Showing papers in "The Journal of Business in 1986"

Economic Forces and the Stock Market

Abstract: This paper tests whether innovations in macroeconomic variables are risks that are rewarded in the stock market. Financial theory suggests that the following macroeconomic variables should systematically affect stock market returns: the spread between long and short interest rates, expected and unexpected inflation, industrial production, and the spread between high- and low-grade bonds. We find that these sources of risk are significantly priced. Furthermore, neither the market portfolio nor aggregate consumption are priced separately. We also find that oil price risk is not separately rewarded in the stock market.

The Hubris Hypothesis of Corporate Takeovers

Abstract: Despite many excellent research papers, we still do not fully understand the motives behind mergers and tender offers or whether they bring an increase in aggregate market value. In their comprehensive review article (from which the above quote is taken), Jensen and Ruback (1983) summarize the empirical work presented in over 40 The hubris hypothesis is advanced as an explanation of corporate takeovers. Hubris on the part of individual decision makers in bidding firms can explain why bids are made even when a valuation above the current market price represents a positive valuation error. Bidding firms infected by hubris simply pay too much for their targets. The empirical evidence in mergers and tender offers is reconsidered in the hubris context. It is argued that the evidence supports the hubris hypothesis as much as it supports other explanations such as taxes, synergy, and inefficient target management. * The earlier drafts of this paper elicited many comments. It is a pleasure to acknowledge the benefits derived from the generosity of so many colleagues. They corrected several conceptual and substantive errors in the previous draft, directed my attention to other results, and suggested other interpretations of the empirical phenomena. In general, they provided me with an invaluable tutorial on the subject of corporate takeovers. The present draft undoubtedly still contains errors and omissions, but this is due mainly to my inability to distill and convey the collective knowledge of the profession. Among those who helped were C. R. Alexander, Peter Bernstein, Thomas Copeland, Harry DeAngelo, Eugene Fama, Karen Farkas, Michael Firth, Mark Grinblatt, Gregg Jarrell, Bruce Lehmann, Paul Malatesta, Ronald Masulis, David Mayers, John McConnell, Merton Miller, Stephen Ross, Richard Ruback, Sheridan Titman, and, especially, Michael Jensen, Katherine Schipper, Walter A. Smith, Jr., and J. Fred Weston. I also benefited from the comments of the finance workshop participants at the University of Chicago, the University of Michigan, and Dartmouth College, and of the referees.

Fairness and the Assumptions of Economics

Abstract: The advantages and disadvantages of expanding the standard economic model by more realistic behavioral assumptions have received much attention. The issue raised in this article is whether it is useful to complicate-or perhaps to enrichthe model of the profit-seeking firm by considering the preferences that people have for being treated fairly and for treating others fairly. The absence of considerations of fairness and loyalty from standard economic theory is one of the most striking contrasts between this body of theory and other social sciences-and also between economic theory and lay intuitions about human behavior. Actions in many domains commonly conform to standards of decency that are more restrictive than the legal ones: the institutions of tipping and lost-and-found offices rest on expectations of such actions. Nevertheless, the standard microeconomic model of the profitmaximizing firm assigns essentially no role to The traditional assumption that fairness is irrelevant to economic analysis is questioned. Even profit-maximizing firms will have an incentive to act in a manner that is perceived as fair if the individuals with whom they deal are willing to resist unfair transactions and punish unfair firms at some cost to themselves. Three experiments demonstrated that willingness to enforce fairness is common. Community standards for actions affecting customers, tenants, and employees were studied in telephone surveys. The rules of fairness, some of which are not obvious, help explain some anomalous market phenomena. * The research for this paper was supported by the Department of Fisheries and Oceans Canada. Kahneman and Thaler were also supported, respectively, by the U.S. Office of Naval Research and by the Alfred P. Sloan Foundation. Conversations with J. Brander, R. Frank, and A. Tversky were very helpful. We also thank Leslie McPherson and Daniel Treisman for their assistance. The paper presented at the conference and commented on by the discussants included a detailed report of study 3, which is only summarized here. It did not contain study 1, which was incomplete at the time. Daniel Kahneman is now in the Department of Psychology, University of California, Berkeley 94720.

