Showing papers in "Journal of Finance in 1984"

The Capital Structure Puzzle

Abstract: The Capital Structure Puzzle Author(s): Stewart C. Myers Source: The Journal of Finance, Vol. 39, No. 3, Papers and Proceedings, Forty-Second Annual Meeting, American Finance Association, San Francisco, CA, December 28-30, 1983 (Jul., 1984), pp. 575-592 Published by: Blackwell Publishing for the American Finance Association Stable URL: http://www.jstor.org/stable/2327916 Accessed: 29/10/2008 12:03

A Simple Implicit Measure of the Effective Bid‐Ask Spread in an Efficient Market

Abstract: In an efficient market, the fundamental value of a security fluctuates randomly. However, trading costs induce negative serial dependence in successive observed market price changes. In fact, given market efficiency, the effective bid-ask spread can be measured by Spread=2−cov where “cov” is the first-order serial covariance of price changes. This implicit measure of the bid-ask spread is derived formally and is shown empirically to be closely related to firm size.

On the existence of an optimal capital structure: theory and evidence

Abstract: ONE OF THE MOST contentious issues in the theory of finance during the past quarter century has been the theory of capital structure. The geneses of this controversy were the seminal contributions by Modigliani and Miller [18, 19]. The general academic view by the mid-1970s, although not a consensus, was that the optimal capital structure involves balancing the tax advantage of debt against the present value of bankruptcy costs. No sooner did this general view become prevalent in the profession than Miller [16] presented a new challenge by showing that under certain conditions the tax advantage of debt financing at the firm level is exactly offset by the tax disadvantage of debt at the personal level. Since then there has developed a burgeoning theoretical literature attempting to reconcile Miller's model with the balancing theory of optimal capital structure [e.g., DeAngelo and Masulis [5], Kim [12], and Modigliani [17]. The general result of this work is that if there are significant "leverage-related" costs, such as bankruptcy costs, agency costs of debt, and loss of non-debt tax shields, and if the income from equity is untaxed, then the marginal bondholder's tax rate will be less than the corporate rate and there will be a positive net tax advantage to corporate debt financing. The firm's optimal capital structure will involve the trade off between the tax advantage of debt and various leverage-related costs. The upshot of these extensions of Miller's model is the recognition that the existence of an optimal capital structure is essentially an empirical issue as to whether or not the various leverage-related costs are economically significant enough to influence the costs of corporate borrowing. The Miller model and its theoretical extensions have inspired several timeseries studies which provide evidence on the existence of leverage-related costs. Trczinka [28] reports that from examining differences in average yields between taxable corporate bonds and tax-exempt municipal bonds, one cannot reject the Miller hypothesis that the marginal bondholder's tax rate is not different from the corporate tax rate. However, Trczinka is careful to point out that this finding does not necessarily imply that there is no tax advantage of corporate debt if the personal tax rate on equity is positive. Indeed, Buser and Hess [1], using a longer time series of data and more sophisticated econometric techniques, estimate that the average effective personal tax rate on equity is statistically positive and is not of a trivial magnitude. More importantly, they document evidence that is consistent with the existence of significant leverage-related costs in the economy.

A Further Empirical Investigation of the Bankruptcy Cost Question

Abstract: In this paper, empirical evidence with respect to both the direct and indirect costs of bankruptcy is assessed. This should be of interest for three related reasons. First, there is a need to provide further evidence as to the size of bankruptcy costs. Second, for the first time a proxy methodology for measuring indirect costs of bankruptcy is presented and actually measured. Third, a simple format for measuring the present value of expected bankruptcy costs is compared with the present value of expected tax benefits from interest payments on leverage. This comparison has important implications for the continuing debate as to whether or not an optimum capital structure exists for corporations. THIS PAPER PRESENTS an empirical investigation of the costs of bankruptcy. The relevance of bankruptcy costs remains as one of the major unresolved issues of financial theory. Empirical evidence, especially as to the amount of the expected bankruptcy costs and its consequent impact on optimum corporate capital structure is extremely sparse. If bankruptcy costs are relatively significant then it may be argued that at some point the expected value of these costs outweighs the tax benefit derived from increasing leverage and the firm will have reached its optimum capital structure point. An alternative view is that bankruptcy costs are relatively trivial and probably cannot explain capital structure decisions. At the extreme, one might argue that these costs are not even relevant to the cost of capital and capital structure decision and therefore should not be considered seriously. This study assumes that the expected bankruptcy cost issue is relevant and that firms do recognize the probability of bankruptcy as an important ingredient when making operating and financial decisions. A simple model is presented for identifying and measuring the expected bankruptcy costs and, then, for a sample of retail and industrial firm failures in the U.S., the following items are investigated: (1) direct bankruptcy costs including legal, accounting, filing and other administrative costs; (2) indirect bankruptcy costs, namely the lost profits that a firm can be expected to suffer due to significant bankruptcy potential; and (3)

