Search

The article presents a series of abstracts of papers presented at the 1996 American Finance Association meeting, including "The Timing and Subsequent Performance of Seasoned Offerings: The Case of Rights Issues," "Testing Continuous-Time Models of the Spot Interest Rate," and "Bias in Analysts' Earnings Forecasts as an Explanation for the Long-Run Underperformance of Stocks Following Equity Offerings."

The article presents commentary from Matthew Richardson about a paper written by Geert Bekaert and Robert J. Hodrick (B&H), entitled "Expectations Hypotheses Tests," which appeared in the August, 2001 issue of the "Journal of Finance." In that paper B&H examined the expectations hypothesis for interest rates. The author of the current paper notes that B&H have made three important contributions by focusing attention on testing methodologies, by developing a general econometric methodology, and by highlighting the poor finite sample properties of the Wald test.

This paper constructs a general equilibrium model with endogenous stochastic production and establishes that the equilibrium interest rate can he constant in a closed production economy when the preferences are represented by constant absolute risk aversion utility functions. The results in this paper and their limitations are compared and contrasted with related contributions in the financial economics literature. [ABSTRACT FROM AUTHOR]

In this paper, we analyze the behavior of equilibrium real interest rates in an identical consumer economy in which the preferences are represented by time additive logarithmic utility functions and production technologies are Cobb-Douglas with stochastic constant returns to scale. The following main results are established. (i) When there is no relative price uncertainty, it is shown that the equilibrium interest rate exhibits a mean reverting tendency. A nontrivial steady state distribution is found to exist for the equilibrium interest rate. The properties of the equilibrium interest rate are also derived and discussed. (ii) In a multigood economy, even with additive preferences across goods, the equilibrium interest rates depend explicitly on relative prices. The substitution possibilities in production technologies induce this result. This is in contrast to the findings of Richard and Sundaresan [11] who show that the analytical general equilibrium term structure of interest rates formula of Cox, Ingersoll, and Ross [5] is unaffected by the introduction of relative price uncertainty when the technologies are linear and hence involve no substitution. Furthermore, we relate our results to those of Cox, Ingersoll, and Ross [5], Breeden [3], and Richard and Sundaresan [11] with special emphasis on stochastic production and relative price uncertainty. [ABSTRACT FROM AUTHOR]

Bond prices reflect investors' expectations of the after-tax stream of cash flows generated by the bond and of the path of interest rates, as embodied in the term structure. In the absence of taxes on capital gains income, the stream of cash flows generated by a default-free bond is deterministic. The valuation problem in this case consists of computing the expected present value of a stream of known cash flows, but with stochastically varying interest rates as a part of a stochastically varying investment opportunity set. Cox, Ingersoll and Ross addressed this problem in a general equilibrium context and presented a comprehensive theory of bond pricing and the term structure of interest rates. With personal taxes on accrued capital gains, a similar model applies. (See Skelton and Torous.) With capital gains taxes only on realized capital gains and losses, the after-tax stream of cash flows generated by a bond is stochastic and depends on the fluctuations of interest rates. A sophisticated bondholder should follow the optimal trading policy with the objective of minimizing the discounted value of his stream of tax payments, and consequently maximizing the value of his stream of after-tax cash flows. The corresponding problem for a portfolio of stocks and the equilibrium implications of personal tax on the pricing of stocks were discussed in Constantinides and Scholes and Constantinides. The present paper unifies these two strands of research. We examine the optimal bond trading policies in the presence of personal taxes. We also explore the tax implications for the pricing of bonds. In particular we examine the bias in estimating tax brackets and yield curves, when the possibility that investors follow a sophisticated trading policy which differs for a buy-and-hold policy is ignored. [ABSTRACT FROM AUTHOR]

Recent discussions of the Eurodollar market have revealed considerable controversy among economists over its structure and impact. In the hope of clarifying the functioning of the market, this paper presents two models in which Eurobanks are viewed as a special type of intermediary in the financial sector of the United States. These overseas banks issue Eurodollar deposits, time deposits denominated in dollars, and acquire U.S. and foreign securities and non-deposit branch claims on U.S. commercial banks. Changes in asset yields, including the Eurodollar deposit rate, alter the size and composition of the balance sheets of Eurobanks, U.S. commercial banks, and the public. These models will be used to determine (1) how the behavior of transactors in the Eurodollar market affects the impact on U.S. interest rates of monetary disturbances in the United States; (2) how the size of the market is affected by these disturbances; (3) whether switches into Eurodollar deposits by the public are likely to lead to an induced expansion of the market; (4) whether raising Regulation Q ceilings is expansionary or contractionary; and (5) the importance of Regulation Q ceilings to the size of the market. The Gramley-Chase-Smith financial sector model is reviewed and modified in Section I and extended in Section II to include Eurodollar transactions. Section III presents an alternative model of the Eurodollar market, in which Regulation Q ceilings are imposed on U.S. time deposit rates. Section IV is a summary of the results. The major limitation of this paper is its omission of induced changes in foreign interest rates, the inclusion of which would require the addition of a foreign financial sector to the models, and in spot and forward exchange rates, which are taken to be pegged by the exchange authorities. [ABSTRACT FROM AUTHOR]

