Showing papers in "Journal of Finance in 1981"

Performance Hypothesis Testing with the Sharpe and Treynor Measures

Abstract: Asymptotic distributions of the estimators of the Sharpe and Treynor performance measures are derived. Multivariate performance comparison measures, based on the traditional Sharpe and Treynor measures, are developed with their corresponding asymptotic distributions. The behavior of these new performance measures are evaluated in small samples. For single comparisons, a Sharpe z statistic is well behaved and for multiple comparisons a Sharpe chi-square statistic is reasonably well behaved. The powers of the tests are quite sensitive to the population coefficients of variation. Multivariate test statistics based upon the Treynor measure were not very satisfactory. THIS STUDY DEVELOPS SIGNIFICANCE tests of portfolio performance utilizing the Sharpe and Treynor measures. The approximate bias and asymptotic distributions of the estimators of the traditional Sharpe and Treynor performance measures are derived. Multivariate performance comparison measures based on these traditional measures are proposed for comparing the performance of n portfolios. The approximate bias and asymptotic distributions of the multivariate comparison measures are then derived and test statistics proposed. The behavior and usefulness of the statistics for hypothesis testing are evaluated in small samples with simulation experiments. We find that for single comparisons a z statistic based on Sharpe's measure is well behaved at small sample sizes although its power in detecting typical differences with monthly data is small. The z statistic, based on the Treynor measure, is not well behaved in small samples and also lacks power. For multiple comparisons a chi-square statistic, obtained from the Sharpe measures, is reasonably well behaved at small samples and its power increases as the number of portfolios increases and/or the coefficients of variation decrease. A chi-square statistic derived from the Treynor measure is not so well behaved. Section I of the paper discusses the availability of test statistics for various classes of performance measures. It also discusses the use of the Sharpe and Treynor statistics in light of certain undesirable properties they possess and the section concludes with a brief literature survey. Section II derives the performance measure moments, asymptotic distributions, and proposed test statistics. Section III contains the results and conclusions of the univariate and multivariate simul-ations.

On the Effects of Barriers to International Investment

Abstract: A simple model is presented in which it is costly for domestic investors to hold foreign assets. The implications of the model for the composition of optimal portfolios at home and abroad are derived. It is shown that all foreign assets with a beta larger than some beta ,/* plot on either one of two security market lines. Some foreign assets with a beta smaller than /* are not held by domestic investors even if their expected return is increased slightly. WHILE IT IS OBVIOUSLY not true that asset markets are completely segmented between countries, there is evidence of barriers to international investment. Although reality seems to lie in that grey area between complete segmentation and no segmentation at all, most international asset pricing models are concerned with the extreme case of no barriers to international investment. No effort seems to have been made to study the effect on portfolio choice of such barriers, which make it costly to hold foreign securities, as opposed to domestic securities, but which do not, in general, render international diversification so onerous that investors avoid foreign securities completely.' Casual empiricism suggests that models without barriers to international investment should be suspect; those models cannot explain why it appears that in every country investors, on average, hold more domestic securities than would be required if they held the world market portfolio.2 This paper constructs a model of international asset pricing in which there is a cost associated with holding-either long or short-risky foreign securities. For the sake of simplicity, in most of the paper we assume that while domestic investors face barriers to international investment, foreign investors face no such barriers. It turns out that nothing significant is lost with such an assumption. The main conclusions of this paper for the case in which foreign investors face no barriers to international investment are: 1. In the presence of barriers to international investment, some risky foreign

Federal Deposit Insurance, Regulatory Policy, and Optimal Bank Capital*

Abstract: This paper seeks to explain the combination of explicit and implicit pricing for deposit insurance employed by the FDIC. Essentially, the FDIC sells two products-insurance and regulation. To span the product space, it must and does set two prices. We argue that the need to establish regulatory disincentives to bank risk-taking is the heart of the controversy over the adequacy of bank capital and that the ability to close risky banks before exhausting their charter value (i.e., the value of their right to continue in business) stands at the center of these disincentives and in front of the FDIC's insurance reserves. JUST AS A BOOK shouldn't be judged by its cover, a government agency shouldn't be judged by the words behind its initials. With the FDIC (Federal Deposit Insurance Corporation), the agency's name describes only part of its formal operations: the FDIC is quasi-governmental, has a regional structure and sells deposit insurance. However, the initials fail to convey the FDIC's critical place in the governmental regulatory structure as the sole federal overseer of the approximately 8900 state-chartered commercial banks that have chosen not to belong the Federal Reserve System.' Reflecting the Federal Reserve's membership problem, the number of these banks is growing year by year. Besides selling deposit insurance at bargain explicit rates, the FDIC performs four regulatory functions: (1) Entry regulation. It passes on new banks' applications for deposit insurance and on branch and merger proposals as well, thereby protecting the value of existing bank charters; (2) Examination. Two-thirds of FDIC employees are concerned with inspecting bank records and supervising managerial activity; (3) Regulation of deposit rates and conditions for withdrawal. By tradition, FDIC policies on these matters conform entirely with regulations applicable to Federal Reserve member banks; and (4) Disposition of failed banks. When an insured bank fails, the FDIC usually chooses not to liquidate it.2