The Effect of Interest Rate Changes on the Common Stock Returns of Financial Institutions

Abstract: This paper examines the relation between the interest rate sensitivity of common stock returns and the maturity composition of the firm's nominal contracts. Using a sample of actively traded commerical banks and stock savings and loan associations, common stock returns are found to be correlated with interest rate changes. The co-movement of stock returns and interest rate changes is positively related to the size of the maturity difference between the firm's nominal assets and liabilities.

A Further Investigation of the Weekend Effect in Stock Returns

Abstract: This study uses a longer time period and additional stocks to further investigate the weekend effect. We find consistently negative Monday returns (1) for the S & P Composite as early as 1928, (2) for Exchange-traded stocks of firms of all sizes, and (3) for actively traded over-the-counter (OTC) stocks. The OTC results are based on bid prices and therefore appear to reject specialist-related explanations. For the 30 individual stocks of the Dow Jones Industrial Index, the average correlation between Friday and Monday returns is positive and the highest of all pairs of successive days. The latter finding is inconsistent with fairly general measurement-error explanations. SOME OF THE MOST puzzling empirical findings reported in recent years indicate that the distribution of common stock returns varies by day of the week. Most notably, the average return for Monday (close Friday to close Monday) is significantly negative. Cross [3] and French [6] find negative Monday returns using the Standard and Poor's Composite Index, and Gibbons and Hess [7] find negative Monday returns for the 30 individual stocks of the Dow Jones Industrial Index.1 This negative Monday return, or "weekend effect," has yet to be explained. This study undertakes a further investigation of the weekend effect in stock returns. We examine additional time periods, extending the total period covered to 55 years; we examine additional stocks, such as those of small (low-capitalization) firms and those traded over the counter. In all cases, the data exhibit a weekend effect that is at least as strong as that reported in previous studies. The study also readdresses potential explanations for the effect, such as measurement error, but concludes that none of these explanations is satisfactory. The first section presents a history of the weekend effect from 1928 through 1982 based on the Standard and Poor's Composite Index. We essentially double the length of the period (beginning in 1953) examined by French [6]. The results indicate consistently negative Monday returns throughout the 55-year period. During much of the 25-year period from 1928 through 1952, the New York Stock Exchange was open on Saturdays, so Monday's return is then computed from Saturday's close to Monday's close.2 These returns for "one-day" weekends are consistently negative and not significantly different from the "two-day" weekend

Contingent Claims Analysis of Corporate Capital Structures: an Empirical Investigation

Abstract: Analysis is consistent with the approach of Fisher (1959) in that the model's inputs can be viewed as measures of financial and business risk. The advantage of CCA over the regression based analysis of Fisher (1959) is that CCA provides a specific functional relationship to be tested. In addition, given the structure of the CCA model, it is straightforward to infer firm values or other security values from the values of traded claims, and to price different convenant structures separately. In Section 2 of the paper, a brief discussion of the CCA valuation problem for a firm with equity and multiple issues of callable non-covertible sinking fund

Models of Stock Returns—A Comparison

Abstract: In this paper a discrete mixture of normal distributions is proposed to explain the observed significant kurtosis (fat tails) and significant positive skewness in the distribution of daily rates of returns for a sample of common stocks and indexes. Stationarity tests on the parameter estimates of this discrete mixture of normal distributions model revealed significant differences in the mean estimates that can explain the observed skewness and significant differences in the variance estimates that can explain the observed kurtosis. An alternative explanation for the observed fat tails is the symmetric student model. The result of a comparison between the models is that the discrete mixture of normal distributions model has substantially more descriptive validity than the student model. FOR MANY YEARS both financial economists and statisticians have been concerned with the description of stock market returns. The form of the distribution of stock returns is a crucial assumption for mean-variance portfolio theory, theoretical models of capital asset prices, and the prices of contingent claims. For example, understanding the behavior of the variance is essential to option pricing models. Empirical tests of asset pricing models and the efficient markets hypothesis draw statistical inferences that are also conditional on distributional assumptions. The most convenient assumption for financial theory and empirical methods is that the distribution of security rates of return be multivariate normal with parameters that are stationary over time. Since the normal distribution is stable under addition, any arbitrary portfolio of stocks will also be normally distributed. With the additional assumption of risk aversion, mean-variance theory follows. Furthermore, the assumptions of normality and parameter stationarity are required for most of the econometric techniques typically used in empirical research. Tests of the normality hypothesis on the daily returns of the Dow Jones Industrial stocks by Fama [121 revealed more kurtosis (fatter tails) than that predicted from a sample of independent and identically distributed normal variates. Fama concluded from this evidence that the distribution of price changes conforms better to the stable Paretian distribution with characteristic exponent

