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I test the disposition effect, the tendency of investors to hold losing investments too long and sell winning investments too soon, by analyzing trading records for 10,000 accounts at a large discount brokerage house. These investors demonstrate a strong preference for realizing winners rather than losers. Their behavior does not appear to be motivated by a desire to rebalance portfolios, or to avoid the higher trading costs of low priced stocks. Nor is it justified by subsequent portfolio performance. For taxable investments, it is suboptimal and leads to lower after-tax returns. Tax-motivated selling is most evident in December. [ABSTRACT FROM AUTHOR]

The article includes abstracts on articles related to the financial services industry, including "Firm Performance and Mechanisms to Control Agency Problems between Managers and Shareholders," "Dynamic Equilibrium and Volatility in Financial Asset Markets," and "Liquidation Costs and Capital Structure."

The article presents commentary from Jessica A. Wachter about a paper written by Yacine Ait-Sahalia and Michael W. Brandt entitled (A&B) "Variable Selection for Portfolio Choice," which appeared in the August, 2001 issue of the "Journal of Finance." In that paper A&B employed conditional moments of return to select an optimal portfolio. The author of the current paper acknowledges the validity of their work for single-period investments, but raises questions about its suitability for investments that extend over multiple periods.

The three papers presented at this session have provided a fine balance of theoretical analysis and statistical investigation. The paper by Black and Scholes is a particularly commendable contribution, thoroughly professional in execution and a very constructive piece of work in its broader implications. The authors has previously derived an equation for the valuation of options from the condition that opportunities for profitable arbitrage will be eliminated in efficient capital markets. In the present paper they carefully analyze a sizeable body of data to examine the efficiency of the operation of the option market as it is now structured. They validate their formula for the pricing of options by showing that in the absence of transactions costs, buying "undervalued" contracts and selling "overvalued" contracts at model prices computed with foreknowledge of the actual variances of the returns on the underlying stock over the holding period would produce quite insignificant average gains or losses. But when ex ante variances are estimated from previous stock price histories, buying "undervalued" contracts and selling "over-valued" contracts at model prices would have produced significantly negative excess portfolio returns, while substantial positive excess portfolio returns would have been made by buying overvalued and selling undervalued options at market prices. These results indicated that the true value of options is somewhere midway between market prices and "model" prices based on historical data. [ABSTRACT FROM AUTHOR]

The article presents commentary about a paper written by E. Han Kim entitled "Miller's Equilibrium, Shareholder Leverage Clienteles, and Optimal Capital Structure," which was published in the May, 1982 edition of the "Journal of Finance." The author regards Kim's paper as a survey of research on optimal capital structure inspired by Merton Miller's article "Debt and Taxes." He discusses the portion of Kim's paper that contrasted complete and incomplete capital market environments, and notes the importance of tax arbitrage restrictions in understanding them.

This paper analyzes the major factors which determine the effects of taxation on the value of risky assets and on the cost of capital, and shows how the magnitudes and even the signs of these effects depend on the values assumed for a few key parameters in the model. Using plausible values for these parameters, it is shown that the results obtained are frequently counter-intuitive. [ABSTRACT FROM AUTHOR]

Several recent writings have raised questions concerning the effectiveness of commonly used analytical measures and techniques which have their basis in Modern Portfolio Theory. Questions have been raised about the use of beta in the interpretation of risk adjusted equity performance and about the usefulness of the capital asset pricing model (CAPM) as a tool for measuring and interpreting investment performance. This paper restricts itself to questions concerning beta and CAPM as they relate to performance measurement. In the process of this examination it discusses some basic principles of performance measurement as they relate to judgments of investment management skill and ability. It has been shown that simple applications of beta used in adjusting equity performance for risk can possibly produce misleading or incorrect interpretations of risk adjusted performance. Errors have been shown to be related to the market index used as a basis for the determination of beta. These findings are independent of the validity of CAPM, but the line of reasoning which leads to these conclusions is not totally antithetical to the derivation of CAPM. This paper has three major sections: 1. The capital asset pricing model is assumed to be valid, and a broader index of capital assets is constructed. This index is “better” in the sense that it includes many more assets than the S&P 500 and hence is more complete. 2. The better index is then used to “game” performance measurement using current investment technology and the Standard & Poor's 500. 3. Some conclusions are drawn as to the effectiveness of gaming and the ways in which performance measurement numbers should be interpreted in general. General issues are discussed in the text. A parallel, more detailed and more technical argument is presented in the appendix. [ABSTRACT FROM AUTHOR]

