Irwin Friend

Bio: Irwin Friend is an academic researcher from University of Pennsylvania. The author has contributed to research in topics: Arbitrage pricing theory & Capital asset pricing model. The author has an hindex of 24, co-authored 55 publications receiving 5618 citations.

THE DEMAND FOR RISKY ASSETS: Some Extensions

Abstract: Publisher Summary This chapter discusses some extensions on the demand for risky assets. The research on capital asset pricing has until very recently been devoted almost exclusively to the interrelationships of the risk premiums among different risky assets rather than to the determinants of the market price of risk. Such research has also generally relied on theoretical preconceptions to determine the appropriate utility functions of individual investors upon which both the market price of risk and the pricing of individual risky assets depend. The chapter discusses the highlights of the theoretical and empirical analysis and their conclusions. Then, the same analytical framework is used to obtain new results on the effect of inflation on the market price of risk. It turns out that by using nominal values for returns, the market price of risk under inflation is increased by positive covariance between the rate of inflation and the market rate of return, and decreased by negative covariance. However, statistically as the actual covariance has been very small since the latter part of the 19th century, at least in the USA, the measured market price of risk is not affected appreciably by the adjustment for inflation.

An Empirical Test of the Impact of Managerial Self-interest on Corporate Capital Structure

Abstract: This paper provides a test of whether capital structure decisions are at least in part motivated by managerial self-interest. It is shown that the debt ratio is negatively related to management's shareholding, reflecting the greater nondiversifiable risk of debt to management than to public investors for maintaining a low debt ratio. Unless there is a nonmanagerial principal stockholder, no substantial increase of debt can be realized, which may suggest that the existence of large nonmanagerial stockholders might make the interests of managers and public investors coincide. A RECENT PAPER BY Friend and Hasbrouck (F-H) [7] used data on holdings of stock owned by managerial insiders (officers and directors) to test the hypothesis that the corporate capital structure is determined at least in part by optimization of management interests even when these interests conflict with stockholders' interests. The value of the stock held by corporate insiders (MV) and the ratio of their holdings to the total value of their stock outstanding (FR) were used in that study as measures of the greater incentive to management than to other stockholders for maintaining a low debt ratio to avoid bankruptcy possibility. The regression results were supportive of the hypothesized inverse relationship between unscaled MV and debt, but a less satisfactory result was obtained when MV was scaled by logarithm or FR was used as a second measure of the relevant risk. The result less satisfactory than expected seems to question the ability of management in adjusting debt ratio by its own interests, especially when these conflict with stockholders' interests. To effectively test the managerial-optimization hypothesis raised by F-H, this paper intends to address the effect of various constraints on management's ability or desire to reduce the specific risks to them implicit in a higher debt ratio that might otherwise be desired by public investors in view of the tax shield on interest paid on corporate debt or for other reasons. A simple theory was presented in Lang [15] that illustrates that, if management also loses its stake at bankruptcy, it may desire to use an amount of debt that is less than optimum (which maximizes firm's value) to reduce its bankruptcy risks implicit in a higher debt

A new look at the capital asset pricing model

Abstract: IN A RECENT PAPER in the American Economic Review [6], we presented empirical evidence that the relationship between rate of return and risk implied by the market-line theory is unable to explain differential returns in the stock market. As a result, the risk-adjusted measures of portfolio performance based on this theory yield seriously biased estimates of portfolio performance.' We advanced but did not test several tenable reasons for these observed biases, which included the inability of investors to borrow large amounts of money at the same risk-free interest rate at which they can lend, and deficiencies in the return generating models which are required to translate ex ante expected returns and "risks" into ex post realizations. Recent papers by Fischer Black [1] and Stephen Ross [11] present theoretical models which suggest that the breakdown of the borrowing and lending mechanism would be expected to bias these measures, but not for the explicit reasons we gave. The purpose of this paper is to examine both theoretically and empirically in greater depth than was done previously the reasons why the market-line theory does not adequately explain differential returns on financial assets. The first section of the paper briefly reviews the salient points of the marketline theory as recently modified and analyzes the implications of the theory. The second section estimates several types of risk-return tradeoffs implied by stocks on the New York Stock Exchange for three different periods after World War II and shows that the empirical results cast serious doubt on the validity of the market-line theory in either its original form or as recently modified. On the other hand, these results do confirm the linearity of the relationship for NYSE stocks. The third section suggests that the market for NYSE stocks is segmented from the bond market unless the return generating process is different from any heretofore tested. This has important implications for both the measurement of portfolio performance and the determination of optimal corporate financing.