Dunn and Singleton argue that previous work on the pricing of GNMA pass through securities such as Dunn and McConnell (1981), make various restrictive assumptions about the stochastic processes describing the term structure of interest rates and preferences. The objective of this paper is to test a consumption based asset pricing model and to identify the parameters of the representative agent's utility function, without imposing restrictive assumptions on the probability distributions describing the relevant economic variables. Consider the Dunn and McConnell (1981) paper. The key assumptions of that paper are: the instantaneous rate of interest can be described by a mean reverting process, and individuals have logarithmic utility functions. The assumption that individuals have logarthmic utility is very strong and is unlikely to hold. Given the work of Brennan and Schwartz (1980), the assumption that interest rates follow a mean reverting process can certainly be questioned. Does this imply that the Dunn and McConnell paper is worthless? Not necessarily. Whether the model is of any use, depends upon the accuracy of its predictions. [ABSTRACT FROM AUTHOR]

This paper demonstrates that temporal risk aversion makes smoothing consumption over time less attractive, while the usual risk aversion makes it more attractive. As temporal risk aversion increases, the equilibrium interest rate decreases and the equity premium increases. This paper also shows a striking and novel result that an increase in time impatience can lead to either a decrease or an increase in the interest rate, depending on the nature of the nonseparability. [ABSTRACT FROM AUTHOR]

The purpose of this paper is to provide a test of a state-dependent multinomial model of intertemporal changes in the term structure of interest rates. The theoretical background for the model comes from Ho and Lee (1986). The current paper extends their model in several significant ways. First, we perform diagnostic tests on the data to demonstrate that the empirical results reject a binomial model in favor of a trinomial one. After theoretically deriving the appropriate trinomial model, the current paper extends their model to allow for state-dependent shifts which are determined by the set of ex ante observable state variables. The methodology for the study utilizes OLS regressions to identify the exogenous explanatory variables which drive the hypothesized trinomial process of term structure evolution. The empirical tests indicate that the set of state variables explains a significant portion of the variability in the shifts of the term structure over time. The model also identifies and quantifies a set of variables which impact on changes in the term structure of interest rates. [ABSTRACT FROM AUTHOR]

This paper derives an arbitrage-free interest rate movements model (AR model). This model takes the complete term structure as given and derives the subsequent stochastic movement of the term structure such that the movement is arbitrage free. We then show that the AR model can be used to price interest rate contingent claims relative to the observed complete term structure of interest rates. This paper also studies the behavior and the economics of the model. Our approach can be used to price a broad range of interest rate contingent claims, including bond options and callable bonds. [ABSTRACT FROM AUTHOR]

This note updates Mishkin's empirical work through 1984, confirming his original findings and demonstrating that using period-average interest rates does not produce Makin's result. I also show that lagged money surprises have a significant positive impact on rates, a possibility that Mishkin did not investigate. The next section briefly reviews the efficient markets methodology used in Mishkin, comparing it to the specification found in Makin. Then regressions updating Mishkin's results and incorporating Makin's dependent variable are presented. The paper concludes with an attempt to account for the difference in the two paper's results.
Mishkin's result of a significant positive correlation of unexpected money growth and interest rate surprises is found to still hold after adding the years 1977 through 1984 to the sample. The result "passes" several Chow tests, indicating a degree of temporal stability, and is shown not to depend on whether the interest rate is measured at the end of the quarter or as a period average as Makin claimed. I conjecture that Makin's result is due to an inappropriate restriction in his specification and offer some brief evidence suggesting that this is the case. [ABSTRACT FROM AUTHOR]

This paper analyzes the market for financial assets in a production and exchange economy with several realized outputs and a single unobservable source of nondiversifiable risk. The paper demonstrates that, for a large class of diffusion outputs and preferences, optimizing consumers first estimate the realizations of the unobservable factor and then use these estimates to determine portfolio and consumption rules. Moreover, the explicit consideration of this unobservable productivity factor affects equilibrium demands and prices. The equilibrium spot rate of interest emerges as the "best estimate" of the unobservable factor, and multiperiod default-free bonds arise as the optimal hedge for the unobservable changes of the stochastic investment opportunity set. [ABSTRACT FROM AUTHOR]

This paper modifies the Black-Scholes option pricing model to include the effects of transaction costs and different borrowing and lending rates. The paper demonstrates that these market imperfections tend to offset each other yielding a bounded range of prices for each option. The paper also shows that under some conditions the option pricing hedge may be society's lowest cost financial intermediary. [ABSTRACT FROM AUTHOR]