The article presents commentary from M.J. Brennan about a paper written by Nicholas Barberis and Ming Huang (B&H) entitled "Mental Accounting, Loss Aversion, and Individual Stock Returns," which appeared in the August, 2001 issue of the "Journal of Finance." In that paper B&H analyzed the behavior of investors who are concerned about the returns of both their portfolios and the individual stocks that compose them. The author of the current paper observes that this represents a departure from modern portfolio theory. In his view B&H's analysis, while interesting and informative, must be approached with caution.

This paper investigates options market reaction to changes in the instantaneous variance of the underlying asset. There are three main findings. First, options market investors underreact to individual daily changes in instantaneous variance. Second, these same investors overreact to periods of mostly increasing or mostly decreasing daily changes in instantaneous variance. Third, they tend to underreact (overreact) to current daily changes in instantaneous variance that are preceded mostly by daily changes of the opposite (same) sign. The third finding can reconcile the first two and is also consistent with well-established cognitive biases. [ABSTRACT FROM AUTHOR]

This paper analyzes how mutual fund performance relates to past performance. These tests are based on a multiple portfolio benchmark that was formed on the basis of securities characteristics. We find evidence that differences in performance between funds persist over time and that this persistence is consistent with the ability of fund managers to earn abnormal returns. [ABSTRACT FROM AUTHOR]

The assumption that the market portfolio follows a specified diffusion process implies, in a simple equilibrium framework, that the representative individual must have a certain utility function which is identified in the paper. Not every diffusion process is viable, i.e., can be "endogenized" to be the market portfolio's price process in such an equilibrium model. The paper provides necessary and sufficient conditions for viability which imply that viable diffusion processes constitute a rather restricted family. [ABSTRACT FROM AUTHOR]

This paper answers the comments of readers of our earlier paper. Additional insight is gained by adding recent data to show the effect of following Value Line Investment Service recommendations in active stock market trading over the years 1974-81. We show that Value Line makes a statistically significant contribution, which cannot be explained by the Beta risk factor. We offer our results as an unexplained divergence from the Efficient Market Hypothesis, but with the tentative hypothesis that investment timing (i.e., the fact that the Efficient Market Hypothesis does not operate instantaneously) may explain much of the abnormality. [ABSTRACT FROM AUTHOR]

In this paper we will introduce and develop a nontraditional theory of portfolio selection. The theory assumes that investors choose their portfolios to have a certain minimax property which we will describe in detail below. As we will see in the next two sections, the minimax portfolios turn out to be identical to portfolios that are often recommended on other grounds. In this paper we have examined the implications of certain forms of minimax behavior in portfolio selection. Though minimax behavior is not truly optimal, there are reasons to suppose that it might approximate the behavior of some investors. One reason is the obvious discomfort that many decision-makers feel when forced to make decisions based on subjective probability distributions, particularly when those distributions were formed on the basis of vague information. One would not be surprised if a decision-maker sought to protect himself against the possibility that his distribution is incorrect. Portfolio selection seems a natural context for minimax behavior because of the enormous amount of information, both direct and indirect, that an investor must incorporate into his probability distributions. The results of this paper, which show that minimax behavior leads to reasonable portfolios of the sort we observe in practice, lend some support to the minimax hypothesis. [ABSTRACT FROM AUTHOR]

