The Financial Review

Anna Dodonova, Yuri Khoroshilov

This paper provides an explanation for the widespread use of stock option grants in executive compensations. It shows that the optimal incentive contract for loss-averse managers must contain a substantial portion of stock options even when it should consist exclusively of stock grants for “classical” risk-averse managers. The paper also provides an explanation for the drastic increase in the risk-adjusted level of CEO compensations over the past two decades and argues that more option-based compensation should be used in firms with higher cash flow volatility and in industries with higher degree of heterogeneity among firms.

Keywords: Executive stock options, incentive compensation, incentive contract, managerial risk aversion, restricted stock, behavioral finance

James C. Brau, Patricia A. Ryan, Irv DeGraw

We examine four issues pertaining to IPOs using a survey of 438 CFOs. First, why do firms go public? Second, is CFO sentiment stationary across bear and bull markets? Third, what concerns CFOs about going public? Fourth, do CFO perceptions correlate with returns? Results support funding for growth and liquidity as the primary reasons for IPOs. CFO sentiment is generally stationary in pre- and post-bubble years. Managers are concerned with the direct costs of going public, such as underwriting fees, as well as indirect costs. We find a negative relation between a focus on immediate growth and long-term abnormal returns.

Keywords: IPOs, initial public offerings, equity offering, survey, chief financial officer, CFO, perceptions

Nikiforos T. Laopodis

This paper examines the dynamic interactions among the equity market, economic activity, inflation, and monetary policy under three monetary policy regimes using bivariate and multivariate Vector Autoregressive cointegrating specifications. The bivariate results for the real stock returns-inflation pair weakly support a negative correlation in the 1970s and 1980s. While the bivariate findings suggest a weak, negative relationship between real returns and the federal funds in the 1970s and 1980s, the multivariate findings strongly support short-term linkages in the 1970s. There appears to be no consistent dynamic relationship between monetary policy and stock prices in that the relationship differs across monetary regimes.

Keywords: Monetary policy, equity market, inflation, economic activity, VAR, cointegration, Granger causality

Christophe Faugère, Julian Van Erlach

We find that the long-term equity premium is consistent with both GDP growth and portfolio insurance. We use a supply-side growth model and demonstrate that the arithmetic average stock market return and the returns on corporate assets and debt depend on GDP per capita growth. The implied equity premium matches the U.S. historical average over 1926– 2001. Separately, we find that the equity premium tracks the value of a put option on the S&P 500. Our theory predicts a smaller equity premium in the future, assuming the recent regime shifts in dividend policies, interest rates, and tax rates are permanent.

Keywords: Equity premium, GDP growth, T-bills, downside risk, and portfolio insurance

Hui Guo

We investigate the risk-return relation in international stock markets using realized variance constructed from MSCI (Morgan Stanley Capital International) daily stock price indices. In contrast with CAPM, realized variance by itself provides negligible information about future excess stock market returns; however, we uncover a positive and significant risk-return tradeoff in many countries after controlling for the (U.S.) consumption-wealth ratio. U.S. realized variance is also significantly related to future international stock market returns; more importantly, it always subsumes the information content of its local counterparts. Our results indicate that stock market variance is an important determinant of the equity premium.

Keywords: capital market integration, stock return predictability, out-of-sample forecasts

Michael A. Kelly

We present a faster, more accurate technique for estimating implied volatility using the standard partial derivatives of the Black-Scholes option-pricing formula. Beside Newton-Raphson and slower approximation methods, this technique is the first to provide an error tolerance, which is essential for practical application. All existing non-iterative approximation methods do not provide error tolerances and have the potential for large errors.

Keywords: options, implied volatility