Merger Announcements and Insider Trading Activity: An Empirical Investigation

Abstract: This paper provides evidence of excess returns earned by investors in acquired firms prior to the first public announcement of planned mergers. The study is distinguished from earlier merger studies in its use of daily holding period returns for the 194 firms sampled. The results confirm statistically what most traders already know. Impending merger announcements are poorly held secrets, and trading on this nonpublic information abounds. Specifically, leakage of inside information is a pervasive problem occurring at a significant level up to 12 trading days prior to the first public announcement of a proposed merger.

A Possible Explanation of the Small Firm Effect

Abstract: Recent empirical studies have found that small listed firms yield higher average returns than large firms even when their riskiness is equal. The riskiness of small firms, however, has been improperly measured. Apparently, the error is due to auto-correlation in portfolio returns caused by infrequent trading. Other anomalous predictors of riskadjusted returns, such as price/earnings ratios and dividend yields, may also derive some of their apparent power from this spurious source.

Resolving the Agency Problems of External Capital through Options

Abstract: This paper investigates the role of stock options in resolving the agency problems of external capital as originally identified by Jensen and Meckling (1976). These problems are precipitated by managerial incentives a) to consume excessive non-pecuniary benefits or perquisites beyond the optimal level for sole ownership and b) to engage in risk shifting in productive decisions so as to transfer wealth from external capital contributors. These incentive problems can be resolved through a strategy that judiciously combines call and put options retained by the owner-manager and external financiers, respectively. The resolution of the agency problems through this mechanism provides an economic rationale for the existence of managerial stock options and convertible debt. THE WORK BY JENSEN and Meckling [7] has brought more realism to the theory of the firm. In their paper JM address agency problems in the context of a firm which is viewed as a nexus of contracts among various factors of production. The contractual relationships involve incentive conflicts arising from the pursuit of self-interest. By limiting themselves to an entrepreneur or owner-manager who retains complete control of the firm, JM have demonstrated that financing through the issuance of common stock or debt to outsiders engenders costs. These costs are precipitated in part by the manager's propensity to consume nonpecuniary benefits or perquisites (perks) by employing certain resources in excess of their optimal usage,1 and by his propensity to engage in high risk investment projects so as to transfer wealth from bondholders to stockholders.2

An Equilibrium Model of Asset Trading with Sequential Information Arrival

Abstract: In an effort to better understand the dynamic market price adjustment process, this paper develops a model which describes the impact of new information on a financial market. The primary emphasis is on the price change-volume relationship in the presence of a margin requirement. We find that the margin requirement significantly affects the relation of price change to volume. Furthermore, this relationship is shown to be affected by the number of investors in the market, the degree of information dissemination, differences in interpretation of information and the implicit cost of the margin requirement.

The Effects of International Operations on the Market Value of the Firm: Theory and Evidence

Abstract: THIS PAPER INVESTIGATES the existence of monopoly rents associated with international operations in a market-value theoretic framework. The benefits of international operations evolve from such factors as (1) imperfections in the product and factor markets, (2) differential international taxation, and (3) imperfections in the financial markets. In this paper, these factors are subject to an equilibrium analysis in the context of recent advances in financial theory. In particular, imperfections in the financial sector arising from corporate international diversification are examined in a framework which allows (a) supply adjustments by multinational firms and (b) the interaction of barriers to international capital flows faced by both firms and investors. Taking the U.S. capital market and investors as a base, we then specify the conditions under which the foregoing imperfections get "priced out" in an equilibrium. These pricing effects cannot be detected empirically through the methodologies employed by the existing studies which examine the effects of corporate international diversification. Indeed, it was an attempt to rescue the limitations of these studies which initially motivated our paper. The existing empirical inquiries into this area rely on traditional risk-adjusted performance measures (e.g., [7]) or international analogs of return generating processes (e.g., [1, 8]). Instead, at the empirical level, we employ a "value-based" method which is in the same vein of the Thomadakis [17] approach developed to identify the monopoly benefits of industrial market structure. We conduct the tests over subperiods characterized by differential government controls in an attempt (a) to separate the pure financial motives for multinationality from other motives, and (b) to detect if the benefits of international operations carry through recent periods.