The American Put Option Valued Analytically

Abstract: An analytic solution to the American put problem is derived herein. The hedge ratio and other derivatives of the solution are presented. The formula derived implies an exact duplicating portfolio for the American put consisting of discount bonds and stock sold short. The formula is extended to consider put options on stocks paying cash dividends. A polynomial expression is developed for evaluating these formulae. Values and hedge ratios for puts on both dividend and nondividend paying stocks are calculated, tabulated, and compared with values derived by numerical integration and binomial approximation. As with European options, evaluating an analytic formula is more efficient than approximating the stock price process or the partial differential equation by binomial or finite difference methods. Finally, applications of this American put solution are discussed.

Corporate Behavior in Adjusting to Capital Structure and Dividend Targets: An Econometric Study

Abstract: This study of financing decisions by U.S. corporations examines the issuance of long term debt, issuance of short term debt, maintenance of corporate liquidity, issuance of new equity, and payment of dividends. Given costs and imperfections inherent in markets, a firm's financial behavior is characterized as partial adjustment to long run financial targets. Individual firm data are used so that speeds of adjustment are allowed to vary by company and over time. The results suggest that financial decisions are interdependent and that firm size, interest rate conditions, and stock price levels affect speeds of adjustment. THIS STUDY OF FINANCING DECISIONS by U.S. corporations examines the issuance of long term debt, short term debt and equity, the maintenance of corporate liquidity, and the payment of dividends. The firm's financial behavior is characterized as partial adjustment to long run financial targets, and individual firm data (1966-1978) are used to estimate firm-specific, time varying speeds of adjustment. The results suggest that financial decisions are interdependent and that firm size, interest rate conditions, and stock price levels affect speeds of adjustment. Also, the estimated coefficients are more plausible than the very small (Taggart [28]) or very large (Spies [26]) values found in earlier studies. Section I of the paper introduces the general model. In Section II, a tractable empirical model is developed. Section III presents the data to be used in the study and discusses econometric issues. In Section IV, results and conclusions are offered.

Mean-Variance Versus Direct Utility Maximization

Abstract: Levy and Markowitz showed, for various utility functions and empirical returns distributions, that the expected utility maximizer could typically do very well if he acted knowing only the mean and variance of each distribution. Levy and Markowitz considered only situations in which the expected utility maximizer chose among a finite number of alternate probability distributions. The present paper examines the same questions for a case with an infinite number of alternate distributions, namely those available from the standard portfolio constraint set. IT IS FREQUENTLY ASSERTED that mean-variance analysis applies exactly only when distributions are normal or utility functions quadratic, suggesting that it gives almost optimum results only when distributions are approximately normal or utility functions look almost like a parabola. On the other hand, in a recent paper Levy and Markowitz [6] showed empirically that the ordering of portfolios by the mean-variance rule was almost identical to the order obtained by using expected utility for various utility functions and historical distributions of returns. For example, the authors calculated an "exact" expected utility (of, say, a logarithmic utility function) for each of 149 mutual funds by attributing an equal probability for each year in the sample. Using the same data, the expected utility was approximated by a function of mean and variance U = f(E, V), where E represents the mean and V represents the variance. The exact expected utility and the approximation based only on E and V were found to be highly correlated. The analysis was repeated for various sets of data and various utility functions, and the same results were obtained in almost every case. Good results were obtained, then, when EU and f(E, V) were compared for a finite number of portfolios, e.g., 149 mutual funds. However, it may be that f(E, V) would do less well when asked to find the best portfolio among the infinite number of possible mixtures of a finite number of securities. In this case, the exact maximizing of expected utility might lead to quite different results than those obtained by using the mean-variance approximation. The aim of the present paper is to compare the expected utility of the optimum portfolio for given utility functions with the expected utility of well-selected portfolios from the mean

New Findings Regarding Day‐of‐the‐Week Returns over Trading and Non‐Trading Periods: A Note

Abstract: This paper decomposes daily close to close returns into trading day and non-trading day returns. We discover that all of the average negative returns from Friday close to Monday close documented in the literature for stock market indexes occurs during the non-trading period from Friday close to Monday open. In addition, average trading day returns (open to close) are identical for all days of the week. January/firm size/turn-of-the-year anomalies are shown to be interrelated with day-of-the-week returns.

