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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.

This article presents the author's comments on a paper that examined expected returns on stocks. The author suggests that the paper did an excellent job evaluating variance-bound literature; however, he believes that the analysis conducted was partial and failed to highlight the conclusions reached by other prominent researchers on volatility. The author also is skeptical of the conclusion drawn in the paper that suggests turning to nonstandard models for expected returns to explain stock price volatility. The author notes that the field has come a long way in understanding the statistical traps involved with volatility and pushes for more research.

This paper discusses the pricing of assets in an intertemporal rational-expectations model when real production and inflation evolve according to first-order autocorrelated processes. The focus is on the structure of the various intertemporal discount rates (yields) exhibited by this economy. Yield curves are identified for consumption claims, indexed bonds, and nominally riskless bonds and can be extended to any claim that can be approximated by a (finite) linear combination of such securities. The model demonstrates that, if the average term structure for nominally riskless securities is upward sloping, then the yield curve for consumption (market) claims is downward sloping, suggesting that conventional methods for computing long-term discount rates err by not accounting for maturity factors. The paper also explores the relationship between the intertemporal equilibrium and its embedded single-period equilibria. The single-period risk measures in this economy are derived and shown to be (generally) functions of maturity. A model of nominal bond betas is constructed along these lines. It is shown that bond betas that are increasing functions of maturity do not necessarily imply an upward-sloping term structure. [ABSTRACT FROM AUTHOR]

This paper presents a simple model of net foreign investment. It is shown that an increase in the expected return of investments in the foreign technology decreases net foreign investment in the domestic country, whereas an increase in the variance of the return of investments in the foreign technology increases net foreign investment in the domestic country. An increase in foreign wealth accompanied by an equivalent decrease in domestic wealth is shown to increase net foreign investment in the domestic country. Finally, it is shown that an increase in the risk tolerance coefficient of the domestic investor has, to a first approximation, no effect on net foreign investment in the domestic country. A closed-form solution is given for the case in which all investors have a logarithmic utility function and is used to derive the dynamics of net foreign investment. One direction in which the present model could be extended consists in taking into account the fact that it is harder for domestic investors to enforce property rights abroad than at home. If property rights cannot be enforced abroad by domestic investors and at home by foreign investors, net foreign investment is always equal to zero, even though gross foreign investment differs from zero. Whereas the differential cost of enforcing property rights at home and abroad for domestic investors creates incentives for foreign investors to take actions which reduce the value of the net investment abroad by domestic investors, domestic investors can impose substantial penalties on foreign investors if they engage in confiscatory actions. The suggested extension of the analysis involves the development of a concept of equilibrium that accounts for the dependence of the actions of domestic investors on what they believe foreign investors will do. [ABSTRACT FROM AUTHOR]

This paper shows that the empirical tests of the Arbitrage Pricing Theory (APT) model are very sensitive to the anomalies observed in January in the stock returns data. There is a strong seasonal pattern in the estimates of the risk premia from the APT model. The most important implication of the findings in this paper is that the APT model can explain the risk-return relation mostly for January. Once the January returns are excluded from the data, there is no significant relation between the expected stock returns and the risk measures predicted by the APT model. [ABSTRACT FROM AUTHOR]

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]

This paper develops a model of bond prices and yield spreads that incorporates the effect of both taxes and differences in default probabilities. The tax loss consequences of default are recognized. Traditionally, tax-free (municipal) bond yields have been viewed as linearly related to taxable yields with a slope coefficient equal to one minus the tax rate and the intercept representing differences in default risk. While our model supports the linearity assumption, it implies that the slope and intercept are both functions of both the break-even tax rate and the default probability(ies). Clientele effects among both municipal and taxable bonds are demonstrated. Finally, the implied marginal tax rates and the implied default probabilities are estimated for different categories of municipal bonds. [ABSTRACT FROM AUTHOR]

This paper tests the tax explanation of the January effect by examining small firm stock returns before the War Revenue Act of 1917. No evidence of a turn-of-the-year effect is found. This paper also extends previous authors' work on the subject to 1918-29. A January effect is found during that period. [ABSTRACT FROM AUTHOR]

The paper by Dhrymes, Friend, and Gultekin (DFG) in this issue criticizes empirical work on the Arbitrage Pricing Theory (APT) conducted by ourselves, (RR), and by a number of others. We are honored that such eminent professors as DFG have taken an interest in our work. Unfortunately, the DFG paper contains analysis which might foster misconceptions in the casual reader. Our purpose here is to present a brief, nontechnical comment. We are confident that those who are inclined to study the DFG paper in detail will be able to discern its merit for themselves. [ABSTRACT FROM AUTHOR]

