Waterloo economics series | 2008

#08-001 -- Margaret Insley and Tony Wirjanto

Contrasting two approaches in real options valuation contingent claims versus dynamic programming (PDF)

Abstract

This paper compares two well-known approaches for valuing a risky investment using real options theory: contingent claims (CC) with risk neutral valuation and dynamic programming (DP) using a constant risk adjusted discount rate. Both approaches have been used in valuing forest assets. A proof is presented which shows that, except under certain restrictive assumptions; DP using a constant discount rate and CC will not yield the same answers for investment value. A few special cases are considered for which CC and DP with a constant discount rate are consistent with each other. An optimal tree harvesting example is presented to illustrate that the values obtained using the two approaches can differ when we depart from these special cases to a more realistic scenario. Further, the implied risk adjusted discount rate calculated from CC is found to vary with the stochastic state variable and stand age. We conclude that for real options problems the CC approach should be used.

#08-002 -- Shan Chen and Margaret Insley

Regime switching in stochastic models of commodity prices: an application to an optimal tree harvesting problem (PDF)

Abstract

This paper investigates a regime switching model of stochastic lumber prices in the context of an optimal tree harvesting problem. Using lumber derivatives prices, two lumber price models are calibrated: a regime switching model and a single regime model. In the regime switching model, the lumber price can be in one of two regimes in which different mean reverting price processes prevail. An optimal tree harvesting problem is specified in terms of a linear complementarity problem which is solved using a fully implicit finite difference, fully-coupled, numerical approach. The land value and critical harvesting prices are found to be significantly different depending on which price model is used. The regime switching model shows promise as a parsimonious model of timber prices that can be incorporated into forestry investment problems.

#08-003 -- Matthew Doyle and Jacob Wong 

Wage posting without full commitment (PDF)

Abstract

Wage posting models of job search typically assume that firms can commit to paying workers the posted wage. This paper investigates the consequences of relaxing this assumption. Under "downward" commitment firms can commit only to paying at least their advertised wage. We show that wage posting is always an equilibrium, although in special cases other equilibria can exist. Surprisingly, the wage posting equilibrium in our economy is identical to the equilibrium when firms can commit to paying exactly their posted wage. When firms cannot even commit to paying at least their advertised wage, equilibrium exhibits job auctions with wage dispersion which generally are not constrained  efficient.

#08-004 -- Margaret Insley and M. Lei

Hedges and trees: incorporating fire risk into optimal decisions in forestry using a no-arbitrage approach (PDF not available)

Abstract

#08-005 -- Dinghai Xu and John Knight 

This paper develops an efficient method for estimating the discrete mix- tures of normal family based on the continuous empirical characteristic function (CECF). An iterated estimation procedure based on the closed form objective distance function is proposed to improve the estimation efficiency. The results from the Monte Carlo simulation reveal that the CECF estimator produces good finite sample properties. In particular, it outperforms the discrete type of methods when the maximum likelihood estimation fails to converge. An empirical example is provided for illustrative purposes.

JEL classification

C13; C15; C16

#08-006 -- Dinghai Xu, John Knight, and Tony S. Wirjanto

Asymmetric stochastic conditional duration model a mixture of normals approach (PDF)

Abstract

This paper extends the stochastic conditional duration model by imposing mixtures of bivariate normal distributions on the innovations of the observation and latent equations of the duration process. This extension allows the model not only to capture the asymmetric behavior of the expected duration but also to easily accommodate a richer dependence structure between the two innovations. In addition, it proposes a novel estimation methodology based on the empirical characteristic function. A set of Monte Carlo experiments as well as empirical applications based on the IBM and Boeing transaction data are provided to assess and illustrate the performance of the proposed model and the estimation method. One main empirical finding in this paper is that there is a significantly positive "leverage effect" under both the contemporaneous and lagged inter-temporal de pendence structures for the IBM and Boeing duration data.

