Working Paper Abstracts – 1984

Working Paper Abstracts – 1984


This paper presents a comprehensive set of tests of the implications of the Arbitrage Pricing Theory. We find unlike previously reported results, a very limited relationship between the expected returns and the covariance (factor loadings) measures of risk. Furthermore, unique variance measures of risk, while generally making only small contributions to the explanation of asset returns, turn out to be significant about as frequently as the coveriance measures of risk — which is inconstant with the Arbitrage Pricing Theory model. The intercept tests are more mixed but provide only limited support to the model.


In a capital budgeting decision, timing is often an important part of the decision-maker’s opportunity set. The ability of the manager to choose when to undertake an investment has similarities to the ability of the holder of a securities option to choose when to exercise that option. This paper uses formulas developed for the valuation of securities options to evaluate the timing option and to derive decision rules for optimal investment timing. The paper provides examples of application in the cases of plant and equipment replacement, marketing of new products, and real estate development.

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Financial economists have generally asserted that, in a world of corporate taxes and bankruptcy costs, the debt level of a firm is negatively related to its risk. Surprisingly, our paper shows that neither the face value of debt, the market value of debt, nor the ratio of market value of debt to market value of equity need be a negative function of a firm’s variability.


The classical, finite horizon, consumption portfolio choice problem is reexamined, when the current return depends on the history of past observations. Optimal policies are characterized for the class of uncertainty/information structures, which result in an underlying Gaussian conditional distribution at any trading date. Decisions will be time dependent functions of wealth and of the mean and variance of the risky return.

For Bernoulli tastes, consumption is proportional to wealth but insensitive to information, whereas, in the isoelastic case, the proportionality coefficient is affected by new observations. The portfolio decision in both instances depends exclusively on information. For the logarithmic utility in addition, the optimal decision is myopic.

More informative structures in this latter case imply, under additional assumptions, a higher investment in the risky asset, for histories of observations resulting in a specified conditional mean. An increase in the latest observation has the same effect if it indicates a favorable shift in the mean risk faced. Finally, the dollar amount invested in the financial market remains unchanged in both instances.

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This paper examined the information content of financial columns. Since the stock market is informationally efficient, no investor can extract excess returns by blindly following the advice of financial column. However, the labor market for financial columnist is competitive, a surviving columnist should provide some positive services. This paper demonstrated that a surviving columnist can provide consistently superior service in the short run but not in the long run. We also showed that the surviving columnist’s advice is better than tossing a fair coin. Hence an investor with his own prior information should benefit positively from the financial column.

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This paper provides new tests of the arbitrage pricing theory (APT). Test results appear to be extremely sensitive to the number of securities used in the two stages of the tests of the APT model. New tests also indicate that unique risk is fully as important as common risk. While these tests have serious limitations, they are inconsistent with the APT.

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Empirical tests are reported for Ross’ arbitrage pricing theory using monthly data for U.S. Treasury securities during the 1960-1979 period. We find that mean returns on bond portfolios are linearly related to at least two factor loadings. Multivariate test results, however, are not consistent with the APT. Our sample data in the U.S. Treasury securities market are also not consistent with either version of the CAPM. One-month-ahead forecasts of excess returns using factor-generating models are compared with corresponding naive predictions or predictions using the “market model” with various market portfolios.

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This paper analyzes the theoretical and empirical relation between the growth of government debt and monetary policy for seven industrialized countries: France, Germany, Italy, Japan, Switzerland, the U.K., and the U.S. After analyzing the data we find that:

(i) rates of monetary growth frequently differ sharply from the rate of growth of nominal government debt, so that there is no evidence that a rapidly growing level of government debt encourages immediate monetization;

(ii) the rate of inflation is approximately equal to the difference between the rate of growth of the money supply and real output in all countries over all subperiods, so there is no evidence that an increase in government debt is a significant independent cause of inflation; and,

(iii) 1974 signals a turning point in postwar data trends, marked by a decline in the rate of growth of real output and a sharp rise in the rate of growth of nominal debt for all the countries.

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A new methodology for statistically testing contingent claims asset-pricing models based on asymptotic statistical theory is developed. It is introduced in the context of the Black-Scholes-Merton option pricing model, for which some promising estimation, inference, and simulation results are also presented. The proposed methodology is then extended to arbitrary contingent claims by first considering the estimation problem for general Ito-processes and then deriving the asymptotic distribution of a general contingent claim which depends upon such an Ito-process.

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A welfare analysis of a simple noisy rational expectations model is carried out. It is shown that the more information prices convey, the worse off everybody is. However, the equilibrium where everybody is uninformed may not be Pareto optimal: imposing a tax on information gathering which finances a lump sum grant may allow everybody to be better off when some people are informed. A corresponding result holds when the model is used to consider the release of information by firms: all shareholders may be better off if information is released to a group of insiders as a form of compensation.


In this paper a theory of capital structure based on imperfections in firms’ product markets is illustrated with numerical examples. In the model used there is a corporate tax advantage to debt but there are no direct bankruptcy costs. The effect of bankruptcy rather is to delay investment decisions. Although these delays are not in themselves costly, they can put the bankrupt fit at a strategic disadvantage and can result in the firm being forced to liquidate. In order to prevent this happening it is optimal for firms to use a sufficient amount of equity in their capital structure to prevent bankruptcy.


Particularly since the passage of ERISA, institutional investors have increasingly been willing to consider potential investments that traditionally have been considered highly speculative. Indeed, some institutional investors now routinely use options and futures, instruments that formerly were viewed as highly speculative and thus inappropriate investments. The rationale is that these instruments, although risky if viewed alone, provide, in combination with other assets, portfolios that overall are conservative (witness the writing of covered calls).

The purpose of this paper is to examine the risk and return characteristics of lower-grade corporate bonds. Institutional investors have frequently considered such bonds as inappropriate for a conservative portfolio. However, if diversification eliminates much of the risk of individual bonds, lower-grade bonds might have an appropriate place in a conservative portfolio. Whether they do or not depends upon their prospective risk and return characteristics. The usual starting point for judging the prospective characteristics of an investment is a detailed analysis of historical data, the subject of this paper.

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