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How stock options trading fuels corporate research & development

By Himanshu Joshi

Since the late 19th century, financial markets have been contributing to global economic and social progress by providing public offerings of stocks to help firms take advantages of economies of scale resulting from technological advancements. These public offerings allow firms to undertake innovative but risky projects. But, of late, financial markets have seen huge growth in shareholder activism. These activists take minority equity positions in public companies they believe are undervalued or underperforming, and then work to increase their profitability and value by proposing changes in their strategy or in their policies. Such activist investors can produce short-sighted cutbacks in corporate investment.

Factors like quarterly disclosure norms, activist investors, enhanced and impeding coverage by analysts, and demanding money managers make it challenging for corporate managers to focus on long-term growth. Many firms in the US and Europe have responded to these challenges by going private, but it is not a viable option for R&D-intensive firms in emerging markets. Such firms require huge amount of risk capital to carry out R&D, which can be raised only through public offering of stocks. Moreover, unlike developed markets, the penetration of PE firms and venture capitalists is low in emerging markets.

Here, R&D-intensive firms can look at the financial derivatives market. The primary objective of introduction of financial derivatives is to provide investors with an opportunity to hedge risk. Derivatives also increase liquidity of the underlying asset market, thereby making it more information efficient. But financial derivatives are often criticised for destabilising underlying spot markets. In fact, asset securitisation and misuse of financial derivatives, specifically credit default swaps, played a major role in the Global Financial Crisis.

In a paper in the Journal of Financial Economics, Ivan Blanco & David Wehrheim explained how trading in equity options written on underlying individual stocks can encourage firm innovativeness. An option gives the holder of that option right to buy (or sell) the underlying asset in predetermined quantities for a certain price at any time. Pricing or value of an option depends on the volatility of the underlying asset, apart from other factors like time-to-expiration, risk-free rate of interest, exercise price, and spot rate. Active options markets alter incentives for market participants to gather information that is relevant for long-term investments.

Since stock prices reflect quality of investment decisions, and managers can gather clues from stock price movements around the announcement of their long-term investment commitments in R&D, this should provide corporate managers with more incentives to engage in value-enhancing innovative activities. In India, options contracts are available on 175 company stocks, for which selection criteria is stipulated by the SEBI. The presence of many pharmaceutical (Cadila, Biocon, Cipla, Dabur) and heavy engineering (BEML, BHEL, BEL, Eicher Motors) companies confirms the notion of impact of option trading on firm innovativeness.

(The author is associate professor, FORE School of Management, New Delhi)