The Adjustment of Stock Prices to Information About Inflation

Abstract: This paper analyzes the reaction of stock prices to the new information about inflation. Based on daily returns to the Standard and Poor's composite portfolio from 1953–78, it seems that the stock market reacts negatively to the announcement of unexpected inflation in the Consumer Price Index (C.P.I.), although the magnitude of the reaction is small. It is interesting to note that the stock market seems to react at the time of announcement of the C.P.I., approximately one month after the price data are collected by the Bureau of Labor Statistics.

Valuation of GNMA Mortgage-Backed Securities

Abstract: GNMA mortgage-backed pass-through securities are supported by pools of amortizing, callable loans. Additionally, mortgagors often prepay their loans when the market interest rate is above the coupon rate of their loans. This paper develops a model for pricing GNMA securities and uses it to examine the impact of the amortization, call, and prepayment features on the prices, risks and expected returns of GNMA's. The amortization and prepayment features each have a positive effect on price, while the call feature has a negative impact. All three features reduce a GNMA security's interest rate risk and, consequently, its expected return.

The Use of Volatility Measures in Assessing Market Efficiency

Abstract: RECENTLY a number of studies have used measures of the variance or "volatility" of speculative asset prices to provide evidence against simple models of market efficiency. These measures were interpreted as implying that prices show too much variation to be explained in terms of the random arrival of new information about the fundamental determinants of price. The first such use of the volatility measures was made independently by LeRoy and Porter [1981] in connection with stock price and earnings data, and myself [1979], in connection with longterm and short-term bond yields. Subsequently, further use of these measures was made to study efficient markets models involving stock prices and dividends (Shiller [1981b]), yields on intermediate and short-term bonds (Shiller [1981a], Singleton [1980]), preferred stock dividend price ratios and short-term interest rates (Amsler [1980]) and foreign exchange rates and money stock differentials (Huang [1981], Meese and Singleton [1980]). My intent here is to interpret the use of volatility measures in these papers, to describe some alternative models which might allow more variation in prices, and to contrast the volatility tests with more conventional methods of evaluating market efficiency. My initial motivation for considering volatility measures in the efficient markets models was to clarify the basic smoothing properties of the models to allow an understanding of the assumptions which are implicit in the notion of market efficiency. The efficient markets models, which are described in section II below, relate a price today to the expected present value of a path of future variables. Since present values are long weighted moving averages, it would seem that price data should be very stable and smooth. These impressions can be formalized in terms of inequalities describing certain variances (section III). The results ought to be of interest whether or not the data satisfy these inequalities, and the procedures ought not to be regarded as just "another test" of market efficiency. Our confidence of our understanding of empirical phenomena is enhanced when we learn how such an obvious property of data as its "smoothness" relates to the model, and to alternative models (section IV below). On further examination of the volatility inequalities, it became clear that the

Taxation and Corporate Pension Policy

Abstract: This paper focuses on the impact of taxes on optimal corporate pension policy. The analysis is based upon an integration of corporate and individual shareholder considerations. The major conclusions are that a company should fully fund its pension plan and should invest the pension fund totally in bonds.

Futures Trading and Volatility in the GNMA Market

Abstract: FUTURES MARKETS FOR AGRICULTURAL commodities have existed for well over 100 years. Recently there has been a major expansion of futures trading into nontraditional areas, particularly interest-bearing securities and foreign currenciesthe so-called "financial futures." The introduction of exchange traded futures contracts for Treasury Bills, GNMA pass-through certificates, and other securities has created new hedging, arbitrage, and speculative opportunities for the investors, issuers, and dealers who are active in the cash markets for these securities. Futures trading has also opened these markets to participation by new classes of traders, particularly private and smaller institutional investors. Through the process of arbitrage, a financial futures market will be closely linked to the cash market for the underlying securities. An important concern of the regulatory authorities is what effect opening a futures market is likely to have on an existing cash market. The purpose of this paper is to analyze the impact of futures trading in Government National Mortgage Association (GNMA) passthrough certificates on price volatility in the cash market for these securities. There are several major ways in which opening futures trading can increase efficiency and smooth price variations in a cash market. Most importantly, futures provide a mechanism for those who buy and sell the actual security or commodity to hedge themselves against unfavorable price changes. Through the futures market, risk can be spread across a large number of investors, and transferred away from those hedging spot positions to professional speculators who are more willing and able to bear it. This risk transfer may substantially improve the functioning of the spot market because it reduces the need to incorporate risk premia in cash market transactions to compensate for the risk of price fluctuations. Second, futures market may increase the informational efficiency of a cash market. Since futures prices are determined in a unified, highly visible market by traders who specialize in gathering and evaluating information, the futures market is expected to be an "efficient" market, in the sense that prices will reflect the best estimate of true future values given the information currently available. If anything, an informationally efficient futures market should lead to more efficient pricing in the cash market. The importance of both of these effects will depend upon the structure of the existing cash market. The more developed and integrated is the cash market, the

