The Recovery Theory and CEO Risk-Taking

In the first essay, we examine two related questions. First, can the recover theory recover the whole physical stock price distribution? Second, if the recover theory cannot recover the physical distribution, what partial information can the recovery theory recover? The novelty of this study is based on our new observation that the information in short term options is important for empirically testing the validity of the recovery theory. First, our results using short term options data (as well as long-term options) reject that the recovery theory can fully recover the whole physical distribution. The rejections are not caused by the high serial correlation in the data. Second, we show that substantial information about the second and fourth moments (and central moments) can be recovered, but this is generally not the case for the first and third moments. In the second essay, we propose a new method for empirically recovering key objects in Ross recovery theory. Our method does not involve any discretization and hence avoids problems such as found spurious spikes in recovered pricing kernels caused by the discretization errors as in most existing empirical studies. The new method is based on a key orthogonal representation of the state-price transition kernel, which leads to an elegant correspondence of the eigenvalue-eigenfunction pairs that allows for easy computation of key objects in the recovery theory. Using real options prices, we demonstrate the advantages of our method for generating smooth and well-behaved pricing kernels and physical densities. In the third essay, we examine how investor protection affects managerial risk-taking. We provide strong evidence that the positive relation of investor protection and risk-taking can be explained by CEO termination risk, not by CEO private benefits of control (PBC).We find that investor protection is negatively associated with CEO termination probability, which leads a CEO to undertake riskier investments, and higher CEO risk-taking is associated with higher corporate growth. Although better investor protection is associated with higher CEO PBC, CEO PBC is unrelated to risk-taking. We conclude that CEOs are more likely to react to their termination risks when they make investment decisions