Shareholder Benefits from Corporate International Diversification

Abstract: This study provides further evidence on the rates of return realized by the shareholders of multinational firms relative to those of purely domestic firms. The results indicate that the risk-adjusted returns realized by the shareholders are identical across the two groups except where the MNC operates in competitive foreign markets. In that case, MNC shareholders experience negative abnormal returns. The study also provides further evidence on the risk-reduction effect of international diversification. The results fail to support the hypothesis that the beta is a convex function of the degree of international involvement. Finally, the paper provides some preliminary evidence on the effect of corporate international diversification on shareholders' returns. It is found that abnormal returns rise by some 18 percent during the 14 months preceding the initial foreign diversification. A NUMBER OF EXPLANATIONS have been proffered for the popularity of inter

Hedging Performance and Basis Risk in Stock Index Futures

Abstract: IN EARLY 1982, TRADING BEGAN at three different exchanges in futures contracts based on stock indexes. Stock index futures were an immediate success, and quickly led to a proliferation of new futures and options markets tied to various indexes. One reason for this success was that index futures greatly extended the range of investment and risk management strategies available to investors by offering them, for the first time, the possibility of unbundling the market and nonmarket components of risk and return in their portfolios. Many portfolio management and other hedging applications in investment banking and security trading have been described elsewhere1 ranging from use by a passive fund manager to reduce risk over a long time horizon to use by an underwriter to hedge the market risk exposure in a stock offering for one or two days. In considering the potential applications of index futures, it is clear that in nearly every case a cross-hedge is involved. That is, the stock position that is being hedged is different from the underlying portfolio for the index contract.2 This means that return and risk for an index futures hedge will depend upon the behavior of the "basis," i.e., the difference between the futures price and the cash price. Hedging a position in stock will necessarily expose it to some measure of basis risk-risk that the change in the futures price over time will not track exactly the value of the cash position. Basis risk can arise from a number of different sources, and is a more significant problem for stock index contracts than for other financial futures, like Treasury bills and bonds.3 The most apparent cause of basis risk is the nonmarket component of return on the cash stock position. Since the index contract is tied to the behavior of an underlying stock market index, nonmarket risk cannot be hedged. This is the essential problem of a cross-hedge. However, basis risk can be present even when the hedge involves a position in the index portfolio itself and there is no nonmarket risk. For one thing, returns to the index portfolio include dividends, while the index, and the index future, only track the capital value of the portfolio. Any risk associated with dividends on the portfolio will become basis risk in a hedged position. Still, dividends are fairly low and also quite stable, so this may not be a terribly important shortcoming.

International Corporate Diversification, Market Valuation, and Size-Adjusted Evidence

Abstract: Errunza and Senbet [ES, 7] analyze the effects of international operations on the market value of the firm both at theoretical and empirical levels. The theoretical model, which is largely heuristic, exploits the costly supply adjustment of multinational firms (MNCs) in providing international portfolio diversification services to investors who face differential cost barriers to direct holdings of assets across national boundaries. MNCs compete as financial intermediaries to undo the barriers so that, in equilibrium, profits are driven out; MNCs and pure domestic firms sell at an equivalent risk-adjusted return. However, costly financial intermediation and the associated relative efficiency leads to a positive valuation effect for MNCs relative to purely domestic firms. Further, the equilibrium analysis implies that demand-side (investor) barriers to international capital flows alone are inconsequential to the valuation of MNCs in their pure financial role, but that the interaction with the supply-side costs are necessary to produce a valuation effect at the corporate level. ES subject the theory to an empirical analysis in a value-based approach by employing a variant of Tobin's [17] qratio. The analysis, controlling for industrial market power, suggests that the relationship between the excess valuation and the degree of international involvement (DOI) has magnified over periods characterized by severe U.S. government controls vis-a-vis the more recent periods. In this paper we formalize the theoretical argument by viewing indirect portfolio diversification by MNCs as a means of completing the international capital market. We employ a paradigm in the unanimity literature and formally characterize the equilibrium in which there is a rationale for MNC financial intermediation. We then perform an expanded empirical study by employing generalized least squares and maximum likelihood procedures. Since the positive relationship between excess valuation and DOI (as suggested in ES [7]) might be attributed to the so-called "small firm" or size and the P/E effects, the test methodology controls for such effects. Also, the traditional literature has relied upon foreign sales percentage as a proxy for DOI. In view of the well recognized limitations of this proxy, we employ four different measures of international