This paper is an application of efficient markets-rational expectations theory to analyze empirically the relationship of money supply growth and short-term interest rates, a hotly debated issue in the literature. This approach has the advantage over earlier research on this subject in that it imposes a theoretical structure that allows easier interpretation of the empirical results as well as more powerful statistical tests. The empirical results uniformly do not support the proposition that increases in money growth are correlated with declines in short rates. [ABSTRACT FROM AUTHOR]

The paper by Messrs. Ho and Saunders rationalizes the determination of the Federal funds rate in the context of a micro theoretic model that is relatively rich in institutional detail. For several reasons, I believe that the line of inquiry developed in the paper is of basic significance for the study and modeling of capital markets. In the first place, because it is the closest thing to an instantaneous spot rate that we observe in the actual capital market, the (overnight) funds rate is pivotal in the term structure if expectations matter. Then too, the particular role played by the funds rate in the conduct and interpretation of monetary policy gives it a unique significance in the capital market. It is therefore important that we thoroughly understand the mechanism whereby this rate is determined. Secondly, the funds rate is typically explained in an aggregative framework—i.e., without explicit reference to the actual market in which Federal funds are traded. The funds rate is used variously, for example, to clear the aggregate "market" for bank reserves, or even the market for "money." But this type of analysis does not embody enough institutional detail to be useful for studying the relationship between the funds rate and other short-term rates or for analyzing interesting variations in monetary policy. Finally, those studies which have looked specifically at the market in which Federal funds are traded have been primarily descriptive rather than analytical in nature. Ho and Saunders are clearly aware of these shortcomings in the existing literature, and their paper represents a constructive effort to fill the gaps. [ABSTRACT FROM AUTHOR]

This article presents the author's opinion on an article that provided evidence that advances a rehabilitation of the expectations theory of the term structure of interest rates. The author focuses on the econometric meaning and implications of this argument and expresses some concerns about the work. The paper presents a novel approach to testing the expectations theory; however, the evidence is weak and the explanations offered for interest rate movements should be view with suspicion.

The underlying premise of the Tucker paper is that institutional arrangements must be made, primarily in the form of regulatory changes, such that thrift institutions can be protected from the vagaries of fluctuating interest rates. This view ignores the more fundamental issue of whether it might be desirable to allow the housing sector to continue to play its role as handmaiden to monetary policy by contracting when monetary conditions are tight and expanding when conditions ease. On this issue Gibson (1) has presented rather convincing argument against buffering the housing sector at all. A stronger case should be made for the opposing view, which seems to limit its analysis to the microeconomics of thrift institutions rather than the macroeconomics of the effectiveness of monetary policy. However, the author avoids the issue and chooses to investigate ways in which the maturity differential can be reduced. [ABSTRACT FROM AUTHOR]

The article presents commentary on a paper written by Oldrich A. Vasicek and H. Gifford Fong (V&F) entitled "Term Structure Modeling Using Exponential Splines," which appeared in the May, 1982 issue of the "Journal of Finance." The author believes V&F should have acknowledged potential problems inherent in their assumption that expected rates are equal to forward rates. He also discusses spline functions in general and raises questions about V&F's particular application. He hopes further research will yield more insight into the estimating equation for the term structure.

This article presents a discussion of a paper that examined the credit union industry. The author states that the industry experienced rapid growth in the 1960s and 1970s due to relaxed deposit rate ceilings and that consumers responded favorably to this atmosphere. The author examines a model that attempted to portray credit unions as a financial intermediary; however, the paper failed to recognize empirical research that would have influenced this decision based on evidence on bank and thrift institution retail competition.

The article presents commentary from Richard S. Bower about two papers contained in the current issue, "A Programming Approach to Corporate Financial Management" by Myers and Pogue, and "Debt Management and the Form of Business Financing" by White. He is disappointed that neither paper addresses such questions as whether financial managers should incorporate speculation about interest rates into their decisions about debt financing, what the optimal level of debt is, and whether dividends make sense when external equity is available as a source of funds. He doesn't believe White's paper backs up his hypothesis about rate speculation.

The paper is a welcome contribution to comparative economic analysis. The authors conclude that (1) general credit restraint is pervasively associated with more or less severe downturns in new construction, (2) financial stringency affects residential building disproportionately compared to other major sectors of the economy such as industrial investment, and (3) cyclical declines occur "almost regardless of prevailing institutional arrangements" for the financing of housing. Thus, the contraction of new building during tight-money periods seems to be rooted in the "nature of the beast"--the particular sensitivity of housing to changes in financial conditions. We have again learned this morning how difficult it is to specify the nature of the beast more precisely and in a form that lends itself to empirical verification. The Fisher-Siegman paper points up the unresolved issue of credit availability versus cost of funds. If this problem has so far proved to be intractable in a single country--our own--, it is compounded for comparative analysis. Professor Fair's paper stresses the failure of most U.S. housing models to separate clearly demand and supply coefficients, including the financial variables operating on the demand for housing or the supply of new construction or, for that matter, on the volume and price of existing housing offered in the market. We have still some distance to travel for a fuller understanding of the interactions between the mortgage market and the housing market, and the interactions between the mortgage market and the general capital market as well. [ABSTRACT FROM AUTHOR]

