Three essays on testing and application of financial theories

This dissertation addresses three important business and policy related issues regarding financial theories and their application in different markets. Chapter one extends option-pricing theory to value alternative asset-securitization structures. By decomposing each structure into fixed income securities, residual cash flows, and external credit enhancements, we provide market practitioners a unified framework to price and manage securities originated from securitization across various asset types and deal structures. Techniques developed in this chapter can assist bank regulators in determining the amount of economic risk transferred in a securitization transaction and assigning appropriate capital reserves accordingly. Chapter two tests competing capital structure theories, utilizing the unique legal status of Real Estate Investment Trusts (REITs). Using a sample of 148 Equity REITs, we find little support for the trade-off theory although REIT debt ratios are mean reverting. Our results also show that the issuance of long-term debt by REITs is highly sensitive to their new investment opportunities. Thus with limited internal cash flow, REITs strictly prefer debt to equity, which is predicted by the pecking-order theory. Chapter two raises an important policy issue—does limited internal cash flow by regulation raise the funding cost of REITs? The pecking-order theory suggests that internal financing is cheaper than external financing. Intense lobbying by REITs resulted in the REIT Modernization Act of 1999, which lowered the minimum dividend distribution requirement from 95% to 90% for REITs. Whether the current distribution rate is still too high remains a future research topic. Chapter three develops an accurate and consistent method to price weather derivatives. The method is based on Monte Carlo simulation of daily temperatures and is able to adjust for the long-term warming trend in weather. Compared with the standard industry practice, our method produces far better estimates of the fair value of weather derivatives. Accuracy and consistency of our methods can also improve risk management and mark-to-model accounting of such exotic and illiquid derivatives, whose abuse has led to collapse of merchant energy companies such as Williams, Dynagy, and Aquila