Taxes affect capital budgeting under inflation in many ways. This note focuses on two of the most important—depreciation deductions and interest deductions. Because depreciation for tax purposes is based on historical costs rather than current values, investments in depreciable assets become less attractive under inflation. Because debtors can deduct nominal interest payments, not just real interest charges, debt-financed investments become more attractive under inflation. The impact of inflation and taxes on the value of potential investment projects depends on which factor dominates. In a recent paper in this journal, Gandolfi argued that the existence of a tax on corporate profits will not alter the real rate of return on the firm's marginal investment. In a subsequent paper, Jaffe exposed Gandolfi's error in ignoring the tax subsidy to debt-financed investments. Both authors assumed that the firm's investment takes the form of a non-depreciating machine—a special case, as Jaffe notes, among an infinite number of possible depreciation schedules. An extension of Jaffe's analysis to handle alternative depreciable lives confirms his assertion that investments which would be marginal in a world without taxes can become profitable in a world with taxes. However, the cutoff rate of return exceeds the rate calculated by Jaffe whenever the machines have finite lives. Moreover, in the limiting case of an asset which has a single period life, the required rate of return will be unaffected by a tax on profits. The section which follows introduces a depreciable asset into Jaffe's analysis; quantitative results of the impact of inflation and taxes on the firm's cutoff rate of return are calculated. Section three summarizes the main conclusions from the analysis. [ABSTRACT FROM AUTHOR]

In the early sixties a number of papers developed stock value models in which the cost of equity capital is a function of the firm's equity investment rate. The conclusions reached, however, have for the most part been rejected in the subsequent literature. Instead, it has become widely accepted both in the theoretical work and in the textbooks on finance that the cost of equity capital is equal to the yield at which a firm's stock is selling, and the latter is independent of the firm's investment rate. In fact, one frequently finds the two terms, share yield and cost of equity capital used interchangeably in the literature. However, contributions to the literature during the last few years provide additional support for and clarification of the alternative theory, and a broad reconsideration of the subject is in order. Part I below critically reviews the literature of the early sixties on both sides of the subject and certain subsequent papers which contributed to the conclusion that share yield and cost of equity capital are equal and independent of investment policy. Parts II and III examine the recent contributions which have materially strengthened the theoretical basis for the contrary conclusion, that the cost of equity in a firm is an increasing function of its investment rate. Part IV reviews the empirical evidence on the subject, and Part V both summarizes the conclusions reached and discusses the areas in which the model requires further development. [ABSTRACT FROM AUTHOR]

This paper has introduced L(W[sub 0], k, A) and R(W[sub 0], k, A) as three-parameter risk measures embodying decisions about a reference level about which deviations are to be measured, the relative importance of small versus large deviations, and the range of deviations that will be included in the risk measure. The popular risk measures of variance, semi-variance, mean absolute deviation, and probability of an outcome worse than some prespecified level are special cases of L(W[sub 0], k, A) and standard deviation is a special case of R(W[sub 0], k, A). These risk measures were shown to differ in their choice of one or more of the parameters W[sub 0], k, and A. It was shown that both L and R are monotone increasing functions of A; however, neither L nor R are necessarily monotone increasing functions of k. Clearly L(W[sub 0], k, A) and R(W[sub 0], k, A), are not the only potentially useful functions of the three decision parameters that have been implicit in the selection of the popular risk measures; they are, however, a rich and fairly general family. Further study of their properties should lead to advances in the theory of risk and specification of criteria for the selection of risk measures. This paper has attempted to establish a foundation for these advances. [ABSTRACT FROM AUTHOR]

A conference paper is presented that examines firm income taxation and asset expansion. The author explores some of the problems associated with the measurement of asset expansion during periods of changing price levels. The author investigates the impact that changes in corporate income tax rates have on asset expansion and offers some suggestions on how to stimulate investments by means of special tax measures.

