Knowledge that Transforms

G. Marc Choate, Stephen H. Archer, Irving Fisher, Inflation, and the Nominal Rate of Interest, The Journal of Financial and Quantitative Analysis, Vol. 10, No. 4, 1975 Proceedings (Nov., 1975), pp. 675-685

Most textbooks in finance are apparently embarrassed by the Modigliani-Miller (MM) theorem on capital structure. The intense controversy it has provoked in academic circles over the past sixteen years makes it hard to ignore, and yet many textbook writers seem to be unable to distill anything from it that might be of interest to their readers. A typical example might begin by laying out the economist's conventional perfect market assumptions and showing that the theorem may be derived deductively from these assumptions. It is then observed that markets are not perfect and it is implied that perfect market theorems, while perhaps interesting to ivory-tower academics, are of no use to a businessman who has to act in imperfect real-world markets. (For example, Weston and Brigham [16], in their appendix to Chapter 11, on p. 339 state: “Given their assumptions, their theoretical arguments were quite correct. However, their assumptions have been questioned extensively, and very few authorities today accept the MM position.”) We are then returned rather uneasily to the traditional world of U-shaped cost of capital curves, in which managers are required to examine such holy relics as financial break-even charts (Van Home [15, p. 231]) or to exercise judgment about the stockholders' utility preferences (Weston and Brigham [16, p. 258]) in order to make their debt/equity decision.

Numerous empirical studies have appeared in recent years concerning the behavior of stock market prices. Cootner's book [2] presents an excellent summary of pre-1964 efforts, while Fama's paper [5] discusses some of the more recent work. While a few writers believe that certain price trends and patterns exist which enable the investor to make better predictions of the expected value of future stock price changes, the majority of these studies conclude that past price data alone cannot form the basis for the prediction of the expected value of price movements in the stock market.

R. Burr Porter, Roger P. Bey, David C. Lewis, The Development of a Mean-Semivariance Approach to Capital Budgeting, The Journal of Financial and Quantitative Analysis, Vol. 10, No. 4, 1975 Proceedings (Nov., 1975), pp. 639-649

The problem of allocating a fixed set of time-phased investment allowances among competing investment projects and proposals has received great attention in the literature since Weingartner [11] established a linear/integer programming formulation. Reviews of the literature can be found in Weingartner [12], Hunter [6], Hodges [5], and Bernhard [2].

In Gonedes [5], the results of an empirical analysis of accounting-based and market-based estimates of systematic risk were presented. These results suggested that there is, in general, a “statistically significant” relationship between accounting-based and market-based estimates of systematic risk at the level of individual securities, if the accounting-based estimates are conditional upon first-differences or scaled first-differences of the accounting numbers. The differencing transformation seemed to induce relatively better specified models for the accounting numbers.

Prior to the recent experience with relatively flexible exchange rates, there was much concern that a high degree of exchange-rate flexibility might somehow overburden the institutions of the foreign-exchange market, particularly the forward market, with disruptive consequences for international commerce. While seldom clearly stated, the reasoning underlying this concern usually proceeded along the following lines. Substantial exchange-rate flexibility would lead business management to expect greater exchange-rate variations, with the result that businesses would seek to cover much more of their foreign-exchange exposure (i.e., would seek to “insure” against the greater exchange-rate risk) by purchasing or selling foreign currency forward. However, foreign-exchange traders either could not accommodate this greatly increased demand for their services, or could accommodate it only at substantially higher cost. Consequently, business firms would significantly reduce the volume of their international transactions.

Preference orderings of uncertain prospects have progressed from the two-moment EV model first developed by Markowitz [1952] to the more general efficiency analysis that is based on the entire probability function. This general efficiency approach, referred to as the Stochastic Dominance (SD) approach, does not depend on specific assumptions about the investor's utility function and has been shown to be theoretically superior to the “moment methods” [1].

There is broad consensus that three types of risk confront the potential bond purchaser: the risk of default (possible interest and/or principal loss), the risk of interest rate changes (possible principal loss or gain if the bonds are sold before maturity), and price level risk (loss of purchasing power). The analysis in this paper is directed toward the first of these risks, the risk of default. By assuming that investors require interest rate adjustments on debt subject to default sufficient to give them an expected present value equal to the present value associated with the investment of their funds in default-free securities, we examine the process that determines the risk-adjusted equilibrium interest rate and the factors affecting that rate. We also examine the implications of the model for the cost of debt and a firm's debt capacity.

The financial experiences of the last two years impel a careful and wide-ranging review of the stability of our major types of financial institutions. That review ought to be followed by actions to redress weaknesses or proclivities that, upon analysis, are judged to contribute an undesirable degree of instability within the financial system.