Risk, Return, and Equilibrium: Empirical Tests

Abstract: This paper tests the relationship between average return and risk for New York Stock Exchange common stocks. The theoretical basis of the tests is the "two-parameter" portfolio model and models of market equilibrium derived from the two-parameter portfolio model. We cannot reject the hypothesis of these models that the pricing of common stocks reflects the attempts of risk-averse investors to hold portfolios that are "efficient" in terms of expected value and dispersion of return. Moreover, the observed "fair game" properties of the coefficients and residuals of the risk-return regressions are consistent with an "efficient capital market"--that is, a market where prices of securities

An intertemporal capital asset pricing model

Abstract: An intertemporal model for the capital market is deduced from the portfolio selection behavior by an arbitrary number of investors who aot so as to maximize the expected utility of lifetime consumption and who can trade continuously in time. Explicit demand functions for assets are derived, and it is shown that, unlike the one-period model, current demands are affected by the possibility of uncertain changes in future investment opportunities. After aggregating demands and requiring market clearing, the equilibrium relationships among expected returns are derived, and contrary to the classical capital asset pricing model, expected returns on risky assets may differ from the riskless rate even when they have no systematic or market risk. ONE OF THE MORE important developments in modern capital market theory is the Sharpe-Lintner-Mossin mean-variance equilibrium model of exchange, commonly called the capital asset pricing model.2 Although the model has been the basis for more than one hundred academic papers and has had significant impact on the non-academic financial community,' it is still subject to theoretical and empirical criticism. Because the model assumes that investors choose their portfolios according to the Markowitz [21] mean-variance criterion, it is subject to all the theoretical objections to this criterion, of which there are many.4 It has also been criticized for the additional assumptions required,5 especially homogeneous expectations and the single-period nature of the model. The proponents of the model who agree with the theoretical objections, but who argue that the capital market operates "as if" these assumptions were satisfied, are themselves not beyond criticism. While the model predicts that the expected excess return from holding an asset is proportional to the covariance of its return with the market

A Simple Model of Capital Market Equilibrium with Incomplete Information

Abstract: THE SPHERE of model financial economics encompasses finance, micro investment theory and much of the economics of uncertainty. As is evident from its influence on other branches of economics including public finance, industrial organization and monetary theory, the boundaries of this sphere are both permeable and flexible. The complex interactions of time and uncertainty guarantee intellectual challenge and intrinsic excitement to the study of financial economics. Indeed, the mathematics of the subject contain some of the most interesting applications of probability and optimization theory. But for all its mathematical refinement, the research has nevertheless had a direct and significant influence on practice. ’ It was not always thus. Thirty years ago, finance theory was little more than a collection of anecdotes, rules of thumb, and manipulations of accounting data with an almost exclusive focus on corporate financial management. There is no need in this meeting of the guild to recount the subsequent evolution from this conceptual potpourri to a rigorous economic theory subjected to systematic empirical examination? Nor is there a need on this occasion to document the wide-ranging impact of the research on finance practice.2 I simply note that the conjoining of intrinsic intellectual interest with extrinsic application is a prevailing theme of research in financial economics. The later stages of this successful evolution have however been marked by a substantial accumulation of empirical anomalies; discoveries of theoretical inconsistencies; and a well-founded concern about the statistical power of many of the test methodologies.3 Finance thus finds itself today in the seemingly-paradoxical position of having more questions and empirical puzzles than at the start of its