Pricing options with extendible maturities: analysis and applications

Article Abstract:

Many common types of financial contracts incorporate options with extendible maturities. This paper derives closed-form expressions for options that can be extended by the optionholder and presents a number of applications including the valuation of American options with stochastic dividends, junk bonds, and shared-equity mortgages. We also derive closed-form expressions for writer-extendible options and discuss the writer's economic incentives for extending an out-of-the-money option. We apply these results to show that corporate debtholders have a strong incentive to extend the maturity of defaulting debt if there are liquidation costs. We model and solve the debtholders' optimal extension problem and show that the possibility of an extension can induce shareholders in highly leveraged firms to accept negative NPV projects. (Reprinted by permission of the publisher.)

Author: Longstaff, Francis A.
Research, Options (Finance)

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Sequential tests of the arbitrage pricing theory: a comparison of principal components and maximum likelihood factors

Article Abstract:

We examine the cross-sectional pricing equation of the APT using the elements of eigenvectors and the maximum likelihood factor loadings of the covariance matrix of returns as measures of risk. The results indicate that, for data assumed stationary over twenty years, the first vector is a surprisingly good measure of risk when compared with either a one- or a five-factor model or a five-vector model. We conclude that in some circumstances principal components analysis may be preferred to factor analysis. (Reprinted by permission of the publisher.)

Author: Trzcinka, Charles, Shukla, Ravi
Models, Analysis, Finance, Arbitrage, Financial research

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