The paper focuses on the valuation of caps, floors, and collars in a contingent claim framework under continuous time. These instruments are interpreted as options on traded zero coupon bonds. The bond prices themselves are used as the underlying stochastic variables. This has the advantage that we end up with closed form solutions which are easy to compute. Special attention is devoted to the choice of the stochastic process appropriate for the price dynamics of the underlying zero coupon bonds. [ABSTRACT FROM AUTHOR]

Academic finance has explored the effect of taxes on corporate capital structure in great detail. By contrast, the effect of taxes on the capital structure of partnerships, REIT's, and related entities has received little attention. The present paper shows that, under general conditions, the values of partnerships and REIT's are invariant to leverage, contradicting the sparse literature in the area. A proof similar to that of Modigliani-Miller is employed. The effect of real world imperfections is also examined. [ABSTRACT FROM AUTHOR]

This paper demonstrates how Bayesian information may be analyzed as a variable input in determining an optimal bank portfolio and investigates the impact of information in a way that is statistically satisfactory. A portfolio model is developed, and the impact of information is analyzed. Information is treated as an economic input that is used up to the point where its predicted marginal benefit is exactly equal to its marginal cost, and, from there, the optimal demand for information is derived. A comparative-static analysis demonstrates that the reaction of optimal portfolio holdings to interest rate changes under variable uncertainty is dramatically different from portfolio behavior when uncertainty is exogenous. Finally, the elasticity of reserves with respect to scale is examined under the assumption of variable uncertainty. [ABSTRACT FROM AUTHOR]

COX, INGERSOLL, AND ROSS [1] distinguished various forms of the expectations hypothesis of the term structure of interest rates. They proved that, with one exception, these are consistent with general equilibrium only in the trivial case in which interest rates are nonrandom. The exception is the Local Expectations Hypothesis. Because of this nonexistence result, those who regard the expectations hypothesis as a natural starting point in investigating the term structure of interest rates are motivated to understand under what restrictions the local expectations hypothesis is valid. In our experience, many readers of Cox, Ingersoll, and Ross's paper--particularly those not conversant with stochastic calculus--have difficulty following the discussion. Such readers may find it easier to work through an analysis of the local expectations hypothesis in a more familiar discrete-time framework. This paper provides such an exposition.
The first example above exhibits an exchange economy with a representative risk-averse agent who knows his or her next-period's endowment. Consumption is then locally certain, and the local expectations hypothesis holds. The second example exhibits a production economy. The representative agent knows the next-period rate of growth of wealth and his or her logarithmic preferences make consumption again locally certain; thus, the local expectations hypothesis holds also. In both cases, one-period rates of return on bonds of different maturities are random, so the validity of the local expectations hypothesis is not trivial. In a third example, a risk-neutral agent has zero consumption (a corner solution) until a final date. in this case, the local expectations hypothesis does not hold. We see that the local expectations hypothesis holds if the marginal utility of consumption is locally certain. For this condition to be satisfied, risk neutrality is neither necessary nor sufficient. [ABSTRACT FROM AUTHOR]

This paper investigates the effect of inflation on a firm's investments in fixed assets. When future prices are certain, inflation affects the present value of depreciation tax shields, and the impact of inflation on the choice between different lived assets is non-monotonic. Future asset price uncertainty creates a valuable switching option and benefits shorter-lived assets. [ABSTRACT FROM AUTHOR]

In their seminal work Black and Scholes (1973) provide a significant insight which arguably is of more academic and practical value than their famous option pricing model. They demonstrate that corporate liabilities can be viewed as combinations of simple option contracts. This generalization of option pricing, as refined by Merton (1974, 1977), has become known as Contingent Claims Analysis (CCA). While CCA has subsequently been used by many researchers as a theoretical framework in which to view the pricing of corporate liabilities, its empirical validity remains an open question. Ingersoll (1976, 1977b) has tested the model's ability to predict prices for dual purpose funds and call policies for convertible bonds respectively. In a recent paper, JMR (1983), we tested CCA in one of its potentially most important applications, namely the valuation of debt in typical corporate capital structures. The objective of JMR (1983) was to test the predictive power of a prototypical model based on the usual set of assumptions in the CCA literature. The data base used in JMR (1983) was made up primarily of investment grade bonds, i.e. bond rating of BBB or higher. This paper extends that test of the prototypical model to a larger data base which includes a number of noninvestment grade, or “junk”, bonds. In addition, this paper demonstrates that in the multiple bond problem the value of callable debt need not be a monotonic function of firm value. [ABSTRACT FROM AUTHOR]

