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This paper compares the impact of shocks to U.S. interest rates and emerging market bond spreads on domestic interest rates and exchange rates across several emerging market economies with different exchange rate regimes. Consistent with conventional priors, the results indicate that interest rates in Hong Kong react much more to U.S. interest rate shocks and shocks to international risk premia than interest rates in Singapore. The results are less clearcut in the comparison of Argentina and Mexico: While interest rates (and the exchange rate) in Mexico seem to react less to U.S. interest rate shocks, they react about the same to bond spread shocks, in addition to a significant impact on the exchange rate.

At the time of writing there were widespread concerns about the health of the U.S. economy. There is conclusive evidence that the pace of growth has slowed, which has prompted the Federal Reserve to cut interest rates on two occasions (a total of 100 basis points thus far). As usual, when faced with this kind of turning point, analysts and policy makers alike wonder whether the United States will achieve a "soft landing" or whether the downturn is more serious and protracted in the worst scenario, the new weakness could signal the end of the new economy. Furthermore, recent inflation surprises have not been encouraging, as higher-than expected inflation numbers may curtail the Federal Reserve's desire and ability to act counter cyclically.

We document strong persistence in the performance of trades of individual investors. The correlation of the risk-adjusted performance of an individual across sample periods is about 10 percent. Investors classified in the top performance decile in the first half of our sample subsequently outperform those in the bottom decile by about 8 percent per year. Strategies long in firms purchased by previously successful investors and short in firms purchased by previously unsuccessful investors earn abnormal returns of 5 basis points per day. These returns are not confined to small stocks nor to stocks in which the investors are likely to have inside information. Our results suggest that skillful individual investors exploit market inefficiencies to earn abnormal profits, above and beyond any profits available from well-known strategies based upon size, value, or momentum. The paper is available at https://ssrn.com/abstract=364000.

This paper studies the impact effect of monetary policy shocks—identified by the reaction of three month market interest rates to policy announcements—on the exchange rate in Australia, Canada, and New Zealand during the 1990s. The main results are that (1) on average, a 100 basis point contractionary shock will appreciate the exchange rate by 2-3 percent on impact; (ii) seemingly “perverse” reactions of the exchange rate to monetary policy are mainly attributable to reverse causality; (iii) in a few instances, there were true “perverse” reactions of exchange rates to policy— generally, appreciations following expansionary shocks.

In this paper we empirically analyze the impact of transaction costs on the performance of affine interest rate models. We test the implied (no arbitrage) Euler restrictions, and we calculate the specification error bound of Hansen and Jagannathan to measure the extent to which a model is misspecified. Using data on T-bill and bond returns we find, under the assumption of frictionless markets, strong evidence of misspecification of one- and two-factor affine interest rate models. This is in line with earlier research. However, we show that the pricing errors of these models are reduced considerably, if relatively small transaction costs are taken into account. The average transaction costs for T-bills, due to the bid-ask spread, are around 1.5 basis points. At this size of transaction costs and for monthly holding periods, the misspecification of one- and two-factor affine interest rate models becomes statistically insignificant and economically very small. For quarterly holding periods, higher transaction costs of around 3 basis points are required to avoid misspecification.

I analyze the impact of competition on the risk premia of R&D ventures engaged in a multiple-stage patent race with technical and market uncertainty. After solving in closed-form for the case of a two-stage race in continuous-time, I show that a firm's risk premium decreases as a consequence of technical progress and increases when a rival pulls ahead in the race. Compared to the case where firms collude, R&D competition (i) erodes the option value to mothball a project (ii) reduces the completion time and the failure rate of R&D and (iii) causes higher and more volatile in risk premia. Numerical simulations reveal that competition can generate risk premia up to 500 annual basis point higher and up to three times more volatile than in a collusive industry.

This paper offers a comprehensive study of survivorship issues, in the context of mutual fund research, using the mutual fund data set of Carhart (1997). We find that funds in our sample disappear primarily because of multi-year poor performance. Then we demonstrate analytically that this survival rule typically causes the survivor bias in average performance to increase in the length of the sample period, though it is possible to construct counterexamples. In the data, we find a strong positive relation between the survivor bias in average performance and sample period length. The bias is economically small at 17 basis points per annum for one-year samples, but a significantly larger one percent per annum for samples longer than fifteen years. We also find evidence of performance persistence in our sample and, consistent with the presence of a multi-period survival rule, we find that the persistence is weakened by survivorship bias. Finally, we explain how the relation between performance and fund characteristics can be affected by the use of a survivor-only sample and show that the magnitudes of the biases in the slope coefficients are large for fund size, expenses, turnover and load fees in our sample. Because survivorship issues are relevant for many data sets used in finance, the analysis in this paper has potential applications in areas of financial economics beyond just mutual fund research.

