Essays on Stock Options, Incentives, and Managerial Action

Executive compensation and managerial behavior have received an increasing amount of attention in the financial economics literature since the mid 1970s. The purpose of this thesis is to extend our understanding of managerial compensation, especially how stock option compensation is linked to the actions undertaken by the management. Furthermore, managerial compensation is continuously and heatedly debated in the media and an emerging consensus from this discussion seems to be that there still exists gaps in our knowledge of optimal contracting. In Finland, the first executive stock options were introduced in the 1980s and throughout the last 15 years it has become increasingly popular for Finnish listed firms to use this type of managerial compensation. The empirical work in the thesis is conducted using data from Finland, in contrast to most previous studies that predominantly use U.S. data. Using Finnish data provides insight of how market conditions affect compensation and managerial action and provides an opportunity to explore what parts of the U.S. evidence can be generalized to other markets. The thesis consists of four essays. The first essay investigates the exercise policy of the executive stock option holders in Finland. In summary, Essay 1 contributes to our understanding of the exercise policies by examining both the determinants of the exercise decision and the markets reaction to the actual exercises. The second essay analyzes the factors driving stock option grants using data for Finnish publicly listed firms. Several agency theory based variables are found to have have explanatory power on the likelihood of a stock option grant. Essay 2 also contributes to our understanding of behavioral factors, such as prior stock return, as determinants of stock option compensation. The third essay investigates the tax and stock option motives for share repurchases and dividend distributions. We document strong support for the tax motive for share repurchases. Furthermore, we also analyze the dividend distribution decision in companies with stock options and find a significant difference between companies with and without dividend protected options. We thus document that the cutting of dividends found in previous U.S. studies can be avoided by dividend protection. In the fourth essay we approach the puzzle of negative skewness in stock returns from an altogether different angle than in previous studies. We suggest that negative skewness in stock returns is generated by management disclosure practices and find proof for this. More specifically, we find that negative skewness in daily returns is induced by returns for days when non-scheduled firm specific news is disclosed.

Hedging Options with Different Time Units in the Pricing Models

This study examined the effects of the Greeks of the options and the trading results of delta hedging strategies, with three different time units or option-pricing models. These time units were calendar time, trading time and continuous time using discrete approximation (CTDA) time. The CTDA time model is a pricing model, that among others accounts for intraday and weekend, patterns in volatility. For the CTDA time model some additional theta measures, which were believed to be usable in trading, were developed. The study appears to verify that there were differences in the Greeks with different time units. It also revealed that these differences influence the delta hedging of options or portfolios. Although it is difficult to say anything about which is the most usable of the different time models, as this much depends on the traders view of the passing of time, different market conditions and different portfolios, the CTDA time model can be viewed as an attractive alternative.

Executive Stock Options: Exercise Policy and Market Reaction

In this paper I investigate the exercise policy, and the market reaction to that, of the executive stock option holders in Finland. The empirical tests are conducted with aggregated firm level data from 34 firms and 41 stock option programs. I find some evidence of an inverse relation between the exercise intensity of the options holders and the future abnormal return of the company share price. This finding is supported by the view that information about future company prospect seems to be the only theoretical attribute that could delay the exercise of the options. Moreover, a high concentration of exercises in the beginning of the exercise window is predicted and the market is expected to react to deviations from this. The empirical findings however show that the market does not react homogenously to the information revealed by the late exercises.

Share Repurchases, Dividends, and Executive Options

This paper reports empirical results on the determinants of the authorization decision for share repurchases and dividends in Finland. We use a data set with precise data on share repurchases as well as characteristics for the option programs. Contrary to the U.S., we use a data set where 41% of the options are dividend protected, which allows us to separate between the "option funding" and "substitution / managerial wealth" hypothesis for the choice of the distribution method. We find that foreign ownership is the main determinant for share repurchases in Finland and attribute this relationship to tax factors. We also find evidence in support of both the signaling and agency cost hypotheses for cash distributions, especially in the case of share repurchases. Finally, we find a significant difference between companies with and without dividend protected options. When options are dividend protected, the relationship between dividend distributions and the scope of the options program turns to a significantly positive one instead of the negative one documented on U.S. data. This gives some support for the substitution / managerial wealth hypothesis as a determinant for the choice of the distribution method.