Policy makers, the financial press, and some economists periodically express alarm over the "unregulated" growth of offshore banking markets, particularly the Eurocurrency markets. Offshore banks operating without benefit of strong government guidance, they contend, may act in ways that are publicly irresponsible, hence may ultimately bring about the collapse of the world's financial system through the uncontrolled credit creation. But the size of the offshore banking market is already regulated by the value maximizing supply behavior of banking firms and the attendant demand adjustments by depositors. External efforts to impose restrictions on behavior may not be effective in producing intended results, such as a reduction in the rate of expansion. Consequently, policy makers may be confronted with a very difficult, if not entirely elusive, task. The task, moreover, may not be one even worth trying so long as investors, both external depositors and equityholders, are not mislead regarding the nature of the risks and costs that they bear. This paper analyzes the external currency market behavior of banking firms in the context of the modern theory of finance. Equilibrium is obtained in which external banking activities are completely neutral to the value of the firm while the size of the external currency market is determinate at the aggregate level. This aggregate level expands or contracts through time despite the inconsequential effect of external banking activity on the value of the individual banking firm. The external currency banking neutrality results when rents are "priced out" through costless supply adjustments by competing firms. Non-uniform costly supply adjustments, on the other hand, may impact the value of an individual bank, resulting in interior or corner solutions for the degree of external currency banking involvement, but again the equilibrium size of the market expands or contracts through time. Thus, there is no necessary linkage bet... [ABSTRACT FROM AUTHOR]

This paper reports a new test of two competing theories of the relation between tax exempt and taxable interest rates. The Miller hypothesis predicts that the tax-exempt rate is 52 percent of the taxable rate, while the institutional demand hypothesis predicts a volatile relationship. The tests in this paper employ a random intercept model to control for the risk of average interest rates. The results favor the Miller hypothesis. Marginal tax rates are found to be close to Miller's predicted 48 percent. The relationship is not influenced by relative demand or supply and the marginal tax rate appears stable over time. [ABSTRACT FROM AUTHOR]

This paper demonstrates that the response of nominal interest rates to changes in inflationary expectations should lie between that predicted by the "Fisher" and "Darby" effects. The exact nature of the response will depend on the relative size of the income and capital gains tax rates, and the relative size of the derivatives of investment and savings to their respective after-tax real rates. The other major conclusion of this paper is that capital gains taxation offsets the negative effect on investment produced by treating depreciation on a historic rather than a replacement cost basis. [ABSTRACT FROM AUTHOR]

Increasing awareness of the potential risks involved in lending to heavily indebted governments focuses attention on credit pricing in the Eurodollar market. This paper utilizes a recent survey of country-by-country risk assessments as perceived by lenders to show that a systematic relationship exists between these assessments and interest rates in the Euromarket. The relationship is derived from an underlying model described in the paper. The estimated parameters verify a number of hypotheses, providing insights on the loss rates lenders expect to incur in case of default. [ABSTRACT FROM AUTHOR]

Individuals in the United States consistently do most of their saving through financial intermediaries, but over time there have been and continue to be major shifts in people's reliance on specific kinds of intermediary institutions. This paper assesses the potential effects on interest rates, and via interest rates (and asset prices and yields more generally) on nonfinancial economic activity, of four specific shifts in saving behavior: additional pension contributions financed by individuals, additional pension contributions financed by businesses, additional purchases of life insurance by individuals, and additional deposits in thrift institutions by individuals. The paper's results indicate that such shifts, in plausible magnitudes, would have significant effects not only on interest rates and asset-liability flows but also on both the level and the composition of nonfinancial economic activity. In particular, although the specific effects differ from one shift to another, each would disproportionately stimulate capital formation in comparison to other forms of spending. [ABSTRACT FROM AUTHOR]

This article presents a discussion of an article that examined the joint behavior of price-earnings ratios, nominal interest rates and inflation. The author asserts that the paper may have prematurely expressed enthusiasm over the hypothesis that investors in many countries make two specific types of valuation errors. The author notes that the valuation error hypothesis has implications that were not examined, namely that ex post real rates of return to shareholders should, on average, actually be positively related to ex ante expected inflation rates. He also notes that the failure to account for declines in the real value of nominal liabilities has implications that went unexamined as well.