The financial press makes frequent and bold claims regarding the performance of investment clubs. One oft quoted figure from a National Association of Investment Club survey states that 60 percent of investment clubs beat the market. Are these claims myth or reality? We analyze the common stock investment performance of 166 investment clubs using account data from a large discount broker from February 1991 to January 1997. We document that the average club earned an annualized geometric mean return of 14.1 percent, while a market index returned 17.9 percent. In addition, 60 percent of the clubs we analyze underperform the index. Not only did the average club fail to beat the market, it failed to match the performance of the average individual investor, who earned 16.4 percent during our sample period. There are two reasons for the poor performance of investment clubs relative to individuals during our sample period -- trading costs and investment style. Despite having roughly similar account sizes, clubs execute smaller trades and hold more stocks than do individuals. Thus their proportionate cost of trading is higher. These higher proportionate trading costs account for approximately one-third of the clubs? performance shortfall relative to individuals. The remaining two-thirds of the shortfall are accounted for by investment style. Relative to individuals, clubs tilt more toward large stocks and growth stocks. During our sample period, large stocks underperformed small stocks (by 15 basis points per month) and growth stocks underperformed value stocks (by 20 basis points per month). Investment clubs serve many useful functions: They encourage savings. They educate their members about financial matters. They foster friendships and social ties. They entertain. Unfortunately, their investments do not beat the market.

In this paper we examine the ex-ante importance of accounting changes in debt contracts by examining how the exclusion of the flexibility to make voluntary and mandatory accounting changes from the calculation of covenant compliance affects the interest rate charged on the loan. After controlling for a selectivity correction and other factors known to affect loan spreads, we find that the interest rate charged on a loan is 40 basis points lower when mandatory accounting changes are excluded and is 104 basis points lower when voluntary accounting changes are excluded. Our results support findings in previous studies that accounting changes are important in debt contracts ex-post for borrowers who violate their accounting based covenants.

We compare the price impact of trades across market structures by examining firms that switch exchanges. When firms are listed on Nasdaq, quoted prices adjust quite slowly to the information contained in order flow. On average, it takes about 5 minutes (or about 6 transactions) for half of the eventual price impact to be incorporated into quotes. In contrast, quotes in NYSE and AMEX firms adjust much more quickly, with half-lives around one transaction. This has important implications for measures of adverse selection or information content. Price impacts are likely to be severely downward biased (particularly on Nasdaq) if they are estimated using only the immediate quote response. For example, using immediate price impacts (e.g., the change in quotes prior to the next trade), Nasdaq price impacts are far smaller than NYSE price impacts (1 vs. 9 basis points). Using cumulative price impacts four hours later, the conclusions are different: price impacts average about 20 bps on both exchanges. In terms of methodology, quote adjustment is too slow to be explained solely by the Madhavan, Richardson, and Roomans (1997) model. For this reason, we model midpoint adjustment using both a VAR and a partial adjustment model. We also discuss possible explanations for this phenomenon.

This paper is a statistical analysis of the manner in which the Federal Reserve determines the level of the Federal funds rate target, one of the most publicized and anticipated economic indicators in the financial world. The analysis presents two econometric challenges: (1) changes in the target are irregularly spaced in time; (2) the target is changed in discrete increments of 25 basis points. The contributions of this paper are: (1) to give a detailed account of the changing role of the target in the conduct of monetary policy; (2) to develop new econometric tools for analyzing time-series duration data; (3) to analyze empirically the determinants of the target. The paper introduces a new class of models termed autoregressive conditional hazard processes, which allow one to produce dynamic forecasts of the probability of a target change. Conditional on a target change, an ordered probit model produces predictions on the magnitude by which the Fed will raise or lower the Federal funds rate. By decomposing Federal funds rate innovations into target changes and nonchanges, we arrive at new estimates of the effects of a monetary policy "shock."

This paper estimates the profits to insiders when they trade their company's stock. We construct a rolling purchase portfolio' that holds all shares purchased by insiders over the previous year and an analogous sale portfolio' that holds all shares sold by insiders over the previous year. We then analyze the returns to these value-weighted portfolios using performance-evaluation methods. This approach allows us to study the returns to insider transactions beginning on the day after their execution, and is free of the statistical difficulties that plague event studies on long-horizon returns. Using a comprehensive sample of reported insider transactions from 1975 - 1996, we find that the purchase portfolio earns abnormal returns of about 40 basis points per month, with about one-sixth of these abnormal returns accruing within the first five days after the initial transaction, and one-third within the first month. The sale portfolio does not earn abnormal returns. Our portfolio-based approach also allows for straightforward decompositions of the purchase and sale portfolios by various characteristics. We find that the abnormal returns to insider trades in small firms are not significantly different from those in large firms, and that top executives do not earn higher abnormal returns than do other insiders.

P ension fund sponsors are well aware it is their job to diversify their portfolios among asset classes. They can improve returns and reduce risks by investing in asset classes that have high expected returns, low volatility, and low correlations with other asset classes. How can it be then that the major pension funds have overlooked roulette chips as an ideal asset class? I show here that over the past ten years a scientifically managed roulette program would have yielded a return better than the S&P 500 with negligible correlation with equity market returns. A portfolio with 10% of funds invested in a roulette asset class could have improved returns by over 160 basis points with no increase in risk.

In this paper we estimate one and two factor models of the term structure of interest rates using Australian and Canadian panel data from the yield curve. We use Kalman filtering econometrics to estimate the parameters of the model and our empirical results indicate that the two factor model provides a good description of the Australian and Canadian money market yield curves.