These are two excellent papers that view the Modigliani-Miller (MM) theorem from different perspectives. The Leland and Pyle (LP) paper considers what occurs when the financial claims of an entrepreneur convey information to the market about the type of project that is being financed. The Grossman and Stiglitz (GS) paper considers the financial decision when the market possesses full information about the returns of firms but where the market incompletely covers or markets claims in all contingencies. These are different approaches towards the same goal of developing a theory of corporate finance. The role of the MM theorem in these studies is analogous to that of Arrow's impossibility theorem in the theory of social choice. In both cases, to obtain an acceptable theory one must weaken the underlying assumptions. [ABSTRACT FROM AUTHOR]

The article comments on two articles published within the issue; "Some Notes on Financial Incentive-Signalling Models, Activity Choice and Risk Preferences," by S. Ross, and "Welfare Aspects of Options and Supershares," by N. Hakansson. The author notes that both Hakansson and Ross are prominent figures in literature which focuses on the power of options to complete financial markets. The author views the basic premise of Hakansson's paper to be the normative desirability of introducing derivative assets which complete the financial market. He feels that Hakannson's work establishes conditions under which the market portfolio can play the powerful role which is assigned in Ross' paper. The author notes that, if the conditions described by the authors were realized, financial markets could be completed by an institution facilitating trades in options written on the market portfolio.

This paper tests whether the "disposition effect," that is the tendency of investors to ride losses and realize gains, induces "underreaction" to news, leading to return predictability. I use data on mutual fund holdings to construct a new measure of reference purchasing prices for individual stocks, and I show that post-announcement price drift is most severe whenever capital gains and the news event have the same sign. The magnitude of the drift depends on the capital gains (losses) experienced by the stock holders on the event date. An event-driven strategy based on this effect yields monthly alphas of over 200 basis points. [ABSTRACT FROM AUTHOR]

In this paper, we document regularities in trading patterns of individual and institutional investors related to the day of the week. We find a relative increase in trading activity by individuals on Mondays. In addition, there is a tendency for individuals to increase the number of sell transactions relative to buy transactions, which might explain at least part of the weekend effect. [ABSTRACT FROM AUTHOR]

This paper develops a consumption-oriented model of asset prices in a multigood economy that is, in principle, testable even when aggregate consumption of goods and their market prices are only partially observable. Previous studies show that, when there are m consumption goods, equilibrium expected excess returns on securities are functions of their covariances with m + 1 variables-aggregate consumption expenditure and market prices of consumption goods. Without making any further assumptions, the present model shows that a similar equilibrium relationship can be expressed in terms of covariances of asset returns with the following m + 1 variables: market prices of k consumption goods and aggregate consumption of m + 1 - k goods. Because the author's result provides researchers with some flexibility in choosing the set of m + 1 variables that measure riskiness of securities, it should lead to more powerful tests of the model. [ABSTRACT FROM AUTHOR]

This paper analyzes an economy in which investors operate under partial information about technology-relevant state variables. It is shown that for Gaussian information structures under incomplete observations, the consumer's problem can be transformed into an equivalent program with a completely observed state: the conditional expectation of the underlying unobservable state variables. A consequence of this transformation is that classic results in finance remain valid under an appropriate reinterpretation of the state variables. [ABSTRACT FROM AUTHOR]

This paper deals with the producer's optimal use of commodity futures in hedging. The framework for analysis is an intertemporal consumption and investment model. The producer makes his production decisions at the beginning of the period and realizes his return at the end of the time interval. During the period, he faces both price and output uncertainties. In applying stochastic dynamic programming methods, this paper shows the effect of these risks on his consumption behavior. Further, the paper investigates his optimal hedging positions in the futures market over time and his optimal production decisions. Finally, implications of these results on the futures markets are discussed. [ABSTRACT FROM AUTHOR]

This paper, utilizing dealer's "trading book" information, presents some empirical evidence supporting the validity of a dealer pricing model. It shows that much of the transaction prices variation may be explained by the specialist's optimal determination of his bid and ask quotes. Furthermore, it demonstrates that the dealer's bid-ask spread is an important explanatory variable in the observed transaction return. Finally, it indicates that the dealer's inventory level may affect his quotes and thus the transaction prices and order arrivals. The paper provides insights into the relationship between transaction prices and equilibrium prices, which will permit more extensive use of transaction data in empirical investigations. It also provides a better understanding of optimal dealer pricing strategies, suggesting that the proposed empirical model may be used to evaluate a dealer's trading performance. [ABSTRACT FROM AUTHOR]