Rationality in Psychology and Economics

Abstract: The task I shall undertake here is to compare and contrast the concepts of rationality that are prevalent in psychology and economics, respectively. Economics has almost uniformly treated human behavior as rational. Psychology, on the other hand, has always been concerned with both the irrational and the rational aspects of behavior. In this paper, irrationality will be mentioned only obliquely; my concern is with rationality. Economics sometimes uses the term "irrationality" rather broadly (e.g., Becker 1962) and the term "rationality" correspondingly narrowly, so as to exclude from the domain of the rational many phenomena that psychology would include in it. For my purposes of comparison, I will have to use the broader conception of psychology. One point should be set immediately outside dispute. Everyone agrees that people have reasons for what they do. They have motivations, and they use reason (well or badly) to respond to these motivations and reach their goals. Even much, or most, of the behavior that is called abnormal involves the exercise of thought and reason. Freud was most insistent that there is method in madness, that neuroses and psychoses were patients' solutions-not very satisfactory solutions in the long run-for the problems that troubled them. The assumption that actors maximize subjective expected utility (economic rationality) supplies only a small part of the premises in economic reasoning, and that often not the essential part. The remainder of the premises are auxiliary empirical assumptions about actors' utilities, beliefs, expectations, and the like. Making these assumptions correctly requires an empirically founded theory of choice that specifies what information decision makers use and how they actually process it. This behavioral empirical base is largely lacking in contemporary economic analysis, and supplying it is essential for enhancing the explanatory and predictive power of economics.

Salaries and Piece Rates

Abstract: Compensation can take many forms. Remuneration can come as pecuniary payments, as fringes such as health and pension benefits, or as a nonpecuniary reward such as plush office furniture that costs the firm less than it benefits the worker. A significant literature has examined the trade-offs between pecuniary and nonpecuniary compensation, the modern work having been pioneered by Rosen (1974). More recently, another body of literature has examined the selection of method of total compensation, ignoring the distinction between pecuniary and nonpecuniary payment. This work has focused on risk and incentive factors. It has resulted in comparisons of compensation based on absolute output levels to that based on relative performance.' It has also led to explorations of the relation of compensation to experience over the work life.2 Little attention has been paid to what may be among the most important and obvious distinction in methods of compensation, namely, the choice between a fixed salary for some period of time, that is, paying on the basis of input and Some workers receive compensation that is specified in advance and not directly contingent on performance. Instead, it depends on an input measure, such as hours worked. For others, compensation is directly related to output. This essay is an attempt to predict a firm's choice of compensation method. Piece rates are defined more rigorously. Among the more important factors discussed are worker heterogeneity, incentives, sorting considerations, monitoring costs, and asymmetric information. One result is that salary workers tend to be of lower quality and more homogeneous than are their piece-rate counterparts. Numerous additional results are provided. * Helpful comments by Victoria Lazear and Yoram Weiss are gratefully acknowledged. Support was provided by the Department of Labor and the National Science Foundation. 1. See Lazear and Rosen (1981), Stiglitz (1981), Holmstrom (1982), Green and Stokey (1983). 2. See Lazear (1979, 1981) and Harris and Holmstrom (in press).

Decision Making under Ambiguity.

Abstract: : Ellsberg's paradox demonstrates that ambiguous or vague probabilities derived from choices between gambles are not coherent. A descriptive model of judgement under ambiguity is developed in which an initial estimate serves as a starting point and adjustments are made for abbiguity. The adjustments involve a mental simulation in which higher and lower probabilities are considered and differentially weighted. Implications of this model include ambiguity avoidance and seeking; sub- and superadditivity of complementary probabilities; dynamic ambiguity; and reversals in the meaning of data. Three experiments involving Ellsberg's paradox and the setting of buying and selling prices for insurance and warranties test the model. A choice rule under ambiguity is developed that implies a lack of independence between ambiguous probabilities and the sign of payoff utility. The applicability of the model to the case where probabilities are explicitly stated is considered, including the handling of context effects. Keywords: Ambiguity, Decision making, Insurance.