In this paper we document that an investment strategy based on the consensus (average) analyst recommendations of security analysts earns positive returns. For the period 1986-1996, a portfolio of stocks most highly recommended by analysts earned an annualized geometric mean return of 18.8 percent, while a portfolio of stocks least favorably recommended earned only 5.78 percent. (In comparison, an investment in a value-weighted market index earned an annualized geometric mean return of 14.5 percent.) Alternatively stated, purchasing stocks most highly recommended yielded a return of 102 basis points per month. The magnitude of this return is surprisingly large, and is far greater than the size effect (negative 16 basis points) and book-to-market effect (17 basis points) for the same period. Even after controlling for these two effects, as well as for price momentum, we show that the strategy of purchasing stocks most highly recommended and selling short those least favorably recommended yielded a return of 75 basis points per month. These results are robust to partitions by time period and overall market direction, and are most pronounced for small and medium-sized firms. The abnormal returns also persist when we allow a lapse of up to 15 days before acting on the investment recommendations. There is no extant theory of asset pricing that explains these results.

The provision of intraday credit to an RTGS system can also take the form of secured overdraft facilities. This is a way to increase the possibility for the participating banks to get intraday liquidity by allowing them to overdraw their account at the central bank against collateral without countervailing the recommendation (rules) contained in the statute of the European System of Central Banks (ESCB).1 This approach to overdraft facilities seems to stem from the assumption that collateralisation has beneficial effects particularly in terms of risk reduction, despite the ample literature about the shortcomings of collateralisation as a means of securing risks in financial markets in presence of asymmetric information [Jaffee and Modigliani (1969); Azzi and Cox (1976); Bester (1985); Stiglitz and Weiss (1981, 1986)]. In the Appendix to this chapter, it is shown how collateral requirements might affect banks’ attitude towards risks and, hence, their probability of default.

We propose a cross-sectional time-series model to assess the impact of market lib- eralizations in emerging equity markets on the cost of capital, volatility, beta, and correlation with world market returns. Liberalizations are defined by regulatory changes, the introduction of depositary receipts and country funds, and structural breaks in equity capital flows to the emerging markets. We control for other eco- nomic events that might confound the impact of foreign speculators on local equity markets. Across a range of specifications, the cost of capital always decreases after a capital market liberalization with the effect varying between 5 and 75 basis points. THROUGHOUT HISTORY AND IN MANY MARKET ECONOMIES, the speculator has been characterized as both a villain and a savior. Indeed, the reputation of the speculator generally depends on the country where he does business. In well- functioning advanced capital markets, such as the United States, the specu- lator is viewed as an integral part of the free-market system. In developing capital markets, the speculator, and in particular the international specula- tor, is looked upon with many reservations. Recently, many so-called "emerging" markets have opened up their capital markets to foreign investors, creating an ideal laboratory for examining the impact of increased foreign portfolio investment in developing equity mar- kets. Our main focus is the impact on expected equity returns-the cost of equity capital. However, we also examine the effects of increased foreign

This paper presents new evidence on the effect of state fiscal institutions, particularly balanced-budget rules and restrictions on state debt issuance, on the yields on state general obligation bonds. We analyze information from the Chubb Relative Value Survey, which contains relative tax-exempt yields on the bonds issued by different states over the period 1973-1996. We find that states with tighter anti-deficit rules, and more restrictive provisions on the authority of state legislatures to issue debt, pay lower interest rates on their bonds. The interest rate differential between a state with a very strict anti-deficit fiscal constitution, and one with a lax constitution, is between fifteen and twenty basis points. States with binding revenue limits tend to face higher borrowing rates by approximately the same amount, while states with expenditure limits face lower borrowing costs. Thus fiscal restraints that control expenditures are viewed favorably by bond market participants, while those that restrict taxes, and therefore might interfere with the state's ability to repay interest, result in higher borrowing costs. The effect of strict fiscal institutions is particularly evident when a state's economy is weak. These results provide important evidence that bond market participants consider fiscal institutions in assessing the risk characteristics of tax-exempt bonds, and further support the view that fiscal institutions have real effects on fiscal policy outcomes.

The international capital market is the marginal provider of capital to the Canadian economy, and the current account balance is the measure of demand pressure from Canadian borrowing in that market. If the foreign supply of capital to Canada is less than perfectly elastic, Canadian interest rates will have to rise as Canadian borrowing increases. Past attempts to test empirically for the effect of Canadian fiscal policy on interest rates have generally been unsuccessful, because the link between fiscal policy and the current account balance is indirect and influenced by other factors such as monetary policy. In equilibrium, there is likely to be a strong correlation between fiscal balances and the current account balance. Econometric analysis is complicated by the fact that the current account balance and the Canada- U.S. interest differential are non-stationary variables, which may render OLS estimates unreliable. These variables were found to be cointegrated, and vector error correction was used to estimate the relationship, which produced estimates quite similar to those coming from OLS regressions. Over the past two decades, it appears that the Canadian three month T-bill rate increased by at least 50 basis points for each percentage point increase in the current account deficit as a percentage of GDP. There is no guarantee that an impact of this magnitude will hold in the future, but it is a strong indication that lower foreign borrowing by Canada should result in considerably lower real interest rates than those experienced in the past.