The Pricing of American Put Options on Stock with Dividends

Pricing American put options on dividend-paying stocks has largely been ignored in the option pricing literature because the problem is mathematically complex and valuation usually resorts to computationally expensive and impractical pricing applications. This paper computed a simulation study, using two different approximation methods for the valuation of American put options on a stock with known discrete dividend payments. This to find out if there were pricing errors and to find out which could be the most usable method for practical users. The option pricing models used in the study was the dividend approximation by Blomeyer (1986) and the one by Barone-Adesi and Whaley (1988). The study showed that the approximation method by Blomeyer worked satisfactory for most situations, but some errors occur for longer times to the dividend payment, for smaller dividends and for in-the-money options. The approximation method by Barone-Adesi and Whaley worked well for in-the-money options and at-the-money options, but had serious pricing errors for out-of-the-money options. The conclusion of the study is that a combination of the both methods might be preferable to any single model.

Pricing Index Options with Stochastic Volatility

The objective of this paper is to investigate the pricing accuracy under stochastic volatility where the volatility follows a square root process. The theoretical prices are compared with market price data (the German DAX index options market) by using two different techniques of parameter estimation, the method of moments and implicit estimation by inversion. Standard Black & Scholes pricing is used as a benchmark. The results indicate that the stochastic volatility model with parameters estimated by inversion using the available prices on the preceding day, is the most accurate pricing method of the three in this study and can be considered satisfactory. However, as the same model with parameters estimated using a rolling window (the method of moments) proved to be inferior to the benchmark, the importance of stable and correct estimation of the parameters is evident.