Accelerating Inflation, Technological Innovation, and the Decreasing Effectiveness of Banking Regulation

Abstract: To explain the evolution of U.S. deposit institutions and markets in the 1960sand 1970s, we feed into the regulatory dialectic assumptions about the objectives of federal banking regulation and about outside forces that disturb the adjustment process. The disturbing exogenous forces are accelerating change in the technological and market environment of commercial banking and increasing uncertainty concerning the future speed of enviromental change. We hypothesize that, in the face of these environmental changes, the adaptive efficiency shown on average by deposit-institution managers is greater than that shown by managers of the several competing banking agencies. Incorporating this differential adaptive capacity into the regulatory dialectic helps us to understand how increases in the pace of environmental change and in the degree of environmental uncertainty led regulatee responses to come more quickly and regulatory responses to come more slowly. The bottom line is that, when the environment changes rapidly and becomes more uncertain, traditional forms of U.S. banking regulation can be overwhelmed by technological and regulation-induced innovation.

Market Response to the Weekly Money Supply Announcements in the 1970s

Abstract: The hypothesis that the weekly announcement of the money supply affects interest rates is examined. The announcement effect is interpreted as a policy anticipation effect. That is, an unanticipated increase in the money supply leads to an increase in interest rates in anticipation of future tightening by the Federal Reserve. Estimates of this effect with proxies for the unanticipated change constructed from a survey of money supply forecasts and an ARIMA model indicate that: (a) financial markets respond very quickly to the announcement; and (b) the response was largest when policymakers emphasized the importance of the monetary aggregates. FINANCIAL MARKET PARTICIPANTS ARE careful observers of the weekly money supply announcement, and generally agree that the announcement often leads to changes in interest rates. This occurs because the announcement leads market participants to revise their expectations both of future Federal Reserve policy actions and of future economic conditions. In this paper we examine the response of yields on Treasury bills to the announcement of the money supply and the extent to which that response has varied in the last ten years. Money supply announcements may affect market interest rates in three ways. First, actual expansion of the money supply leads to lower interest rates through a liquidity effect. However, rapid monetary growth which is not anticipated leads market participants to expect the Federal Reserve to counteract such growth in the future. As a consequence, there may be a policy anticipation effect which causes higher interest rates in anticipation of future tightening. Furthermore, prolonged rapid monetary growth also creates inflation and inflationary expectations which lead to higher interest rates. Thus, there may exist a third effect, the inflationary expectations effect which also leads to higher interest rates. Our interest in this paper is in the immediate market response to the weekly announcement of the money supply, which, as we argue below, is most likely to be a policy anticipation effect. The policy anticipation effect is best described by example. Suppose that the announced change in the money supply exceeds that which was expected by

A Note on Exchange-Rate Expectations and Nominal Interest Differentials: A Test of the Fisher Hypothesis

Abstract: THIS NOTE TESTS THE hypothesis that nominal interest differentials between similar assets denominated in different currencies can be explained entirely by the expected change in the exchange rate over the holding period. This proposition, often called the "Fisher open" hypothesis or the hypothesis of perfect asset substitutability, has been a major component of recent theories of exchange-rate determination, and has important implications for monetary policy.1 The Fisher hypothesis differs from the covered interest parity theorem enunciated by Keynes [11]. While covered interest parity equates the nominal interest differential between financial centers to a known premium or discount on forward foreign exchange, and is thus in principle riskless, Fisher parity involves risk in an essential way. The two conditions are equivalent only when forward exchange rates equal expected future spot rates. Recent theoretical work, for example that of Grauer, Litzenberger, and Stehle [8], Kouri [12], and Frankel [6], shows that this need not be the case when market participants are risk averse. Thus, while covered interest parity must always hold exactly in an informationally efficient asset market with no transactions costs, Fisher parity need not. Nominal interest differentials may reflect risk premia in addition to expected exchange-rate movements.2 It should be emphasized at the outset that the tests conducted in this paper are really joint tests of the Fisher hypothesis and a weak form of foreign exchange market informational efficiency. Levich [14] has argued that tests of market efficiency are always joint tests involving some hypothesized structure of "normal" equilibrium returns. Below, we assume informational efficiency and instead test Fisher's hypothesized arbitrage condition that nominal interest differentials equal expected percentage changes in exchange rates.

