# Working Paper Abstracts – 1987

**01-87**

In recent years there has been a resurgence of interest in the empirical behavior of inventories. A great deal of this research examines some variant of the production smoothing model of finished goods inventories. The overall assessment of this model that exists in the literature is quite negative: there is little evidence that manufacturers hold inventories of finished goods in order to smooth production patterns.

This paper examines whether this negative assessment of the model is due to one or both of two features: costs shocks and seasonal fluctuations. The reason for considering costs shocks is that if firms are buffetted more by cost shocks than demand shocks, production should optimally be more variable than sales. The reasons for considering seasonal fluctuations are that seasonal fluctuations account for a major portion of the variance in production and sales, that seasonal fluctuations are precisely the kinds of fluctuations that producers should most easily smooth, and that seasonally adjusted data is likely to produce spurious rejections of the production smoothing model even when it is correct. .

We integrate cost shocks and seasonal fluctuations into the analysis of the production smoothing model in three steps. First, we present a general production smoothing model of inventory investment that is consistent with both seasonal and non-seasonal fluctuations in production, sales, and inventories. The model allows for both observable and unobservable changes in marginal costs. Second, we estimate this model using both seasonally adjusted and seasonally unadjusted data plus seasonal dummies. The goal here is to determine whether the incorrect use of seasonally adjusted data has been responsible for the rejections of the production smoothing model reported in previous studies. The third part of our approach is to explicitly examine the seasonal movements in the data. We test whether the residual from an Euler equation is uncorrelated with the seasonal component of contemporaneous sales. Even if unobservable seasonal cost shocks make the seasonal variation in output greater than that in sales, the timing of the resulting seasonal movements in output should not necessarily match that of sales.

The results of our empirical work provide a strong negative report on the production smoothing model, even when it includes cost shocks and seasonal fluctuations. At both seasonal and non-seasonal frequencies, there appears to be little evidence that firms hold inventories in order to smooth production. A striking piece of evidence is that in most industries the seasonal in production closely matches the seasonal in shipments, even after accounting for the movements in interest rates, input prices, and the weather.

**02-87**

In the absence of monetary superneutrality, inflation affects capital accumulation and the demand for real balances. This paper derives the combination of monetary end lump-sum fiscal policy which maximizes the sum of discounted utilities of representative consumers in present and future generations. Under the optimal policy package, the steady state has a zero nominal interest race and has monetary contraction at the rate of intergenerational discount. As the rate of intergenerational discount rate approaches zero, optimal policy maximizes steady state utility of the representative consumer. In this case, the optimal steady state is characterized by a constant nominal money supply.

**03-87**

This paper analyzes the joy of giving bequest motive in which the utility obtained from leaving a bequest depends only on the size of the bequest. It exploits the fact that this formulation can be interpreted as a reduced form of an altruistic bequest motive to derive a relation between the value of the altruism parameter and the value of the joy of giving parameter. Using previous discussions of an a priori range of plausible values for the altruism parameter we then derive plausible restrictions on the joy of giving parameter. We demonstrate that this parameter may well be orders of magnitude larger than assumed in the existing literature.

**04-87**

There is some empirical evidence that high tax bracket investors hold the equity of unlevered firms while low tax bracket investors hold levered firms. It has been suggested that an extension of the Miller model can provide a theory which is consistent with this observation. However, it has been stated elsewhere that this separation arises only for some sequences of shareholder voting and trading, implying that solid theoretical support for the existence of clienteles is lacking. This note argues that the sequencing of trading and voting does not affect the formation of capital structure clienteles.

**05-87**

In this paper, we test the random walk hypothesis for weekly stock market returns by comparing variance estimators derived from data sampled at different frequencies. The random walk model is strongly rejected for the entire sample period (1962-1985) and for all sub-periods for a variety of aggregate returns indexes and size-sorted portfolios. Although the rejections are largely due to the behavior of small stocks, they cannot be completely attributed to either the effects of infrequent trading or time-varying volatilities. Moreover, the rejection of the random walk cannot be interpreted as supporting a mean-reverting model of asset prices, but is more consistent with a specific nonstationary alternative hypothesis.