The structure of security returns has been an object of constant attention in the financial economics literature. Several stochastic models for security returns have been proposed, and many of these subjected to strenuous empirical testing. Yet theory demands closure: security returns do not exist in isolation, but are intimately interconnected to all the other features of an economy in equilibrium. Of concern are the consistency of contemporaneous features, such as interest rates and prices, and importantly the dynamic characteristics, i.e., whether equilibrium is sustained over a multiperiod environment. In this paper, we develop a consistent, dynamic equilibrium for the Ross arbitrage model of capital asset pricing. Our objective is to develop a multi-period model which is consistent with the Ross K-factor linear return generating process and its associated single-period equilibrium. Section 2 of the paper gives the initial description of the Ross model. In section 3 we construct a dynamic equilibrium. The state space is given by current dividends and these in turn are mapped into current prices. Section 4 demonstrates that additional state variables of an "informational" nature can also be introduced without damaging the essential structure of equilibrium. Several of the points developed herein are also discussed in Garman and Ohlson where the focus centers on valuation in arbitrage-free markets generally; here we concentrate purely on the dynamic equilibrium nature of the Ross model in particular. [ABSTRACT FROM AUTHOR]

Since the publication of the seminal papers by Black and Scholes and Merton on the pricing of options and corporate liabilities, their basic framework has been extended and applied to a variety of problems in finance. More recently, the same framework has been used for the valuation of interest dependent claims, and in particular for the pricing of default free bonds. These securities (generally government bonds of various types) are valued by treating them as "contingent" upon the course of one or more interest rates, along with suitable assumptions about the term structure of interest rates. Brennan and Schwartz assume that the value of a default free bond is a function solely of the instantaneous interest rate and time to maturity, and show that various types of bonds—savings bonds, retractable and extendible bonds, and callable bonds—all follow the same partial differential equation as discount bonds, the distinguishing feature being the associated boundary conditions. Taking into account the considerable theoretical work that has been done, there is relatively little published empirical research testing these models. Most of the empirical work in the area of contingent claims analysis has been on the stock options market, with the exception of Ingersoll on the pricing of dual fund shares and Brennan and Schwartz on the valuation of Canadian Federal Government coupon bonds. In this paper contingent claims analysis is applied to the valuation of retractable and extendible bonds and the resultant model is then applied to price Government of Canada bonds. [ABSTRACT FROM AUTHOR]

In the period following Modigliani and Miller's correction paper, it was generally agreed that where capital markets are perfect (taxes notwithstanding) there is an advantage to debt financing. In reaching this conclusion, Modigliani and Miller disregarded the effect of personal income taxes on the behavior of investors. When Miller introduced personal income taxes into the analysis, he was able to state that for a wide range of values of dividend, interest, and corporate tax rates "the gain from leverage vanishes entirely or even turns negative" (p. 267). In deriving this result Miller assumed the following: (1) all investors are taxed at the same rate; (2) the objective of the firm is to maximize its value; (3) no capital gains tax exists; (4) no bankruptcy risk exists; and (5) the firm pays all of its earnings in dividends. Later on in his paper Miller drops assumption (1) in order to reach the surprising result that there is no optimal capital structure for the individual firm but there is an economywide optimal capital structure. This paper argues that when individuals differ in the tax rates imposed on their interest income, value maximization is a meaningless dictum. Assumption (1) is therefore adopted throughout in order to investigate the impact of removing assumptions (3), (4), and (5). A short discussion of previous references to these assumptions is in order. [ABSTRACT FROM AUTHOR]

A great deal of recent research has been concerned with the effect of inflation on economic variables such as the interest rate, the premium for risk, and the value of the firm. Many of these articles have argued that, except for depreciation effects, the value of future investments in a world with taxes is unaffected by a change in the rate of inflation. Since it is difficult to discuss in depth the work of many writers, we will zone in on the reasoning of this type employed in only one paper, the recent article by Gandolfi. However, we believe that the discussion presented here has implications formerly other articles as well. As is common in the literature, Gandolfi builds his macromodel in two steps. First, he sets up the investment, consumption and other schedules as functions of simple parameters such as income and the rate of interest. Second, he combines the schedules to determine the equilibrium values of these parameters. This note is only concerned with part of the first step since we merely want to reevaluate the investment schedule. Since we believe that the use by Gandolfi and others of the IS/LM and/or the neo-classical growth model for the second step is correct, we leave it to future research to place our amended investment schedule in the appropriate model. [ABSTRACT FROM AUTHOR]

The tax treatment of homeowners has been and continues to be an emotionally and politically charged issue. This paper analyzes how alternative tax treatments of homeowners affect the incidence of homeownership across income groups and the relationship between rents and housing prices. The paper is divided into five sections. Section II introduces the conceptual framework of our study. Sections III and IV examine the incidence of homeownership across income groups and the relationship between rents and housing prices—first under the present system and then under alternative tax treatments of homeowners. The alternatives examined include: taxing imputed rent, eliminating mortgage interest deductions, limiting the size of the interest deduction allowed on all consumer loans, and substituting a tax credit or subsidy for mortgage interest and property tax deductions. The final section discusses the implications of our study. The conclusions of most previous studies concerning the choice between rental and purchased housing [Aaron, Goode, Laidler, Tinney, White] are either explicitly or implicitly based upon the comparison of the cost of shelter to two individuals in the same marginal tax bracket under two alternative regimes. In the first regime both own their own homes, while in the second each acts as the landlord for the other. These studies conclude that under the current tax system, the tax-sheltered component of the imputed return on housing exceeds that obtainable from investing in rental units. Hence, each individual would prefer to own his home rather than paying a rent sufficiently high to induce the other individual to invest in rental units. These authors seem to imply that this highly simplified example illustrates that renters have an inequitably high tax burden relative to homeowners and that the after-tax cost of shelter to renters exceeds the after-tax cost of shelter to homeowners. They conclude that the current tax system provides an in... [ABSTRACT FROM AUTHOR]

