A Separating Equilibrium for Stock Repurchase Programs via PUT Options: Transforming a Mathematical Proof into Visual Form

27 Pages Posted: 4 Dec 2012

See all articles by Stanley B. Gyoshev

Stanley B. Gyoshev

XFI Centre for Finance and Investment - University of Exeter Business School

Michael Gombola

Drexel University - Department of Finance

Date Written: December 4, 2012

Abstract

We develop a mathematical proof demonstrating that only financially-strong firms will sell put options on their own stock, but financially-weak firms will not. The sale of options on a company’s own stock exposes the buyer to default risk of the issuer, which additionally complicates the payoff structure of the put option. This signaling equilibrium is unique because it allows producing a non-costly signal of quality. Instead, the signal allows a cash inflow to the signaling firm.

We next develop a graphical presentation of the mathematical proof showing the separating equilibrium. We then show how presenting visually the separating equilibrium before presenting the mathematical proof aids in understanding. We provide some empirical evidence that the combination of three very difficult concepts, put options, separating equilibria, and issuer default risk can be grasped more easily when a mathematical proof can be presented in graphical form prior to a mathematical proof.

Keywords: derivatives, PUT derivatives, options, PUT options, stock repurchase programs, signaling, separating equilibria, default risk, teaching and learning financial derivatives

JEL Classification: C62, C68, D58, G12, G13, G18, G24, G28, G33, A22, A23, I22

Suggested Citation

Gyoshev, Stanley B. and Gombola, Michael, A Separating Equilibrium for Stock Repurchase Programs via PUT Options: Transforming a Mathematical Proof into Visual Form (December 4, 2012). Available at SSRN: https://ssrn.com/abstract=2185093 or http://dx.doi.org/10.2139/ssrn.2185093

Stanley B. Gyoshev (Contact Author)

XFI Centre for Finance and Investment - University of Exeter Business School ( email )

University of Exeter
Xfi Building, Rennes Dr.
Exeter, EX4 3BZ
United Kingdom
+44-1392-72-3227 (Phone)
+44-1392-262475 (Fax)

HOME PAGE: http://business-school.exeter.ac.uk/about/whoswho/index.php?web_id=Stanley_Gyoshev&tab=profile

Michael Gombola

Drexel University - Department of Finance ( email )

LeBow College of Business
Philadelphia, PA 19104
United States

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