Knowledge that Transforms

We evaluate the performance of models for the covariance structure of stock returns, focusing on their use for optimal portfolio selection. We compare the models' forecasts of future covariances and the optimized portfolios' out-of-sample performance. A few factors capture the general covariance structure. Portfolio optimization helps for risk control, and a three-factor model is adequate for selecting the minimum-variance portfolio. Under a tracking error volatility criterion, which is widely used in practice, larger differences emerge across the models. In general more factors are necessary when the objective is to minimize tracking error volatility.

The dynamics of the unobservable short rate are frequently estimated directly using a proxy. We examine the biases resulting from this practice (the “proxy problem”). Analytic results show that the proxy problem is not economically significant for single-factor affine models. In the two-factor affine model of Longstaff and Schwartz (1992), the proxy problem is only economically significant for pricing discount bonds with maturities of more than five years. We also describe two different numerical procedures for assessing the magnitude of the proxy problem in a general interest rate model. When applied to a nonlinear single-factor model, they suggest that the proxy problem can be economically significant.

Journal Article Time-Varying Risk and Return in the Bond Market: A Test of a New Equilibrium Pricing Model Get access Cynthia J. Campbell, Cynthia J. Campbell Iowa State University Address correspondence to Cynthia J. Campbell, Department of Finance, College of Business, Iowa State University, Ames, IA 50011, or e-mail: [email protected]. Search for other works by this author on: Oxford Academic Google Scholar Hossein B. Kazemi, Hossein B. Kazemi University of Massachusetts, Amherst Search for other works by this author on: Oxford Academic Google Scholar Prasad Nanisetty Prasad Nanisetty Prudential Securities, New York Search for other works by this author on: Oxford Academic Google Scholar The Review of Financial Studies, Volume 12, Issue 3, July 1999, Pages 631–642, https://doi.org/10.1093/revfin/12.3.0631 Published: 01 June 2015

This article integrates strategic product market analysis with price-taking asset pricing theory. We demonstrate that a firm's market power can lead to scale-dependent and potentially infinite required returns. Scale dependency, which we relate to risk spillovers between expansionary and existing cash flows, reflects the divergence of incremental from existing required returns. The firm-specific nature of risk spillovers potentially destroys the concept of a common industry "risk class". Our analysis raises important questions regarding the validity of widely used "comparables" methods for determining risk-adjusted discount rates.

This article uses bond market data to empirically test the asset pricing model of Kazemi (1992). According to this model the rate of return on a long-term, pure-discount, default-free bond will be perfectly correlated with changes in the marginal utility of the representative investor. The covariability between financial asset returns and returns on such a bond can therefore serve as a measure of the riskiness of assets. The aim of this study is to determine whether the model can explain cross-sectional differences in the monthly returns of bonds with different maturity dates. We estimate and test the restrictions imposed by the model on returns of default-free bonds, while allowing the conditional distribution of bond returns to be time varying. The model is rejected during the full sample period (1973–1995) and the subperiod (1973–1980) when the Federal Reserve's focus is on interest rates, while the model is not rejected during the subperiod (1981–1995) when the Federal Reserve's focus is on money supply.

This article integrates strategic product market analysis with price-taking asset pricing theory. We demonstrate that a firm's market power can lead to scale-dependent and potentially infinite required returns. Scale dependency, which we relate to risk spillovers between expansionary and existing cash flows, reflects the divergence of incremental from existing required returns. The firm-specific nature of risk spillovers potentially destroys the concept of a common industry “risk class”. Our analysis raises important questions regarding the validity of widely used “comparables” methods for determining risk-adjusted discount rates.

Journal Article Cheap Talk, Fraud, and Adverse Selection in Financial Markets: Some Experimental Evidence Get access Robert Forsythe, Robert Forsythe University of Iowa Search for other works by this author on: Oxford Academic Google Scholar Russell Lundholm, Russell Lundholm University of Michigan Search for other works by this author on: Oxford Academic Google Scholar Thomas Rietz Thomas Rietz University of Iowa Address correspondence and reprints requests to Thomas Rietz, Department of Finance, College of Business Administration, University of Iowa, Iowa City, IA 52242, or e-mail: [email protected]. Search for other works by this author on: Oxford Academic Google Scholar The Review of Financial Studies, Volume 12, Issue 3, July 1999, Pages 481–518, https://doi.org/10.1093/revfin/12.3.0481 Published: 01 June 2015

Analysis of absence of arbitrage normally ignores payoffs in states to which the agent assigns zero probability. We extend the fundamental theorem of asset pricing to the case of “no empty promises” in which the agent cannot promise arbitrarily large payments in some states. There is a superpositive pricing rule that can assign positive price to claims in zero probability states important to the market as well as assigning positive prices to claims in the states of positive probability. With continuous information arrival, no empty promises can be enforced by shutting down the agent's subsequent investments once wealth hits zero.

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