This paper by Kane, Rosenthal and Ljung follows the work of Fama (1975) in examining the adjustment of nominal interest rates to expected inflation. In that piece, Fama presented evidence that was not inconsistent with the joint hypothesis that the real pre-tax rate of interest is constant and nominal interest rates incorporate rational expectations about future inflation. One of the criticisms raised by Nelson and Schwert (1977), among others, about Fama's work has been the low power of his tests. The authors, in this paper, attempt to provide a more powerful test of the Fisher hypothesis using data from six countries, including the U.S. Their main contribution is to shed some light on whether nominal interest rates have fully adjusted to reflect expected inflation for countries other than the U.S. While this provides us with a greater quantity of evidence, the main shortcomings of the paper is that the authors could have provided us with better quality evidence. [ABSTRACT FROM AUTHOR]

Rate of return regulation in principle suggests strong linkages between interest rates, utility return on book equity (ROE), and stock price/book equity ratios: ceteris paribus, changes in interest rates should be quickly transformed into changes in ROEs, and stock prices should tend toward book value. Absent lags in the process, it also suggests that utility investors are minimally exposed to the risks of unanticipated changes in interest rates, notably those associated with inflation. In this paper we examine the financial implications of electric utility regulation from 1971-1980. Over this period, which was characterized by inflation-related rises in interest rates, we find that the gap between allowed and earned ROEs, on the one hand, and interest rates, on the other hand, increased. Since this outcome is in contradiction of the conceptual model of regulation and investors' exposure to inflation risk, we test the hypothesis that investors respond to the reality of regulation by imposing risk premiums which are functionally related to interest rates. The basic idea is that an ROE shortfall leads to an expectation that regulation will respond in the future with a higher earnings level, but this "IOU" in the implicit social contract is risky. And the question addressed in this paper is whether the degree of riskiness is related to the level of interest rates. Using two valuation models we conclude that at least during the 1970s risk premiums were not related to the level of interest rates. [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]

A common statistic for a bond is its market yield or internal rate of return. Numerous articles have been written utilizing the internal rate of return to examine the price volatility of bonds. However, all these studies have two factors in common. One, they are nonstochastic and two, they involve Macaulay's duration. This paper, by introducing uncertainty, derives the general relationship between the expected return on a bond and its market yield. The derivation is for risky corporate as well as for default free government bonds. The relationship is nonlinear and involves an expression which is an approximation to the duration of a bond. As a corollary to the above methodology, an alternate expression for the systematic risk of a bond is discovered. The expression involves only the market yield and the approximation to a bond's duration. This corollary generalizes the previous work of Boquist, Racette, and Schalarbaum in two respects. First, this paper's formulation is for any type of a bond, while Boquist, et al. examined only default free securities. Second, the single period capital asset pricing model (CAPM) is replaced by its intertemporal counterpart as formulated by Merton. An outline for the paper is as follows. Section I derives the relationship between a bond's market yield and expected return. Section II examines the systematic risk of a bond, while Section III concludes the paper. [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 short paper had addressed the question of whether or not the stochastic nature of capitalization rates gives rise to a component of the risk of common stocks that we term systematic capitalization risk and whether corporate growth plays an important role in determining the magnitude of that risk. A second objective of the paper was to determine the most relevant definition of corporate growth for purposes of studying the determinants of systematic risk. Employing Cov[sub t-1](R[sub jt], R[sub mt])/Var[sub t-1](R[sub mt]) from the Sharpe-Lintner security market line as the appropriate measure of systematic risk for a stock we succeeded in deriving the underlying functions for R[sub jt] and R[sub mt] in terms of fundamental corporate characteristics such as the rate of return on investment, the rate of earnings retention, and the rate of stock financing. The result is that the systematic capitalization risk of common stocks is undoubtedly a positive function of the rate of growth of expected total corporate earnings. Moreover, retention policy, per se, appears to be neutral as a causal variable but is probably closely associated with systematic risk through its correlation with the rate of investment. Since the rate of growth of total expected earnings on equity is a positive multiplicative function of the investment rate and the rate of return on that investment it follows that an increase in either or both of these variables tends to increase systematic capitalization risk as well. The extension of capital market theory to include the notion that systematic risk is a positive function of total earnings growth promises to have profound implications for almost every type of economic decision. For example, Hamada, Myers, and others have shown with the use of stationary earnings distributions that the cost of capital for an investment project is a function of the covariance of return on the project with the return on the market portfolio. However, if we m... [ABSTRACT FROM AUTHOR]