Market Interest Rates and Commercial Bank Profitability: An Empirical Investigation

Abstract: The widespread notion that commercial banks "borrow short and lend long" implies that sharp market interest rate increases may induce a significant number of banking failures. This paper develops a method for estimating average asset and liability maturities for a sample of large money center banks. Regression models are tested to determine if market rate fluctuations have a significant impact on bank profitability. The conclusion is negative: large banks have effectively hedged themselves against market rate risk by assembling asset and liability portfolios with similar average maturities. THE IMPACT OF MARKET interest rates on commercial bank revenues, costs, and profitability has increasingly concerned economists and policymakers as financial market conditions have become more volatile in recent years. The widespread notion that depository intermediaries "borrow short and lend long" implies that rapid market rate increases may induce an unacceptable number of financial firm failures. Monetary policy discussions have reflected this concern. For many years, the Federal Reserve Board considered stable market rates a goal (or at least an intermediate target) of monetary policy: "The extent to which money market conditions are permitted to fluctuate in the short run is also affected by the unique role of the Federal Reserve System as the Nation's lender of last resort. Liquidity pressures ultimately devolve on the money market and the Federal Reserve has a responsibility for maintaining orderly conditions in that market."

Forward and Futures Prices: Evidence from the Foreign Exchange Markets

Abstract: Empirical studies of the Treasury Bill markets have revealed substantial differences between the futures price and the implied forward price. These differences have been attributed to taxes, transaction costs, and the settling up procedure employed in the futures market. This paper examines the forward and futures prices in foreign exchange in an attempt to distinguish between the competing explanations. EMPIRICAL STUDIES OF THE Treasury bill market have revealed differences between the futures price (or rate) and the implicit forward price derived from the term structure of interest rates.1 These differences have generally been attributed to market "imperfections" such as taxes and transaction costs. (See, for example, Arak [1], Capozza and Cornell [2], and Rendelman and Carabini [6]). Recently, however, Cox, Ingersoll, and Ross [3], henceforth CIR, derived a model in which forward and futures prices need not be equal, even in perfect markets without taxes, as long as interest rates are stochastic. The significance of the CIR effect may be hard to investigate using only data from the bill market, because of the potentially complicating effects of taxes and transaction costs unique to this market. By using data from the foreign exchange market, we are able to eliminate the tax effect and reduce the impact of transaction costs. The question we address is whether the discrepancies observed in the Treasury Bill market are also observed in the foreign exchange market. If they are, then we have evidence that the differences are due to a combination of the CIR effect and the transaction costs common to both markets. If they are not, then either the magnitude of the CIR effect is much less in the foreign exchange market, or the Treasury Bill results are due to the unique tax treatment and transaction costs of that market. This paper is organized as follows. In Section I the trading mechanics of the forward and futures markets in foreign exchange are discussed. Section II reviews the explanations for the discrepancies between the forward and futures prices for Treasury Bills. The institutional differences between the foreign exchange and bill markets are also summarized to show which of these explanations cannot apply to the foreign exchange market. In Section III, the data are decribed and the empirical results are presented. The conclusions are summarized in the final section.

The Arbitrage Pricing Theory: Some Empirical Results

Abstract: THE ACCUMULATION of empirical evidence inconsistent with the simple oneperiod capital asset pricing models of Sharpe (1964), Lintner (1965), and Black (1972) indicates that alternative models of capital market equilibrium deserve investigation. A minimum requirement for any alternative model should be that it explains the empirical anomalies which arise within the simple CAPM. One such anomaly is observed when portfolios are formed on the basis of firm size (see Banz [1978] and Reinganum [1980b, c]). Small firms systematically experienced average rates of return nearly 20% per year greater than those of large firms, even after accounting for differences in estimated betas. An adequately specified model of equilibrium should eliminate these persistent "abnormal" returns. The arbitrage pricing theory (APT) proposed by Ross (1976) is a plausible alternative to the simple one-factor CAPM. The appeal of the APT probably comes from its implication that compensation for bearing risk may be comprised of several risk premia, rather than just one risk premium as in the CAPM. Roll and Ross (1979) claim to find empirically at least three and probably four factors that are priced from 1962 to 1972. However, Roll and Ross do not offer an economic interpretation of these factors and admit that their test is a weak one. This research investigates empirically whether a parsimonious arbitrage pricing model can account for the differences in average returns between small firms and large firms which are traded on the New York and American Stock Exchanges. If a parsimonious APT can explain these differences, then one might feel more confident in using the APT as an empirical replacement for the CAPM, even though the economic nature of the risks is not fully understood. However, if a parsimonious APT fails to account for differences in average returns, then the model ought to be rejected. There can be no justification for embracing a complicated model if it does not convey any more information than does the simple model.

