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Derivatives Use in Corporate Finance
Mar 1, 2001
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| Abstract: The foundation for modern corporate finance was established in 1952 when Harry Markowitz publishes Portfolio Selection. The work of Markowitz and the later work by William Sharpe on the Capital Asset Pricing Model is based on the premise that the benefit of diversification is the driving force behind investor risk preferences and decision making. Using a framework developed from Game Theory, we are convinced that since the 1980's the "game" of corporate management and investment has been transformed. The players have changed, the rules have changed and the incentives have changed. In 1999, for CEO's and investors to maximize their utility, and, thereby, "win" the game: maximize "total returns" must be the primary driver for decision making. Stock specific risk and its corresponding return are now key factors, and shareholders have given executives incentives to optimize these two factors. In this paper we will introduce a new model for calculating forward-looking investor expectations of the "total returns" required for equity. The inputs for the model are derived from traded market instruments, and the model provides a metric system that incorporates the probability of future outcomes and time. The resulting term structure of equity from the model answers many of the paradoxes encountered previously when applying CAPM metrics to issues in corporate finance. |
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