Volume 38 CONTENTS Spring/Summer 2012
The Dangers of Calibration and Hedging the Greeks in Option Pricing
Arkadev Chatterjea and Robert A. Jarrow
This paper shows the dangers of calibration and hedging the greeks in option pricing theory. We focus on two problems that arenít adequately addressed in existing textbooks. First, the inappropriate use of vega hedging and, second, the errors that a misspecified but calibrated model introduces into delta hedging. A simple example illustrates our insights in a transparent manner.
Building a Financial Trading Lab: Step 1 and Beyond
Richard J. Kish and Karen M. Hogan
The use of financial trading labs within university settings is in a growth phase, with more colleges and universities finding the need to build one just to stay competitive. This paper gives information on the various steps in the development process of the trading lab, key factors for building a lab, and key questions that need to be addressed while in the formulation phase of the lab design. In addition various hardware designs, fund raising opportunities, utilization methods are discussed.
Ethical Analysis of the Personal Financial Managerís Dilemma in a Bankruptcy Case
Jocelyn D. Evans
The literature demanding more ethics-based decision making in the business environment greatly outweighs the actual amount of literature in which specific business decisions are evaluated based on their ethical efficacy. This paper helps to remedy this gap by introducing four ethical models and their relevance to bankruptcy proceedings in a case study context. It objectively introduces students to multiple ethical models while directly applying those models to a specific situation. Thus, the studentsí ethical imagination ability will be greatly increased, regardless of what their particular pre-conceived beliefs about business ethics are. The case study also has students assess the impact of their pre-conceived beliefs on their decision-making processes. Neither the introduction to ethical models nor the case study is prescriptive; it is up to the students to make their own ethical evaluations.
Shifts in the Optimal Portfolio in Response to Simultaneous Changes in Expected Returns
Peter M. Ellis and Alan A. Stephens
Linear programming models and their extensions have enjoyed a long history with portfolio optimization problems. Maximization of expected returns is typically sought under a set of restrictions. After an optimal portfolio is identified, sensitivity analysis of the objective function coefficients (the expected returns) might be of interest. This presents a problem however, since sensitivity analysis traditionally must be done for a single coefficient at a time. There has not heretofore been known a method that permits this sensitivity analysis when several coefficients (returns) vary simultaneously. A new procedure is presented here that carries out the range of optimality sensitivity analysis for the optimal portfolio when expected returns are subject to synchronized and simultaneous fluctuations.
A Note on Capital Budgeting: Treating a Replacement Project as Two Mutually Exclusive Projects
Su-Jane Chen and Timothy R. Mayes
This note, with a numerical example, demonstrates that evaluating a replacement project is equivalent to assessing two mutually exclusive projects. This unconventional view requires no more knowledge on the part of students than what is required to evaluate a single expansion project. Textbooks typically use separate sections of a chapter to explain how to evaluate expansion projects and replacement projects, leading students to think that there are two entirely different methodologies. We show that there is really only one methodology. Conceptually, our proposed approach is much easier for students to understand. Moreover, this alternative view uncovers a potential pitfall associated with the NPV when the two assets involved in the replacement project do not have the same remaining useful life. This note further revises the MIRR and modifies the PI to reconcile possible ranking conflicts between the two rules and the NPV when dealing with mutually exclusive projects.
Home Care Case: Aging Baby Boomer Possibilities
Thomas Cook and Hugh Grove
The co-founders of Home Care, Inc. were the wife and husband team, Joan and John Kervorkian with each being 50% shareholders. Home Care began operating in 1997 and had grown to 15 full-time employees with annual sales over $5 million in 2008. The two owners met in 1994 at a board meeting of the American Diabetes Association in Houston when Joan, a regional director of this association, recruited John, a medical doctor (general practitioner) for the board of directors. Prior to 1994, Joan had been a fund raiser for the Alzheimerís Association in Houston for five years. Joan was the Chief Executive Officer (CEO) of Home Care since its inception in 1997. She earned a business management certificate in public service in 2006 and became a Certified Senior Advisor (CSA) in 2002 to help develop skills for her CEO position at Home Care. She continued to serve on several non-profit boards of directors in the Houston area. John followed in the footsteps of his father who became a general practitioner after serving in the Vietnam War upon completion of medical school. John enjoyed his work and wanted to continue as a general practitioner which provided a good family income.
Derivatives and Bank Ethics: Terminating an Interest Rate Swap
James E. McNulty
Suppose a company enters into an interest rate swap as the fixed-rate payer, and the swap agreement is terminated prior to maturity. If interest rates have fallen in the interim, the firm will be required to pay a swap termination fee. The fee (over a quarter of a million dollars in this case) should be easily calculated as the present value of the difference in two sets of interest payments. The first would be based on the fixed rate on the swap; the second would be based on market rates for similar swaps on the termination date. Yet calculation of the appropriate fee became the subject of litigation; the alleged error may be as much as $100,000 on a $2 million dollar swap. The case also raises the ethical question as to whether it is appropriate banking practice to advise a small firm to enter into a nine-year swap and then force termination in two years. The case is designed for courses in both derivatives and bank management.
Using Reverse Mergers to Take Chines Companies Public on U.S. Securities Markets: The Case of China AutoStar
Daniel Borgia, Arthur Rubens and Travis L. Jones
In early 2005, Art Davis, managing partner at Automotive Venture Fund (AVF), a large U.S. based venture capital firm, was presented with a business opportunity to invest in China AutoStar, a private Chinese company engaged in the automotive services and repair industry in Beijing. Art had extensive experience in the automotive industry, having owned a chain of automotive dealerships in the northeast United States that he sold in late 2000. After selling his business, Art, along with several wealthy friends and business associates he knew from the automotive industry, chose to pool their capital to create AVF in 2001. Under Artís leadership, the mission of AVF was to identify and invest in early-stage firms with high growth potential in the rapidly evolving automotive industry.2