If papers presented at our annual meetings are not addressed to the small group of academicians who attend the actual programs, but to a much larger audience that includes decision makers in the field, then Dr. Pellatt's paper on the analysis of real estate investment opportunities represents a significant contribution. He has done a competent, intelligent job of applying capital budgeting theory to the problem of real estate investment. Admittedly, there is nothing new or unique in the tools, techniques, or concepts employed in his paper, but he has produced a worthwhile marriage. He brings together a potentially fruitful union of capital budgeting, where we have had significant progress in the last decade, with the field of real estate evaluation where we have had little change in the last century. [ABSTRACT FROM AUTHOR]

The article presents discussion regarding the 19867 paper "Optimal Portfolio Choice Under Incomplete Information," by G. Gennotte. The article discusses research done on investment decisions in a Merton/Cox Ingersoll & Ross production economy. The article states that Gennotte's paper provides two interesting observations: that an increase in the uncertainty regarding instantaneous expected returns of a certain production process will reduce its weight in the portfolio, and that the decisions of investors with logarithmic preferences behave as if the conditional means are the true ones, given that their estimates of expected returns are independent of the estimation error.

This paper documents that strategies which buy stocks that have performed well in the past and sell stocks that have performed poorly in the past generate significant positive returns over 3- to 12-month holding periods. We find that the profitability of these strategies are not due to their systematic risk or to delayed stock price reactions to common factors. However, part of the abnormal returns generated in the first year after portfolio formation dissipates in the following two years. A similar pattern of returns around the earnings announcements of past winners and losers is also documented. [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]

This paper provides some new insights about approximate factor structures, as defined by Chamberlain and Rothschild [2], and their implications for empirical tests. First, we show that any economy that satisfies an approximate factor structure can be transformed, in a manner that does not alter the characteristics of investor portfolios, into an economy that satisfies an exact factor structure, as defined by Ross [9]. Second, we show that principal components analysis represents just one of many methods of forming groups of well-diversified portfolios with no idiosyncratic risk in large samples. Correct factor loadings will be obtained by regressing security returns on any group of these portfolios. Our interpretations of the Chamberlain and Rothschild results also provide additional insights into the testability of the Arbitrage Pricing Theory. We show that securities cannot be repackaged to hide factors in the manner suggested by Shanken [10] without the variance of some of the repackaged securities approaching infinity in large economies. [ABSTRACT FROM AUTHOR]

In this paper a systematic procedure is developed to determine necessary conditions for all degrees of stochastic dominance. The previously known necessary conditions are specified as to which degrees of dominance they belong, and two new necessary conditions, a ranking of harmonic means and a ranking of algebraic combinations of the first three moments, are derived. [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]

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]

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 article comments on a paper published within the issue, "New Evidence on the Capital Asset Pricing Model," by Irwin Friend, Randolph Westerfield, and Michael Granito. The author reviews the paper and discusses the two tests used on the Capital Asset Pricing Model (CAPM). The model is first tested on its own ground, then using an expanded set of securities including bonds and stocks. The author notes that greater availability of bond data makes it possible to better estimate the market portfolio. It is also mentioned that individual bond returns may be used for cross-sectional testing of the CAPM.

Previous work by the authors has described how optimal portfolios can be assembled given various assumptions about the variance covariance arrangement of stock returns, and stipulating the existence of a risk-free asset. The current paper offers additional simplification by relaxing the requirement for a risk-free asset. The authors show how to construct a complete frontier of efficient portfolios for the single-index model, and for when identical correlation coefficients prevail among all stocks.

A balanced commentary on David Glenn's paper, "Super Premium Security Prices and Optimal Corporate Financing Decisions," should be one which indicates what I consider to be two general, but important, contributions of this work, as well as one major negative aspect. On the positive side, Glenn has approached his topic in a very professional, analytical manner. He starts by noting that the real world has investment grade restrictions on some institutional investors, and that this would lead to capital markets which are, to an extent, segmented and possibly could result in premiums on certain quality securities. Premiums could occur due to this institutional requirement, but Glenn, unlike so many before him, does not then jump to the conclusion that these premiums do, in fact, exist. He analyzes, within the two-parameter framework, this partially-segmented capital market structure (assuming perfect capital markets in all other respects) and proceeds to prove that this structure alone is not sufficient to yield price premiums on quality securities. Noninstitutionally constrained investors can simply buy more, or sell short, those securities that are not on their risk-expected return line to wipe out would-have-been premiums. Having carefully demonstrated the emptiness of the institutional quality grade requirement, he then combines this market imperfection with a restriction on short-selling (since the proceeds of a short sale cannot be used) to show that all price deviations from a unified capital market prescription cannot be eliminated by unrestricted investors--thus, the premiums. [ABSTRACT FROM AUTHOR]

