sum of the present value of the overall increase in pre-tax debt service requirements, after-tax transaction costs, and any tax incurred on the gain. The paper contrasts the factors that give rise to profitable opportunities to refund high-coupon debt and discounted debt. it also shows that, of the analytical approaches previously suggested for calculating the net advantage of refunding discounted debt, discounting the change in after-tax debt service payments at the after-tax cost of money for the refunding issue is the only one consistent with preserving debt service parity.

Given the importance that the finance profession places on puhlieation in refereed journals, a constructive dialogue on the quality and integrity of the review process is needed. This paper uses an interview format to provide informed opinions and guidance on basic standards for effective reviewing. The final section of the paper presents suggested guidelines for reviewers. The issues covered in the paper should he especially helpful for less experienced authors and reviewers.

The stock price effects of 113 stock-for-debt swaps that occurred during August 1981-August 1983 are analyzed using the Comparison Period Returns approach. Separate tests on 2 subsamples are performed to determine whether the stock market's reaction to the swap announcement depends upon differences in the characteristics of the swap transaction. The postannouncement behavior of the share prices of the companies in the swap sample is then examined. Analysis reveals that the stock market reacted negatively to the announcement of stock-only-for-debt swap transactions, but that a company's share price ordinarily recovered within a few weeks of the announcement. The stock market's reaction to the announcement of a stock-plus-cash-for-debt swap, on the other hand, was on average roughly neutral. When a swap was followed by a share repurchase and/or a bond refunding transaction, the market impact was positive. The initial negative reaction can be explained in terms of an information effect.

SFAS 133, Accounting for Derivative Instruments and Hedging Activities, marked a large step forward in FASB's quest to record financial instruments at fair value. The new accounting for hedges can introduce some complexity into the financial statements that can be avoided if the hedge qualifies as a "highly effective" hedge. Applying the definition of such a hedge, however, is subject to debate. Three common methodologies for testing hedge effectiveness are presented and analyzed: the dollar-offset method, the variability-reduction method, and the regression method. The dollar-offset method, which is more sensitive to small changes, but also stresses the importance of examining all the specifics of the situation, is not recommended. SFAS 133 standardizes the accounting treatment for derivative instruments by requiring all entities to report derivatives as assets and liabilities on the balance sheet at their fair value. A case of a company that is considering hedging a purchase is used to illustrate the methods described.

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One of the fundamental models of common stock valuation holds that a company's share price is equal to the discounted value of its Future dividend stream. Several versions of the basic model have appeared in the literature, among them some noteworthy early contributions [8, 9, 11, 15]. In the continuous time models, dividends are assumed to be paid continuously, and the ex-dividend date is, as a result...

A study investigates the behavior of equity, bond horizon, small stock, and default risk premiums during the 1926-1989 period. The data suggest that the processes generating these risk premiums are generally mean-reverting, with the nominal default risk premium being an exception. The data also suggest that the stochastic processes generating these risk premiums are trending downward over time, with the possible exception of the small stock risk premium, which, although trending downward, was not found to have a statistically significant trend. The test for volatilities of risk premiums showed that the volatilities of the equity, capital gains equity, and small stock risk premiums (both nominal and real) have declined over time. However, the volatilities of the horizon and capital gains horizon risk premiums seem to have risen, which seems inconsistent with their declines in mean. These findings imply that using the historical average risk premium as the forecast for the risk premium for some future period can bias financial decision making.

A study investigates the behavior of equity, bond horizon, small stock, and default risk premiums during the 1926-1989 period. The data suggest that the processes generating these risk premiums are generally mean-reverting, with the nominal default risk premium being an exception. The data also suggest that the stochastic processes generating these risk premiums are trending downward over time, with the possible exception of the small stock risk premium, which, although trending downward, was not found to have a statistically significant trend. The test for volatilities of risk premiums showed that the volatilities of the equity, capital gains equity, and small stock risk premiums (both nominal and real) have declined over time. However, the volatilities of the horizon and capital gains horizon risk premiums seem to have risen, which seems inconsistent with their declines in mean. These findings imply that using the historical average risk premium as the forecast for the risk premium for some future period can bias financial decision making.

Credit derivatives have the potential to alter fundamentally the way credit risk is originated, priced, and managed; they permit investors to diversify their credit risk exposure; and they enable the credit markets to reallocate credit risk exposures to those market participants who are best equipped to handle them. But as credit derivative use has grown, so has concern about whether users really understand the risks involved and whether these instruments are fairly priced. This primer explains how total return swaps work and how companies and investors can use them to manage their exposure to credit risk more effectively and to enhance their investment returns through better diversification.

I examined the stock market impact of the switch from flow-through to normalization in the ratemaking treatment of the tax savings from accelerated depreciation for 24 electric utilities that made the switch since 1970. I found that there was some tendency for an electric utility's common stock beta to shift downward as a result of the switch but that, in general, such shifts were not significant statistically. I also found that the stock market tended to react favorably to the switch but that this reaction generally did not give rise to abnormal returns. Finally, I found that the stock market's reaction to the switch appears to have become more muted in recent years. My results suggest that the switch from flowthrough to normalization has had a less pronounced market impact than the long list of purported benefits and the results of prior empirical research might have led one to expect. I argued that investor concerns regarding other aspects of the rate order authorizing the switch might be responsible for this. This would imply that if, as a result of the Economic Recovery Tax Act of 1981, utility commissions authorize the switch to normalization and do not make offsetting adjustments and can convince investors of this, the switch could have a significant market impact, the results reported herein notwithstanding. In other words, the results reported in this paper do not imply that the switch from flow-through to normalization cannot have a significant market impact; rather, they suggest that investors pay attention to the totality of a rate order and not to any single component in isolation and that, on balance, they may have become increasingly concerned in recent years that utility regulatory commissions might have depressed allowed rates of return or taken other actions that would largely offset the beneficial effects of the switch to normalization.

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"Comparable" valuation methods are a set of methods that use comparable situations to infer the value of a firm. The comparable company method of valuation is one such technique. Comparable valuation methods estimate a firm's value by multiplying a ratio estimated from comparable firms (valuation multiple) times the firm's earnings before interest, taxes, depreciation, and amortization (EBITDA), earnings before interest and taxes (EBIT), revenue, or some other performance measure. This article explains how to adjust the comparable company method for the value of corporate control. A demonstration is presented of the efficiency of the adjusted comparable company method to value a sample of 51 firms involved in highly leveraged transactions. The value of corporate control is embodied in the control premium. When an estimate of the industry control premium is not available, a control premium of 25% on the acquisition equity value can be used to obtain a rough approximation.

Long-term contracts may contain valuable embedded options. I develop an alternative approach to traditional discounted cash flow (DCF) analysis for valuing the profits that are lost when a long-term contract is breached, resulting in the loss of potentially valuable options. One recent example concerns the much publicized supervisory goodwill contracts, some of which were scheduled to expire more than 30 years from the time the US government breached them. I illustrate the contingent-claims approach using this example. I develop a contingent-claims damages model and use it to measure the lostpro fits damages that two thrifts - California Federal Bank and Glendale Federal Bank - suffered when the US government terminated their long-dated goodwill options. The same analytical approach can be adapted to value other opportunities lost due to moral hazard risk.

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The domestic corporate zero coupon bond market virtually evaporated following passage of the Tax Equity and Fiscal Responsibility Act in 1982. But the corporate zero coupon Eurobond market continued to thrive. Its existence illustrates how differences in national tax systems can create attractive financing opportunities for companies in foreign capital markets. In addition, a form of arbitrage transaction involving the...