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1 – 10 of over 1000Peter Brous, Bonnie G. Buchanan and Tony Orcutt
The “raise your rate” (RYR) certificate of deposit (CD) allows investors to raise the rate on their CD to the current market rate over the life of the CD. The purpose of this…
Abstract
Purpose
The “raise your rate” (RYR) certificate of deposit (CD) allows investors to raise the rate on their CD to the current market rate over the life of the CD. The purpose of this paper is to present a binomial option pricing model to value this option to raise the rate. The model also demonstrates conditions under which the investor should choose to exercise their option and raise their rate prior to maturity. Understanding the value of this option is useful to both banks setting rates, and investors comparing alternative investment opportunities. The results of this model suggest that, for CDs with short maturities and low yields, the value of the option is relatively small, roughly one to four basis points, however, for CDs with longer maturities and higher yields the value of the option can be as much as 50-80 basis points.
Design/methodology/approach
This paper demonstrates how to value raise your rate CDs by applying a binomial option pricing model and provides the value of this option over a range of current CD yields and over a range of CD maturities.
Findings
When CD rates are low and maturities are short the value of the option is small (one to four basis points), however, when CD rates are high with longer maturities, the value of this option can be significant (50-80 basis points).
Research limitations/implications
The research implication is that the rate discount that the institution offers and the investor accepts should reflect the value of the option to raise the rate. The benefit to the institution and the cost to the investor reflected in the rate discount can be determined by the procedures presented in this paper regarding the valuation of the option to raise the rate.
Practical implications
The purpose of this paper is to demonstrate how to apply a binomial option pricing model to value the option that is attached to a raise your rate CD. Knowing the value of this option should be useful both to banks, in determining the discounted rate they should offer on these CDs, and to investors choosing among alternative investment opportunities. An additional benefit of applying a binomial model to value the option is that the model can be used by investors to determine the optimal point at which to exercise their option and lock in the current higher rate.
Social implications
Given the recent financial turmoil, pressure has been placed on banks to increase their liquidity and deposit base. CDs are crucial to this. Understanding the value of the RYR option is useful to both banks setting rates and investors comparing alternative investment opportunities.
Originality/value
Given the current economic climate, deciding which strategic investment options to pursue is of paramount importance. To the best of the knowledge this is the first study that applies binomial option pricing to certificates of deposit to help investors make these decisions.
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Alejandro Hazera, Carmen Quirvan and Salvador Marin-Hernandez
The purpose of this paper is to highlight how the basic binomial option pricing model (BOPM) might be used by regulators to help formulate rules, prior to financial crisis, that…
Abstract
Purpose
The purpose of this paper is to highlight how the basic binomial option pricing model (BOPM) might be used by regulators to help formulate rules, prior to financial crisis, that help prevent loan overstatement by banks in emerging market economies undergoing financial crises.
Design/methodology/approach
The paper draws on the theory of soft budget constraints (SBC) to construct a simple model in which banks overstate loans to minimize losses. The model is used to illustrate how guarantees of bailout assistance (BA) (to banks) by crisis stricken countries’ financial authorities may encourage banks to overstate loans and delay the implementation of IFRS for loan valuation. However, the model also illustrates how promises of BA may be depicted as binomial put options which provide banks with the option of either: reporting loan values on poor projects accurately and receiving the loans’ liquidation values; or, overstating loans and receiving the guaranteed BA. An illustration is also provided of how authorities may use this representation to help minimize bank loan overstatement in periods of financial crisis. In order to provide an illustration of how the option value of binomial assistance may evolve during a financial crisis, the model is generalized to the Mexican financial crisis of the late 1990s. During this period, Mexican authorities’ guarantees of BA to the nation’s largest banks encouraged those institutions to overstate loans and delay the implementation of (previously adopted) international “best practices” based loan valuation standards.
Findings
Application of the model to the Mexican financial crisis provides evidence that, in spite of Mexico’s “official” 1997 adoption of international “best accounting practices” for banks, “iron clad” guarantees of BA by the country’s financial authorities to Mexico’s largest banks provided those institutions with an incentive to knowingly overstate loans in the late 1990s and early 2000s.
Research limitations/implications
The model is compared against only one country in which the BA was directly infused into banks’ loan portfolios. Thus, as conceived, it is directly applicable to crisis countries in which the bailout took this form. However, the many quantitative variations of SBC models as well as recent studies which have applied the binomial model to other forms of bailout (e.g. direct purchases of bank shares by authorities) suggest that the model could be modified to accommodate different bailout scenarios.