The purpose of this paper is to investigate the opposite case: What is the impact of ever lengthening revision horizon on the optimal portfolio of a mean-variance investor? We do not intend to examine in this paper what will be the overall division of the investors' wealth between the riskless asset and the risky portfolio but rather we will determine how in the framework of the mean-variance analysis the long-run investor will construct his risky portfolio. Neither do we intend to examine the adequacy of the mean-variance criterion for this investment in light of the considerable skewness of multiperiod multiplicative returns. The purpose of this paper is to investigate the opposite case: What is the impact of ever lengthening revision horizon on the optimal portfolio of a mean-variance investor? We do not intend to examine in this paper what will be the overall division of the investors' wealth between the riskless asset and the risky portfolio but rather we will determine how in the framework of the mean-variance analysis the long-run investor will construct his risky portfolio. Neither do we intend to examine the adequacy of the mean-variance criterion for this investment in light of the considerable skewness of multiperiod multiplicative returns. [ABSTRACT FROM AUTHOR]

One of the most important problems confronting stock market analysts is the valuation of stocks at any point in time. In fact, the name of the game is to determine whether stocks are selling above or below their real worth. Presumably, "real worth" is synonymous with economic equilibrium based upon the "correct" model of common stock valuation. Deviations from equilibrium will eventually be corrected by the market mechanism and this is the stuff of which profits and losses are made. The purpose of this paper is to extend the work of Malkiel and Cragg since they have apparently opened up a rich vein of exploration in the quest to explain the structure of share prices. The most serious limitation of the Malkiel and Cragg study was its sample size. Unfortunately, the sample was restricted to only 178 corporations. The authors state "... our sample tends to contain the 'blue-chip' group of companies in which investment interest is centered.". Would it be possible to improve the market representativeness and size of the sample and still obtain the excellent results reported by Malkiel and Cragg? In addition to attempting to answer this question, this paper will also consider the role of industrial classification in determining price-earnings ratios holding important financial variables constant. Section II briefly reviews the stock evaluation model. Section III discusses the data source for this study. Section IV reports the regression results while Section V summarizes the findings. [ABSTRACT FROM AUTHOR]

Mao & Helliwill have two very ambitious objectives: (1) to present a new theoretical model in the area of investment and financing decisions under uncertainty and (2) to evaluate critically the current practices and suggest the directions future theoretical and empirical research on investment decisions can take. These objectives are not attainable by any single paper and M & H's attempt is no exception. By other more conventional standards, however, M & H have written an interesting paper. [ABSTRACT FROM AUTHOR]

Professor Ball's paper reports the results of an extremely detailed and exhaustive study of the effect on security prices of changes in accounting techniques affecting the reported net income figure. His contribution is both substantive, in that it provides further evidence in support of the efficient markets hypothesis, and methodological, in that it proposes refinements to the usual technique used to study the impact of new information on stock prices. I shall discuss these two aspects of his paper separately. The major finding of the paper is that capital markets are efficient to the extent that investors are able to see through the accountant's veil to derive independent estimates of the true economic income of firms. We may conclude from this that annual income reports do nothing to obstruct the flow of information from firm to investor, even if they do relatively little to facilitate it. However, it would be wrong to take this as implying that the principle of consistency in accounting is irrelevant' market efficiency is quite compatible with variations in investor sophistication, and it is possible that changes in accounting techniques lead to wealth transfers from the naive to the sophisticated, which would be widely regarded as undesirable. [ABSTRACT FROM AUTHOR]

