Some Theoretical Problems Suggested by the Movements of Interest Rates, Bond Yields and Stock Prices in the United States Since 1856.

The last thirty years have witnessed a fundamental change in the regulation of infrastructure industries Whereas firms were subject to rate of return regulation and protected from entry in the past, now they face various forms of incentive regulation, competition is actively promoted by many regulators, and both regulators and the firms they regulate must often confront rapid technological progress This paper surveys the literature on the investment implications of different regulatory schemes, highlighting the relevance of modern investment theory, which puts risk and intertemporal issues, such as the irreversibility of much infrastructure investment, center stage It discusses the impact on regulated monopolists' investment behavior of key regulatory characteristics, namely the price flexibility allowed by the regulator, the length of the regulatory cycle, and the costs the regulator will allow the firm to recover at future regulatory hearings It also considers the impact of competition, especially the situation where a vertically integrated firm has its operation of a bottleneck asset regulated, on investment by regulated firms and their competitors

/pdf/regulating-infrastructure-the-impact-on-risk-and-investment-2w7skms5xs.pdf

Regulating Infrastructure: The Impact on Risk and Investment

The last thirty years have witnessed a fundamental change in the regulation of infrastructure industries. Whereas firms were subject to rate of return regulation and protected from entry in the past, they now face various forms of incentive regulation, competition is actively promoted by many regulators, and both regulators and the firms they regulate must often confront rapid technological progress. This paper surveys the literature on the investment implications of different regulatory schemes, highlighting the relevance of modern investment theory, which puts risk and intertemporal issues, such as the irreversibility of much infrastructure investment, center stage. It discusses the impact on regulated monopolists investment behavior of key regulatory characteristics, namely the price flexibility allowed by the regulator, the length of the regulatory cycle, and the costs the regulator will allow the firm to recover at future regulatory hearings. It also considers the impact of competition, especially the situation where a vertically integrated firm has its operation of a bottleneck asset regulated, on investment by regulated firms and their competitors.

/pdf/regulating-infrastructure-the-impact-on-risk-and-investment-5gu0er76gk.pdf

THE TERM STRUCTURE OF interest rates has a very important role in economic theory. On the macroeconomic level the term structure serves as a key transmission link between the monetary and real sectors. On the microeconomic level the term structure not only serves as a tool for bond pricing, but the term structure also has an important role in the valuation of most financial claims. The concept of an equilibrium term structure under uncertainty was introduced by Merton [41] in 1973. Since then, Brennan and Schwartz [4, 5], Vasicek [51], Cox, Ingersoll, and Ross [11, 12], Richard [46], Long [33], and Dothan [16] have made important contributions to the theory of the term structure and equilibrium bond pricing. At this time, "closed form" solutions for the equilibrium term structure have been derived in several special, but important, cases where the term structure is generated from univariate or bivariate stochastic processes such as the elastic random walk, geometric random walk, and square root process. However, it is arguable that the term structure of interest rates is embedded in a large macroeconomic system. Hence, it is arguable that there are generally many economic factors which are related to the term structure. The primary objective of this paper is to develop a multivariate model of the term structure that can accommodate an arbitrary number of economic relationships. The model is of a general form and can be linked with many alternative macroeconomic systems. The major assumptions of the model to be developed are that the set of stochastic factors related to the term structure follow a joint elastic random walk, that the instantaneous riskless rate can be represented as a linear combination of the same factors, and that the market prices of risk (corresponding to the different factors) are, at most, time dependent. The resulting model of the term structure can be expressed in a form that is consistent with traditional notions of the term structure. Even with multiple factors, the term structure can always be expressed in a form characterized by expectations of future short-term rates plus a liquidity premium. We will restrict our attention to the pricing of default-free, purediscount bonds. While this special case is of interest in its own right, a model for pricing the default-free, pure-discount bond also plays an important role in pricing default-free coupon bonds, risky pure-discount bonds, and, as Cox, Ingersoll, and Ross show, the valuation of most financial claims [12].

