Showing papers in "The Journal of Business in 1982"

On the Corporate Demand for Insurance

Abstract: Insurance contracts are regularly purchased by corporations. The Insurance Information Institute reports that “business insurance accounted for approximately 54.2 percent of the $79, 032,923,000 in direct property and liability insurance premiums written in the United States in 1978” (1979, p. 9). Yet even though annual premiums exceeded $42.8 billion,1 the importance of these contracts has been largely ignored by the finance profession. For example, the topic of insurance is completely absent from the index of virtually all corporate finance textbooks.

Intertemporal Asset Pricing with Heterogeneous Consumers and Without Demand Aggregation

Abstract: Consumer heterogeneity raises two problems in the derivation of the intertemporal asset-pricing model. First, it is implausible to assume that all assets' returns are multivariate normal (or exhibit separability). Second, the stocliastically varying distribution of wealth among consumers is a vector of state variables which may add a large number of parameters to the two-parameter asset-pricing model. Consider the first problem. The SharpeLintner asset-pricing model (CAPM) is derived under the assumption that all assets' returns are multivariate normal (or, more generally, that they exhibit separability).' Whereas it may be plausible to assume that stocks' returns are multivariate normal, it is implausible to assume that all financial assets' returns are multivariate normal. (Financial assets are defined to be the assets in zero net supply.) For example, over a finite time interval a call option's return has a truncated (possibly normal or lognormal) distribution Consumer heterogeneity raises two problems in the derivation of the intertemporal asset-pricing model. First, it is implausible to assume that all assets' returns are multivariate normal (or exhibit separability). Second, the stochastically varying distribution of wealth among consumers is a vector of state variables which may add a large number of parameters to the twoparameter asset-pricing model. Both problems are resolved in a complete market. Optimality of the competitive equilibrium implies that prices, production, and aggregate consumption are the same as in the equilibrium of a central planner or composite consumer. In the composite consumer's observationally equivalent equilibrium no distributional assumptions are necessary about zero net supply assets. Also the wealth distribution among heterogeneous consumers becomes an irrelevant state variable. *1 thank Philip H. Dybvig, Jonathan E. Ingersoll, and Edward C. Prescott for helpful criticism on earlier drafts. I remain responsible for errors. 1. Related work includes Mossin (1966), Fama (1970, 1971), Black (1972), and Ross (1976, 1978). The CAPM may be derived under the assumption of quadratic utility without any distributional assumptions. The assumption of quadratic utility resolves the first but not the second of the two problems outlined below.

Mean-Variance Theory in Complete Markets

Abstract: Two paradigms in the pricing of risky assets are the "complete markets" model of Arrow and Debreu and mean-variance pricing as embodied in the capital asset pricing model (CAPM). The former is primarily of theoretical interest. In fact, prior to the recent work of Banz and Miller (1978) and Breeden and Litzenberger (1978) there was little thought or hope of practical applications. On the other hand, the hegemony of the CAPM is due mostly to its apparent ease of applicability and, to a lesser extent, its empirical justification. In a competitive market with no taxes, transactions costs, or institutional constraints on portfolio holdings, the allocation of the available assets will be Pareto optimal. The end-of-period distribution of wealth (or the consumption goods), however, will typically be Pareto optimal only when there is available an Arrow-Debreu security for each contingency. Since, by definition, a Pareto superior reallocation is weakly preferred by all investors, a complete set of Arrow-Debreu markets should naturally arise provided they are not too costly to establish. The complete-markets model of Arrow and Debreu and the meanvariance capital asset pricing model (CAPM) are two paradigms of risky asset markets. This paper provides an integration of these two theories. We prove that the standard meanvariance separation theorem obtains in a complete market only if all investors have quadratic utility. In addition, the familiar CAPM pricing relation can hold for all assets in a complete market only if arbitrage opportunities exist. On the positive side, we show that the validity of this relation for the primary assets in a complete market is unaffected by the distribution of returns on the created financial assets.

Insider Trading and the Dissemination of Firms' Forecast Information

Abstract: It is generally supposed that corporate insiders have access to information superior to that of outsiders. Empirical work on insider trading by Jaffe (1974) and Finnerty (1976a, 1976b) has found that insiders do earn higher returns on their shareholdings than outsiders, on average. Further, insiders in different managerial positions appear to earn differential abnormal returns (Baesel and Stein 1979).1 Investors subscribe to services which summarize insider trading activity2 and act on the information released in the SEC's Official Summary of Insider Trading (Jaffe 1974). This evidence suggests that insiders do indeed have superior information and use that information in trading in their firms' securities. This paper investigates more directly the link between observed insider information and insider trading and also the link between insider trading and information-dissemination activities. The tests reported here examine the security trading of corporate insiders around the time they make public announcements about their