Practical implications
The model and application show that guaranteed BA can be viewed as a put option and that ex-ante regulatory policies based on the correct valuation of the BA as a binomial option might prevent banks from overstating loans.
Social implications
Use of the binomial or similar approaches to valuing BA may help regulators to determine the level of BA that will not encourage banks to overstate the value of their loans.
Originality/value
Recent research has used the BOPM to value, on an ex-post basis, the BA which appears on the balance sheet of institutions which have been rescued. However, little research has advocated the use of this type of model to help prevent, on an ex-ante basis, the overstatement of loans on poor projects.
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Yarima Sallau Lawal, Aliyu Makarfi Ibrahim, Mu'awiya Abubakar, Ziyadul Hassan Ishaq and Mohammed Mustapha Sa'ad
Building developments are often capital intensive, have a long payback period and many associated risks and uncertainties. This makes investments in building projects to be a big…
Abstract
Purpose
Building developments are often capital intensive, have a long payback period and many associated risks and uncertainties. This makes investments in building projects to be a big challenge. This study aims to develop a computerized simulation-based binomial model (CSBBM) for building investment appraisal with a view to improving the economic sustainability of proposed building projects.
Design/methodology/approach
Mathematical equations and algorithms were developed based on the binomial method (BM) of real options analysis and then implemented on a computer system. A hybrid algorithm that integrates Monte Carlo simulation (MCS) and BM was also developed. A real-life project was used to test the model. Sensitivity analysis was also conducted to explore the influence of input variables on development option value (DOV).
Findings
The test result shows that the model developed provides a better estimate of the value of an investment when compared with traditional net present value technique, which underestimate the value. Moreover, inflation rate (i) and rental value (Ri) are the most sensitive variables for DOV. An increase in i and Ri by just 5% causes a corresponding increase in DOV by 202% and 132%, respectively. While the least sensitive variable is the discount rate (r), as an increase in r by 5% causes a corresponding decrease in DOV by just 9%. The CSBBM is capable of determining the optimal time of development of buildings with an accuracy of 80.77%.
Practical implications
The hybrid model produces higher DOV than that of only the BM because MCS considers randomness in uncontrollable variables. Thus, building investment decision-makers should always use MCS to complement the BM in an investment analysis.
Originality/value
There is limited evidence on the use of this kind of hybrid model for determining DOV in practice.
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Kim Hin David Ho and Shea Jean Tay
The purpose of this paper is to examine the risk neutral and non-risk neutral pricing of Singapore Real Estate Investment Trusts (S-REITs) via comparing the average of the…
Abstract
Purpose
The purpose of this paper is to examine the risk neutral and non-risk neutral pricing of Singapore Real Estate Investment Trusts (S-REITs) via comparing the average of the individual ratios (of deviation between expected and observed closing price/observed closing price) with the ratio (of standard deviation/mean) for closing prices via the binomial options pricing tree model.
Design/methodology/approach
If the ratio (of standard deviation/mean) ratio > the ratio (of deviation between expected and observed closing price/observed closing price), then the deviation of closing prices from the expected risk neutral prices is not significant and that the S-REIT is consistent with risk neutral pricing. If the ratio (of deviation between expected and observed closing price/observed closing price) is greater, then the S-REIT is not consistent with risk neutral pricing.
Findings
Capitacommercial Trust (CCT), Capitamall Trust (CMT) and Keppel Real Estate Investment Trust (REIT) have large positive differences between the two ratios (39.86, 30.79 and 18.96 percent, respectively), implying that these S-REITs are not trading at risk neutral pricing. Suntec REIT has a small positive difference of 2.35 percent between both ratios, implying that it is trading at risk neutral pricing. Ascendas REIT has the largest negative difference between the two ratios at −4.24 percent, to be followed by Mapletree Logistics Trust at −0.44 percent. Both S-REITs are trading at risk neutral pricing. The analysis shows that CCT, CMT and Keppel REIT exhibit risk averse pricing.
Research limitations/implications
Results are consistent with prudential asset allocation for viable S-REIT portfolio investing but that not all these S-REITs exhibit strong market efficiency in their pricing.
Practical implications
Pricing may be risk neutral over a certain period but investor sentiments, fear of risks and speculative activities could affect an S-REIT’s risk neutrality.
Social implications
With enhanced risk diversification activities, the S-REITs should attain risk neutral pricing.
Originality/value
Virtually no research of this nature has been undertaken for S-REITS.