The purpose of this paper is to derive the three MM Propositions using the standard deviation-mean portfolio model in a market equilibrium context. This approach to some of the major issues of corporation finance enables us to derive these propositions in a somewhat more direct way than with the use of the risk-class assumption and the arbitrage proof of the MM paper. Instead, a model is substituted relating the maximization of stockholder expected utility to the selection of portfolios of assets to, finally, the financing and investment decisions within the corporation, A link will be provided between two branches of the field of finance that have so far been evolving more or less separately. [ABSTRACT FROM AUTHOR]

The article presents comments on the papers "The Changing Role of Banks in the Market for Equities," by A. James Meigs, and "Life Insurance Companies and the Equity Capital Markets," by Orson H. Hart, both published within the issue. The author discusses four separate points presented within the papers: the expected growth in the volume of institutionally managed funds, intensification of competition between institutions, innovations in the form of new services offered to firms or individuals, and the investment preferences of equities.

The paper by Professors Ang and Patel on bond rating methods presents some results which are interesting, if not very surprising, and provides a basis for examining some other provocative issues. That the various statistical rating methods replicate Moodys' ratings quite effectively should not be unexpected, since all the methods look at very much the same balance sheet and income statement information. And since the statistical methods do replicate the Moodys' rating, one would expect that they would all predict realized returns of bonds about as well as the Moodys' ratings, as the results in the paper would suggest is the case. This ability to forecast realized returns in a sense, however, overstates the relative effectiveness of the statistical methods, since they are based on data not available at the time that the Moodys' ratings are made. The Moodys' ratings are essentially ex-ante measures, while the statistical ratings are not. [ABSTRACT FROM AUTHOR]

This paper investigates the relationship between portfolio choice and labor income risk in the National Longitudinal Survey of Youth 1979 Cohort. Permanent income risk (variability of shocks to income that have permanent effect) significantly reduces the share of risky assets in the household's portfolio, while transitory income risk (variability of shocks with no lasting effect) does not. This result provides strong evidence that households' portfolio choices respond to labor income risks in a manner consistent with economic theory. [ABSTRACT FROM AUTHOR]

This paper analyzes a model in which long-term risky assets are illiquid due to adverse selection. The degree of adverse selection and hence the liquidity of these assets is determined endogenously by the amount of trade for reasons other than private information. I find that higher productivity leads to increased liquidity. Moreover, liquidity magnifies the effects of changes in productivity on investment and volume. High productivity implies that investors initiate larger scale risky projects which increases the riskiness of their incomes. Riskier incomes induce more sales of claims to high-quality projects, causing liquidity to increase. [ABSTRACT FROM AUTHOR]

This paper derives preference-free option pricing equations in a discrete time economy where asset returns have continuous distributions. There is a representative agent who has risk preferences with an exponential representation. Aggregate wealth and the underlying asset price have transformed normal distributions which may or may not belong to the same family of distributions. Those pricing results are particularly valuable (a) to show new sufficient conditions for existing risk-neutral option pricing equations (e.g., the Black--Scholes model), and (b) to obtain new analytical solutions for the price of European-style contingent claims when the underlying asset has a transformed normal distribution (e.g., a negatively skew lognormal distribution). [ABSTRACT FROM AUTHOR]

The Federal Reserve sets targets for interest rates which it enforces through direct market intervention. These targets are changed periodically. In this paper, we develop a term structure model in which the short rate is subject to a control which keeps it close to a target which changes from time to time. The probability of target changes is not constant in the model, but changes as a function of observables. The model performs well at explaining the shifts in the yield curve that accompany target changes. [ABSTRACT FROM AUTHOR]

This paper analyzes 4,750 mergers from 1963 to 1998 to characterize the risk and return in risk arbitrage. Results indicate that risk arbitrage returns are positively correlated with market returns in severely depreciating markets but uncorrelated with market returns in flat and appreciating markets. This suggests that returns to risk arbitrage are similar to those obtained from selling uncovered index put options. Using a contingent claims analysis that controls for the nonlinear relationship with market returns, and after controlling for transaction costs, we find that risk arbitrage generates excess returns of four percent per year. [ABSTRACT FROM AUTHOR]