The article presents a response to the paper "Credit Granting: A Comparative Analysis of Classification Procedures," by Venkat Srinivasan and Yong H. Kim. The author states that the original article describes an elaborate, confusing and imprecise formulation of the credit granting problem. The lack of a precise definition of what will be assumed about the audience's understanding of both the credit granting problem and the statistical techniques being evaluated is one of the author's issues with the tutorial paper, among others.

This paper by Jack Treynor and Robert Ferguson (TF) is an attempt to demonstrate the usefulness of knowing past price information in making investment decisions. The normative contribution of the paper is the development of a Bayesian probability estimate to assess using past price data whether or not the market has already incorporated some firm-specific information, which has been made available to the investor. The obvious implication is that if the market has not discovered the information, and this can be confirmed with past price data, then the holder of private information can act accordingly. [ABSTRACT FROM AUTHOR]

Aharom Ofer's interesting paper presents a method for identifying the growth expectations of investors and then examines the correlation of the constructed expectational variables with the future growth realizations of the firms and with the realized rates of returns on their stocks. I believe the paper contains some errors in specification and technique, and I have methodological difficulties concurring with the conclusions of the paper. Nevertheless, I want to state at the outset that Ofer has attacked an important and relatively neglected problem in finance, and his method of measuring illusive investor expectations is an imaginative one, which may well prove serviceable in the future. [ABSTRACT FROM AUTHOR]

The article presents discussion regarding the 1982 paper "Do We Really Know Financial Markets are Efficient," by Lawrence H. Summers. The author states that Summers' largest contribution with his paper is the observation that the negative correlation between pricing error and variance of returns can be too small to detect using common techniques. The article states that Summers' paper does not suggest new statistical tests, but does call attention to the deficiencies of past tests. The article supplies a mathematical model of a comparison of values for a monthly versus daily returns which implies that the negative autocorrelation of returns approaches zero as the length of the return interval grows.

This paper evaluates various explanations for the profitability of momentum strategies documented in Jegadeesh and Titman (1993). The evidence indicates that momentum profits have continued in the 1990s, suggesting that the original results were not a product of data snooping bias. The paper also examines the predictions of recent behavioral models that propose that momentum profits are due to delayed overreactions that are eventually reversed. Our evidence provides support for the behavioral models, but this support should be tempered with caution. [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.

Myron J. Gordon's paper has an ambitious purpose. It attempts to explain the effects of inflation and real factors on the performance of the U.S. stock market, over the years 1960 to 1980. In doing this, it addresses the empirical finding of the absence of a positive short-run correlation between inflation and a share's holding period rate of return in the U.S. There is no widely accepted explanation for the negative correlation observed between stock market values and inflation (anticipated and unanticipated). However, plausible explanations, some of them competing and some complementary, have been offered. Gordon's paper attempts to evaluate several of the more important of these. That he does not successfully resolve the controversies raised does not mean that he has not furthered the debate. [ABSTRACT FROM AUTHOR]

The paper by professors John and Saunders addresses a fundamental dilemma inherent in the conventional system of public utility regulation. The primary objective of public utility regulation is to limit the revenue of the regulated firm to a sum that will cover prudent operating expenses and interest on debt plus a fair return to equity. The dilemma arises because pursuit of the objective of limiting the firm's profit to the amount that would be earned in competitive markets substantially lessens incentives to reduce cost that are present in competitive markets. Conventional regulation relies primarily on two techniques to address this dilemma. The first is the prudent investment doctrine which allows regulators to disallow unreasonable expenses incurred by managers of jurisdictional firms. This doctrine is only an ultimate deterrent for extreme cases. It creates the danger of regulatory "Monday morning quarterbacking." At best it is a negative force; it does not provide a positive incentive. The other conventional regulatory inducement to cost reduction is the filed-rate doctrine, or as it is more often called by economists, regulatory lag. Public utilities are permitted to charge only filed rates and these are only adjusted periodically and prospectively. Utility rates are fixed for some period of time and are not true cost-plus prices. During the period the fixed rates are in effect, any realized cost efficiencies benefit the firm. However, efficiencies are likely to be reflected in the rates set whenever new rates are filed and approved by regulators. Thus, we must seek new and positive regulatory incentives for efficiency. To this end the paper before us proposes more use of incentive contracting between utilities and their suppliers. [ABSTRACT FROM AUTHOR]