This paper examines the response of exchange rates and interest rates--U.S. and foreign--to economic news. The news is associated with the surprise component of the monthly release of six U.S. macroeconomic variables. The results suggest that dollar exchange rates systematically react to news about real economic activity--a surprise of 100,000 on nonfarm payroll employment leads to a 0.2 percent appreciation of the exchange rate. In general, exchange rates do not react systematically to news on inflation. By contrast, U.S. interest rates respond to both types of news, although the response continues to be extremely small, on the order of 1 to 2 basis points. Finally, Japanese interest rates systematically react, but to a very minor extent, to news about U.S. real economic activity, while German rates in general do not.

The standard method for constructing high-minus-low (HML) portfolios is flawed. That’s because the pricing data used to calculate valuation ratios for these long value/short growth stock portfolios is 6 to 18 months old. By using lagged data, quantitative portfolio managers combining value and momentum strategies could be sacrificing up to 300 to 400 of basis points of alpha every year. The beauty of the research findings in The Devil in HML’s Details lies in their simplicity. Managers don’t have to renounce the common calculation methodology for constructing HML portfolios. They simply need to tweak it. In this Practical Applications report and the accompanying video, Cliff Asness, Founding and Managing Principal at AQR Capital Management, outlines the tweak. The article appeared in the Summer 2013 issue of The Journal of Portfolio Management and was co-written by Andrea Frazzini, a Vice President at AQR.

The first government-sponsored enterprise (GSE) risk-sharing transaction, Freddie Mac’s STACR (Structured Agency Credit Risk) 2013-DN, in which private investors bear some of the credit risk, priced on July 23, 2013. These transactions were a cornerstone of the FHFA’s strategic plan. The thought was these transactions could be used not only to transfer risk but also to validate guarantee fee pricing. In this article, the authors first describe the transaction structure and collateral. They argue that with good quality collateral the default and losses will be low, at 66 basis points of default and about 10 basis points of loss in the Amherst base case. The authors then examine the risk–return on the securities themselves, arguing that the M-1 tranche is unlikely to ever take a loss. The M-2 tranche is more “cuspy” but has value at initial pricing levels. Finally, they investigate whether this transaction has been an effective risk transfer for Freddie Mac. The authors’ view is that it is generally very effective but provides insufficient protection in high-prepayment/high-default environments.

The German Bund futures contract is the most important bond futures contract in Europe. It is also unusual in that it trades on competing Exchanges - LIFFE in London and the DTB in Frankfurt. This paper looks at a surprising aspect of this dually traded contract, namely that the contract trades slightly more expensively (1.5 basis points) in LIFFE than in the DTB. LIFFE argue that this price difference helps make their contract more attractive. The paper investigates three possible explanations for the price difference. First, the calculation of price factors (conversion factors that make bonds in the basket of deliverables more comparable) differs slightly between Exchanges. Second, the DTB contract carries on trading for one day longer than the LIFFE one giving the short one more days to choose which bund in the basket to deliver (the so-called quality option) and so makes the contract slightly less valuable to the trader with a long position. Third, the penalty for late delivery is harsher on LIFFE than on the DTB and so investors fearing a short squeeze (where investors that are supposed to deliver the underlying bunds cannot acquire them) will be more nervous of holding a LIFFE contract than a DTB one. It concludes that none of these factors are important enough to explain the observed price difference and so it is hard to explain why the price difference occurs.

Evans (1991) has demonstrated that Blanchard's (1985) finite-horizon model obeys approximate Ricardian equivalence. This paper shows that this result is determined largely by an unrealistic assumption that labor income grows monotonically over the consumer's entire lifetime. With more realistic lifetime earnings profiles, the effects of government debt on the real interest rate and the capital stock are considerably larger. In particular, leaving aside the effects of distortionary capital taxation, the extended model with liquidity constraints predicts that real interest rates would decline by about 150-200 basis points if government debt were eliminated completely in all countries of the Organization for Economic Cooperation and Development (OECD).

This paper considers how monetary policy, a Federal funds rate shock, affects the dynamics of the US housing sector and whether the financial market liberalization of the early 1980s influenced those dynamics. The analysis uses impulse response functions obtained from a large-scale Bayesian vector autoregressive model at the national and four census regions. Overall, a 100 basis point Federal funds rate shock produces larger effects on real house prices, both at the regional level and the national level, in the post-liberalization period when compared to the pre-liberalization era. While the precision of the estimates do not imply significant differences, the finding does offer a caution. That is, the housing market appears more sensitive to monetary policy shocks in the post-liberalization period. Thus, the monetary authorities may need to exercise more care in implementing Federal funds rate adjustments going forward. Finally, we find that the reaction of housing sector proves heterogeneous across regions.

Since the fortunes of different nations do not always move together, investors can diversify their portfolios by holding assets in several countries. The benefits of international diversification have been recognized for decades. In spite of this, most investors hold nearly all of their wealth in domestic assets. In this paper we use a simple model of investor preferences and behavior to show that current portfolio patterns imply that investors in each nation expect returns in their domestic equity market to be several hundred basis points higher than returns in other markets. The lack of diversification appears to be result of investor choices, rather than institutional constraints.

This paper examines the Argentine experience with GDP-indexed warrants in order to gauge the existence of a novelty premium on new financial instruments. It develops a Monte Carlo pricing exercise to calculate the expected net present value of payments, on the basis of various forecast assumptions. The results show that the residual premium paid by these warrants over standard bonds declined significantly by about 600 basis points between December 2005 and July 2007. This suggests that financial innovation may be associated with premia, which decay reasonably fast.