**06-87**

There is often a reliability problem when information is sold since anyone can claim to have superior knowledge. Optimal strategies which allow the seller to overcome this problem are considered in the context of a standard one-period two-asset model. It is shown that when the seller’s risk aversion is unobservable, an information market exists and both the seller and buyers are better off. However, because of the reliability problem the seller cannot obtain the full value of his information. This provides an incentive for intermediation since an intermediary may be able to capture some of the remaining returns.

**07-87**

This paper demonstrates that if banks are faced with significant competition for deposit financing, as well as regulatory constraints in the form of required capital and/or reserves, banks cannot be profitable solely by holding marketable assets. They must provide other services, such as information gathering and monitoring activities related to making loans. For a bank which originates loans, loan selling will likely provide a cheaper source of funds than traditional deposit or equity finance. However, the extent to which banks can sell loans is limited by the ability of the bank–loan buyer contract to overcome a moral hazard problem. The bank’s choice of an optimal loan sales contract is analyzed with and without allowance for recourse.

**08-87**

This paper develops a framework that integrates macroeconomic analysis and consumption-oriented asset valuation. All behavioral relations and valuation formulae are derived as results of optimal decisions of individuals or firms. Using the endogeneity of consumption and returns in the macroeconomic context, it is shown how the valuation premia on stocks and nominal bonds relative to riskfree indexed bonds depend on the fundamental stochastic shocks to technology and preferences.

**09-87**

The Ricardian Equivalence Theorem, which is the proposition that changes in the timing of lump-sum taxes have no effect on consumption or capital accumulation, depends on the existence of operative altruistic motives for intergenerational transfers. These transfers can be bequests from parents to children or gifts from children to parents. In order for the Ricardian Equivalence Theorem to hold, one of these transfer motives must be operative in the sense that the level of the transfer is not determined by a corner solution resulting from a binding non-negativity constraint. This paper derives conditions that determine whether the bequest motive will be operative, the gift motive will be operative, or neither motive will be operative in a model in which consumers are altruistic toward their parents and their children.

**10-87**

This paper presents a general equilibrium model with logarithmic preferences and technology. If the non-negativity constraint on bequests is strictly binding, then the bequest motive is characterized as inoperative. After determining the conditions for operative and inoperative bequest motives, the paper examines the effect of pay-as-you-go social security on the stochastic evolution of the capital stock. If the non-negativity constraint on bequests is strictly binding, then an increase in social security reduces the unconditional long-run expected capital stock. If the social security taxes and benefits are large enough, then the non-negativity constraint ceases to bind, and further increases in social security have no effect. This paper extends previous analyses by examining bequest behavior outside of the steady state and by allowing a non-degenerate cross-sectional distribution in the holding of capital.

**11-87**

A linear duopoly model is used to consider investment and financing decisions. Bankruptcy is assumed to cause a delay in investment which is not costly in itself. However, the imperfect competition in the product market means this delay puts the bankrupt firm at a strategic disadvantage which forces it to either partially or completely liquidate. Since this is costly, firms use only a limited amount of debt despite the corporate tax advantage it enjoys. Equilibrium can be symmetric or asymmetric. In the latter case similar firms have different capital structures.

**12-87**

Under certain conditions, a government can run a “rational Ponzi game,” i.e., issue debt and never repay any interest or principal. Does Ricardian equivalence hold with respect to a tax cut that is financed by such a scheme? We study this question using overlapping generations models in which generations are linked by gifts or bequests. We find that although there are multiple equilibria, Ricardian equivalence can hold, and often seems to be the most natural outcome.

**13-87**

We propose a simple test for the random walk hypothesis using variance estimators derived from data sampled at different frequencies. This Hausman–type specification-test exploits the linearity of the variance of random walk increments in the observation interval by comparing the (per unit time) variance estimates obtained from distinct sampling intervals. Test statistics are derived for both the i.i.d. Gaussian random walk and the more general uncorrelated but possibly heteroscedastic random walk. Monte Carlo experiments indicate that although the finite-sample behavior of our specification test is comparable to that of the Dickey-Fuller t-test and the Box-Pierce Q-statistic under the i.i.d. null, our test is more reliable than either of these tests under a heteroscedastic null. We also perform simulation experiments to compare the power of all three tests against two interesting alternative hypotheses: a stationary mean-reverting Markov process which has been interpreted as a ‘fads’ model of asset prices, and an explosive non-Markovian process which exhibits essentially the opposite time series properties. By choosing the sampling frequencies appropriately, the variance ratio test is shown to be as powerful as the Dickey-Fuller and Box–Pierce tests against both alternatives. As an empirical illustration, we perform our test on weekly stock market data from 1962 to 1985 and strongly reject the random walk hypothesis for several stock indexes.