A Critical Reexamination of the Empirical Evidence on the Arbitrage Pricing Theory

Abstract: This paper demonstrates that the Roll and Ross (RR) and other previously published tests of the APT are subject to several basic limitations. There is a general nonequivalence of factor analyzing small groups of securities and factor analyzing a group of securities sufficiently large for the APT model to hold. It is found that as one increases the number of securities, the number of "factors" determined increases. This increase in the number of "factors" with larger groups of securities cannot readily be explained by a distinction between "priced" and "nonpriced" risk factors as it is impermissible to carry out tests on whether a given "risk factor is priced" using factor analytic procedures. THE APT MODEL as exposited by Ross [17], [18] and extended by Huberman [9] has provided the basis of an extensive literature, as for example, Brown and Weinstein [1], Chen [3], Hughes [10], Ingersoll [11], Jobson [12], Reinganum [15], Roll and Ross (RR) [16] and Shanken [17], to mention but a few. It has also been treated in a more general context by Chamberlain and Rothschild [2]. Our purpose here is not to comment on this collection of papers-many of which are unpublished-but to reexamine the evidence presented by RR and point out major pitfalls involved in the empirical methodology employed by them and others who have followed their lead. RR claim that, on theoretical and more importantly on empirical grounds, arbitrage pricing theory (APT) is an attractive alternative to the capital asset pricing model (CAPM). The APT, it is argued, requires less stringent and presumably more plausible assumptions, is more readily testable since it does not require the measurement of the market portfolio, and may be better able to explain the anomalies found in the application of the CAPM to asset returns. The acceptability of the APT, like that of the CAPM or any other theory, ultimately depends on its ability to explain the relevant empirical evidence. Our subsequent discussion will show that many of the prQblems associated with the CAPM are also present in the APT context and that its ability to explain the relevant empirical evidence is not markedly superior. Moreover, it raises questions not only about the RR and related empirical investigations of the APT but also about the testability of that theory in the present state of the art. A major part of the problem results from the necessity to break down the "universe" being analyzed through the APT model; this is forced upon the investigator by the fact

Are Real Interest Rates Equal Across Countries? An Empirical Investigation of International Parity Conditions

Abstract: This paper conducts empirical tests of the equality of real interest rates across countries. The empirical evidence strongly rejects the hypothesis of real rate equality and the joint hypotheses of uncovered interest parity and ex ante relative PPP, or the unbiasedness of forward rate forecasts and ex ante relative PPP. The evidence suggests that it is worth studying open economy macroeconomic models which allow: 1) domestic real rates to differ from world rates, 2) time varying risk premiums in the forward market, or 3) deviations from ex ante relative PPP. THE RELATIONSHIP OF REAL interest rates across countries is of central importance to our understanding of open economy macroeconomics. In some models where there is costless international arbitrage in goods and financial assets, real interest rates for comparable securities should be equal across countries. This has been a feature of much of the early research in the monetary approach to exchange rates, e.g., Frenkel [11] and Bilson [2]. On the other hand, finance theory indicates that risk premia may well differ for comparable securities denominated in different currencies (Solnick [27], Roll and Solnick [26], Stulz [28], Fama and Farber [7], Hansen and Hodrick [17], and Dornbusch [6]), and more recent theoretical models in the exchange rate literature, such as Dornbusch [5], Frankel [10], and Mussa [24], depend on real rates differing between countries in the short run. The proposition that real rates are equal across countries is worth studying

Investigating the Valuation Effects of Announcements of Voluntary Corporate Selloffs

Abstract: While there has been an abundance of empirical research on the subject of mergers and acquisitions, little research exists on a closely related topic—voluntary corporate selloffs. This study examines the effect on shareholder wealth of the announcement by management of an investment decision to voluntarily sell part of its operations to another firm. Positive abnormal returns are found to occur on the announcement date. However, it is found that such selloffs generally occur after a period of abnormally negative returns, suggesting the announcement is preceded by the release of negative information about the firm.