The effects of the IMF's data standards initiatives on sovereign borrowing costs in private capital markets are investigated for 26 emerging market and developing countries. Stable and significant panel econometric estimates indicate that subscription to the Special Data Dissemination Standard (SDDS) reduces launch spreads by an average of 20 percent while participation in the General Data Dissemination System (GDDS) reduces spreads for those countries with access to capital markets by an average of 8 percent. These estimates correspond to discounts of some 50 and 20 basis points, respectively. Evidence of similar discounts is also found when launch yields are analyzed.

We compute realized transfers implicit in IMF lending from 1973-2003, based on 2003 IMF repayment projections and promised debt relief. IMF lending rates to high-and middleincome countries fell short of industrial country borrowing rates by 30-150 basis points over the period as a whole, but exhibited a small premium after 1987. The subsidy received by low-income and HIPC countries was much higher (400-600 basis points, respectively). In 2002 NPV terms, cumulative transfers were 12-15 percent of 2002 GDP for the HIPCs, 2-3 percent for low income countries, and less than ¾ percent for the emerging market countries.

Both the Singapore Exchange (SGX) and the Taiwan Futures Exchange (TAIFEX) offer future contracts based on Taiwan's stock-market indices. TAIFEX reduced the transaction tax from 5 basis points to 2.5 basis points on May 1, 2000. Hence, empirical tests are performed on the differences in trading costs and information transmissions between SGX and TAIFEX for the sample periods both before and after the tax reduction. It is shown that the reduction in the transaction tax greatly improves the efficiencies of price execution. Due to the structural differences between these two markets, the trading costs and speed of information transmissions also are different. The results also provide implications for the relative efficiencies of different market structures. © 2002 John Wiley & Sons, Inc. Jrl Fut Mark 22:173–196, 2002

I WOULD LIKE TO START by congratulating the organizers of this conference for having been very successfully forward looking. Zero interest rates have become a reality if in a small part of the world. I regret that I have not been forward looking enough. By first accepting the invitation to attend this conference and then having driven the rate down to zero, I have put myself in a very difficult position. Anyway, let me start by spending a few moments discussing what we have been doing since last year. When I joined the board in April 1998 the overnight call rate was already slightly below 50 basis points, not a good time to join a central bank. Since then we have cut it down successively to zero, more precisely 1 basis point for lenders and 2 basis points or above for borrowers. The overnight rate came down to these minimum levels toward the end of March 1999. This was already a very extreme monetary policy stance. But we achieved this by using a traditional tool, that is, the overnight rate. I must say that we needed a lot of courage to go to the zero rate. In April 1999, we went further in a fairly nontraditional way. That is, our governor announced that we would stick to the zero rate policy until deflationary concerns are over. This commitment, we think, delivers something very close to what inflation targeting or quantity targeting might offer, to the extent that you believe that monetary policy works through interest rates. Or, we could say that this has been like our writing a put option on short-term assets. Yet another way of explaining our position could be the following: by the commitment to maintain the zero rate for quite some time to come we have tried to minimize uncertainties about future short rates, thereby decreasing the option value of long-term bonds, hence putting negative pressure on long-term interest rates. With this announcement market interest rates came down sharply again. As of early October, three-month and one-year Treasury bills were trading at 4.5 and 3.5 basis points, respectively. Do we need any further action? Obviously, it depends on where you think the economy is. After growing at negative rates for five consecutive quarters, real GDP grew at surprisingly high rates in the first two quarters of this year. We were worried that this turnaround could be short-lived because the stimulus from fiscal policy was expected to peter out later this year. However, the news we have been getting for the

Using alternative methods, the authors find less support than previous authors for significant interest rate responses to deficit announcements. The main results are that interest rates respond only 40 percent of the time to deficit announcements and when they do respond the impact is only temporary, lasting between one to six days and involving a 0.25 basis point response per percentage change in the deficit. Copyright 1994 by Ohio State University Press.

This paper contains a theoretical development of the relationship of CD premiums to both the risks of the CD issuer and the third party government guarantor of those deposits. The theoretical development shows that the risk of the guarantor derives from the possibility that the guarantee could be repudiated and/or the restitution of the depositor's claim could be costly. The empirical analysis of the premiums for insured CDs indicates that during the years preceding the ultimate collapse of the FSLIC, the market priced the risk of both the guarantor as well as the firm. The guarantor risk pricing was responsive to the insolvency of the guarantor, the attempts to recapitalize the guarantor and the efforts to resolve the insolvent thrifts. During this eventful time period CD premiums rose to 187 basis points and averaged 79 and 54 basis points. Copyright 1994 by Ohio State University Press.

For the period 1976-87 forward rates on U.S. T-bills averaged more than 30 basis points above the comparable futures market rates. Since risk is common to both rates, I argue that this difference can be explained by the substitutability of different maturity T-bills for money. Consistent with this hypothesis, I find that this difference depends positively on interest rates and the spread between the Federal Funds and 3 month T-bill rates, and negatively on the ratio of short term governments to broadly defined money. Also, significant shifts occurred in the relationship in October 1979 and August 1982, coinciding with changes in Federal Reserve operating procedures. Copyright 1994 by Ohio State University Press.