Inflation, Output, and Money

Abstract: This paper uses money-demand theory and a rational-expectations version of the quantity theory of money to study inflation in the United States during the post-Korean War period The major results are as follows 1 The theory and tests explain the phenomenon of stagflation, that is, the negative relation between inflation and real activity observed during the post-1953 period The analysis calls into question the many variants of the Phillips curve which presume that inflation-real activity relations are positive 2 Consistent with the models of Patinkin (1961) and Fama (1980), monthly, quarterly, and annual data indicate that the base (currency plus reserves held against deposits) is the relevant monetary variable in the inflation process and that demand deposits are irrelevant The direct policy implication is that the base is the key monetary variable in the control of inflation 3 The most convincing evidence for the simple quantity-theory view of inflation proposed here comes from the comparison of the conditional exMoney-demand theory and the quantity theory of money are used to study the inflation process As predicted by the model, monthly, quarterly, and annual data indicate that inflation is positively related to money growth rates and negatively related to growth rates of real activity The theoretical and empirical origins of stagflation are explained, and changes in monetary arrangements to simplify the control of inflation are prescribed

Memory and Markets, or Why Are You Paying $2.99 for a Widget?

Abstract: The constraints introduced in the analysis of individual behavior in economics were mainly two: income and time. Although we do sometimes find references to biological constraints like stomach capacity (see Becker 1971, p. 54), it and other biological constraints' implications on market behavior were not investigated. The purpose of this paper is to show that consideration of the limited memory capacity of human beings sheds light both on specific features of literature and arts and on characteristics of advertising. In Section II the formal model, which is based on Becker's (1965) approach, is presented. In Section III the subject of advertising is discussed, while in Section IV we focus on the evidence from literature and arts. Section V contains the conclusions.

Sequential Signals of Recession and Recovery

Abstract: This paper describes a sequential procedure for identifying the beginning and ending dates of business cycle recessions as promptly and accurately as practicable. Its origin lies in a study in progress for the Economic Development Administration (EDA), U.S. Department of Commerce, which deals with the problem of designing and testing an efficient trigger formula for public works expenditures with the aid of a system of cyclical indicators. However, the proposed approach can be applied much more broadly to any temporary countercyclical policy program on the national level. Federal policy programs of job creation through public works or public service employment have been repeatedly called countercyclical without in fact being so. Most such programs came into effect much too late to counter the cyclical Early and confirming signals of business cycle peaks and troughs are produced sequentially on a current basis by a system of monitoring smoothed rates of change in the composite indexes of leading and coincident indicators. Evidence is offered that the system would have identified each of the peaks and troughs of U.S. business cycles since 1949 without undue delays and false alarms. Countercyclical policies activated and deactivated by such signals would have desirable timing properties.

The Returns and Risk of Alternative Put Option Portfolio Investment Strategies

Abstract: This paper is the second in a series of analyses we have prepared based on simulations of a variety of portfolio strategies over a significant period of time. The first of these analyses' examined the "fully covered" call-option-writing strategy and the buying strategy which combines purchase of call options and commercial paper. In the study presented here, we examine the "uncovered" put-writing strategy and the buying strategy which combines the purchase of put options and the underlying stocks. As a preface to the simulations, we analyze the quantitative discrepancies between the parity model of put pricing and a model which takes into account the possibility of early exercise of the put. In connection with this analysis, we simulate the returns to the "conversion" strategy which combines the purchase of put options and the underlying stocks with the simultaneous sale of the corresponding call options. As in our earlier paper on call-option strategies, we find in this study that investors can use uncovered putoption-writing and protective put-optionbuying strategies to produce patterns of returns for investment portfolios, not reproducible by any simple strategy of combining stock with fixed-income securities. Put options are viewed as term insurance, insuring against a loss in value of underlying stock: investors sell insurance by using the uncovered put-writing strategies and investors buy insurance protecting the value of stocks within a portfolio by using protective put-optionbuying strategies. No put strategy or call strategy can dominate any other strategy if options are priced correctly. Although there is no single best strategy for all investors, they are not indifferent among strategies because the patterns of returns differ. We, therefore, show these important patterns of returns on put-option strategies not only using single stocks but also using portfolios of stocks. *This research was financed, in part, by grants from Donaldson, Lufkin, & Jenrette, New York; the Center for Research in Security Prices, University of Chicago; and the National Science Foundation, Washington, D.C. 1. Merton, Scholes, and Gladstein (1978). In the present paper, all references to "our earlier paper" are to this study.