**14-87**

Secondary loan participations, or loan “stripping,” is a recent innovation in banking. In a secondary loan participation, or loan sale, a bank makes a loan and then sells the loan, without recourse, to a third party. Bank loans hitherto were nonmarketable securities which could only be removed from the balance sheet by creating, at least, a contingent liability. Consequently, the recent practice of loan sales raises fundamental questions about the uniqueness of banks relative to markets as mechanisms for allocating capital. In particular, are banks continuing to perform unique services, such as enforcing loan covenants, or are these activities now performed by other economic agents, in markets? If banks are still performing these activities, what incentives to perform do they face if the loans can be sold without recourse?

This paper seeks to clarify these issues in a nontechnical way. We present the available quantitative evidence on the growth of the loan sales market, the identity of buyers and sellers, the types of loans sold, and the characteristics of the participation contracts. Qualitatively, loan participations are distinguished contractually from other bank asset contracts both legally and economically. A set of stylized facts about loan sales contracts, based on a sample of blank secondary loan participation contracts (and associated contracts with the underlying borrower), collected from money center banks, is presented.

Two hypotheses to explain the existence and the recent appearance of loan sales are briefly presented. In particular, we examine the extent to which a bank’s “reputation” can substitute for the bank’s taking a position in the loan to maturity (i.e., equity) as an incentive device for ensuring bank performance of monitoring loan covenants. We consider how reputations are obtained, and informally argue that the recent trend of securitization can be usefully viewed in this way.

**15-87**

This paper examines the within day pattern of common stock returns surrounding announcements of new issues of equity and debt by industrial firms. During the first fifteen minutes following new equity issue announcements, there is an abnormally large number of transactions, high volume, and a -1.3% average return. There is also a small, but statistically significant negative average return one hour preceding the announcement. The size of the offering, the stated purpose of the issue and the estimated profitability of new investments do not have a significant impact on stock returns. New debt issue announcements also do not have a significant impact on stock returns. After the issuance of new shares, there is a significant price recovery of 1.5%. This evidence is not consistent with many theoretical rationales for the negative market reaction to new equity issue announcements.

**16-87**

In a model with incomplete markets, and agents privately producing a circulating media of exchange to coordinate trade, it is shown that closing another market can be Pareto-improving. Producing private money is costly because contracts with the money issuers must be enforced, creating agency costs. By closing the market for trading the circulating media, agents endogenously create an information asymmetry which can result in banking panics. The information asymmetry is desirable, however, because it creates externalities which force banks to cooperate for mutual regulation and insurance for their monies, thus reducing agency costs. The self-enforcing cooperative coalition of banks replaces the market in enforcing the private money contracts. Agents relying on this unobservable enforcement are said to have “confidence” in the banking system.

**17-87**

Particularly since the passage of ERISA, institutional investors have increasingly been willing to consider 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 characteris-tics 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.

**18-87**

The hypothesis being tested in this article is that participants in the foreign exchange market are improperly diversified across currencies. If this type of inefficiency were to be verified, it could constitute an explanation of the large volatility of exchange rates: traders who do not fully exploit the potential for diversification unnecessarily restrict the sizes of the positions they do take in the individual currencies, generate thereby a shortage of speculative interest, and, as a consequence, stabilize exchange rates less than they otherwise would. In order to test the hypothesis, a number of implementable portfolio diversification policies are tried out on a large body of data covering nine major currencies and eighteen years of weekly observations. While some policies do produce abnormal returns (over and beyond proper reward for risk), none does so in a statistically significant way. This means that the evidence does not allow one to conclude that market participants are improperly diversified. As a byproduct of this investigation, techniques are found which would allow portfolio managers to earn a proper reward for risk by following a purely mechanical procedure; such techniques may be valuable in a multi-country world where the aggregate portfolio of currencies and securities is unknown and is not supposed to be efficient.

**19-87**

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 can be. 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.