Rationality of Self and Others in an Economic System

Abstract: In this paper, I want to disentangle some of the senses in which the hypothesis of rationality is used in economic theory. In particular, I want to stress that rationality is not a property of the individual alone, although it is usually presented that way. Rather, it gathers not only its force but also its very meaning from the social context in which it is embedded. It is most plausible under very ideal conditions. When these conditions cease to hold, the rationality assumptions become strained and possibly even self-contradictory. They certainly imply an ability at information processing and calculation that is far beyond the feasible and that cannot well be justified as the result of learning and adaptation. Let me dismiss a point of view that is perhaps not always articulated but seems implicit in many writings. It seems to be asserted that a theory of the economy must be based on rationality, as a matter of principle. Otherwise, there can be no theory. This position has even been maintained by some who accept that economic behavior is not completely rational. John Stuart Mill (1909, bk. 2, ch. 4) argued that custom, not competition, governs much of the economic world. But he adds that the only possible theory is that Standard economic doctrine makes assumptions of rationality that have very strong implications for the complexity of individuals' decision processes. The most complete assumptions of competitive general equilibrium theory require that all future and contingent prices exist and be known. In fact, of course, not all these markets exist. The incompleteness of markets has several side consequences for rationality. For one thing, each decision maker has to have a model that predicts the future spot prices. This is an informational burden of an entirely different magnitude than simply optimizing at known prices. It involves all the complexity of rational analysis of data and contradicts the much-praised informational economy of the price system. It is also the case that equilibria become much less well defined. Similar problems occur with imperfect competition. * This research was supported by the Office of Naval Research grant ONR-N00014-79-C-0685 at the Center for Research in Organizational Efficiency, Institute for Mathematical Studies in the Social Sciences, Stanford University, Stanford, California.

Adaptive Behavior and Economic Theory

Abstract: The relationship between psychological and economic views of behavior, once a subject of heavy dispute, is now understood in a very similar way by practitioners of both these disciplines and of our sister social sciences. In general terms, we view or model an individual as a collection of decision rules (rules that dictate the action to be taken in given situations) and a set of preferences used to evaluate the outcomes arising from particular situation-action combinations. These decision rules are continuously under review and revision; new decision rules are tried and tested against experience, and rules that produce desirable outcomes supplant those that do not. I use the term "adaptive" to refer to this trial-anderror process through which our modes of behavior are determined. If one is interested in modeling particular decisions in any very explicit way, it is obviously necessary to think about rather narrow aspects of an individual's entire set of decision rules: his or her personality. Experimental psychology has traditionally focused on the adaptive process by which decision rules are replaced by others. In this tradition, the influence of the subject's (or, as an economist says, the agent's) preferences This essay uses a series of examples to illustrate the use of rationality and adaptation in economic theory. It is argued that these hypotheses are complementary and that stability theories based on adaptive behavior may help to narrow the class of empirically interesting equilibria in certain economic models. An experiment is proposed to test this idea.

Assessing the Market Timing Performance of Managed Portfolios

Abstract: A number of techniques have been proposed to measure portfolio performance and to distinguish between performance due to forecasting security-specific returns and performance due to forecasting market-wide events. We show theoretically and empirically that it is possible to construct portfolios that show artificial timing ability when no true timing ability exists. In particular, investing in options or levered securities will show spurious market timing. These types of securities will also induce the negative correlation between measured selectivity and timing ability found by others. We suggest specification tests to help distinguish between spurious and true timing ability. In addition, the tests can be used to distinguish between different models of the manager's reaction function.

Banking Theory, Deposit Insurance, and Bank Regulation

Abstract: The last several years have seen extensive change in the U.S. banking industry. ' In the 1950s and 1960s the banking industry was a symbol of stability. By contrast, recent years have seen the greatest frequency of bank failures since the Great Depression. During the same period, the banking environment has undergone the most significant changes since 1933, when the Glass-Steagall Act laid down the ideas underlying the modern regulatory environment. The recent changes include new competitors to banks, new technology, new floating rate contracts, increases in interstate banking, and various regulatory reductions and changes. Some of these changes are accelerated by the current high rate of bank failure; many of the changes are driven by technology and competition and are inevitable. One implication of all these changes is that we now face policy decisions that will affect the future course of the banking industry. Since the current environment is largely outside our past experience, we need theory to extrapolate from past experience to our current situation. The purpose of this paper is to summarize the policy implications of existing economic models of the banking industry and to examine some current recommendations in light of the theory. Our conclusions contrast with the traditional view in economics and with several conclusions in Kareken's (in this issue) lead piece in this symposium. Most references to banks in the microeconomics literature have not looked at banking at the industry level. The bank management litera-