This paper examines holding period returns to constant duration portfolios of U.S. Govern? ment notes and bonds, and measures the return premium generated by liquidity differences in bonds. The approach compares constant duration portfolios constructed in two distinct ways: one using only bonds issued in the most recent Treasury auction, one using all other bonds. Comparisons of the resulting series are made meaningful by choosing narrow du? ration ranges in the portfolio formation procedure. This, in turn, induces a missing data problem in the created time series. Parameters of return distributions are therefore estimated employing a maximum likelihood framework that explicitly accounts for the missing data. It is estimated that recently issued bonds are priced to return a premium of around 55 basis points per annum over otherwise equivalent instruments.

The author, using 1981–86 data on more than 16,000 managers at 250 large corporations, investigates whether the sensitivity of managerial compensation to corporate performance in one year is positively related to corporate performance in the next year. Accounting-based measures of performance yield only weak evidence of such an association, but economic and market measures yield stronger evidence. Payment of an incremental 10% bonus for good economic performance is associated with a 30 to 90 basis point increase in the expected after-tax gross economic return in the following fiscal year; and payment of an incremental raise of 10% following a good stock market performance is associated with a 400 to 1200 basis point increase in expected total shareholder return.

This paper is of interest both for its methodological contribution of new tools for analyzing rational-expectations models and for its substantive conclusions concerning the term structure of interest rates during the monetary experiment of October 1979. The paper studies systems subject to changes in regime, interpreted here as occasional, discrete shifts in the parameters governing the time series behavior of exogenous economic variables. The specification is shown to be quite tractable both theoretically and empirically. The technique is used to analyze yields on three-month Treasury bills and ten-year Treasury bonds during 1962 to 1987. A constant-parameter linear model for short-term rates is shown to be inconsistent both with the univariate time series properties of short rates and with the observed bivariate relation between long and short rates under the expectations hypothesis of the term structure. AN alternative nonlinear model that admits the possibility of changes in regime affords a much better description of the univariate process for short rates. Moreover, the cross-equation restrictions implied by the expectations hypothesis of the term structure are consistent with the nonlinear specification. Indeed, the residuals of the restricted relation have a standard error of only 0.8 basis points. This is a third less than that of a completely unrestricted linear regression of long rates on short rates, and compares with an unconditional standard deviation of long rates of 142 basis points. I conclude that once the recognition by bond traders of changes in regime is taken into account, the expectations hypothesis of the term structure of interest rates holds up fairly well for these data.

OVER THE PAST DECADE there have often been sizable differences between the offering yields on new issues of corporate bonds and the market yields on bonds of similar quality of the secondary market. In the latter half of the 1960's, this yield spread was consistently positive and at times quite large. For instance, in 1967, 1968, and 1969 Moody's average of offering yields on new Aa public utility issues exceeded Moody's series for seasoned utility issues with the same rating by an average of 40 basis points. In late 1970 and early 1971, the yield spread declined as interest rates fell, and in a number of instances negative yield spreads were observed. This paper examines the reasons for this yield spread and its fluctuations over time. Three hypotheses are presented and the evidence of past studies in support of each is analyzed; then the results of a study of the yield spread on corporate bonds issued competitively during the period January 1, 1964 through February 28, 1971 are reported.

THEORY SUGGESTS THAT two bonds which are comparable in all respects should offer investors the same yield. However, the yields of new corporate bonds often differ substantially from almost identical seasoned (outstanding) bonds. The most extensive work investigating this difference in yields between new and seasoned bonds (yield spread) was done by Conard and Frankena (3). Their primary finding was that differences in coupon rates between new and seasoned bonds of equal quality (Aa Public Utility) accounted for about one-half the yield spread.' Because of this finding, equal quality new and seasoned bonds with the same coupon rates are used in the present study. Despite this comparability of coupon rates, the yield spread, although it was most frequently positive, on Aa Public Utilities had a 56 basis point range (- 17 to + 39) between 1963 and 1972. Section I provides information on the institutional structure in the corporate bond market and provides a basis for hypothesizing that changes in seasoned yields lag changes in new issue yields. Sections II and III report the results of the empirical tests used to test this hypothesis and evaluate the "seasoning process." Conclusions are presented in Section IV.

Simulations of a seventy-equation econometric model are run in an attempt to deduce the likely impact of increases in deposit rate ceilings on financial markets, the earnings of depository institutions, and the composition of nonfinancial investment. The analysis suggests that the effect of binding rate ceilings during the 1973–75 period was to raise home mortgage rates (by about 30 basis points), accentuate the downturn in single family housing starts (by about 40,000 per year), and maintain earnings at depository institutions. Without the ceilings thrift earnings would have been about a billion dollars less per year. However, this loss might well be more than compensated for by greater thrift earnings in subsequent years and by lower noninterest expenses.