Optimal Pricing Policy in the Presence of Experience Effects

Abstract: In this paper we analyze the problem of optimal intertemporal pricing for a monopolist when current (and past) output affect future cost and/or demand conditions through "experience" in production and/or in consumption. Learning by doing, the experience curve, contagion, habit formation, bandwagon, and snob effects are all examples of terminologies used to describe such situations. We call these "experience effects" for convenience and explore profit-maximizing pricing behavior when such effects exist.' In the traditional profit-maximization model, a firm chooses the price-output combination so as to maximize short-run (i.e., current) profits. The familiar MC = MR equality (given that price is higher than average variable cost and a nonbinding capacity constraint) is a necessary condition for price takers as well as price makers. This assumes that the current pricing decision has no bearing on the future, so that long-run profit is maximized by a series of short-run maximizing

Consumer Payment Systems: The Relationship of Attribute Structure to Preference and Usage

Abstract: Within the marketing literature a great deal of research effort has been invested in attempting to understand consumer purchasing behavior. While extensive knowledge has been accumulated, one potentially important path of research has remained virtually unexplored. This concerns the systems of payment consumers use to conduct economic exchanges. Consumer attitudes toward, choices among, and use of alternative payment systems would appear to present some unique and important challenges for research. Much prior research on consumer payment systems has consisted of descriptive profiles of credit card users (e.g., Etzel 1968, 1974; Matthews and Slocum 1969, 1972; Plummer 1971; Mandell 1972; Awh and Waters 1974; Wiley and Richard 1974; Russell 1975; Hawes, Talarzyk, and Blackwell 1976; Adcock, Hirschman, and Goldstucker 1977; Hirschman and Goldstucker 1978). Despite the great research attention given to credit cards, a review of published literature revealed no empirical or theoretical studies centered on other major payment systems such as cash, checking accounts, or travel and entertainment (T&E) cards. Two assumptions appear

The Demand for Service Contracts

Abstract: The Magnuson-Moss Warranty-Federal Trade Commission Improvement Act of 1975 for the first time explicitly provided the federal government with the legislative authority to regulate warranties on goods and services. The Act provided for the regulation of the form and some of the terms and language used in warranties (Gerner and Bryant 1976; Heaton and Katz 1978; Heaton, Katz, and Adam 1978). The attention paid to warranties, however, has also created interest in substitutes for written warranties, among which is the service contract. While the service contract has been used not as a substitute for a written warranty but rather as an option available on the expiration of the warranty, there is little question that under appropriate conditions manufacturers would offer service contracts in place of warranties. An appliance service contract typically provides repair service, specified maintenance service, preventive checkups, and may provide specified consequential damages. Service contracts have been available for many years on some products. However, their widespread

The Marketing Intermediary as an Information Seller: A New Approach

Abstract: The rationale for the emergence of intermediary institutions in marketing channels has been the focus of research for many marketing scholars. A review of the work done in this area reveals two broad approaches to this issue. One group of scholars has focused on the ability of such intermediary institutions to reduce costs of the physical flows of goods and services from producers to users. Alderson and Martin (1965) in their ";sortment and assortment" model suggested that marketing intermediaries can streamline physical flows and rearrange them in more economic setups. Stigler (1951) introduced the notion of vertical specialization, whereby he proposed that marketing functions are shifted to specialized agencies to achieve greater efficiencies. Mallen's (1973) notion of vertical spin-off followed basically the same rationale. Another approach adopted by several researchers has been to focus on the role of a marketing intermediary in facilitating the transmission of information within the marketing channel between producers and users. Therefore, these researchers developed analytic frameworks purporting to explain the emergence of marketing intermediaries due to their ability to collect, disseminate, and use information efficiently (Balderston 1958; Bucklin 1965; Baligh and Richartz 1967).