This paper examines how risky labor income and retirement affect optimal portfolio choice. With idiosyncratic labor income risk, the optimal allocation to stocks is unambiguously larger for employed investors than for retired investors, consistent with the typical recommendations of investment advisors. Increasing idiosyncratic labor income risk raises investors' willingness to save and reduces their stock portfolio allocation towards the level of retired investors. Positive correlation between labor income and stock returns has a further negative effect and can actually reduce stockholdings below the level of retired investors. [ABSTRACT FROM AUTHOR]

The objective of the paper is to demonstrate the consistency with which investors push stock prices to unsustainable levels—in both directions. They habitually extrapolate recent earnings trends into the future, ignoring the many random walk elements in earnings patterns as well as ignoring the tendency of most divergences from average earnings performance to correct themselves over time by a familiar process known as reversion to the mean. This tendency ultimately leads to painful disappointment for the optimists who have pushed the prices of rapid-growth companies too high while, at the same time, it leads to pleasant surprises for the pessimists who have pushed the prices of troubled companies too low. [ABSTRACT FROM AUTHOR]

The article presents commentary on a paper that appeared in the May, 1982 issue of the "Journal of Finance," entitled "Plasm: Pension Liability and Asset Simulation Model," by Howard E. Winklevoss. The author acknowledges the sophistication of simulation models such as the one presented in the Winklevoss paper, but believes they disappoint by failing to identify a specific course of action. More typically such models present a range of options, thus bringing into play an element of subjectivity that simulation methods are designed to bypass.

The article comments on a paper published within the issue, "Foreign Exchange Hedging and the Capital Asset Pricing Model," by Alexander A. Robichek and Mark R. Eaker. The author considers whether Robichek and Eaker's paper is able to provide original theoretical insights on the pricing of forward contacts in a portfolio context. Robichek and Eaker are criticized for their evidence on forward rates changes, which the author insists can be just as easily shown to have weak correlations with several other variables. The author feels that the paper should be regarded as a stepping-stone to more refined empirical inquiry rather than as selfsufficient in its evidence.

The article presents commentary about a paper written by Roman L. Weil, Joel E. Segall, and David Green, Jr. (WSG) entitled "Premiums on Convertible Bonds," which was published in the June, 1968 edition of the "Journal of Finance." In that paper WSG observed that the "floor" for convertible bonds contributes little, if anything, to the bond premium. The author of the current paper identifies and explains what he considers to be flaws in their reasoning. In his view it is not clear what contribution the floor makes to a convertible bond premium.

The goal of this paper is the derivation and application of a direct characterization of the inverse of the covariance matrix central to portfolio analysis. Such a characterization, in terms of a few primitive constructs, provides the basis for new and illuminating expressions for key concepts as the optimal holding of a given risky asset and the slope of the risk-return efficiency frontier faced by the individual investor. The building blocks of the inverse turn out to be the regression coefficients and residual variance obtained by regressing the asset's excess return on the set of excess returns for all other risky assets. [ABSTRACT FROM AUTHOR]

Close bank relationships are thought to ameliorate firms' liquidity constraints--a phenomenon frequently measured by liquidity sensitivity of investment. Using German firms during the formative years of universal banking (1903-1913), this paper shows that, even controlling for selection bias, investment is more sensitive to internal liquidity for bank-networked firms than unattached firms. The firm exhibiting the greatest liquidity sensitivity, however, faced no apparent liquidity constraint. The findings yield two implications: they support recent research rejecting a linear relationship between liquidity sensitivity and financing constraints, and they suggest that relationship banking provides no consistent lessening of firms' liquidity sensitivity. [ABSTRACT FROM AUTHOR]

This paper studies the flows of funds into and out of equity mutual funds. Consumers base their fund purchase decisions on prior performance information, but do so asymmetrically, investing disproportionately more in funds that performed very well the prior period. Search costs seem to be an important determinant of fund flows. High performance appears to be most salient for funds that exert higher marketing effort, as measured by higher fees. Flows are directly related to the size of the fund's complex as well as the current media attention received by the fund, which lower consumers' search costs. [ABSTRACT FROM AUTHOR]