Options for selecting dairy cattle for milk coagulation ability

Lypsylehmien maidon juoksettumiskyvyn jalostuskeinot Väitöskirjassa tutkittiin lypsylehmien maidon juustonvalmistuslaadun parantamista jalostusvalinnan avulla. Tutkimusaihe on tärkeä, sillä yhä suurempi osa maidosta käytetään juustonvalmistukseen. Tutkimuksen kohteena oli maidon juoksettumiskyky, sillä se on yksi keskeisistä juustomäärään vaikuttavista tekijöistä. Maidon juoksettumiskyky vaihteli huomattavasti lehmien, sonnien, karjojen, rotujen ja lypsykauden vaiheiden välillä. Vaikka tankkimaidon juoksettumiskyvyssä olikin suuria eroja karjoittain, karja selitti vain pienen osan juoksettumiskyvyn kokonaisvaihtelusta. Todennäköisesti perinnölliset erot lehmien välillä selittävät suurimman osan karjojen tankkimaitojen juoksettumiskyvyssä havaituista eroista. Hyvä hoito ja ruokinta vähensivät kuitenkin jossain määrin huonosti juoksettuvien tankkimaitojen osuutta karjoissa. Holstein-friisiläiset lehmät olivat juoksettumiskyvyltään ayrshire-rotuisia lehmiä parempia. Huono juoksettuminen ja juoksettumattomuus oli vain vähäinen ongelma holstein-friisiläisillä (10 %), kun taas kolmannes ayrshire-lehmistä tuotti huonosti juoksettuvaa tai juoksettumatonta maitoa. Maitoa sanotaan huonosti juoksettuvaksi silloin, kun juustomassa ei ole riittävän kiinteää leikattavaksi puolen tunnin kuluttua juoksetteen lisäyksestä. Juoksettumattomaksi määriteltävä maito ei saostu lainkaan puolen tunnin aikana ja on siksi erittäin huonoa raaka-ainetta juustomeijereille. Noin 40 % lehmien välisistä eroista maidon juoksettumiskyvyssä selittyi perinnöllisillä tekijöillä. Juoksettumiskykyä voikin sanoa hyvin periytyväksi ominaisuudeksi. Kolme mittauskertaa lehmää kohti riittää varsin hyvin lehmän maidon keskimääräisen juoksettumiskyvyn arvioimiseen. Tällä hetkellä juoksettumiskyvyn suoran jalostamisen ongelmana on kuitenkin automatisoidun, laajamittaiseen käyttöön soveltuvan mittalaitteen puute. Tämän takia väitöskirjassa tutkittiin mahdollisuuksia jalostaa maidon juoksettumiskykyä epäsuorasti, jonkin toisen ominaisuuden kautta. Tällaisen ominaisuuden pitää olla kyllin voimakkaasti perinnöllisesti kytkeytynyt juoksettumiskykyyn, jotta jalostus olisi mahdollista sen avulla. Tutkittavat ominaisuudet olivat sonnien kokonaisjalostusarvossa jo mukana olevat maitotuotos ja utareterveyteen liittyvät ominaisuudet sekä kokonaisjalostusarvoon kuulumattomat maidon valkuais- ja kaseiinipitoisuus sekä maidon pH. Väitöskirjassa tutkittiin myös mahdollisuuksia ns. merkkiavusteiseen valintaan tutkimalla maidon juoksettumattomuuden perinnöllisyyttä ja kartoittamalla siihen liittyvät kromosomialueet. Tutkimuksen tulosten perusteella lehmien utareterveyden jalostaminen parantaa jonkin verran myös maidon juoksettumiskykyä sekä vähentää juoksettumattomuutta ayrshire-rotuisilla lehmillä. Lehmien maitotuotos ja maidon juoksettumiskyky sekä juoksettumattomuus ovat sen sijaan perinnöllisesti toisistaan riippumattomia ominaisuuksia. Myöskin maidon valkuais- ja kaseiinipitoisuuden perinnöllinen yhteys juoksettumiskykyyn oli likimain nolla. Maidon pH:n ja juoksettumiskyvyn välillä oli melko voimakas perinnöllinen yhteys, joten maidon pH:n jalostaminen parantaisi myös maidon juoksettumiskykyä. Todennäköisesti sen jalostaminen ei kuitenkaan vähentäisi juoksettumatonta maitoa tuottavien lehmien määrää. Koska maidon juoksettumattomuus on niin yleinen ongelma suomalaisilla ayrshire-lehmillä, väitöksessä selvitettiin tarkemmin ilmiön taustoja. Kaikissa kolmessa tutkimusaineistoissa noin 10 % ayrshire-lehmistä tuotti juoksettumatonta maitoa. Kahden vuoden kuukausittaisen seurannan aikana osa lehmistä tuotti juoksettumatonta maitoa lähes joka mittauskerralla. Maidon juoksettumattomuus oli yhteydessä lypsykauden vaiheeseen, mutta mikään ympäristötekijöistä ei pystynyt täysin selittämään sitä. Sen sijaan viitteet sen periytyvyydestä vahvistuivat tutkimusten edetessä. Lopuksi tutkimusryhmä onnistui kartoittamaan juoksettumattomuutta aiheuttavat kromosomialueet kromosomeihin 2 ja 18, lähelle DNA-merkkejä BMS1126 ja BMS1355. Tulosten perusteella maidon juoksettumattomuus ei ole yhteydessä maidon juoksettumistapahtumassa keskeisiin kaseiinigeeneihin. Sen sijaan on mahdollista, että juoksettumattomuusongelman aiheuttavat kaseiinigeenien syntetisoinnin jälkeisessä muokkauksessa tapahtuvat virheet. Asia vaatii kuitenkin perusteellista tutkimista. Väitöksen tulosten perusteella maidon juoksettumattomuusgeeniä kantavien eläinten karsiminen jalostuseläinten joukosta olisi tehokkain tapa jalostaa maidon juoksettumiskykyä suomalaisessa lypsykarjapopulaatiossa.

Mathematical Aspects of Financial Markets with Frictions

Frictions are factors that hinder trading of securities in financial markets. Typical frictions include limited market depth, transaction costs, lack of infinite divisibility of securities, and taxes. Conventional models used in mathematical finance often gloss over these issues, which affect almost all financial markets, by arguing that the impact of frictions is negligible and, consequently, the frictionless models are valid approximations. This dissertation consists of three research papers, which are related to the study of the validity of such approximations in two distinct modeling problems. Models of price dynamics that are based on diffusion processes, i.e., continuous strong Markov processes, are widely used in the frictionless scenario. The first paper establishes that diffusion models can indeed be understood as approximations of price dynamics in markets with frictions. This is achieved by introducing an agent-based model of a financial market where finitely many agents trade a financial security, the price of which evolves according to price impacts generated by trades. It is shown that, if the number of agents is large, then under certain assumptions the price process of security, which is a pure-jump process, can be approximated by a one-dimensional diffusion process. In a slightly extended model, in which agents may exhibit herd behavior, the approximating diffusion model turns out to be a stochastic volatility model. Finally, it is shown that when agents' tendency to herd is strong, logarithmic returns in the approximating stochastic volatility model are heavy-tailed. The remaining papers are related to no-arbitrage criteria and superhedging in continuous-time option pricing models under small-transaction-cost asymptotics. Guasoni, Rásonyi, and Schachermayer have recently shown that, in such a setting, any financial security admits no arbitrage opportunities and there exist no feasible superhedging strategies for European call and put options written on it, as long as its price process is continuous and has the so-called conditional full support (CFS) property. Motivated by this result, CFS is established for certain stochastic integrals and a subclass of Brownian semistationary processes in the two papers. As a consequence, a wide range of possibly non-Markovian local and stochastic volatility models have the CFS property.