A Multivariate Model of the Term Structure

American Economic Association

The behavior of the firm under uncertainty and the valuation of risky assets are basic concerns of contemporary economic and financial theorists. In this study, we present several models which illustrate the interdependence of the micro-economic decisions of the firm and the market's valuation of its capital assets. Such decisions as price and capital investment are shown to affect the risk-return combination presented by the firm to the financial market for valuation. It is assumed that decisions are made in order to maximize the market value of the firm given the riskreturn preferences of investors. Thus, the models we present directly link behavior in the product and financial markets. To represent the financial markets, we make use of the capital asset pricing model (CA PM) developed by William Sharpe, John Lintner, and Jan Mossin. This theory provides, as a condition for capital market equilibrium, an explicit model of the valuation of risky assets. Several advantages over the more familiar expected utility approach result from the use of a positive theory of market value. First, it is desirable that the model of firm decision making under uncertainty be consistent with a financial market equilibrium. Second, the goal of the firm appropriate to financial market theory is the maximization of the market value of the firm. In contrast to the expected utility approach, analysis under the CAPM does not depend on individuals' preference. Third, the use of an explicit model of asset value enables us to derive explicit and computable comparative static results. The resulting implications for firm behavior appear to be suitable for empirical testing and investigation. The prospects for empirical work are further enhanced by the common dependence of all firms on capital marketdetermined parameters. Finally, although the point is not developed in this paper, it should be noted that our approach has the potential to link firms' actions with changes in macro-economic activity. To the extent macro changes affect risk preferences, there will be an impact on, for example, investment decisions. In turn, these have macro implications. We turn to a brief literature review before presenting the basic model and illustrations.

https://www.jstor.org/stable/info/1805257

The technology of risk and return

This paper is concerned with the problem of price regulation when demand is uncertain. Uncertainty gives rise to substantial difficulties in determining both the return a firm's owners should be provided and a set of prices capable of producing that return. We argue that conventional approaches to price regulation are incapable of attaining the economically desirable objectives of efficiency and an equitable return to investors. The deficiencies in current practices are attributable to the separation of the risk measurement-return determination and price setting activities in the conventional approach. We present a model of the regulated firm that synthesizes contemporary financial market theory and the theory of the firm under uncertainty.' In our approach, the income stream produced by the firm is valued ex ante in the financial market according to investors' perceptions and preferences over risk-return characteristics. We portray the firm as producing risk and return by choosing among available production technologies to maximize its market value, given the prices set by regulators. Within this framework, it is shown that regulators can choose the lowest prices consistent with an equitable return to investors. We also show that prices so chosen induce the choice of the optimal technology by the firm. IN THE TRADITIONAL REGULATORY framework, as thoroughly described and explained by Bonbright [3], the goal of regulators is to set rates in such a way that all costs are covered, including a return on invested capital commensurate with the risk of equity investment. Determination of the latter is difficult at best. It is generally agreed that: (1) the fair return depends on risk; (2) the return required by investors as compensation for risk bearing is most accurately measured by observing the returns to competitive firms in otherwise similar circumstances; and (3) estimation of required returns by observation of other regulated firms is generally inappropriate since the risk and regulation effects are confounded. More recently, Myers [13] has argued for the application of finance theory to rate determination within the traditional regulatory framework. In particular, he argues that the capital asset pricing model (CAPM) developed by Sharpe [14], Lintner [9], and Mossin [12] is especially well suited for this purpose since a single quantitative measure of risk is relevant in that model. Further, since the CAPM offers an explicit equilibrium risk-return relationship, information about the risks and returns of all firms can be directly employed in determining the fair return to a regulated firm.

Optimal Regulation Under Uncertainty

Optimal terms of the call provision on a corporate bond

A Risk-Return Approach to the Selection of Optimal Government Bond Portfolios

IN THIS PAPER we examine the appropriateness of average maturity as a risk proxy for portfolios of government bonds. Our conclusions are generalizable to any bond portfolios which can be standardized for the exposure to credit risk (default). We demonstrate both mathematically and empirically the serious shortcomings in the use of average maturity as a summary risk measure. Its use in the academic literature and in policy statements by practitioners is particularly surprising in light of (1) Malkiel's [6] thorough mathematical presentation of the effect of maturity on price volatility and (2) the computational ease in obtaining appropriate statistical measures of risk by maturity.

William J. Marshall

Papers

The technology of risk and return

Optimal Regulation Under Uncertainty

Optimal terms of the call provision on a corporate bond

A Risk-Return Approach to the Selection of Optimal Government Bond Portfolios

The use of average maturity as a risk proxy in investment portfolios