A Comparison of Alternative Models for Pricing GNMA Mortgage-Backed Securities

Abstract: SINCE THE ISSUANCE OF the first Government National Mortgage Association (GNMA) mortgage-backed pass-through security in February 1970, the total amount of GNMAs issued has grown to over $105 billion. In terms of their trading volume, GNMA securities are the most actively-traded class of long-term fixedrate instruments. However, this gross volume statistic masks the fact that GNMAs are not homogeneous securities. They differ by coupon interest rate and remaining term to maturity. There is also a widely-held belief [12] and some evidence [7] that GNMAs differ according to their expected prepayment rates. The bulk of the trading volume in GNMAs is comprised of newly-issued securities. New securities are generally issued at the Federal Housing Administration (FHA) maximum interest rate and have terms to maturity of 30 years. While most GNMA trading is comprised of new issues, the bulk of the outstanding securities is comprised of "old" securities whose coupon rates may differ from the current FHA ceiling and whose remaining terms to maturity are less than 30 years. This raises a pricing problem for GNMA security dealers, portfolio managers, financial institutions that hold large portfolios of GNMA securities, and other potential GNMA investors. Up-to-date market price quotes are available for new issues, but quotes for "old" ones are not so readily available. Thus, potential traders confront the problem of pricing these infrequently traded securities. The problem of pricing GNMA securities was initially addressed by Curley and Guttentag [5]. They presented a model for the pricing of GNMAs that was an imaginative and important extension of the then widely-used average life procedure. The particular innovation of their model was to incorporate estimates of the prepayment probabilities to determine expected future cash flows. Through simulation and sensitivity analysis, Curley and Guttentag (hereafter C & G) compared prices generated by their model with those generated by the traditional average life procedure. In his discussion of the C & G paper, Brealey [1] encouraged the authors to extend their model to incorporate uncertainty and to value explicitly the call options attached to the underlying mortgage loans. In a previous paper [6], we

Testing the Efficiency of the Canadian-U.S. Exchange Market under the Assumption of no Risk Premium

Abstract: The efficiency of the Canadian-U.S. exchange market for the current float is examined more extensively than previously. Semi-strong-form tests which admit the lagged spot rate as a predictor are considered in addition to the standard weak-form test. These stronger tests reject the joint null hypothesis of an efficient exchange market and no risk premium for the period ending in October 1976, although not for the entire period. For almost every year the current spot rate provided a better forecast of the future spot rate than did the current forward rate. THERE IS NOW AN extensive empirical literature on testing the efficiency of various foreign exchange markets (see [16] for a survey). Yet almost all of these tests are weak-form tests or tests of the bias of the forward exchange rate as a predictor of the future spot rate. Such tests in the Canadian-U.S. exchange market can be found in the work of Porter [20], Eastman [5], Kaserman [10], KohIhagen [11], Cornell [3], and Levich [14]. For the Canadian float of the 1950s, Porter [20] and Kaserman [10] found that one could not reject the unbiasedness of the forward rate. Eastman [5] and Kohlhagen [11] rejected the unbiasedness of the forward rate for the floating period, although not for the subsequent fixed period, but their use of overlapping contracts means that their standard errors are biased. Cornell [3] and Levich [14] found that in terms of the root-meansquared error criterion the lagged spot rate and the lagged forward rate predicted the current spot rate equally well for more recent periods. This paper examines the efficiency of the Canadian-U.S. exchange market for the current float (July 1970 to December 1978) in a more extensive way than it has been previously examined. From the weak-form test the paper proceeds to two semi-strong-form tests which admit the lagged spot rate as a possible predictor. Throughout the paper various subperiods are considered in addition to the period as a whole.