Behavioral Rationality in Finance: The Case of Dividends

Abstract: As the title suggests, this paper attempts to get to the specifics of the behavioral rationality theme of this conference by focusing on an area in the main core of finance, namely, the demand and supply of dividends, where, by common consent, the essentially "rationalist" paradigm of the field seems to be limping most noticeably. Important and pervasive behavior patterns on both the paying and the receiving ends have despairingly been written off as "puzzles" even by theorists as redoubtable as Fischer Black (see esp. his much-cited 1976 article). Behaviorists have homed in on precisely these same dividendrelated soft spots in the current body of theory (see esp. Shefrin and Statman 1984). We seem to have, in sum, an ideal place to look for signs of an imminent "paradigm shift" in the behavioral direction of precisely the kind envisioned by some of the other contributors to this conference. The dividend-related difficulties and supposed anomalies at issue here are more than just the parochial concern of finance specialists. The Dividends seem a natural area in finance where the introduction of behavioral/cognitive elements might help resolve long-standing anomalies, particularly the seeming failure of supply to adjust to taxinduced price penalties. A closer look at the empirical record, however-particularly at evidence of responsiveness to major structural changes shows behavior of the aggregates to be less anomalous than conventional handwringing might suggest. Behavioral/cognitive elements, whatever they might contribute to the description of particular microdecisions, do not appear to be essential adjuncts to the basic finance model in the major, comparative static applications for which it was intended. * Helpful comments on an earlier version of this paper have been received from Nai-fu Chen, Jean-Marie Gagnon, Gur Huberman, Kose John, James Poterba, and especially Melvin Reder.

Futures Price Variability: A Test of Maturity and Volume Effects

Abstract: A number of previous studies have examined the contemporaneous relation between asset price variability and volume traded. For example, Clark (1973), Cornell (1981), and Tauchen and Pitts (1983) have investigated this relation for futures markets and Epps and Epps (1976), Harris (1984a, 1984b), and Smirlock and Starks (1984) for the stock market. Underlying this empirical research is a theoretical framework that suggests that price variability (or the absolute change in prices) and volume traded should be positively correlated. According to this theoretical framework, the so-called mixture of distributions hypothesis (MDH),1 the correlation between price variability and volume should be positive because of joint dependence on a common directing variable or event. This study uses contract disaggregated data on futures prices to obtain evidence on the relation between price variability and volume of trading. Strong positive contemporaneous correlations between trading volume and price volatility are documented consistent with the mixture of distributions hypothesis. It is concluded that maturity is not a suitable surrogate for the common directing variable. Specifically, while maturity has a strong effect on volume, no such relation is found for price variability. Finally, while in the majority of cases price variability and trading volume are contemporaneously correlated, there are a significant number of cases in which a sequential relation appears to be present. * An earlier version of this paper was presented at the 1984 meeting of the European Finance Association in Manchester, England, and at Southern Methodist University, the University of Wisconsin-Madison, Duke University, McGill University, and the University of Toronto. We wish to thank the seminar participants and an anonymous referee from this Journal for constructive comments and criticism. All remaining errors are, of course, our responsibility. We would also like to thank the Columbia Center for the Study of Futures Markets and the Interactive Data Corp. for providing some of the data used in the study. 1. See Clark 1973; and Harris 1984a, 1984b.

Stock Market Reaction to Regulatory Action in the Continental Illinois Crisis

Abstract: Continental Illinois Corporation is a bank holding company whose principal subsidiary is Continental Illinois National Bank, a wholesale unit bank.' In December 1983, it was the eighth largest bank in the United States and the largest in the Midwest. It had assets of $42.1 billion, 75% of which were financed by rate sensitive liabilities.2 Restricted by Illinois law from branching, Continental relied heavily on large deposits from other domestic banks (about 16%) and on foreign deposits (40%). These were liquid short-term deposits, and their withdrawal was the precipitating factor in the virtual collapse of the bank in May 1984. Moreover, insured deposits amounted to only $3 billion (Isaac 1984, p. 3). Thus Continental Illinois was bearing high liquidity risk and interest rate risk, relative to other money center banks. This study examines the stock market reaction to the Continental Illinois crisis and the regulatory action taken in response to that crisis. Through the use of stock market data, this study reveals that there was significant market response to the crisis in terms of both negative abnormal returns and positive abnormal volume of trading. The most significant effect was found in those banks that had a large amount of Latin American debt and other nonperforming assets. But while there was a clear market reaction to information revealed in the crisis about banks' asset quality and regulatory policy, depositors apparently did not withdraw funds in the massive way that regulators anticipated. * I am grateful for the comments and suggestions of Joseph Aharony, Gabriel Hawawini, Barbara Paul, Ramon Rabinovitch, Anthony Saunders, Henny Sender, and the referees of this Journal. 1. The distinction between the holding company and the bank is an important regulatory issue in the Continental Illinois crisis and is discussed later (see Black, Miller, and Posner 1978; Swary 1983). The terms "bank" and "holding company" are used interchangeably. 2. For various measures of these risks and an industry comparison, see Bank Analysts' Quarterly Handbook (1984).

