Distressed Stocks In Distressed Times
University of Connecticut – Department of Finance
University of Connecticut – Department of Finance
November 16, 2015
Financially distressed stocks do not underperform healthy stocks when the entire economy is in distress. The asset beta and financial leverage of distressed stocks rise significantly after major market downturns, resulting in a dramatic increase in equity beta. Hence, a long/short healthy-minus-distressed trading strategy leads to significant losses when the market rebounds. Managing this risk mitigates the severe losses of financial distress strategies, and significantly improves their Sharpe ratios.
Distressed Stocks In Distressed Times – Introduction
Optimism shows up as a pervasive and powerful psychological bias in experimental and business settings (Ben-David, Graham, and Harvey, 2013, Larwood and Whittaker, 1977, March and Shapira, 1987, Scheier, Carver, and Bridges, 1994, Svenson, 1981, Weinstein, 1980), and it has been shown to influence key corporate policies, such as financing, investment, and acquisition decisions (Ben-David, Graham, and Harvey, 2013, Graham, Harvey, and Puri, 2013, Hirshleifer, Low, and Teoh, 2012, Kolasinski and Li, 2013, Malmendier and Tate, 2005a,b, 2008, Malmendier, Tate, and Yan, 2011). As evidence suggests that executives make private and professional decisions similarly (Cronqvist, Makhija, and Yonker, 2012), measures derived from an executive’s personal security holdings have been used to analyze the effect of optimism on corporate outcomes. While the important corporate policy implications of executive optimism have received a great deal of theoretical attention (Bergman and Jenter, 2007, Campbell et al., 2011, Goel and Thakor, 2008, Hackbarth, 2009, Heaton, 2002, Malmendier and Tate, 2005a), how an executive’s optimism affects her management of her personal portfolio of company stock and options has not. Yet, a theoretical foundation that explicitly incorporates optimism is needed to help researchers assess the quality of existing optimism measures and for the development of robust new measures.
We model an optimistic executive’s option exercise and portfolio choice problem under a general concave utility function. Given an initial endowment of outside wealth and a non-transferable call option on company stock, the risk-averse executive in our model maximizes her expected utility from terminal wealth. She chooses when to exercise the option and is allowed to take unrestricted long positions in company stock, but is not permitted to short it. We model optimism as a subjective personal belief that the company stock will have positive abnormal returns, even though the true stock-return process has a zero abnormal return.
In our model, executives exercise options for two distinct reasons: to rebalance their portfolios and to capture dividends. When rebalancing to optimize risk and return, optimistic executives tend to exercise their options in a way that limits the time value lost on early exercise, resulting in exercises closer to expiration and at higher underlying stock prices than exercises by their less optimistic peers. This portfolio-rebalancing exercise motive exists for options on both dividend-paying and non-dividend-paying stocks. Moreover, the model demonstrates that the dividend-capture motivation is universal, affecting even the most optimistic executives. In standard option pricing theory, the ability to dynamically replicate an option’s payoff makes an agent’s outlook on a stock irrelevant; an agent who is allowed to short stock will hedge the option in the market and may exercise before expiration to capture dividends. We show that an optimistic executive who is unable to hedge an option should nonetheless exercise it whenever an unconstrained agent would. An executive will not delay option exercise beyond a reasonable price boundary because she can always buy shares in the open market to satisfy her desire for equity exposure to the firm.
A significant value of our model is the theoretical sandbox it provides for analyzing option exercise policy and evaluating indicators of executive optimism. The model demonstrates an interplay among optimism, option exercise policy, observable stock parameters, like dividend yield, volatility, and beta, and unobservable characteristics of the executive, such as outside wealth and risk aversion. It therefore provides a deeper understanding of how optimism will affect exercise decisions for executives. For example, an option on a high beta stock should be exercised at higher prices and closer to expiration than an option on a stock with a low beta and equivalent total volatility. It may also be optimal for an optimistic executive to exercise options well before expiration or at seemingly low stock prices if the executive has low outside wealth or is very risk averse. A key prediction of the model is that the retention of shares received from option exercise is positively related to the option’s intrinsic value and negatively related to its remaining time until expiration. We confirm these predictions empirically.
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