Journal of Financial and Quantitative Analysis
Vol. 33, No. 3, September 1998


Contents

The Effects of Macroeconomic News on High Frequency Exchange Rate Behavior
Alvaro Almeida, Charles Goodhart, and Richard Payne

Capital Budgeting for Interrelated Projects: A Real Options Approach
Paul D. Childs, Steven H. Ott, and Alexander J. Triantis

Is Foreign Exchange Risk Priced in the Japanese Stock Market?
Jongmoo Jay Choi, Takato Hiraki, and Nobuya Takezawa

A Markovian Framework in Multi-Factor Heath-Jarrow-Morton Models
Koji Inui and Masaaki Kijima

The Determinants of Corporate Liquidity: Theory and Evidence
Chang-Soo Kim, David C. Mauer, and Ann E. Sherman

Asian Options, the Sum of Lognormals, and the Reciprocal Gamma Distribution
Moshe Arye Milevsky and Steven E. Posner

Abstracts

The Effects of Macroeconomic News on High Frequency Exchange Rate Behavior
Alvaro Almeida, Charles Goodhart, and Richard Payne

This paper studies the high frequency reaction of the DEM/USD exchange rate to publicly announced macroeconomic information emanating from Germany and the U.S. By using data sampled at a five-minute frequency, we are able to identify significant impacts of most announcements on the exchange rate change in the 15 minutes post-announcement, although the significance of these effects decreases rapidly as the interval over which the post-announcement change in exchange rates is increased. The direction of the exchange rate response conforms, in general, with a reaction function interpretation whereby reactions to macroeconomic news are driven by the likely operations of monetary authorities in domestic money markets. Further, we detect influences of German monetary policy decisions on the reaction of the exchange rate, and also differences between U.S. and German announcements in the exchange rate reaction time pattern.


Capital Budgeting for Interrelated Projects: A Real Options Approach
Paul D. Childs, Steven H. Ott, and Alexander J. Triantis

This paper explores the effect of project interrelationships on investment decisions and project values in a real options framework. We examine in detail the mutually exclusive case where a firm may invest in the development stage of two projects and then may select only a single project to implement. The firm can develop the projects in parallel or in sequence. The choice of development policy depends on the relative values of the embedded options for each strategy. Sequential development is shown to be superior to parallel development when projects have highly correlated values, and when they require a large commitment of capital for development, are short term in nature, and have relatively low volatility. We also show that the optimal ordering of sequential projects does not always begin with the most profitable project.


Is Foreign Exchange Risk Priced in the Japanese Stock Market?
Jongmoo Jay Choi, Takato Hiraki, and Nobuya Takezawa

The exchange rate is an important variable that affects international competitiveness and performance of Japanese firms. We use an unconditional and a conditional multi-factor asset pricing model to examine whether exchange risk is recognized and priced in the Japanese stock market. The results indicate that the exchange risk is generally priced in Japan. More specifically, we provide evidence, in the unconditional model, that the exchange risk is priced in both weak and strong yen periods, when the bilateral yen/U.S. dollar exchange rate measure is used. The results are more mixed when the trade-weighted exchange rate is used. For the conditional model, the exchange risk is priced regardless of the exchange rate measure used. The combined evidence from the two models suggests an interesting observation about the role of the secular exchange rate trend in shaping the perception of exchange risk in the Japanese capital markets.


A Markovian Framework in Multi-Factor Heath-Jarrow-Morton Models
Koji Inui and Masaaki Kijima

We consider the general n-factor Heath, Jarrow, and Morton model (1992) and provide a sufficient condition on the volatility structure for the spot rate process to be Markovian with 2n state variables. The price of a discount bond is also Markovian with the same state variables and, hence, claims against the term structure can be efficiently priced using standard simulation techniques. Our results extend earlier works such as Ritchken and Sankarasubramanian (1995) where the one-factor model is treated, and Carverhill (1994), where the volatility structure is non-random. Numerical experiments show that our model can explain the volatility smile observed in the interest rate options market and also overcome the biases noted by Flesaker (1993).


The Determinants of Corporate Liquidity: Theory and Evidence
Chang-Soo Kim, David C. Mauer, and Ann E. Sherman

We model the firm's decision to invest in liquid assets when external financing is costly. The optimal amount of liquidity is determined by a tradeoff between the low return earned on liquid assets and the benefit of minimizing the need for costly external financing. The model predicts that the optimal investment in liquidity is increasing in the cost of external financing, the variance of future cash flows, and the return on future investment opportunities, while it is decreasing in the return differential between the firm's physical assets and liquid assets. Empirical tests on a large panel of U.S. industrial firms support the model's predictions.


Asian Options, the Sum of Lognormals, and the Reciprocal Gamma Distribution
Moshe Arye Milevsky and Steven E. Posner

Arithmetic Asian options are difficult to price and hedge as they do not have closed-form analytic solutions. The main theoretical reason for this difficulty is that the payoff depends on the finite sum of correlated lognormal variables, which is not lognormal and for which there is no recognizable probability density function. We use elementary techniques to derive the probability density function of the infinite sum of correlated lognormal random variables and show that it is reciprocal gamma distributed, under suitable parameter restrictions. A random variable is reciprocal gamma distributed if its inverse is gamma distributed. We use this result to approximate the finite sum of correlated lognormal variables and then value arithmetic Asian options using the reciprocal gamma distribution as the state-price density function. We thus obtain a closed-form analytic expression for the value of an arithmetic Asian option, where the cumulative density function of the gamma distribution, G(d) in our formula, plays the exact same role as N(d) in the Black-Scholes/Merton formula. In addition to being theoretically justified and exact in the limit, we compare our method against other algorithms in the literature and show our method is quicker, at least as accurate, and, in our opinion, more intuitive and pedagogically appealing than any previously published result, especially when applied to high yielding currency options.