Elements of Volatility at High Frequency

Volatility is central in options pricing and risk management. It reflects the uncertainty of investors and the inherent instability of the economy. Time series methods are among the most widely applied scientific methods to analyze and predict volatility. Very frequently sampled data contain much valuable information about the different elements of volatility and may ultimately reveal the reasons for time varying volatility. The use of such ultra-high-frequency data is common to all three essays of the dissertation. The dissertation belongs to the field of financial econometrics. The first essay uses wavelet methods to study the time-varying behavior of scaling laws and long-memory in the five-minute volatility series of Nokia on the Helsinki Stock Exchange around the burst of the IT-bubble. The essay is motivated by earlier findings which suggest that different scaling laws may apply to intraday time-scales and to larger time-scales, implying that the so-called annualized volatility depends on the data sampling frequency. The empirical results confirm the appearance of time varying long-memory and different scaling laws that, for a significant part, can be attributed to investor irrationality and to an intraday volatility periodicity called the New York effect. The findings have potentially important consequences for options pricing and risk management that commonly assume constant memory and scaling. The second essay investigates modelling the duration between trades in stock markets. Durations convoy information about investor intentions and provide an alternative view at volatility. Generalizations of standard autoregressive conditional duration (ACD) models are developed to meet needs observed in previous applications of the standard models. According to the empirical results based on data of actively traded stocks on the New York Stock Exchange and the Helsinki Stock Exchange the proposed generalization clearly outperforms the standard models and also performs well in comparison to another recently proposed alternative to the standard models. The distribution used to derive the generalization may also prove valuable in other areas of risk management. The third essay studies empirically the effect of decimalization on volatility and market microstructure noise. Decimalization refers to the change from fractional pricing to decimal pricing and it was carried out on the New York Stock Exchange in January, 2001. The methods used here are more accurate than in the earlier studies and put more weight on market microstructure. The main result is that decimalization decreased observed volatility by reducing noise variance especially for the highly active stocks. The results help risk management and market mechanism designing.

Epidemiology and Treatment Options of Primary Biliary Cirrhosis

Primary biliary cirrhosis (PBC) is caused by an autoimmune inflammation of the small bile ducts. It results to destruction of bile ducts, accumulation of the bile in the liver, and cirrhosis. The prevalence and incidence of PBC is increasing in the Western world. The prevalence is highest in the USA (402 per million) and incidence in Scotland (49/million/year). Our aim was to assess the epidemiology of PBC in Finland. Patients for the epidemiological study were searched from the hospital discharge records from year 1988 to 1999.The prevalence rose from 103 to 180/million from 1988 to 1999, an annual increase of 5.1%. The incidence rose from 12 to 17 /million/year, an annual increase of 3.5%. The age at death increased markedly from 65 to 76 years. The risk of liver related deaths diminished over time. The treatment of PBC is based on Ursodeoxycholic acid (UDCA). During 20 years 50% of patients end up with cirrhosis. Our treatment option was to combine budesonide, a potent corticosteroid with a high first pass metabolism in the liver, to UDCA and evaluate the liver effects and systemic effects such as bone mass density (BMD) changes. Our aim was to find out if combination of laboratory tests would serve as a surrogate marker for PBC and help reducing the need for liver biopsy. Non-cirrhotic PBC patients were randomized to receive budesonide 6 mg/day combined to UDCA 15 mg /kg/day or UDCA alone for three years. The combination therapy with UDCA and budesonide was effective: stage improved 22%, fibrosis 25%, and inflammation 32%. In the UDCA group the changes were: 20% deterioriation in stage and 70% in fibrosis, but a 10% improvement in inflammation. BMD in femoral neck decreased by 3.6% in the combination group and by 1.9% in the UDCA group. The reductions in lumbar spine were 2.8% and 0.7%. Pharmacokinetics did not differ between the stages of PBC. HA, PIIINP, bile acids, and AST were significantly different within stages I-III and could differentiate the mild fibrosis (F0F1) from the moderate (F2F3). The combination of these individual markers (PBC-score) further improved the accuracy. The area under the ROC of the PBC score, using a cut of value 66, had a sensitivity of 81.4% and a specificity of 65.2% to classify the stage of PBC. The prevalence of PBC in Finland increases, which results from increasing incidence and improved survival. The combination of budesonide and UDCA improves liver histology compared to UDCA alone in non-cirrhotic stages of PBC. The treatment may reduce BMD. Hyaluronic acid, PIIINP, AST, and bile acids may serve as tools to monitor the treatment response in the early stages of PBC. The budesonide and UDCA combination therapy is an option for those patients who do not receive full response from UDCA and are still at the non-cirrhotic stage of PBC.