New Evidence That Taxes Affect the Valuation of Dividends

Abstract: This paper uses British data to examine the effects of dividend taxes on investors' relative valuation of dividends and capital gains British data offer great potential to illuminate the dividends and taxes question, since there have been two radical changes and several minor reforms in British dividend tax policy during the last 30 years Studying the relationship between dividends and stock price movements during different tax regimes offers an ideal controlled experiment for assessing the effects of taxes on investors' valuation of dividends Using daily data on a small sample of firms, and monthly data on a much broader sample, we find clear evidence that taxes affect the equilibrium relationship between dividend yields and market returns These findings suggest that taxes are important determinants of security market equilibrium and deepen the puzzle of why firms pay dividends FINANCIAL ECONOMISTS HAVE LONG been puzzled by corporate dividend behavior Many individual investors should value a dollar of corporate dividends less than a dollar of corporate retentions, because the former gives rise to greater tax liabilities Corporations, however, face equal costs of paying out dividends and retaining earnings Miller and Modigliani [31] demonstrated that, in the absence of taxes, dividend policy should have no effect on share valuation If dividends are tax penalized, however, a value maximizing firm should pay no dividends Widespread dividend payments to taxable investors are therefore surprising In 1981, dividend tax revenues in the United States were estimated to exceed 20 billion dollars' Indeed, some have interpreted the large volume of dividends paid as evidence against the rational behavior postulates typically used by economists The dividend question has stimulated a large theoretical and empirical literature concerned with the qluestion of investors' valuation of dividends In particular, the question of how taxes affect the market valuation of dividends has generated considerable controversy Numerous studies including Auerbach [2], Litzenberger and Ramaswamy [24, 26], Morgan [34], and Rosenberg and Marathe

Optimal Financial Policy and Firm Valuation

Abstract: SINCE THE CLASSIC WORK of Miller and Modigliani (1961) laid down the principles for the valuation of firms under conditions of certainty some two decades ago academic interest in the problem of valuing the individual firm has waned. Yet, in addition to the obvious importance of this problem for security analysts, investors, and acquirers of corporations, the issue of firm valuation is fundamental to much of the theory of corporate finance: what determines the risk of the firm; how the rate of return required by investors may be inferred from capital market data; the influence of financing policy on firm value, and other issues of central concern to the theory of financial management. This almost total neglect of firm valuation is attributable perhaps to the overwhelming influence of the research programme initiated by the development of the capital asset pricing model only three years after the publication of the above-mentioned paper by Miller and Modigliani. In its primary form, the capital asset pricing model is a statement about the equilibrium rates of return on securities, rather than about the equilibrium values of securities. It is straightforward to transform the model into a statement about the dependence of current equilibrium values upon an exogenously specified distribution of end of period values. However, in this form the model is inherently unsatisfactory since it fails to take account of the fact that in reality the distribution of end of period firm values is not exogenously given but is determined as part of a subsequent capital market equilibrium. Attempts to iterate the single period capital asset pricing model over several periods in order to avoid the need to take the distribution future security values as exogenous have been unsuccessful for the most part, since, not being able to derive, they have been forced to assume, both the requisite normality of the distribution of subsequent security prices, and the legitimacy of ignoring endogenously determined shifts in the individual investor's investment

Additional Evidence on the Relation Between Divestiture Announcements and Shareholder Wealth

Abstract: This paper presents estimates of the effect of voluntary divestiture announcements on shareholder wealth. The results show that both spin-off and sell-off announcements tend to have a positive influence on the stock prices of the divesting firms, and that the spin-offs “outperform” the sell-offs on the day of the event. We also find that the economic gains to the shareholders of the selling and acquiring firms are nearly identical, suggesting that the sell-off decision is perceived by both investor groups as a positive net present value (NPV) transaction.

Mean‐Gini, Portfolio Theory, and the Pricing of Risky Assets

Abstract: This paper presents the mean-Gini (MG) approach to analyze risky prospects and construct optimum portfolios. The proposed method has the simplicity of a mean-variance model and the main features of stochastic dominance efficiency. Since mean-Gini is consistent with investor behavior under uncertainty for a wide class of probability distributions, Gini's mean difference is shown to be more adequate than the variance for evaluating the variability of a prospect. The MG approach is then applied to capital markets and the security valuation theorem is derived as a general relationship between average return and risk. This is further extended to include a degree of risk aversion that can be estimated from capital market data. The analysis is concluded with the concentration ratio to allow for the classification of different securities with respect to their relative riskiness.

Signaling and the Valuation of Unseasoned New Issues: A Comment

Abstract: IN THE MARCH 1982 issue of this Journal, David Downes and Robert Heinkel [1] present an empirical examination of the role of signaling in the valuation of initial public offerings of common stock. For a large sample of unseasoned new issues, they examine the Leland-Pyle [2] signaling hypothesis that firm value should be positively related to the fraction of equity retained by the original shareholders. Downes and Heinkel conclude that the data are consistent with the Leland-Pyle signaling hypothesis. In this comment, I present a more complete test of the Leland-Pyle signaling model. I also present two alternative explanations for the positive empirical relation between firm value and insider holdings, which I label the agency hypothesis and the wealth effect hypothesis. I find that the testable implications of the agency hypothesis are supported, while the evidence is ambiguous with respect to the testable implications of the wealth effect and signaling hypotheses.