**20-87**

In this paper we examine two different measures of monthly production that have been used by economists. The first measure, which we refer to as IP, is the index of industrial production constructed by the Board of Governors of the Federal Reserve. This measure is used extensively in empirical work on the business cycle, as well as by policymakers and others to assess the current state of the economy. The second measure, which we refer to as Y4, is constructed from the accounting identity that output equals sales plus the change in inventories. Sales and inventory data are reported by the Department of Commerce. This measure of output is frequently used to estimate models of inventory accumulation. Theoretically, these two series measure the same underlying economic variable — the production of goods by firms during the month.

We show here that the time series properties of these two series are radically different. We examine means, variances, and serial correlation coefficients of the log growth rates, and show that these statistics differ substantially between the two series. In addition, the cross-correlations between the two seasonally adjusted series range from .7 to .0 and are in most cases less than .4. We then demonstrate the significance of these differences in two ways. First, we estimate a model of white noise measurement error for the two series. The estimates indicate that in 15 out of 20 2-digit industries measurement error accounts for over 40% of the variation in the monthly growth rates of seasonally adjusted industrial production data. Second, we show that the variance bounds results of Blinder’s (1986) study of inventory behavior are partially reversed when the IF rather than the Y4 output measure is used.

**21-87**

This paper shows that governments’, rather than individuals’, inhibitions are the only source of segmentation in international capital markets. The paper specifically focuses on two countries, Japan and the U.S., to test the integration of international capital markets. In Japan, the enactment of the Foreign Exchange and Foreign Trade Control Law in December 1980 amounted to a true regime switch that virtually eliminated most capital controls. Using several multifactor asset pricing models we show that the price of risk in the U.S. and Japanese stock markets was different before the liberalization, but not after it. This evidence supports the view that the governments are the only source of international capital markets segmentation.

**22-87**

no abstract

**23-87**

no abstract

**24-87**

no abstract

**25-87**

no abstract

**26-87**

How should new securities be designed? Traditional theories have little to say on this: the literature on capital structure and general equilibrium theories with incomplete markets take the securities firms issue as exogenous. This paper explicitly incorporates the transaction costs of issuing securities and develops a model where the instruments that are traded are chosen optimally and the economy’s market structure is endogenous. Among other things, it is shown that the firm’s income stream should be split so that in every state all payoffs are allocated to the security held by the group that values them most.

**27-87**

no abstract

**28-87**

We examine the finite sample properties of the variance ratio test of the random walk hypothesis via Monte Carlo simulations under two null and three alternative hypotheses. These results are compared to the performance of the Dickey-Fuller t and the Box-Pierce Q statistics. Under the null hypothesis of a random walk with independent and identically distributed Gaussian increments, the empirical size of all three tests are comparable. Under a heteroscedastic random walk null, the variance ratio test is more reliable than either the Dickey-Fuller or Box-Pierce tests. We compute the power of these three tests against three alternatives of recent empirical interest: a stationary AR(l), the sum of this AR(1) and a random walk, and an integrated AR(1). By choosing the sampling frequency appropriately, the variance ratio test is shown to be as powerful as the Dickey-Fuller and Box-Pierce tests against the stationary alternative, and is more powerful than either of the two tests against the two unit-root alternatives.

**29-87**

In this paper, we test the random walk hypothesis for weekly stock market returns by comparing variance estimators derived from data sampled at different frequencies. The random walk model is strongly rejected for the entire sample period (1962-1985) and for all sub-periods for a variety of aggregate returns indexes and size-sorted portfolios. Although the rejections are largely due to the behavior of small stocks, they cannot be completely attributed to the effects of infrequent trading or time-varying volatilities. Moreover, the rejection of the random walk for weekly returns does not support a mean-reverting model of asset prices.

**30-87**

This study examines intraday transaction data for S&P 500 stock index futures prices and the intraday quotes for the underlying index. The data indicate that the futures price changes are uncorrelated, and that the variability of these price changes exceeds the variability of price changes in the S&P 500 index. This excess variability of the futures over the index remains even after controlling for the nonsynchronous prices in the index quotes, which induces autocorrelation in the index changes. We advance and examine empirically two hypotheses regarding the difference between the futures price and its theoretical value: that this “mispricing” increases on average with maturity, and that it is path dependent. Evidence supporting these hypotheses is presented.

**31-87**

no abstract