Knowledge that Transforms

Some mean/variance efficient portfolios will have positive investments in all individual assets when covariances satisfy the conditions given here. These conditions are more useful empirically than qualitative results that depend on the inverse covariance matrix. The prospect appears dim for general and useful qualitative results.

Savings bonds, retractable bonds and callable bonds are each equivalent to a straight bond with an option. Neglecting default risk the value of these contingent claims depends upon the riskless interest rate. This paper employs the option pricing framework to value these bonds, under the assumptions that the interest rate follows a Gauss-Wiener process and that the pure expectations hypothesis holds.

This paper examines the behavior of corporate bond prices during the period surrounding the announcement of a rating change. We find some evidence of price change during the period from 18 to 7 months before the rating change is announced. We find no evidence of any reaction during the 6 months prior to the rating change. We also find little reaction, if any, during the month of the change or for 6 months after the change. This evidence contradicts the recent findings of Katz and Grier and Katz.

This paper examines the pricing of convertible bonds and preferred stocks. The optimal policies for call and conversion of these securities are determined via the criterion of dominance. The techniques underlying the Black-Scholes Option Model are used to price convertible securities as contingent claims on the firm as a whole.

This paper develops optimal portfolio choice and market equilibrium when investors behave according to a generalized lexicographic safety-first rule. We show that the mutual fund separation property holds for the optimal portfolio choice of a risk-averse safety-first investor. We also derive an explicit valuation formula for the equilibrium value of assets. The valuation formula reduces to the well-known two-parameter capital asset pricing model (CAPM) when investors approximate the tail of the portfolio distribution using Tchebychev's inequality or when the assets have normal or stable Paretian distributions. This shows the robustness of the CAPM to safety-first investors under traditional distributional assumptions. In addition, we indicate how additional information about the portfolio distribution can be incorporated to the safety-first valuation formula to obtain alternative empirically testable models.

This paper examines some implications of using an estimate of the variance in option valuation models. This procedure produces biased option values. It is shown that the magnitude of this bias is not large. The dispersion induced in the option price is more significant particularly for parameter values of practical interest. The nature and extent of this dispersion is examined by numerical examples. The paper suggests how a Bayesian approach could be used to cope with the estimation error.

What policy should a corporation adopt concerning the funding of a defined-benefit pension plan and the investment of the assets held in trust for the plan? Until recently, pension plans did not have to be insured, and some risk could be borne by intended beneficiaries. Federal legislation has now mandated such coverage. This paper analyzes corporate policy under three conditions which correspond, roughly, to the earlier situation (‘uninsure’ loans), the current situation (‘partially insured’ loans), and the situation required by law to be implemented in the future (‘completely insured’ plans). We show that if insurance premiums are set correctly, corporate policy in this area may not matter; otherwise the optimal policy may simply be that which maximizes the difference between the value of the insurance and its cost.

Using the option pricing methods developed by Black and Scholes as a general technique for contingent claims analysis, this paper examines a class of mutual funds known as Dual Purpose Funds. By constructing a simplified model for these funds under the ‘perfect hedge’ conditions of Black and Scholes, it is demonstrated that the asset value of the fund will always exceed the market value and that it is not inconsistent with market equilibrium or efficiency for the capital shares to sell at a discount. The simple model predicts price fluctuations in the seven dual funds studied quite well; however, there is a persistent downward bias in the predicted price level. Finally, refinements to the model are examined to determine the nature of the misspecification causing this bias.