The Leasing Puzzle

Abstract: Prevailing theories in finance and economics suggest that leases and debt are substitutes; an increase in one should led to a compensating decrease in the other. In particular, there are three views on the magnitude of the substitution coefficient. Standard finance theory treats cash flows from lease obligations as equivalent to debt cash flows, thus describing the tradeoff between debt and leases as one-to-one. Others are willing to use a tradeoff of leases for debt which is less than, but close to, one. The rationale for a dollar of leases using less of debt capacity than a dollar of debt obligation is based upon the differences in the terms and nature of lease and debt contracts. Finally, there are some who argue that since leased assets may be firm-specific, the risk of moral hazard may be great, resulting in a tradeoff of greater than one-to-one; that is, a dollar of a lease obligation uses more of debt capacity than a dollar of a debt obligation. A series of empirical tests are performed in this study on samples of approximately 600 firms, covering the years 1976 through 1981, with none of the three views supported by the results. Instead, the results indicate that leases and debt are complements; greater use of debt is associated with a greater use of leasing. This finding reappears consistently for each year, each definition of leverage ratios, and each approach to analysis. This complementary relationship persists even after refinements are made to the estimation technique.

Option Pricing When the Underlying Asset Earns a Below-Equilibrium Rate of Return: A Note

Abstract: IN THEIR CLASSIC PAPER, Black and Scholes [2] present two derivations of the European call option pricing formula. The first, which we will refer to as the "replication derivation," relies on the fact that the returns from the option can be replicated by holding a continuously revised position in the underlying asset and bonds. This implies that if an option is not priced according to the BlackScholes formula, there is a sure profit to be made by some combination of either short or long sales of the option and underlying asset. This argument is seemingly independent of considerations relating to capital market equilibrium. The second derivation, which we will call the "equilibrium derivation," evolves from the requirement that the option earn an expected rate of return commensurate with the risk involved in holding the option as an asset. This note considers the pricing of a call option on an asset which earns an expected rate of return lower than that necessary to induce investors to hold it. We show in this case that even if the replication strategy is feasible, it is inefficient. A consequence of this is that the correct option pricing formula is different than the Black-Scholes formula. Unlike the Black-Scholes formula, our formula requires as an input the difference between the expected rate of return on the underlying asset and that expected rate of return which would be required to induce holding of the asset. Other papers have made a similar point. Constantinides [3] and Cox et al. [4] have argued that in equilibrium the prices of traded contingent claims must satisfy a partial differential equation which is identical to the Black-Scholes partial differential equation only when the underlying asset pays no dividends and earns a rate of return sufficient to induce holding of the asset. More recently, Ingersoll [5] has noted that commodities often pay a nonpecuniary service yield, the value of which must be taken into account in deriving the option price. None of these authors, however, explain why the Black-Scholes formula is sometimes inappropriate. The purpose of this note is to demonstrate why the Black-Scholes formula needs modification even if replication is feasible. We provide an intuitive derivation of the correct formula and discuss why divergences of the equilibrium price from the Black-Scholes formula do not result in arbitrage opportunities.

The Turn‐of‐the‐Year in Canada

Abstract: A number of investigators have reported that January stock returns in the U.S. exceed returns for other months of the year. This paper documents a similar finding for Canadian stocks over the period 1951-1980. However, Canada did not introduce a capital gains tax until 1973 and the paper reports that January returns in Canada exceed returns for other months of the year before and after this date. Thus, these data do not support the tax-loss-selling-pressure hypothesis as the entire explanation for the turnof-the-year effect in stock returns, nor, by implication, do they support the tax-lossselling-pressure hypothesis as the complete explanation for the "small firm" effect in U.S. stocks returns. RECENTLY KEIM [9] has reported that returns on NYSE and ASE firms with small market values exceed, by significant margins, returns on firms with large market values. This result was previously reported by Banz [1] and Reinganum [11], but Keim's analysis shows that most of the excess return for small firms is concentrated in January.' Indeed, it is concentrated in the first two weeks in January. Roll [13] also documents this phenomenon and investigates a number of possible explanations for it.2 After rejecting several possible "nonexploitable" explanations, Roll is left with year-end tax-loss selling pressure, of the sort discussed by Branch [2], Dyl [5], and Givoly and Ovadia [6], as the most likely explanation of this result. According to the tax-loss-selling-pressure hypothesis, toward the end of the year stockholders sell stocks that have declined in price during the year. Investors do this to take advantage of the opportunity to write-off capital losses against ordinary income in computing their federal income taxes. The year-end sell-off exerts downward pressure on stock prices. As soon as the tax and calendar year ends, the selling pressure is relieved and stock prices quickly rebound to their "equilibrium" levels. Roll [13] presents some evidence consistent with this hypothesis. Specifically, he finds a negative correlation between stock returns in January and returns over the previous 12 months. That is, stocks that decrease in value during the year tend to be big gainers in January. Roll also finds that