OBSERVED DIFFERENTIALS among yield series for different types of long-term instruments-U.S. government bonds, municipal bonds, corporate bonds and residential mortgages-vary considerably over time. Many factors can contribute to observed long-term yield spreads, the most important of which are "technical" factors that relate to differences in the particular characteristics of instruments or in the investors that purchase them. These include the tax status of various types of income accruing to the security and the degree of certainty associated with that income. Long-term yield spreads might also be affected by relative security supplies and relatively exogenous demands, e.g., Federal agency demands for residential mortgages, particularly if institutional constraints on permissible yields or on the various sectors that purchase the long-term instruments exist. Failure to consider the effects of all of these factors has frequently created misunderstanding both in the financial press and in academia about the causes of observed yield spreads. For example, attempts have been made to measure the impact on long-term yield spreads of individual factors-such as default risk or relative security supplies-by comparing yield series without proper regard for the concurrent impact of other technical and/or fundamental factors. This paper deals exclusively with long-term corporate and U.S. government bond yields. The most widely used series are Salomon Brother's Aa deferred call new issue utility yield and the Federal Reserve Bulletin's average yield on bonds maturing or callable in 10 years or more.' The spread between these series is shown as the solid line in Chart 1. (The dashed line will be discussed later.) The spread has moved over a wide range, rising sharply from 40 basis points in late 1965 to 235 basis points in the second quarter of 1970, subsequently falling to 140 basis points in early 1973, and then rising to almost 300 basis points in the third quarter of 1974. The central question addressed in this paper is what have been the relative contributions of taxes, risk, and relative security supplies as determinants of these movements? The general procedure used to deal with this question is as follows: First, direct adjustments are made to the yield series to account for some factors affecting them differently. These include the unusual tax treatment of some of the income from

Because of severe technical difficulties, the U.S. government was unable to repay investors in Treasury bills (T-bills) in late April through early May, 1979. This incident led to a 60 basis point increase in T-bill rates at the initial occurrence of the default. Unlike other information effects of that era, such as Henry Kaufman's predictions or Paul Volcker's “Saturday night special,” this increase in rates was not offset by a subsequent decrease in rates after the Treasury cured the default. The default apparently warned investors that Treasury issues were not completely riskless, which translates into a $12 billion annual increase in federal interest payments as a result of the 60 basis point permanent increase in interest rates.

Penn Square Bank was the largest failed bank to be liquidated by the FDIC. This paper examines the effects of this failure in the market for negotiable CDs. In particular, two major upstream banks, Continental Illinois and Northern Trust, are investigated, as well as First Chicago and the general CD market. Only Continental Illinois was found to be affected, paying an average of more than 50 basis points on CDs over the 6-month period following the Penn Square failure.

This paper analyzes the effects of a share valuation technique, amortized cost valuation, on institutional money market funds (MMFs) and their investors. The possibility of arbitrage between securities priced at market value and amortized MMFs is investigated. It is found that significant dilution has taken place as a result of this valuation technique. Losses per share have been about 10 basis points per year. Evidence that arbitrageurs will take advantage of a misvaluation of the MMF and cause losses to other shareholders may suggest that some investors should reconsider the desirability of amortized MMFs for their investments. IN 1977 THE SEC approved the use of a share valuation technique, amortized cost valuation, that allows certain money market funds (MMFs) to let the reported share value of the fund deviate from its true market value. The possible danger was apparent from the start: shareholders of these MMFs would risk having their capital gains diluted by efficient arbitrageurs, who could increase their holdings of the MMF when it was undervalued and sell their shares when the MMF was overvalued. The SEC finally consented to allowing amortized cost valuation only after intense lobbying by several MMFs, and assurances from them that dilution could not occur. Today, the use of amortized cost and a close variant, penny-rounding, are used by the majority of MMFs, including those open to the general public. Yet no study to date has attempted to look at the possible harm to investors that has resulted from this valuation technique. This paper, while limiting itself to studying institutional MMFs, finds arbitrage has taken place at significant levels. In Section I some background information on MMFs is given and their methods of valuing securities are explained. The opportunity for arbitrage with amortized cost MMFs is further explained. Sections II and III then present empirical evidence to support the hypothesis of arbitrage and show the magnitude of these effects. In Section II it is shown that arbitrage activity may explain much of the variation in weekly asset levels of the institutional MMFs. Section III shows that the resulting dilution lowered the return to an original investor in all institutional MMFs by 10 basis points per year. While the dilution caused by a single arbitrageur is negligible' the potential gain to an arbitrageur from a single transaction can be as large as one-half percent of the arbitrageur's investment. Given the large gains available to

The extent to which deviations from covered interest parity can be attributed to transactions costs has been exa ggerated in the economic literature because the swap market in foreig n exchange has been ignored. It is shown that such deviations should be no greater than the lowest of the transactions costs in one of thr ee markets: the swap market or either of the two relevant securities markets. This reconciles the theory with the data, which show spreads of no more than a few basis points. However, the empirical results h ave no direct bearing on the conventional market efficiency hypothesi s. Copyright 1988 by University of Chicago Press.