Determinants of Bilateral Trade Flows

Abstract: What factors influence the level of trade flows that occur between nations? Past studies have answered this question primarily in terms of distance and economic size. The present study considers additional variables as potential determinants of trade relations between nations. Also, trade flows are analyzed by the type of products being exported and imported. The findings show that several additional variables are significant determinants of the level of bilateral trade relations between nations. In addition, it is found that models of trade flows are more appropriate for manufactured goods than they are for basic commodities.

Detecting Spot Price Forecasts In Futures Prices

Abstract: Futures markets are often described as having two important social functions. First, they facilitate the transfer of commodity price risk, and, second, they provide forecasts of commodity prices. The evidence that futures markets transfer price risk is irrefutable. However, there is some debate about the markets' forecasting ability. In particular, forecasts based on the current spot price are often as good as those based on the futures price. Some economists cite a failure to detect superior forecast power in futures prices as evidence of market inefficiency (see, e.g., Leuthold 1974; and Martin and Garcia 1981). There are at least two other explanations. First, there may be nothing for the futures market to forecast. If the current spot price equals the true expectation of the future spot price, the futures market cannot provide a better forecast. Second, a superior futures market forecast may be obscured by the unexpected component of the realized spot price. The true expectation of the future spot price is unobservable; one must approximate this expectation with the actual future spot price.

Rational Choice in Experimental Markets

Abstract: The theory of rational behavior has several different uses. First, it is used at the most fundamental level of experimental methodology to induce preferences used as parameters in models. Second, it appears repeatedly in experimentally successful mathematical models of complex phenomena such as speculation, bidding, and signaling. Third, it is used as a tool to generate ex post models of results that are otherwise inexplicable. Finally, it has been used as a tool successfully to design new institutions to solve specific problems. When tested directly, the theory can be rejected. It is retained because neither an alternative theory nor an alternative general principle accomplishes so much.

Average Marginal Tax Rates from Social Security and the Individual Income Tax

Abstract: We extend previous estimates of the average marginal tax rate from the federal individual income tax to include social security "contributions." The social security tax is a flat-rate levy on labor earnings (and income from self-employment) up to a ceiling value of earnings. Our computations consider first, the tax rates on employers, employees and the self-employed; second the amounts of income that accrue to persons with earnings below the ceiling; and third, the effective deductibility of employer's social security contributions from workers' taxable income. We find that the net impact of social security on the average marginal tax rate is below .02 until 1966, but than rises to .03 in 1968, .04 in 1973, .05 in 1974,and .06 in 1979. Thus, since 1965, the overall average marginal tax rate rises more rapidly than that from the income tax alone. In 1980 this overall rate is 36%. We note that, in comparison with the income tax, the social security levy generates 3-4 times as much revenue per unit of contribution to the average marginal tax rate. The social security tax is relatively "efficient" because first, it is a flat-rate tax (rather than a graduated one) for earnings below the ceiling, and second, there is a zero marginal tax rate at the top. However, the last feature has become less important in recent years. The rapid increase in the ceiling on earnings raised the fraction of total salaries and wages accruing to persons with earnings below the ceiling from 29% in 1965 to 68% in 1982.

The Effects of Changing Margin Levels on Futures Market Activity, the Composition of Traders in the Market, and Price Performance

Abstract: In December 1984 the Board of Governors of the Federal Reserve System released "A Review and Evaluation of Federal Margin Regulation" (Federal Reserve Bank 1984). This study reexamined the purpose and the necessity of federal margin regulation in light of the changing structure of U.S. and foreign financial markets. Four major issues related to the effect and usefulness of security margin requirements were discussed, including (a) the diversion of credit from productive investment to purely speculative endeavors; (b) the protection of unsophisticated investors, who might overextend their private financial resources; (c) the protection of brokers from customer default; and (d) the use of credit limitations to forestall undue destabilizing price fluctuations. Two issues related to the coordination of margin requirements on securities, options, and fu-