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Hong Nee Ang and Matthew Pinnuck
The purpose of this paper is to address the concern about the impact of accounting regulatory change pertaining to employee share options (ESOs) on earnings management. Following…
Abstract
Purpose
The purpose of this paper is to address the concern about the impact of accounting regulatory change pertaining to employee share options (ESOs) on earnings management. Following Australia's adoption of International Financial Reporting Standards (IFRS) in 2005, companies are required to recognise the fair value of ESOs as expenses. Due to inherent imprecision in the estimate of ESO's fair value, the regulatory change from disclosure to recognition was widely claimed to potentially give rise to an alternative mechanism to manage earnings. This study provides empirical evidence on whether the regulatory change leads to earnings management problems.
Design/methodology/approach
This study uses the regulatory change in accounting for ESOs to provide a direct test of earnings management between disclosed versus recognised regimes for the same sample of firms. The sample consists of Australian firms from S&P/ASX300 for the period from 2003 to 2006.
Findings
The results show that, although the accounting regulatory change from disclosure to recognition may provide an alternative earnings management vehicle, there is no evidence of this occurring. There could be several reasons for this finding. First, the statistical tests lack power. Second, there are stricter audit tests on recognised amounts than on disclosed amounts. Third, given the concern of excessive pay and the close scrutiny of compensation, managers may have already understated ESO values in the disclosure regime. Finally, managers have limited time and resources and the effort involved in the adoption of IFRS in 2005 could have restricted the time available to manage earnings via the ESO reporting channel.
Originality/value
This study adds to the limited research on whether a change in accounting regulation for employee share options from disclosure to recognition gives rise to greater scope for earnings management. One reason for the lack of empirical evidence in the research is due to the problem of designing a test. Bernard and Schipper suggest that within‐firm studies have limitations for comparing the effects of recognition versus disclosure when the change is driven by an estimate becoming more reliable. A cross‐sectional study is also problematic due to self‐selection bias if firms can choose between disclosure versus recognition. This study circumvents potential design problems raised by Bernard and Schipper by setting a test using regulatory change which allows the test to be compared directly using the same company.
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Freddy H. Marín-Sánchez, Julián A. Pareja-Vasseur and Diego Manzur
The purpose of this article is to propose a detailed methodology to estimate, model and incorporate the non-constant volatility onto a numerical tree scheme, to evaluate a real…
Abstract
Purpose
The purpose of this article is to propose a detailed methodology to estimate, model and incorporate the non-constant volatility onto a numerical tree scheme, to evaluate a real option, using a quadrinomial multiplicative recombination.
Design/methodology/approach
This article uses the multiplicative quadrinomial tree numerical method with non-constant volatility, based on stochastic differential equations of the GARCH-diffusion type to value real options when the volatility is stochastic.
Findings
Findings showed that in the proposed method with volatility tends to zero, the multiplicative binomial traditional method is a particular case, and results are comparable between these methodologies, as well as to the exact solution offered by the Black–Scholes model.
Originality/value
The originality of this paper lies in try to model the implicit (conditional) market volatility to assess, based on that, a real option using a quadrinomial tree, including into this valuation the stochastic volatility of the underlying asset. The main contribution is the formal derivation of a risk-neutral valuation as well as the market risk premium associated with volatility, verifying this condition via numerical test on simulated and real data, showing that our proposal is consistent with Black and Scholes formula and multiplicative binomial trees method.
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Jianfu Shen and Frederik Pretorius
The purpose of this paper is to construct option pricing models for real estate development by considering and incorporating institutional arrangements, direct interactions and…
Abstract
Purpose
The purpose of this paper is to construct option pricing models for real estate development by considering and incorporating institutional arrangements, direct interactions and financial constraints in the model. It extends the application of real option theory from the framework borrowed from financial option pricing, and considers the case where a development company has restrictions from outside environment and financial constraint. It explores the effects of these additional practical factors on real asset project value and development timing. This paper makes contributions to bridge the theoretical models and practical applications.
Design/methodology/approach
Real estate development is modelled in the binomial option pricing framework with the considerations of time‐to‐build, foregone rent if delaying, institutional environment and capital budgeting. The investment timings are derived from the models and sensitivity analysis is conducted to explore the effects of these factors.
Findings
Apart from the factors in traditional option pricing theory, this paper confirms that the contractual covenants, positive synergies between properties and financial status of the firm, which enhance or restrict real flexibility embedded in the development land, influence project value and investment timing. Numerical examples illustrate the effects of these factors. It is argued that the valuation of real options should place emphasis on industry‐specific characteristics and start from the perspective of the firm rather than individual options.
Practical implications
The models constructed in this paper and the results can be directly used in the practical real estate development.