Some Results in the Theory of Arbitrage Pricing

Abstract: This paper derives a stronger version of Huberman's recent "preference free" pricing theorem. This pricing result relates the expected return on an asset to its factor responses and the covariance structure of the residuals from a linear factor model. It must characterize any infinite asset economy in which no arbitrage opportunities are present whether or not the factor model has uncorrelated residuals. This result provides the intuition for the role of residual risk in the pricing model and eliminates some classes of arbitrage opportunities still present under Huberman's bound. Some applications to empirical tests and performance measurement are also discussed. THE ARBITRAGE PRICING THEORY is one of several financial pricing models which attempts to explain the cross-sectional variation in expected returns on assets. In certain respects it is similar to the Capital Asset Pricing Model, but there are both substantive and subtle differences. One of the key advantages of the APT is that it derives a simple linear pricing relation approximating that in the CAPM without some of the latter's objectionable assumptions. Perhaps the key disadvantage of the APT is that it provides no clues as to what might be important factors nor as to how to interpret the factor premiums which appear in the pricing equation. This paper serves several purposes. After reviewing the linear factor model formulation in Section I, it derives in Section II a stronger version of Huberman's [9] recent "preference free" pricing theorem. This pricing result relates the expected return on an asset to its factor responses and the covariance structure of the residuals. This relation must characterize any infinite asset economy in which no arbitrage opportunities are present whether or not a linear factor model with uncorrelated residuals is the appropriate returns generating mechanism. Section III specializes this result by eliminating the effects of residual covariances, and compares the results here to those of previous APT models. When applied to the standard linear factor model with uncorrelated residuals, this new pricing bound eliminates arbitrage opportunities which remain under Huberman's bound. This result also provides for the first time the intuition for the role of residual risk in the approximate pricing relation. Section V provides an interpretation of the factor premiums and gives a valid asset pricing model interpretation to the APT which is consistent with Merton's

A Risk Minimizing Strategy for Portfolio Immunization

Abstract: Consider a fixed-income portfolio whose duration is equal to the length of a given investment horizon. It is shown that there is a lower limit on the change in the end-ofhorizon value of the portfolio resulting from any given change in the structure of interest rates. This lower limit is the product of two terms, of which one is a function of the interest rate change only, and the other depends only on the structure of the portfolio. Consequently, this second term provides a measure of immunization risk. If this measure is minimized, the exposure of the portfolio to any interest rate change is the lowest. THE TRADITIONAL THEORY OF immunization as formalized by Fisher and Weil [6] defines the conditions under which the value of an investment in a bond portfolio is protected against changes in the level of interest rates. The specific assumptions of this theory are that the portfolio is valued at a fixed horizon date, that there are no cash inflows or outflows within the horizon, and that interest rates change only by a parallel shift in the forward rates. Under these assumptions, a portfolio is said to be immunized if its value at the end of the horizon does not fall below the target value, where the target value is defined as the portfolio value at the horizon date under the scenario of no change in the forward rates. The main result of this theory is that immunization is achieved if the duration of the portfolio is equal to the length of the horizon. The assumption that interest rates can only change by a parallel shift (that is, by the same amount for all maturities) has been the subject of considerable concern. Bierwag [1, 2], Bierwag and Kaufman [3], Khang [7], and others have postulated alternative models of interest rate behaviors. Each of these specifications implies a different measure of duration, with immunization attained if this duration measure is equal to the horizon length. A limitation of this approach is that the portfolio is protected only against the particular type of interest rate change assumed. In a more recent development, Cox et al. [5], Brennan and Schwartz [4], and others have investigated immunization conditions when interest rates are governed by a continuous process consistent with a market equilibrium. Depending on the specilfication of the interest rate process, there is a duration-like measure (possibly multidimensional, as in Brennan and Schwartz) such that the portfolio is immunized if a proper value of this measure is maintained. This assumes a continuous rebalancing of the portfolio. Again, immunization is achieved only if interest rate changes conform to the specific process assumed. In this paper, we wish to pursue a different approach. If it turned out that the