Option Bounds in Discrete Time: Extensions and the Pricing of the American Put

Abstract: In a recent paper (Perrakis and Ryan 1984), upper and lower bounds on European option prices were derived in discrete time. These bounds were based on an extension of the discrete-time derivation of Black-Scholes pricing, first presented in the work of Black and Scholes (1973). The bounds are functions of the stock and exercise prices, the riskless rate of interest, the time to maturity, and the entire distribution of stock returns. In other words, they need more information than Black-Scholes for their computation, and the derived results are weaker.' On the other hand, they are significantly more general in their assumptions, insofar as they do not rely on the continuous-time riskless hedge of the original Black-Scholes derivations or on the assumption of a binomial distribution of stock returns used in Cox, Ross, and Rubinstein (1979) and Rendleman and Bartter (1979). For this reason they are likely to be particularly useful in valuing options on assets, for which the Black-Scholes methodology is clearly This paper generalizes and tightens the discrete-time bounds for European options and develops similar bounds for American puts. The stock return has a distribution with a finite range and is subject to the restriction that the stock be "nonnegative beta." The bounds are derived from arbitrage portfolios using the stock, the option, and the riskless asset. They converge to the previous ones when the range coincides with the nonnegative real line, and they both become equal to the binomial option model under a two-state stock return. Upper and lower bounds for the American put are derived recursively by the same method, with arbitrage portfolios involving the stock, the riskless asset, and American and European puts. An example is provided with a trinomial return distribution. * Part of this research was done while I was a visiting professor (1983-84), Ecole Superieure de Commerce et d'Administration des Entreprises, Reims, France. I wish to thank Peter Ryan, Albert Madansky, and a referee of this Journal for helpful advice and comment, while retaining all responsibility for any remaining errors or omissions. 1. Note, however, that this is also true of other BlackScholes generalizations, such as Merton (1976).

Bias in Small Sample Tests of Stock Price Rationality

Abstract: While Keynes (1936, chap. 12) regarded stock prices as the outcome of "the mass psychology of a large number of ignorant individuals," the empirical success of modern financial economics, especially concerning "efficient market" models (see, e.g., Fama 1970), has dominated the literature in the last two decades. However, recent research on "variance bounds" by Grossman and Shiller (1981), LeRoy and Porter (1981), and Shiller (1981a, 1981b, 1981c), among others, questions whether the large variation over time in stock prices can be explained in the context of rational valuation models. The model most often used in this literature is the dividend valuation model,

Rationality and Utility from the Standpoint of Evolutionary Biology

Abstract: A major motive of these comments is to offer a perspective in which the important paper on perceptions of fairness by Kahneman, Knetsch, and Thaler (in this issue) is moved from being a description of an exogenous factor "distorting" market rationality and becomes instead an integral part of a theory of collective rationality. In anticipatory summary, perceptions of fairness (like moral norms in general) are our individually rational preferences as to how others behave. If the collective-goods payoffs are sufficient so that the cooperative system is worth maintaining and if that social system is intact, then it may be individually rational to abide by those norms oneself as a rationally paid cost in a strategy of getting others to live up to them. This will be argued on grounds drawn from evolutionary biology and, in particular, from the issues surrounding "altruism" that are so focal to sociobiology. A growing number of economists are participating in a potential integration of economics and evolutionary theory. From participants in this conference this includes, at least, Simon (1973, 1983), Becker (1976), Nelson and Winter (1982), and Lucas (in this issue). Among our nonpresent colleagues participating are Hirshleifer (1977, 1978) and Samuelson (1983). Because I believe this is a trend that should be further developed, I am going to preface my analysis of the issues raised by Kahneman et al.'s paper by an overview of other aspects of the sociobiological perspective relevant to the total agenda of this conference. Shared in common by biology's "population genetics" (the mathematical theory of the evolutionary process) and econometrics are models in which populations of individual decision makers that are optimizing utilities produce macro effects. The concepts of "decision making," "utilities," "self-interest," and self-sacrificial "altruism" are, of course, used in biology as a convenient metaphorical shorthand rather than as a literal description of cognitive decision processes and

The Psychology and Economics Conference Handbook: Comments on Simon, on Einhorn and Hogarth, and on Tversky and Kahneman