#08-007 -- Tony S. Wirjanto and Dinghai Xu

An empirical characteristic function approach to VaR under a mixture of normal distribution with time-varying volatility (PDF)

Abstract

This paper considers Value at Risk measures constructed under a discrete mixture of normal distribution on the innovations with time-varying volatility, or Mixed Normal-Generalized AutoRegressive Conditional Heteroskedasticity (MN-GARCH), model. We adopt an approach based on the continuous empirical characteristic function to estimate the parameters of the model using several daily foreign exchange rates' return data. This approach has several advantages as a method for estimating the MN-GARCH model. In particular, under certain weighting measures, a closed form objective distance function for estimation is obtained. This reduces the computational burden considerably. In addition, the characteristic function, unlike its likelihood function counterpart, is always uniformly bounded over parameter space due to the Fourier transformation. To evaluate the VaR estimates obtained from alternative specifications, we construct several measures, such as the number of violations, the average size of violations, the sum square of violations and the expected size of violations. Based on these measures, we find that the VaR measures obtained from the MN-GARCH model outperform those obtained from other competing models.

#08-008 -- Cathy Ning and Tony S. Wirjanto

Extreme return-volume dependence in East-Asian stock markets: a copula approach (PDF not available)

Abstract

A copula approach is adopted to examine the extreme return-volume relationship in six emerging East-Asian equity markets. The empirical results indicate that the return-volume dependence is significant and asymmetric at extremes for all six East-Asian markets. In particular extremely high returns (large gains) tend to be associated with extremely large trading volumes, but only marginal (extremely small) returns tend to be related to either large or small volumes.

JEL classification

C14, C51, G12

#08-009 -- Dingan Feng, Peter X.-K. Song, and Tony S. Wirjanto

Time-deformation modeling of stock returns directed by duration processes (PDF)

Abstract

#08-010 -- Youngsoo Choi, and Tony S. Wirjanto

A simple model of the nominal term structure of interest rates (PDF)

Abstract

This paper presents a simple two-factor model of nominal term structure of interest rates, in which the log-price kernel has an autoregressive drift process and a nonlinear GARCH volatility process. With these two state-variable processes, closed-form solutions are derived for zero-coupon bond prices as well as yield to maturity for a given time to maturity.

#08-011 -- Alan Huang, Yao Tian and Tony S. Wirjanto

Re-examining accounting conservatism: the importance of adjusting for firm heterogeneity (PDF not available)

Abstract

Prior studies have documented the extent of accounting conservatism (in the form of the asymmetric response of accountings earnings to  news) and its increase over time. However, many of these studies implicitly assume that unobserved firm-specific characteristics (known as firm heterogeneity or firm-specific fixed effects) are homogenous and, thus, unimportant to earnings determination. In this paper, we show that this assumption is over-restrictive, and there are significant cross-sectional differences (firm heterogeneity) in earnings. We find that, after accounting for firm-specific fixed effects in the earnings determination, [i] the level of accounting conservatism is smaller in magnitude than previously documented, and [ii] there is no clear pattern of increasing conservatism over time. Our results stand in stark contrast to much of the findings in the literature and raise the awareness among researchers of the importance of accounting for firm-specific heterogeneity in  examining earnings-returns relations.

#08-012 -- Jee Hae Lim, Theophanis C. Stratopoulos and Tony S. Wirjanto

IT Innovation Persistence and State Dependence: An Empirical Investigation (PDF not available)

Abstract

In this study we examine the persistence of a firm's ability to differentiate itself from its peers and stand out in a crowd of competitors through IT innovation. By using cross-sectional data set of large US firms from 1997-2004, our empirical evidence shows that prior IT innovation experience is an important determinant of current IT innovation capability even after we account for firm heterogeneity factors such as financial performance (halo effect), size, and industry. This evidence supports our proposition that there is a structural true state (path) dependence in the sense that prior IT innovation experience constrains future IT innovation choices and outputs. Therefore, the IT innovation capability is heterogeneously distributed and not easy to imitate.