On Diversification Given Asymmetry in Returns

Abstract: Complete diversification is the rational investment strategy for a risk averse individual in a homogeneous securities market who considers only the first two moments of return. Observed behavior of market participants, however, demonstrates that the majority of individual investors hold imperfectly diversified portfolios. The purpose of the present study is to examine one potential cause for this behavior which does not rely on imperfection in the capital market. Specifically, we show that given the existence of, and investor preference for, positive skewness, a rational investor may hold an optimal limited number of homogeneous risk assets. THE RELATIONSHIP BETWEEN THE number of risk assets in a portfolio and the total risk of the portfolio has been examined extensively both theoretically and empirically [7, 8, 16]. The general conclusion from these analyses (which are set in a mean-variance framework) is that adding randomly selected and equally weighted risk assets to a portfolio will reduce total risk without affecting return. The implication for risk averse investors in a perfect market is that complete diversification is optimal. Observed behavior of market participants, however, demonstrates that the majority of individual investors hold imperfectly diversified portfolios. In the Wharton Survey of 1975 in [4], the median number of stocks held was found to be fewer than 4, with 34 percent of the investors holding no more than 2 stocks. The two primary studies providing evidence of the undiversified portfolios of individual investors are Blume and Friend [3] and Blume, Friend, and Crockett [5]. The former analysis was based on a sample of individual income tax returns from 1971 and indicated that, considering only dividend paying stocks, 34.15 percent of investors sampled held only one stock; 50.51 percent held no more than 2 stocks; and only 10.72 percent held 10 or more stocks. The latter study which included nondividend paying stocks was based on the Federal Reserve Board's 1962 Survey of the Financial Characteristics of Consumers. The median number of holdings per household was 2, while the average was 3.41. In both [3] and [5] numerous other measures of diversification were employed with the results confirming the conclusion that individual investors are, on average, highly undiversified. The principal theoretical reasons advanced by the authors of these studies relate to the relaxation of assumptions of the standard capital asset

Pension Funding, Share Prices, and National Savings

Abstract: This paper examines empirically the effect of unfunded pension obligations on corporate share prices and discusses the implications of these estimates for national saving, the decline of the stock market in recent years, and the rationality of corporate financial behavior. The analysis uses the information on inflation-adjusted income and assets which large firms were required to provide for 1976 and subsequent years. The evidence for a sample of nearly 200 manufacturing firms is consistent with the conclusion that share prices fully reflect the value of unfunded pension obligations. Since the conventional accounting measure of the unfunded pension liability has a number of problems (which we examine in the paper), it would be more accurate to say that the data are consistent with the conclusion that shareholders accept the conventional measure as the best available information and reduce share prices by a corresponding amount. The most important implication of the share price response is that the existence of unfunded private pension liabilities does not necessarily entail a reduction in total private saving. Because the pension liability reduces the equity value of the firm, shareholders are given notice of its existence and an incentive to save more themselves. For this reason, unfunded private pensions differ fundamentally from the unfunded Social Security pension and the other unfunded federal government civilian and military pensions.

An Economic Theory of a Credit Union

Abstract: THE majority of research to date on CUs has been empirical (cf. Cargill [1] and Kidwell and Peterson [7]), yet there is serious need to develop a theoretical framework of CU behavior that incorporates their unique characteristics. A CU is essentially a financial intermediation cooperative. However, the standard theoretical treatments of financial intermediaries (cf. Meyer [8]) and cooperative enterprises cannot be directly applied to model credit union behavior. There are two principal characteristics of CUs that prevent this: First, in a CU (and cooperatives in general) the members are both the owners of the organization and the consumers of its output or suppliers of its input. One cannot simply assume that the members seek to maximize the profit generated by their transactions with the CU irrespective of the price and quantities of those same transactions, thus models of a financial firm based on profit maximization cannot be directly translated to a CU environment. Second, in a CU the membership provides both the demand for and supply of loanable funds. The CU then intermediates between its member-savers and member-borrowers. This heterogeneity is an inherent source of conflict between members. Clearly, a CU cannot simultaneously maximize its dividend rate for savers and minimize its loan rate for borrowers. Since most theoretical models of cooperative enterprises assume a homogeneous member objective, they are not generally applicable to CUs. There are two basic requirements for a framework to model CU behavior. First, the specification of the objective function should focus on the value of CU participation to the members. This value should include the prices and quantities of transactions as well as any profit that results. Second, the analysis should explicitly consider the possibility of conflict among members, and the resolution of that conflict being a preference to either the borrowers or savers. The existing literature on CUs contains a wide variety of objective functions. Hempel and Yawitz [5] ignore the owners-are-consumers issue and simply contend that CUs, like other financial intermediaries, should maximize profit. Most writers, however, recognize that profit-maximization would be a somewhat incongruous objective for an organization that typically labels itself not-for-profit. Murray and White [9] use cost minimization subject to an output constraint. Keating [6] employs the managerial discretion approach by maximizing the manager's utility function subject to minimum member benefit constraints. Taylor [11, 12] suggests that the CU should minimize the difference between its average loan rate and savings rate paid. Smith [10] argues that the CU should

