International Journal of Theoretical and Applied Finance

We present a simple new explanation for the diversification discount in the valuation of firms. We demonstrate that, ceteris paribus, limited liability of equity holders is sufficient to explain a diversification discount. To derive this result, we use a credit risk model based on the value of the firm's assets. We show that a conglomerate can be regarded as an option on a portfolio of assets. By splitting up the conglomerate, the investor receives a portfolio of options on assets. The conglomerate discount arises because the value of a portfolio of options is always equal to or higher than the value of an option on a portfolio. The magnitude of the conglomerate discount depends on the number of business units and their correlation, as well as their volatility, among other factors.

This paper addresses the issue of how insider trading rules affect price formation in securities markets and suggests the application of information theory to market microstructure theory. We analyze a variant of the setting in [20] by simply introducing a more general criterion for informational efficiency borrowed from information theory — namely maximum information transmission. The analysis shows that both the insider's optimal trading strategy and the market price of the risky security depend on the insider trading restriction. Insider trading restrictions are reported to be detrimental to the liquidity of the securities market. We find that a unique insider trading rule exists which implements semi-strong form informational efficiency of the securities market. Alternative restrictions on insider trading give rise to either underreaction or overreaction in securities prices. Too strict insider trading rules are shown to account for excess volatility in securities prices. Contrary to common notion, the uninformed investors are shown to be hurt by too restrictive insider trading rules. We conclude that loose insider trading rules are preferred by the group of investors as a whole.

This paper is a contribution to the pricing and hedging of options in a market where the volatility is stochastic. The new concept of relative indifference pricing is further developed. This relative price is the price at which an option trader is indifferent to trade in an additional option, given that he is currently holding and dynamically hedging a portfolio of options. We find that the appropriate volatility risk premium depends on the trader's risk aversion coefficient and his portfolio position before selling or buying the additional option. We suggest two asymptotic expansions which relate the volatility risk premium to the Vega of the option portfolio. This approach provides a tool for traders to (i) integrate option pricing with risk management and (ii) quote competitive prices that depend on their aggregate risk exposure.

In this paper, we extend the results of Carmona and Touzi [6] for an optimal multiple stopping problem to a market where the price process is allowed to jump. We also generalize the problem of valuation swing options to the context of a Lévy market. We prove the existence of multiple exercise policies under an additional condition on Snell envelops. This condition emerges naturally in the case of Lévy processes. Then, we give a constructive solution for perpetual put swing options when the price process has no negative jumps. We use the Monte Carlo approximation method based on Malliavin calculus in order to solve the finite horizon case. Numerical results are given in the last two sections. We illustrate the theoretical results of the perpetual case and give the numerical solution for the finite horizon case.

In this work, the valuation of energy-related financial contracts written on prices of flow commodities (such as natural gas, oil and electrical power) will be elaborated. Due to restrictions on storability of the underlying, the pricing of flow commodity derivatives is not trivial and thus correct valuation is still under discussion. In this paper, an axiomatic setting is followed, which provides a connection to interest rate theory, whose toolkit we utilize to consistently price frequently quoted flow commodity options such as caps, floors, collars and cross commodity spreads.

This article develops a numerical method to price American-style Asian option in the context of the generalized autoregressive conditional heteroscedasticity (GARCH) asset return process. The development is based on dynamic programming coupled with the replacement of the normally distributed variable with a binomial one and the whole procedure is under the locally risk-neutral valuation relationship (LRNVR). We investigate the computational and implementation issues of this method and compare them with those of a candidate procedure which involves piecewise-polynomial approximation of the value function. Complexity analysis and computational results suggest that our method is superior to the candidate one and the generated GARCH option prices are capable of reflecting the changes in the conditional volatility of underlying asset.

In this paper, we first study the problem of minimal hedging for an insider trader in incomplete markets. We use the forward integral in order to model the insider portfolio and consider a general larger filtration. We characterize the optimal strategy in terms of a martingale condition. In the second part we focus on a problem of mean-variance hedging where the insider tries to minimize the variance of his wealth at time T given that this wealth has a fixed expected value A. We solve this problem for an initial enlargement of filtration by providing an explicit solution.

This paper studies the dynamic relationship between stock prices and exchange rates in the Brazilian economy. We use recently developed unit root and cointegration tests, which allow endogenous breaks, to test for a long run relationship between these variables. We performed linear, and nonlinear causality tests after considering both volatility and linear dependence. We found that there is no long run relationship, but there is linear Granger causality from stock prices to exchange rates, in line with the portfolio approach: stock prices lead exchange rates with a negative correlation. Furthermore, we found evidence of nonlinear Granger causality from exchange rates to stock prices, in line with the traditional approach: exchange rates lead stock prices. We believe these findings have practical applications for international investors and in the design of exchange rate policies.