On Functions, Quality, and Timeliness of Economic Information

Abstract: Economic decisions confront more uncertainty as they grow in scope and reach further into the future. They are likely to do so increasingly in decentralized economies that expand and diversify. The economic incentives to reduce uncertainty and improve predictions and decisions give rise to the demand for large amounts of diverse information. This is not a new phenomenon, of course, but it is revealed more clearly than ever in the present era of great advances in informational technology, for now the demand is to a large extent visibly satisfied. The "knowledge industries" or "services of inquiring, comThe uncertainty about economic information increases with the probability of error in the underlying data and their processing and interpretation. Many errors cannot be promptly detected and eliminated but can be gradually reduced over time, as attested by the revisions in economic statistics. This paper presents substantial evidence on the accuracy of provisional estimates of quarterly and monthly changes in 18 important variables. Measures of several aspects of data quality and of average lags of data release and signal detection are provided for a collection of 110 widely used economic indicators. These materials help identify the location of the more serious measurement errors by variables and period, and they show that informational lags of 5 and more months are frequent. *This paper is part of the National Bureau of Economic Research Program on Economic Fluctuations. It was presented at the First International Symposium on Forecasting in Quebec City on May 27, 1981 and at the Ifo-Institute for Economics Research in Munich on September 23, 1981. Financial support from the National Science Foundation and the aid of the Graduate School of Business of the University of Chicago and NBER are gratefully acknowledged. I am indebted to Louis Lambros for helpful suggestions and efficient research and to John Gould and Geoffrey Moore for useful comments. 1. Growth in the modem economy is motivated by the desire to accumulate human and physical resources (capital in the most general sense) and is accomplished by actions that necessarily have long-term consequences. The decisions to choose these particular courses of action (strategies) must therefore be based on similarly long expectations, which are fallible. As the risk is high, so is the premium on any knowledge that might help the decision maker.

The Price Differential between Domestic and Imported Steel

Abstract: : In most years since the late 1950's, the price of imported steel has been below the domestic price. This low import price has been a recurrent worry to steel workers and producers, who fear that imports will force domestic mills out of business. Little help is expected from buyer loyalty to American steel: steel is steel and the buyer need only find the cheapest source. The concerns of the steel producers and workers seem, at first, well founded in economic theory: two products which substitute perfectly in use simply cannot sell at different prices; either the higher price will fall to meet the competition or production of the higher priced one will stop. But the production of domestic steel has not stopped, even though domestic producers have lost some ground to imports. Since the late 1950's, when imports first became low priced, the demand for imports has grown steadily and, sometimes, suddenly, as in 1968. Still, the amazing story is not that imports have grown swiftly, but that they have grown slowly. In 1962, imports had 6 percent of the U.S. market. In 1976, 14 years later, they had 14 percent. So each year, on the average, imports have increased their share of the market by less than one percent. (Author)

Hedging Against Commodity Price Inflation: Stocks and Bills as Substitutes for Futures Contracts

Abstract: This study is concerned with the influence of changes in commodity prices on security prices. The study is motivated by the observation that stochastic changes in commodity prices represent a risk to each consumer-investor and that attempts to deal with these risks may be reflected in the demand for securities and ultimately in their prices and rates of return. If security rates of return do reflect information regarding relative price-change risk, it should be possible to extract that information from the price and returns history of the securities. Following this reasoning, we attempt to form portfolios of stocks and U.S. Treasury bills that hedge against price changes of various commodities. This approach differs from previous studies on hedging because we attempt to hedge against price changes in individual commodities, not macro aggregates. Our empirical results, however, indicate that the history of stock and bill returns contains very little information regarding relative price changes so that our attempts to hedge against commodity price

A Game Theoretic Approach to Cash Management

Abstract: The cash management function is a general designation for two distinct corporate activities: cash flow acceleration and liquidity account allocation. The former problem concerns procedures for speeding cash collections from customers and slowing cash disbursements to suppliers so as to optimize the firm's use of cash. The latter problem, on the other hand, takes the firm's cash flow as given and determines the minimum cash balance, the excess to be held in the form of marketable securities. Although a well-developed literature exists for the liquidity account allocation problem (e.g., Baumol 1952; Tobin 1956; Miller and Orr 1966; Eppen and Fama 1968), analysis of the cash flow acceleration problem has been less extensive. Some papers examine techniques for speeding cash collections, such as lock box systems (e.g., Kraus, Janssen, and McAdams 1970) while others explore methods for slowing cash disbursements, such as remote disbursement systems (e.g., Gitman, Forrester, and Forrester 1976), but no one has investigated the interaction of the two. This is a serious deficiency, because, as a practical matter, firms simultaneously utilize both types of procedures, so that the cash management efforts of other firms tend to counteract each firm's own efforts. An inherently

Measuring Dynamic Marketing Mix Interactions Using Translog Functions

Abstract: Jagpal et al. (1979) showed, using multiplicative nonhomogeneous (MNH) sales response functions, that current econometric specifications for measuring marketing mix interactions and/or carryover effects may be structurally restrictive, regardless of their predictive usefulness. They concluded that there is a need for more flexible specifications of the sales response function which provide greater consistency with marketing theory and hence allow more effective control of marketing instruments. This paper proposes the transcendental logarithmic (translog) formulation because it is more general than the MNH function. First, we develop the rationale for the translog specification. In the second part of the paper, we estimate a translog advertisingsales model using the monthly Lydia Pinkham data. The translog results are shown to be consistent with marketing theory, to differ significantly from previous analyses of the same data, and to have useful policy implications.