Abstract: While most of George Stigler's articles have received the attention they deserve, there is one piece that I think has been neglected, though its potential contribution to the knowledge transmitted at a conference like this one is enormous. The article I refer to is titled "The Conference Handbook" (Stigler 1977). In this incisive piece Stigler argues that conferences could be run much more efficiently if discussants could utilize a standard list of comments that could be called out by number, much as in the old story about the prisoners who told their jokes by number. Stigler offers several introductory remarks and 32 specific comments. For example, introductory remark F could be used nicely at an interdisciplinary conference like this one: "It is good to have a nonspecialist looking at our problem. There is always a chance of a fresh viewpoint, although usually, as in this case, the advantages of the division of labor are reaffirmed." The specific comments begin with the classic 1: "Adam Smith said that." Two others that might come in handy at this conference are 23: "The motivation of the agents in this theory is so narrowly egotistic that it cannot possibly explain the behavior of real people"; and 24: "The flabby economic actor in this impressionistic model should be replaced by the utility-maximizing individual" (pp. 442, 443). While Stigler's comments are insightful and quite versatile, I have found that conferences that combine psychologists and economists present a special set of problems to discussant and attendee alike, and so I am taking this opportunity to provide a customized list of comments that can be used in these situations. The comments I will mention are those that are most frequently offered by economists when discussing the work of psychologists. For the sake of fairness, a subject in which I have recently become interested, I will also offer brief responses.

Defining and improving the accuracy of macroeconomic forecasts: contributions from a var model

Abstract: Thirty years ago it appeared that the best strategy for improving economic forecasts was to build bigger, more detailed models. As the cost of computing plummeted, considerable detail was added to models, and more elaborate statistical techniques became feasible. Yet dissatisfaction with conventional macroeconometrics has grown steadily in recent years.1 One outgrowth of this dissatisfaction has been increasing interest in atheoretical forecasting techniques, which, in a sense, represent a return to "measurement without theory." Proponents might prefer the label "measurement without pretense," however, since they do not accept the idea that conventional models actually embody theory that is consistent with the behavior of optimizing individuals in a stochastic, dynamic environment. Instead, they believe that conventional models contain ad hoc representations that are manipulated until they become consistent with historic time series. This paper is an empirical study of unconditional forecasting performance. One object of the paper is to review the performance of several well-known forecasters. Since there is little agreement on the definition of a successful forecast, we introduce a vector autoregressive (VAR) model as a benchmark for predictive accuracy. In addition, the VAR model is able to capture relevant information that is omitted from other forecasts. We can therefore demonstrate the value of VAR forecasts as an input to composite forecasts.

Correcting for Heteroscedasticity in Tests for Market Timing Ability

Abstract: Evaluating the performance of portfolio managers has received wide attention in the finance literature. The common practice is to divide performance into (a) market timing ability and (b) security selection ability. The former is the ability of a fund manager to produce a better return distribution by forecasting marketwide movements. The latter is the ability to produce more favorable return distributions based on superior information about individual stocks. Several methods have been proposed in the literature for the evaluation of the selection and the timing abilities of portfolio managers, using only the observed time series of realized returns on the managed portfolios. Among the approaches proposed, the multiple regression approach suggested by Treynor and Mazuy (1966), Henriksson and Merton (1981), and Pfleiderer and Bhattacharya (1983) are particularly attractive since they are simple and easy to apply. While the above multiple regression methods are easy to apply, statistical inference requires care. 1 In this paper we examine the parametric test proposed by Henriksson and Merton for evaluating the market timing ability of portfolio managers. Using simulation techniques we show that correction for heteroscedasticity can significantly affect the conclusions. We find that the heteroscedasticity corrections suggested by Hansen and by White are particularly effective.

Implied Interest Rates

Abstract: One of the most important assumptions in financial economics models is the existence of a risk-free rate, available for borrowing and lending. In any economy, however, the borrowing rate does not coincide with the lending rate even for the short run. The difference between the rates is considered a compensation for intermediation that is necessary in the imperfect real world. In a well-functioning financial market this difference would be small, and the smaller it is, the better off is the economy. The two short-term rates that best approximate riskless lending and borrowing rates are the Treasury-bill rate and the brokers' loan-call rate, respectively. With the introduction of put and call options a new risk-free instrument has been created. Using options alone or options combined with the underlying asset' one could turn to these markets for his borrowing or lending needs, thereby With the introduction of put and call options a new risk-free asset has been created. The objective of this study is to estimate the rate implied in option prices and compare it to other riskless instruments. We have used transactions data on Chicago Board Options Exchange options taking into account the American feature of these options. We find that options markets provide rates that are competitive with other short-term rates. These rates are closer to the borrowing rate than to the lending rate.