This paper presents the results of simulation experiments of an econometric model specifically designed to evaluate the short-run impact of these agencies. The model incorporates, in particular, four features that we feel are critical for evaluating the short-run stabilization activities of these agencies: (i) The model is monthly. To our knowledge, all previous econometric studies in this area have used quarterly or annual models. Since the relevant time span is less than a year, the timing patterns observed on a monthly basis are key. (ii) The model distinguishes carefully between the commitment and mortgage purchase activity of the agencies. We presume that the commitment activity of the agencies provides an initial and powerful stimulant to the housing market, whereas their mortgage purchase activity may substantially offset this initial stimulus. Since the time lag between commitment and purchase can be over a year, this distinction may explain why the agencies can stabilize short-run activity, but without any continuing long-run effect. (iii) The structure of the model differentiates between periods of equilibrium and disequilibrium in the mortgage market. Previous studies have observed that the mortgage interest rate may not at times adjust to clear the market, leading to credit rationing. Our model is specified to include credit rationing effects in both the mortgage and housing markets. This is important because agency interventions may be much more powerful when undertaken during disequilibrium episodes. (iv) The model allows for capital market feedback effects whereby debt issues of the agencies (to finance mortgage purchases) impact capital market interest rates. As a result, rising capital market interest rates will offset a portion of the initial positive impact of agency commitments. The agenda for the paper is as follows. Section II reviews the theoretical foundations of the model, with special emphasis on the features just listed. Section ... [ABSTRACT FROM AUTHOR]

In a recent issue of this Journal, Frank Steindl (1974), drawing on his previous article in the Journal of Political Economy (Steindl, 1971) which contained a reduced form of Carl Christ's "A Simple Macroeconomic Model with a Government Budget Restraint" (Christ, 1968), purported to show that the money multiplier is negative. The purpose of this paper is to show that Steindl's definition of equilibrium might be theoretically as well as empirically uninteresting, both because his model is largely vacuous and because it depends on a reaction between the economy and the government which may make his solution unachievable. [ABSTRACT FROM AUTHOR]

No theoretical insight has had as much effect on the understanding of movements in interest rates as the distinction lrving Fisher (1896) made between nominal and real interest rates. His theory postulates that the nominal rate of interest will be equal to the real rate of interest plus the anticipated or expected rate of change in prices. If the equilibrium real rate is stable, or if it is not affected by changes in the rate of change of prices, then a rise in the expected rate of inflation will cause an equivalent rise in the nominal rate of interest. In this case, both the saving supply function and the investment demand function remain fixed with respect to the real interest rate, but shift upward with respect to the nominal interest rate by an amount equal to the rise in the expected inflation rate. Fisher's theory has formed the basis of most recent empirical investigations into secular changes in interest rates. These studies have ignored the effect that the existence of income and corporate taxes might have on the "Fisher Effect." It is the purpose of this paper to develop a simple model of saving and capital accumulation and to investigate in terms of this model the impact that a change in the expected rate of inflation has on nominal and real interest rates when taxes are paid on interest income. [ABSTRACT FROM AUTHOR]

Empirical studies employing the term structure of interest rates have generally suffered from the defect that yield curves have been used as surrogate measures of the term structure. A number of scholars and professional bond analysts have, in the past decade, called attention to the problem (Malkiel [12], Buse [2], Weingartner [21], Homer and Leibowitz [8], and most recently Carr, Halpern and McCallum [4]) that only when the yield curve is flat can it be so used, legitimately. Only McCulloch [13] and Schaefer [18] have attempted to measure the term structure directly. In this paper we summarize briefly the analytical issues; suggest some of the uses to which term structure estimates could be put; propose an estimation method and describe some preliminary results; and finally, present an empirical application of term structure estimates in a stock valuation model. Most research papers conclude with a promise of more research. To a greater than usual degree the present paper is a promissory note because of the implications of our approach (and McCulloch's [13] and Schaefer's [18] for that matter) for a wide range of topics in financial and monetary economics. [ABSTRACT FROM AUTHOR]