IN MANY HIGHLY ORGANIZED financial markets, investors can substitute easily between alternative financial assets. Differences in asset yields tend to reflect differences in term to maturity (or duration), in risk arising either from possible default or from illiquidity, or in the tax treatment of investment returns. During the 1961-77 period, the average yield on privately placed corporate bonds exceeded those on publicly issued corporate bonds-of roughly similar quality, duration, and tax treatment-by about 50 basis points. Higher flotation costs in public offerings and increased flexibility for borrowers in private placements account for most of this average private-public yield spread of 50 basis points. However, the level of the spread did not remain fixed at 50 basis points but varied over the 1961-77 period from a quarterly low of 5 basis points in 1970:2 to a quarterly high of 94 basis points in 1962:4. While lower flotation costs and greater convenience seem adequate to explain most of the average private-public yield spread, changes in relative cost and convenience do not seem sufficient to explain changes in the spread. The purpose of this paper is to analyze private placement yields relative to yields on public offerings of roughly similar quality and duration. The parameters of a reduced form private placement yield model are estimated using quarterly data from the 1961-74 period. The empirical results indicate how private placement rates, relative to public rates, are affected by the level of the public rate, changes in this rate, the supply of credit relative to demand in the private market, and interest rate expectations adjusted for uncertainty about future rates. These results provide information about the degree of segmentation between the private and public markets, the impact of interest rate expectations and uncertainty about future rates on private placement rate negotiations, and the rate of adjustment of the private placement market to broader public market conditions. Insofar as the model can be used for forecasting the private-public rate spread, the results are useful for borrowing and lending decisions in the private and public markets for corporate bonds. The paper consists of three sections. Section I presents a reduced form model of the private placement rate. Empirical results from estimating the parameters of the model are presented in Section III, along with a discussion of the major implications of these results. Section VI is a summary and conclusion.

This research applies an entirely new approach to examining the efficiency of futures markets for Treasury bills and avoids many shortcomings of previous studies that rely on comparing yields on spot versus futures market positions. Efficiency is examined by comparing the consistency of yields within the futures market itself since, at one time, the International Monetary Market (IMM) traded futures contracts for both three-month and one-year bills. The results indicate a remarkably large average annual yield differential of 32 basis points when the yields on the one-year contract are compared to the appropriate corresponding strip of three-month contracts. Possible explanations such as low volume, market thinness, transaction costs, strategy interdependence, serial correlation among differences, and daily resettlement (the Cox, Ingersoll, and Ross effect) are unsuccessful in explaining this pricing anomaly.

* When asked to compare the value of two bonds, many portfolio managers refer to spread relations obtaining in the past -a practice that can be a dangerous trap unless it takes into account changes in the general level of interest rates. For example, spread differences are influenced by vulnerability to call, which becomes a problem for high coupon bonds as the general level of interest rates falls. As soon as such a bond begins to sell on the basis of its yield to call, rather than its yield to maturity, the historical spread between its yield to maturity and that on a lower coupon bond will cease to govern. The author suggests that the investor begin his yield spread analysis by calculating the yield to maturity that a current coupon bond of the same credit would enjoy. Using the concept of basis points per eighth of coupon, the investor can then work upward or downward to establish the approximate yield for the actual coupon of interest. Because of call considerations, the yield impact of one-eighth difference in coupon is less for a discount issue than for a premium issue. Then too, basis points per eighth of coupon will vary over time depending on interest rate expectations; the market places an increased value on discounts when interest rates are falling. Fluctuations in spreads can produce enormous change in bond prices. Understanding the effect of coupon yield spreads at various stages of the interest rate cycle can sharpen the portfolio manager's ability to make advantageous yield swaps. P

In recent years, the conforming loan limit hes risen rapidly (62 percent between 1985 and 1989 versus a 10 percent rise in the price of a constant-quality new house) and has assumed significant importance to homebuyers and portfolio lenders. Fannie Mae and Freddie Mac have become the price setters for conforming FRMs, and the yield being set appears to be 30 basis points below what it would otherwise be. The lower yield raises the old issue of overinvestment in housing, but its most important effect is on thrifts who now earn 30 basis points less on FRM investments under the conforming limit end who have difficulty originating ARMs. Moreover, given other thrift problems, taxpayers will apparently end up directly funding the interest income lost owing to low yields on conforming FRMs. In this paper we calculate the impact on thrift interest income of two redefinitions of conforming loans: making all refinancings nonconforming and lowering the loan limit to the loan ceiling for FMA/VA loans (which was, in fact, the conforming limit prior to 1975) . Each of these redefinitions makes sense from a public policy perspective. Thrifts would have earned nearly $700 million more in 1987 had both redefinitions been in place at the start of 1986. This would have amounted to a 23 percent increase in the industry net operating income (income excluding profits of losses from the sale of assets) and a corresponding increase in return to equity. By the early 1990s, the income gain from these changes, had they been put in place in early 1986, would likely be over a billion dollars -- certainly a noticeable saving for taxpayers.

Perhaps the most striking characteristic of the performance of the money market during the past few years has been the unusual stability of interest rates on a day-to-day and week-to-week basis. During the past two years, in particular, there have been stretches of many weeks in which three-month Treasury bills, for example, moved within as narrow a band as 2 or 3 basis points. A broad view of the market reduction in short-run rate fluctuations in recent years may be obtained by noting the average issuing rates emerging from the weekly auction of three-month Treasury bills over the past several years. As shown in the upper panel of the accompanying chart, the average issuing rate on these bills in successive weekly auctions has gradually but consistently recorded smaller changes since 1960. The average absolute week-to-week change was only 3 and 2 basis points in 1963 and 1964, respectively, compared with average changes of 18 basis points in 1958 and 23 basis points in 1960. What is the explanation for the extraordinary short-run stability of rates in recent years? The most fundamental part of the explanation, I believe, is to be found in the stable behavior of the economy itself. But also of great importance in this connection are certain changes that have emerged in the money market mechanism, and the response of the monetary and debt management authorities to our persisting balance-of-payments problem in a context of interdependent national money markets. I shall deal with these factors in turn.