Reinsurance under Conditions of Capital Market Equilibrium: A Note*

Abstract: HAVING ACCEPTED A CONTINGENT liability under an insurance contract, the insurer has an insurable interest in the subject of the insurance policy and can insure all or part of that liability with a second insurer. This reinsurance agreement protects the first insurer (known as the primary or ceding insurer) against unusually large claims, since it permits the risk to be broken down into smaller units which can be absorbed easily by individual insurers. These agreements are commonly placed with other direct insurers and with specialist reinsurance companies usually holding internationally diversified portfolios. The reinsurance agreement affects the risk return structure of the insurer's liability portfolio and consequently affects the risk-return characteristics of the insurer's common stock. The insurance literature has long assumed such reinsurance is an important procedure and much attention has been devoted to analyzing its use. Explicit statements of the objectives of reinsurance can be found in most insurance texts.' These texts commonly stress the portfolio risk effects of reinsurance, that is, the reduction in the probability of the failure (or "ruin") of the insurance fund and the stabilization of returns to its owners.2 The subdivision of policies and the spreading of risk between insurers permits each insurer to hold a more completely diversified portfolio of liabilities than would be available without reinsurance. Apart from explicit statements, the bulk of analytical literature on optimal reinsurance agreements has assumed risk reduction to be the objective. In earlier works, such as Vajda [15] and Ohlin [11], the benefits of reinsurance were identified in the reduction of the variance of the insurer's loss distribution. Subsequently, writers such as Borch [3, Chs. 1-11]; Buhlmann and Jewell [5]; Du Mouchel [6]; and Gerber [7] have used utility analysis to isolate the effects of reinsurance and to identify the properties of the optimal reinsurance treaty. Here, reinsurance is studied as a bilateral risk-reducing device arranged between two or more risk averse insurers. The Pareto condition has been evoked to define the optimality of a reinsurance treaty and, not surprisingly, it is shown to depend upon the form and parameters of the participating insurers' utility functions. The equilibrium conditions for reinsurance have also been established by Borch [3,

An Equilibrium Analysis of Debt Financing under Costly Tax Arbitrage and Agency Problems

Abstract: IN HIS RECENT PAPER, Merton Miller [12] extends the notion of tax-induced differential returns on securities into a general equilibrium framework in which firms make adjustments in the supply of corporate debt. In an environment of progressive personal taxation, the interest rates on taxable corporate bonds are greater than rates on tax exempt securities so as to compensate investors for the associated tax burden. On the supply side, value-maximizing firms have an incentive to issue additional debt so long as the personal tax-induced compensation is less than the tax savings from interest-payment deductions at the corporate level. Miller argues that in the final equilibrium, the interest rate differential between taxable and tax-exempt bonds exactly reflects the tax advantage of debt financing at the corporate level. Thus, the tax subsidy disappears in its entirety, and we are back to an environment in which corporate leverage is inconsequential to the value of any particular firm. What emerges in equilibrium is merely an optimal debt-equity ratio for the corporate sector as a whole.1 Miller derives this invariance proposition under the following assumptions: (1) progressive personal tax rates reach a maximum at a level beyond the corporate tax rate; (2) no tax arbitrage by individuals and firms is allowed; (3) there is a personal tax rate differential in favor of income from stocks; and (4) the opportunity for riskless borrowing and lending exists.2 Indeed, Miller's equilibrium analysis is based on a zero effective personal tax rate on income from stocks, but

The Allocational Role of Takeover Bids in Situations of Asymmetric Information

Abstract: have special information about the target firm's resources which indicates that the target is really worth more than its current market valuation. Hence, the acquiring firm, by paying only a small premium, is able to acquire these resources at a price below the true worth to shareholders indicated by the inside information. Thus shareholders are unable to capture the true benefits of their investments, and an inefficient amount of investment will take place. Therefore the government should restrict takeover bids.' The above argument is clearly wrong if there is competition among informed bidders for the target firm's assets. However, proponents of the argument claim that some takeover bids occur exactly because only one agent has special, inside information about the target company's resources. In this paper we show that

Fisher, Phillips, Friedman and the Measured Impact of Inflation on Interest: A Reply

Abstract: THE PURPOSE OF THIS paper is to demonstrate that empirical findings, which persistently appear to contradict the Fisher hypothesis that the nominal rate of interest should rise by the full amount of an increase in anticipated inflation, are due basically to a failure to control for changes in the real rate of interest that are associated with changes in anticipated inflation. We are guided in our search for proper specification of a Fisher equation by a simple general equilibrium model, which is employed to derive the impact of a change in anticipated inflation upon nominal interest given the requirement that commodity, money and labor markets remain in equilibrium. In effect we depart from the empirical tradition which has grown up around testing of the Fisher hypothesis that takes the real interest rate to be independent of anticipated inflation and argues that, for anticipated inflation properly measured, the data ought to support the Fisher hypothesis.1