Few of us have not at some time become intrigued with the relation between the social and the private discount rates. My interest in the subject was renewed by a series of papers by Arrow [1966], Hirschleifer [1966], Bailey and Jensen [1972], and others. These papers used state preference or capital asset pricing theory to demonstrate that with perfect and complete capital markets the government is no more efficient than the capital markets as a means for diversifying away risk, and that the social and private discount rates are the same. Special circumstances may limit the effectiveness with which government or capital markets can be used to diversify away risk, and in such circumstances either the private or the social discount rate would be raised. [ABSTRACT FROM AUTHOR]

The purpose of this paper is to conduct a comparative test of several of the competing theories of the determinants of term premiums, employing data on the yields of three, six, nine and twelve-month Treasury bills. The basic methodology, employed—directly or indirectly—in several recent studies of the term structure, is to invoke the rational expectations hypothesis of John F. Muth to create a series of synthetic interest rate forecasts and thus to isolate the term premiums implicit in the forward rates in the empirical term structure. As will be shown, Treasury bill data are particularly well-suited to exploit this more rigorous treatment of the mechanism by which expectations are presumed to be formed. On an a priori basis, one might expect the relative capital certainty of Treasury bills to reduce the value of the more conventional risk-return models, whose application may be more relevant to an analysis of the full spectrum of interest rate maturities. On the other hand, support for the more conventional models of the determinants of term premiums garnered from the short-end of the maturity spectrum could serve to strengthen the case for their overall validity. The study proceeds in three stages. In the first, the sue of the rational expectations hypothesis to isolate the term premiums is described. In the second, the competing theories of the determinants of term premiums are sketched briefly. In the third, the data base is described and the empirical results presented. A summary section completes the paper. The purpose of this paper is to conduct a comparative test of several of the competing theories of the determinants of term premiums, employing data on the yields of three, six, nine and twelve-month Treasury bills. The basic methodology, employed—directly or indirectly—in several recent studies of the term structure, is to invoke the rational expectations hypothesis of John F. Muth to create a series of synthetic interest... [ABSTRACT FROM AUTHOR]

The existing empirical literature fails to agree on the nature of the intertemporal relation between risk and return. This paper attempts to resolve the issue by estimating a conditional two-factor model motivated by Merton's intertemporal capital asset pricing model. When long-term government bond returns are included as a second factor, the partial relation between the market risk premium and conditional market variance is found to be positive and significant. The paper also helps explain the convoluted empirical relation between the market risk premium, conditional market variance, and the nominal risk-free rate previously reported in the literature. [ABSTRACT FROM AUTHOR]

There are many different systems to improve the domestic payments mechanism in operation or at advanced stages of planning. This paper is an attempt to identify and describe some of the important evolving mechanisms for effecting transactions within the American economy, with particular emphasis on how their adoption is likely to affect the implementation of monetary policy. Check clearing is a large and growing business in the United States. In 1971, the Federal Reserve has reported that the annual number of checks written in the United States is about 22 billion and that this number is likely to double during the current decade. No doubt similar growth rates have been experienced in the past. At the outset it is important to understand why banks are anxious to modify the existing payments mechanism. First, stock exchange brokerage houses have given banks a most discomforting view of what can happen to financial intermediaries which ignore growing transaction volumes. [ABSTRACT FROM AUTHOR]

Starleaf and Stephenson (S&S) have recently presented an interesting paper [8] whose central theme is similar to that of my book [2]. S&S argue that observed interest rates are strongly influenced by forces other than monetary policy actions and thus cannot be taken as a measure of the latter. I argued that the money stock, as well, is influenced by forces other than policy actions and that it, too, is thus an inappropriate indicator of policy actions. We both then advocated measures of monetary policy analogous to the full-employment surplus measure of fiscal policy; that is, measures that are independent of the business cycle except insofar as policymakers respond to the cycle. [ABSTRACT FROM AUTHOR]

This paper analyzes the role of the Federal Reserve to money markets and bank management regarding their reserves. The author outlines three goals: to test the applicability of a model that views bank borrowing from the Reserve's discount window as a buffer to short-run reserve flows; to examine how the price of Federal Funds is influenced by the eight large money market institutions; and to investigate the existence of structural changes in the market. Weekly data from 1960-1968 is used throughout the paper.

A conference paper is presented that focuses on the impact that the price of credit has on consumers and how they react to changes in the finance rates of installment loans. The author argues that some consumers will be more interested in changes to finance rates and less so to contract maturities while other consumers will be the opposite. The article concludes that more consumers are indifferent than has been thought but that the reason for this is the length of contract maturities.

The article presents a discussion of papers written by Norris Johnson and John Scanlon. These authors discuss economic forecasting from 1957 to 1967. Particular attention is given to how the demand for capital funds are crowding the supply during most of this period but not in such a manner as to give rise to major capital shortages. The author states that there is no proof positive way of assessing the reliability of the assumptions made in this paper or their implications for the adequacy of funds.