Originality/value
This paper incorporates many practical factors in real estate development which are not investigated in previous studies. It values the option project from the firm perspective rather than project perspective as previous studies. It also shows the effects of institutional arrangement and firm factors on project value and development timing.
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Hui Sun, Yuning Wang and Jia Meng
The purpose of this paper is to develop a trading and pricing method of expansion option (EO) model to solve expansion problems of build-operate-transfer (BOT) freeway project.
Abstract
Purpose
The purpose of this paper is to develop a trading and pricing method of expansion option (EO) model to solve expansion problems of build-operate-transfer (BOT) freeway project.
Design/methodology/approach
This paper proposes an ex ante mechanism through trading the EO to avoid the transaction costs. By editing the paths generated from binomial option pricing model, this paper establishes an American real option binomial lattice model and evaluates the value of EO. Data are collected from Liaoning province in China and the model is practiced in the context of a BOT freeway in Liaoning province.
Findings
Supported by empirical evidence, this study finds out that there exists a minimum price at which the government can sell the EO and a maximum price that the private sector is willing to pay. When the minimum price is negative, the government should transfer the EO to the private sector free of charge to avoid the transaction costs. Otherwise, the government should sell the EO at a reasonable price to protect public interests.
Practical implications
The study can be used for the government to reducing the transaction costs. By using the trading EO model, the government can sell its share of the EO to the private sector to manage its resources efficiently.
Originality/value
This paper builds a trading EO model to solve expansion problems instead of renegotiations. In addition to reducing the transaction costs for the whole society, trading EO can also raise the respective payoffs of both public and private sectors. An EO trading framework and algorithm is further developed. It realized an American option model, making the owner can exercise the option whenever he wants. Thus, the whole model is adapted to best fit BOT highway practice.
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Jan M. Smolarski, Neil Wilner and Jose G. Vega
This paper aims to examine the applicability of real options methodology with respect to developing internal transfer pricing mechanisms. A pervasive theme in existing models is…
Abstract
Purpose
This paper aims to examine the applicability of real options methodology with respect to developing internal transfer pricing mechanisms. A pervasive theme in existing models is their inability to handle the dynamic and volatile nature of today’s business environment, as well as their lack of objective managerial flexibility. The authors address these and other issues and develop a transfer pricing mechanism based on Black–Scholes and the binomial options pricing methodology, which is better suited in today’s dynamic business environment.
Design/methodology/approach
The authors use a conceptual approach in developing theoretical justifications and show, practically, how a transfer price can be developed using two different real options pricing models.
Findings
The authors find that real options transfer price mechanism (real options framework [ROF]) can effectively deal with many of the issues that permeate a modern organization with complex multi-dimensional operations. The authors argue that uncertainty and behavioral issues commonly associated with setting transfer prices are better handled using a transfer pricing mechanism that preserves flexibility at the business unit level, the managerial level and the firm level. The approach allows for different managerial styles in both centralized and decentralized sub-units within the same organization. The authors argue that an open multi-dimensional framework using real options is suitable under conditions of uncertainty and managerial opportunism.
Practical implications
ROF-based transfer pricing may be significant in that firms can use it as a tool to manage an organization by setting the prices centrally and at the same time allowing managers to select the transfer price that best suits their specific situation and operating conditions. This may result in a more efficient and more profitable organization.
Originality/value
The contribution of the paper is the melding of the ROF from the finance literature with the accounting problem of setting a transfer price for items lacking a competitive market price. The authors also contribute to existing research by explicitly developing a framework that values managerial flexibility, takes into account uncertainty and considers the behavioral aspects of the transfer pricing process. The authors establish the conditions under which a generic real options model is a feasible alternative in determining a transfer price.
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Tien Foo Sing and Wei Liang Tang
This paper models the lessee's default options and estimates the economic value of the options for a lessee using a discrete time binomial American option pricing model. Results…
Abstract
This paper models the lessee's default options and estimates the economic value of the options for a lessee using a discrete time binomial American option pricing model. Results show a positive relationship of the option premium with the original rent and a negative relationship with the relocation costs. Finds that the default probability is higher for lessees who are more sensitive to rental changes and place less emphasis on the fitting‐out quality. Suggests that rental volatility and rental growth rate are two significant factors that have positive relationships with the default option values. The risk‐free rate, on the other hand, has an inverse relationship with the default option values because a higher risk‐free interest rate reduces the present value of rental savings. Lease term length to expiration has a positive effect on the default option value, implying that the default option premium will decay as the term to expiry is shortened.
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