Primes and scores: an essay on market imperfections

Article Abstract:

This paper investigates the reported relative mispricing of primes and scores to the underlying stock. Given transaction costs, we establish arbitrage-based bounds on prime and score prices. We then develop a new nonparametric statistical technique to test whether prime and score prices violate these bounds. We find that prime and score prices do exceed stock prices, and often by a considerable amount. We demonstrate that this increased value is most likely due to the score's ability to save on the costs of dynamic hedging. We also show how short sale and trust size constraints impede the ability to arbitrage price disparities. (Reprinted by permission of the publisher.)

Evaluation, Stocks, Stock-exchange, Stock exchanges, Investments, Price-earnings ratio, Price earnings ratio

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Pricing derivatives on financial securities subject to credit risk

Article Abstract:

This article provides a new methodology for pricing and hedging derivative securities involving credit risk. Two types of credit risks are considered. The first is where the asset underlying the derivative security may default. The second is where the writer of the derivate security may default. We apply the foreign currency analogy of Jarrow and Turnbull (1991) to decompose the dollar payoff from a risky security into a certain payoff and a "spot exchange rate." Arbitrage-free valuation techniques are then employed. This methodology can be applied to corporate debt and over the counter derivatives, such as swaps and caps. (Reprinted by permission of the publisher.)

Management, Prices and rates, Risk management, Derivatives (Financial instruments), Debt financing (Corporations), Debt financing

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Arbitrage, continuous trading, and margin requirements

Article Abstract:

This paper studies the impact that margin requirements have on both the existence of arbitrage opportunities and the valuation of call options. In the context of the Black-Scholes economy, margin restrictions are shown to exclude continuous-trading arbitrage opportunities and, with two additional hypotheses, still to allow the Black-Scholes call model to apply. The Black-Scholes economy consists of a continuously traded stock with a price process that follows a geometric Brownian motion and a continuously traded bond with a price process that is deterministic. (Reprinted by permission of the publisher.)

Margins (Security trading), Margins (Securities trading), Arbitrage, Financial research

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