Cephalon, Inc. Taking Risk Management Theory Seriously
We study a firm that justifies its novel use of equity derivatives as a cash-flow hedging strategy. Our purpose is to understand the challenge of translating risk management theory into managerial action. Cephalon Inc., a biotech firm, bought a large block of call options on its own stock. If the FDA approved the firm's new drug, the firm would have large cash needs, which the options were designed to meet. We analyze this stated rationale for the firm's choice, applying the cash flow hedging concepts articulated by Froot, Scharfstein and Stein (1993). In applying the theory to practice, there are lessons for both managers and theorists. Managers consider deadweight costs of financing and of risk management, whereas theory tends to ignore the latter costs. While theory is driven by costs of external financing, managers must measure these costs to arrive at decisions and this measurement problem is severe. Cephalon's risk management decisions seem motivated as much by fluctuations in the availability and cost of external financing and by accounting considerations as by fluctuations in operating cash flows or desired investment. Finally, even a field-based examination of this strategy cannot reject the conclusion that the transaction was motivated by goals other than risk management.
|Date of creation:||Jun 2000|
|Date of revision:|
|Publication status:||published as Chacko, George, Peter Tufano and Geoffrey Verter. "Cephalon, Inc. Taking Risk Management Theory Seriously," Journal of Financial Economics, 2001, v60(2-3,May), 449-485.|
|Contact details of provider:|| Postal: National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.|
Web page: http://www.nber.org
More information through EDIRC
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.:
- Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
- Danielsson, Jon, 1994. "Stochastic volatility in asset prices estimation with simulated maximum likelihood," Journal of Econometrics, Elsevier, vol. 64(1-2), pages 375-400.
- Nelson, Daniel B., 1990. "ARCH models as diffusion approximations," Journal of Econometrics, Elsevier, vol. 45(1-2), pages 7-38.
- Gallant, A. Ronald & Hsieh, David & Tauchen, George, 1995.
"Estimation of Stochastic Volatility Models with Diagnostics,"
95-36, Duke University, Department of Economics.
- Gallant, A. Ronald & Hsieh, David & Tauchen, George, 1997. "Estimation of stochastic volatility models with diagnostics," Journal of Econometrics, Elsevier, vol. 81(1), pages 159-192, November.
- Schwartz, Eduardo S., 1977. "The valuation of warrants: Implementing a new approach," Journal of Financial Economics, Elsevier, vol. 4(1), pages 79-93, January.
- Crouhy, Michel & Galai, Dan, 1994. "The interaction between the financial and investment decisions of the firm: the case of issuing warrants in a levered firm," Journal of Banking & Finance, Elsevier, vol. 18(5), pages 861-880, October.
- Schulz, G. Uwe & Trautmann, Siegfried, 1994. "Robustness of option-like warrant valuation," Journal of Banking & Finance, Elsevier, vol. 18(5), pages 841-859, October.
- Merton, Robert C., 1975.
"Option pricing when underlying stock returns are discontinuous,"
787-75., Massachusetts Institute of Technology (MIT), Sloan School of Management.
- Merton, Robert C., 1976. "Option pricing when underlying stock returns are discontinuous," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 125-144.
- Melino, Angelo & Turnbull, Stuart M., 1990. "Pricing foreign currency options with stochastic volatility," Journal of Econometrics, Elsevier, vol. 45(1-2), pages 239-265.
- Jacquier, Eric & Polson, Nicholas G & Rossi, Peter E, 2002.
"Bayesian Analysis of Stochastic Volatility Models,"
Journal of Business & Economic Statistics,
American Statistical Association, vol. 20(1), pages 69-87, January.
- Glosten, Lawrence R & Jagannathan, Ravi & Runkle, David E, 1993.
" On the Relation between the Expected Value and the Volatility of the Nominal Excess Return on Stocks,"
Journal of Finance,
American Finance Association, vol. 48(5), pages 1779-1801, December.
- Lawrence R. Glosten & Ravi Jagannathan & David E. Runkle, 1993. "On the relation between the expected value and the volatility of the nominal excess return on stocks," Staff Report 157, Federal Reserve Bank of Minneapolis.
- Mark Rubinstein., 1994. "Implied Binomial Trees," Research Program in Finance Working Papers RPF-232, University of California at Berkeley.
- Galai, Dan & Schneller, Meir I, 1978. "Pricing of Warrants and the Value of the Firm," Journal of Finance, American Finance Association, vol. 33(5), pages 1333-42, December.
- Andrew Harvey & Esther Ruiz & Neil Shephard, 1994. "Multivariate Stochastic Variance Models," Review of Economic Studies, Oxford University Press, vol. 61(2), pages 247-264.
- Rubinstein, Mark, 1994. " Implied Binomial Trees," Journal of Finance, American Finance Association, vol. 49(3), pages 771-818, July.
- Robert C. Merton, 1973. "Theory of Rational Option Pricing," Bell Journal of Economics, The RAND Corporation, vol. 4(1), pages 141-183, Spring.
- Constantinides, George M., 1984. "Warrant exercise and bond conversion in competitive markets," Journal of Financial Economics, Elsevier, vol. 13(3), pages 371-397, September.
When requesting a correction, please mention this item's handle: RePEc:nbr:nberwo:7748. See general information about how to correct material in RePEc.
If references are entirely missing, you can add them using this form.