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Vulnerable American options

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  • Peter Klein
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    Abstract

    Purpose – Scholars have examined the importance of a firm's dividend policy through two competing paradigms: the signalling hypothesis and the free cash-flow hypothesis. It has been argued that our understanding of dividend policy is hindered by the lack of a model that integrates the two hypotheses. The purpose of this paper is to address this by developing a theoretical dividend model that combines the signalling and free cash-flow motives. The objective of the analysis is to shed light on the complex relationship between dividend policy, managerial incentives and firm value. Design/methodology/approach – In order to consider the complex nature of dividend policy, a dividend signalling game is developed, in which managers possess more information than investors about the quality of the firm (asymmetric information), and may invest in value-reducing projects (moral hazard). Hence, the model combines signalling and free cash-flow motives for dividends. Furthermore, managerial communication and reputation effects are incorporated into the model. Findings – Of particular interest is the case where a firm may need to cut dividends in order to invest in a new value-creating project, but where the firm will be punished by the market, since investors are behaviourally conditioned to believe that dividend cuts are bad news. This may result in firms refusing to cut dividends, hence passing up good projects. This paper demonstrates that managerial communication to investors about the reasons for the dividend cut, supported by managerial reputation effects, may mitigate this problem. Real world examples are provided to illustrate the complexity of dividend policy. Originality/value – This work has been inspired by, and develops that of Fuller and Thakor, and Fuller and Blau, which considers the signalling and free cash-flow motives for dividends. Whereas those authors consider the case where firms only have new negative net present value (NPV) projects available (so that dividend increases provide unambiguously positive signals to the market in both the signalling and free cash-flow cases), in this paper's model, the signals may be ambiguous, since firms may need to cut dividends to take positive NPV projects. Hence, the model assists in understanding the complexity of dividend policy.

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    Bibliographic Info

    Article provided by Emerald Group Publishing in its journal Managerial Finance.

    Volume (Year): 36 (2010)
    Issue (Month): 5 (May)
    Pages: 414-430

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    Handle: RePEc:eme:mfipps:v:36:y:2010:i:5:p:414-430

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    Web page: http://www.emeraldinsight.com

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    Postal: Emerald Group Publishing, Howard House, Wagon Lane, Bingley, BD16 1WA, UK
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    Related research

    Keywords: Derivative markets; Diffusion; Pricing; Stock options; United States of America;

    References

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    Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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    1. Hull, John & White, Alan, 1995. "The impact of default risk on the prices of options and other derivative securities," Journal of Banking & Finance, Elsevier, vol. 19(2), pages 299-322, May.
    2. Hull, John & White, Alan, 1990. "Valuing Derivative Securities Using the Explicit Finite Difference Method," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 25(01), pages 87-100, March.
    3. Johnson, Herb & Stulz, Rene, 1987. " The Pricing of Options with Default Risk," Journal of Finance, American Finance Association, vol. 42(2), pages 267-80, June.
    4. Klein, Peter, 1996. "Pricing Black-Scholes options with correlated credit risk," Journal of Banking & Finance, Elsevier, vol. 20(7), pages 1211-1229, August.
    5. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-70, May.
    6. Klein, Peter & Inglis, Michael, 2001. "Pricing vulnerable European options when the option's payoff can increase the risk of financial distress," Journal of Banking & Finance, Elsevier, vol. 25(5), pages 993-1012, May.
    7. Black, Fischer & Cox, John C, 1976. "Valuing Corporate Securities: Some Effects of Bond Indenture Provisions," Journal of Finance, American Finance Association, vol. 31(2), pages 351-67, May.
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    Cited by:
    1. Xu, Weidong & Xu, Weijun & Li, Hongyi & Xiao, Weilin, 2012. "A jump-diffusion approach to modelling vulnerable option pricing," Finance Research Letters, Elsevier, vol. 9(1), pages 48-56.

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