[Northwestern][Kellogg][Finance]
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Abstract:This paper proposes a form of contingent capital for financial institutions that converts from debt to equity if two conditions are met: the firm's stock price is at or below a trigger value and the value of a financial institutions index is also at or below a trigger value. This structure protects financial firms during a crisis, when all are performing badly, but during normal times permits a bank performing badly to go bankrupt. I discuss a number of issues associated with the design of a contingent capital claim, including susceptibility to manipulation and whether conversion should be for a fixed dollar amount of shares or a fixed number of shares; the susceptibility of different contingent capital schemes to different kinds of errors (under and over-capitalization); and the losses likely to be incurred by shareholders upon the imposition of a requirement for contingent capital. I also present some illustrative pricing examples.
Abstract: Fundamental economic principles provide a rationale for requiring financial institutions to use mark-to-market, or fair value, accounting for financial reporting. The recent turmoil in financial markets, however, has raised questions about whether fair value accounting is exacerbating the problems. In this paper we review the history and practice of fair value accounting, and summarize the literature on the channels through which it can adversely affect the real economy. We propose a new model to study the interaction of accounting rules with regulatory capital requirements, and show that even when market prices always reflect fundamental values, the interaction of fair value accounting rules and a simple capital requirement can create inefficiencies that are absent when capital is measured by adjusted book value. These distortions can be avoided, however, by redefining capital requirements to be procyclical rather than by abandoning fair value accounting and the other benefits that it provides.
Abstract The debt of Fannie Mae and Freddie Mac carries an implicit government guarantee (recently made explicit). The value of this guarantee has been estimated in the literature by comparing the spreads on Fannie and Freddie debt to that of treasury debt and by using option-based estimators. Spread-based estimates generally exceed option-based estimates. We show that one explanation for this difference can be that firms with a debt guarantee will follow a more conservative default policy than otherwise identical non-guaranteed firms. Thus, the observed interest rate spread overestimates the value of the guarantee. For different assumptions we obtain guarantee estimates in the $20 - $70 billion range.
Abstract Fannie Mae and Freddie Mac assume a significant amount of interest and prepayment risk and all of the credit risk for about half of the $8 trillion U.S. residential mortgage market. Their hybrid government–private status, and the perception that they are too big to fail, make them a potentially large, but largely unaccounted for, risk to the federal government. Measuring the size and risk of this liability is technically difficult, but important for the debate over the appropriate regulation of these institutions. Here we take an options pricing approach to evaluating these costs and risks. Under the base case assumptions, the estimated value of the guarantees is $7.9 billion over 10 years, with a combined .5 percent value at risk of $122 billion. We evaluate the sensitivity of these estimates to various modeling assumptions, and also to the regulatory regime, including forbearance policies and capital requirements. The analysis highlights the benefits, but also the challenges, of taking an options-based approach to evaluating the value of federal credit guarantees.
Abstract: It is common for firms to issue or purchase options on the firm's own stock. Examples include convertible bonds, warrants, call options as employee compensation, or the sale of put options as part of share repurchase programs. This paper shows that option positions with implicit borrowing---such as put sales and call purchases---are tax-disadvantaged relative to the equivalent synthetic option with explicit borrowing. Conversely, option positions with implicit lending---such as compensation calls---are tax-advantaged. We also show that firms are better off from a tax perspective issuing bifurcated convertible bonds---bonds plus warrants---rather than an otherwise equivalent standard convertible. The put option sales which have been popular with some firms are like issuing debt with non-deductible interest and thus have a tax cost. For example, we estimate that in 1999 the tax cost to Microsoft of written puts was about $80m per year.
Abstract: The value of stock-based compensation is typically taxed as ordinary income to the employee, but the timing of the tax can be discretionary. For non-qualified compensation options, the value of the option is taxed as ordinary income when the option is exercised. If the employee continues to hold the stock after exercise, subsequent appreciation is taxed as a capital gain. Some argue that an option-holder who is sufficiently optimistic about the stock should exercise the option before expiration, incurring tax at a high rate in order that subsequent gains are taxed at a lower rate. Similar arguments have been made in favor of Section 83(b) elections, which permit employees who receive grants of restricted stock to accelerate the payment of ordinary income tax on the grant. I show that such tax arguments for option exercise and Section 83(b) elections are generally incorrect. However, I also show that if the employee cannot trade the stock outside the compensation account, there are circumstances in which an employee would rationally exercise an option before expiration or perform a Section 83(b) election.
Abstract: German dividends typically carry a tax credit which makes the dividend worth 42.86% more to a taxable German shareholder than to a tax-exempt or foreign shareholder. As a result of the credit, the ex-dividend-day share price drop exceeds the amount of the dividend. I document that the ex-day drop reflects approximately one-half of the tax credit, and show that futures and option prices embed approximately one-half of the tax credit. The existence of the tax credit creates possibilities for cross-border tax arbitrage and also has implications for market integration, market efficiency, tax policy, and tax-efficient foreign investment. In particular, it is tax-efficient for foreign investors to hold DAX index futures rather than investing directly in the DAX cash index.
Abstract: Most firms do not make explicit use of real option techniques in evaluating investments. Nevertheless, real option considerations can be a significant component of value, and firms which approximately take them into account should outperform firms which do not. This paper asks whether the use of seemingly arbitrary investment criteria, such as hurdle rates and profitability indexes, can proxy for the use of more sophisticated real options calculation. We find that for a variety of parameters, particular hurdle rate and profitability index rules can provide close-to-optimal investment decisions. This suggests that firms using seemingly arbitrary "rules of thumb" may be trying to approximate optimal decisions.