Replies to comments on the authors'paper which attempts to modify the valuation model for the case of depreciable assets published in the June 1973 issue of 'The Journal of Finance.' Misspecification on cash flows available for distribution; Relationship between discount rates and the probability distribution of returns; Separation of the cash flow stream into certain and uncertain components. [ABSTRACT FROM AUTHOR]

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 analyzes the behavior of stock prices around ex-dividend days after the implementation of the 1986 Tax Reform Act that dramatically reduced the difference between the tax treatment of realized long-term capital gains and dividend income in 1987 and completely eliminated the differential in 1988. We shows that this tax change had no effect on the ex-dividend stock price behaviour, which is consistent with the hypothesis that long-term individual investors have no significant effect on ex-day stock prices during this time period. The results indicate that the activity of short-term traders and corporate traders dominates the price determination on the ex-day. [ABSTRACT FROM AUTHOR]

This work examines the relation between option prices and the true, as opposed to risk-neutral, distribution of the underlying asset. If the underlying asset follows a diffusion with an instantaneous expected return at least as large as the instantaneous risk-free rate, observed option prices can be used to place bounds on the moments of the true distribution. An illustration of the paper's results is provided by the analysis of the information concerning the mean and standard deviation of market returns contained in the prices of S&P 100 index Options. [ABSTRACT FROM AUTHOR]

Empirical evidence of time varying term premia in bond returns is frequently interpreted as evidence against the Expectations Hypothesis. This paper shows that the Expectations Hypothesis can actually imply time varying term premia if the time frame for which the Expectations Hypothesis holds differs from the return measurement period. Furthermore, many of the properties of these term premia are consistent with those of observed term premia. These results are important because they imply that the case against the Expectations Hypothesis is weaker than claimed in the empirical literature. [ABSTRACT FROM AUTHOR]

This paper examined the returns earned by subscribing to initial public offerings of equity (IPOs). Rock (1986) suggests that IPO returns are required by uninformed investors as compensation for the risk of trading against superior information. We show that IPOs with more informed investor capital require higher returns. The marketing underwriter's reputation reveals the expected level of "informed" activity. Prestigious underwriters are associated with lower risk offerings. With less risk there is less incentive to acquire information and fewer informed investors. Consequently, prestigious underwriters are associated with IPOs that have lower returns. [ABSTRACT FROM AUTHOR]

This paper examines the variance of hourly market returns during 1964-1989. Results indicate that return volatility falls from the opening hour until early afternoon and rises thereafter and is significantly greater for intraday versus overnight periods. Market variance is also shown to change significantly over time, rising after NASDAQ began in 1971, rising after trading in stock options began in 1973, falling after fixed commissions were eliminated in 1975, rising after trading in stock index futures was introduced in 1982, and falling after margin requirements for stock index futures became larger in 1988. [ABSTRACT FROM AUTHOR]

In this paper, we investigate the effects of relative price variability on output and the stock market and gauge the extent to which inflation proxies for relative price variability in stock return-inflation regressions. The evidence shows that the negative stock return-inflation relations proxy for the adverse effects of relative price variability on economic activity, particularly during the seventies, when the U.S. experienced oil supply shocks. Hence, it appears that inflation spuriously affects the stock market in two ways: the aggregate output link of Fama (1981) and the supply shocks reflected in relative price variability. [ABSTRACT FROM AUTHOR]

This paper analyzes asset pricing in a partially segmented market where citizens of a small country are allowed to hold only their domestic securities, whereas the rest of the investors (“foreigners”) are essentially allowed to hold all securities. In this market setting it may occur that the citizens of the small country are willing to pay less for their domestic securities than are the foreign investors. The paper derives equilibrium required rates of return for different investors in this market setting which perfectly occurred in Finland and tests this equilibrium model using data from the Finnish stock market. Empirical results are consistent with the hypotheses derived from the model. [ABSTRACT FROM AUTHOR]

The average returns on low-capitalization stocks are unusually high relative to those on large-capitalization stocks in early January, a phenomenon known as the turn-of-the-year effect. This paper finds that the ratio of stock purchases to sales by individual investors displays a seasonal pattern, with individuals having a below-normal buy/sell ratio in late December and an above-normal ratio in early January. Year-to-year variation in the early January buy/sell ratio explains forty-six percent of the year-to-year variation in the turn-of-the-year effect during 1971-1985. [ABSTRACT FROM AUTHOR]