Studies on Binary Time Series Models with Applications to Empirical Macroeconomics and Finance

This thesis studies binary time series models and their applications in empirical macroeconomics and finance. In addition to previously suggested models, new dynamic extensions are proposed to the static probit model commonly used in the previous literature. In particular, we are interested in probit models with an autoregressive model structure. In Chapter 2, the main objective is to compare the predictive performance of the static and dynamic probit models in forecasting the U.S. and German business cycle recession periods. Financial variables, such as interest rates and stock market returns, are used as predictive variables. The empirical results suggest that the recession periods are predictable and dynamic probit models, especially models with the autoregressive structure, outperform the static model. Chapter 3 proposes a Lagrange Multiplier (LM) test for the usefulness of the autoregressive structure of the probit model. The finite sample properties of the LM test are considered with simulation experiments. Results indicate that the two alternative LM test statistics have reasonable size and power in large samples. In small samples, a parametric bootstrap method is suggested to obtain approximately correct size. In Chapter 4, the predictive power of dynamic probit models in predicting the direction of stock market returns are examined. The novel idea is to use recession forecast (see Chapter 2) as a predictor of the stock return sign. The evidence suggests that the signs of the U.S. excess stock returns over the risk-free return are predictable both in and out of sample. The new "error correction" probit model yields the best forecasts and it also outperforms other predictive models, such as ARMAX models, in terms of statistical and economic goodness-of-fit measures. Chapter 5 generalizes the analysis of univariate models considered in Chapters 2 4 to the case of a bivariate model. A new bivariate autoregressive probit model is applied to predict the current state of the U.S. business cycle and growth rate cycle periods. Evidence of predictability of both cycle indicators is obtained and the bivariate model is found to outperform the univariate models in terms of predictive power.

Finnish Short-Term Stock Returns

Functioning capital markets are a crucial part of a competitive economy since they provide the mechanisms to allocate resources. In order to be well functioning a capital market has to be efficient. Market efficiency is defined as a market where prices at any time fully reflect all available information. Basically, this means that abnormal returns cannot be predicted since they are dependent on future, presently unknown, information. The debate of market efficiency has been going on for several decades. Most academics today would probably agree that financial markets are reasonably efficient since virtually nobody has been able to achieve continuous abnormal positive returns. However, it is clear that a set of return anomalies exists, although they are apparently to small to enable substantial economic profit. Moreover, these anomalies can often be attributed to market design. The motivation for this work is to expand the knowledge of short-term trading patterns and to offer some explanations for these patterns. In the first essay the return pattern during the day is examined. On average stock prices move during two time periods of the day, namely, immediately after the opening and around the formal close of the market. Since stock prices, on average, move upwards these abnormal returns are generally positive and cause the distinct U-shape of intraday returns. In the second essay the results in the first essay are examined further. The return pattern around the former close is shown to partly be the result of manipulative action by market participants. In the third essay the focus is shifted towards trading patterns of the underlying stocks on days when index options and index futures on the stocks expire. Generally no expiration day effect was found. However, some indication of an expiration day effect was found when a large amount of open in- or at-the-money contracts existed. Also, the effects were likelier to be found for shares with high index-weight but fairly low trading volume. Last, in the forth essay the attention is turned to the behaviour of different tax clienteles around the dividend ex-day. Two groups of investors showed abnormal trading behaviour. Domestic non-financial investors, especially domestic companies, showed a dividend capturing behaviour, i.e. buying cum-dividend and selling ex-dividend shares. The opposite behaviour was found for foreign investors and domestic financial institutions. The effect was more notable for high yield, high volume stocks.