Academic journal article Financial Management

What Every CFO Should Know about Scientific Progress in Financial Economics: What Is Known and What Remains to Be Resolved

Academic journal article Financial Management

What Every CFO Should Know about Scientific Progress in Financial Economics: What Is Known and What Remains to Be Resolved

Article excerpt

Editor's Note: Contemporary Issues is a new section created to deal with recent developments and current thinking in finance. Potential topics for this section include (but are not limited to) discussions of recent significant changes in tax law or regulation, descriptions of innovative securities/strategies, brief analyses of major events, interesting descriptive material, comments by major figures in the field, and argument and opinions expressed by members of the profession. In a sense, this section might be called "the Editors' choice." As a consequence, some of the material appearing here has not been subjected to a formal refereeing process. This first installment consists of Richard Roll's keynote address at the 1993 FMA meeting in Toronto; William Beranek and Steven L. Jones's discussion of the recent growth in the trading of claims against bankrupt firms, along with some preliminary evidence; and Martin S. Fridson's argument that high-yield bonds do in fact contain an equity component. We hope you find our selections here, and in future issues, interesting.

What topics in financial economics have empirical relevance? What are the contributions made by scholarly finance that a typical CFO should know? Which problems can be described as continuing research whose solution a CFO of the future will have to know?

Although most questions in financial economics remain in the unresolved category, there are some items that every CFO, even the president/CFO of a small firm, but certainly the CFO of any company of moderate size and larger, should already have in his repertoire of tools.

Option Valuation. The first candidate is the valuation of simple and complex options. Following the original Black and Scholes (1975) solution for a relatively simple option, the valuation of more complex options has been a major research success story in finance. There has been a tremendous volume of scholarly papers on this general subject, but success also can be measured by noting that complex option-valuation methods are widely employed by finance practitioners. Investment bankers, money managers, consultants, non-financial corporations, and government entities are today frequent implementers of various option-valuation techniques.

Option valuation is probably most frequently undertaken in the financial industry, but there are applications in other industries too. Many capital budgeting projects have option components, corporate debt is callable or convertible, bank lines of credit often contain contingent elements, labor contracts may endow options on workers (e.g., the choice of early retirement), real estate leases can be renewed, shelf space in supermarkets can he reserved at a price, mines can be opened and closed, etc. I would argue that option theory ought to be the first thing taught in finance, even before discounting arithmetic. A great thing in its favor is that we can actually tell business executives how to do something useful and important.

An interesting application of complex option valuation is in asset securitization. When I went to work at Goldman Sachs in September 1985, and began research on mortgage-backed securities, the secondary mortgage market already had a large volume of trading, but static mortgage yields were still employed when discussing value. An assumed constant rate of prepayment was used to calculate cash flows and the internal rate of return of the cash flows was computed and expressed as a yield spread over what was considered a "comparable" Treasury bond. Many market participants knew, of course, that this exercise was fraught with problems of an option-like nature. The decision to prepay is contingent on a number of factors: the refinancing rate, the value of the real estate collateral, the economic condition of the borrower, and perhaps the borrower's beliefs about the future course of interest rates. Put simply, the option to prepay is very complex.

Today, in contrast to 1985, all major dealers regularly attempt to compute the value of this option when conveying price information about mortgage products. …

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