In this paper, we develop a model for valuing debt options that takes into account the changing characteristics of the underlying bond by assuming that the standard deviation of return is proportional to the bond's duration. The resulting model uses the bond price as the single state variable and thus preserves much of the simplicity and robustness of the Black-Scholes approach. The paper provides comparisons between option prices computed using this model and those using the Black-Scholes and Brennan and Schwartz models. [ABSTRACT FROM AUTHOR]

The Arbitrage Pricing Theory (APT) has been proposed as an alternative to the mean-variance Capital Asset Pricing Model (CAPM). This paper considers the testability of the APT and points out the irrelevance for testing of the approximation error. We refute Shanken's objections, including his assertion that Roll's critique of the CAPM is applicable to the APT. We also explain the testability of the APT on subsets, and we explore the relationship between the APT and the CAPM. [ABSTRACT FROM AUTHOR]

This paper explores the relations between the prices of capital assets and the specifications of the underlying technologies of the economy. Professor Huffman deduces the equilibrium price of capital for several economies, and then examines how the behavior of this price and investments in capital are affected by the presence of installation costs. These comparisons across alternative technologies are interesting and will be discussed in more detail subsequently. First, I shall comment briefly on the motivation for this analysis, and discuss the structure of Huffman's model and its relation to several asset pricing models that have been studied previously in the literature. [ABSTRACT FROM AUTHOR]

Recent work demonstrates serious statistical problems with standard volatility tests. This paper proposes new tests that are unbiased in small samples and that do not require assumptions of stationarity. The new tests continue to find evidence against the model positing rational expectations and a constant required rate of return on equity. [ABSTRACT FROM AUTHOR]

This paper values options on assets whose returns, over a finite interval of time, are generated by a binomial process. It shows that a simple valuation relationship, between the option and the underlying stock, obtains if investors have preference functions that belong to a particular class, even if opportunities to hedge do not exist. One particular application of the theory is in the case where the stock price over a finite interval could increase by an amount, fall by the same amount, or stay at the same level. The results in this paper may be viewed as the foundation of the preference-based approaches to obtaining a risk neutral valuation relationship. [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]

The greater availability of daily data in the U.S. has led to a number of studies of the seasonality of daily stock (index) returns. While the studies recognized the potential impacts of nontrading and price-adjustment delays in general, no formal analyses of such impacts were presented; in this paper analytic results are presented for the articulation between these phenomena. The implications of the analysis are discussed and shown to be consistent with a sample of U.K. index data. A modified form of the negative weekend effect is found to be present in the U.K. data analyzed. [ABSTRACT FROM AUTHOR]

A number of investigators have reported that January stock returns in the U.S. exceed returns for other months of the year. This paper documents a similar finding for Canadian stocks over the period 1951-1980. However, Canada did not introduce a capital gains tax until 1973 and the paper reports that January returns in Canada exceed returns for other months of the year before and after this date. Thus, these data do not support the tax-loss-selling-pressure hypothesis as the entire explanation for the turn-of-the-year effect in stock returns, nor, by implication, do they support the tax-loss-selling-pressure hypothesis as the complete explanation for the "small firm" effect in U.S. stocks returns. [ABSTRACT FROM AUTHOR]

An observer of quantitative practices in the financial community of 1980 discovers that what is called “Modern Portfolio Theory” or MPT consists of two classes of models which appear to have little to do with each other although they are applied to the same market price behavior. The two classes of models are long range present value models, which are exemplified by dividend discount models of equity prices and yield to maturity pricing of bonds, and short run models of the behavior of total return which are provided by the various versions of Capital Asset Pricing Theory (CAPT). The former models contain only an ad hoc treatment of risk if it is treated at all, and the latter ones without exception model risk as short run total return volatility. CAPT models use a short time horizon, usually thought of as 30 to 90 days, with the price formation at the horizon implicit and undefined. The present value models of the equities markets have an infinite time horizon. After 90 days, the long term holder has received only 1-2% of the present value. Hence, where the horizon of the one leaves off virtually none of the value measure of the other has been achieved. Clearly, investors have radically varying investment horizons. With few exceptions, there exists no theoretical explanation of how these views can be in equilibrium with each other. This paper makes a beginning at the construction of a unified framework for discussing both points of view in a logically consistent manner. [ABSTRACT FROM AUTHOR]