[This article investigates the structure on preferences required to derive Ross's arbitrage pricing theory (APT). It is shown that only ordinal preferences are required. In particular, the APT does not require that agents possess preferences representable as risk-averse expected utility functions. This characteristic of the APT is not shared by the standard equilibrium-based capital asset pricing models.]

[This article presents a new definition of market completeness that is independent of the notions of no arbitrage and equivalent martingale measures. Our definition has many advantages, all shown herein. First, it preserves the Second Fundamental Theorem of Asset Pricing, even in complex economies. Second, under our definition, the market can be complete yet arbitrage opportunities exist. This is important in practice, and stands in contrast to the traditional definitions. Third, under the assumption of no arbitrage and when used in the standard models, our definition is equivalent to the traditional one.]

[The downside risk in a leveraged stock position can be eliminated by using stop-loss orders. The upside potential of such a position can be captured using contingent buy orders. The terminal payoff to this stop-loss start-gain strategy is identical to that of a call option, but the strategy costs less initially. This article resolves this paradox by showing that the strategy is not self-financing for continuous stock-price processes of unbounded variation. The resolution of the paradox leads to a new decomposition of an option's price into its intrinsic and time value. When the stock price follows geometric Brownian motion, this decomposition is proven to be mathematically equivalent to the Black-Scholes (1973) formula.]

This paper studies a new theory for pricing options in a large trader economy. This theory necessitates studying the impact that derivative security markets have on market manipu? lation. In an economy with a stock, money market account, and a derivative security, it is shown, by example, that the introduction ofthe derivative security generates market manip? ulation trading strategies that would otherwise not exist. A sufficient condition is provided on the price process such that no additional market manipulation trading strategies are introduced by a derivative security. Options are priced under this condition, where it is shown that the standard binomial option model still applies but with random volatilities.

This paper investigates market manipulation trading strategies by large traders in a securities market. A large trader is defined as any investor whose trades change prices. A market manipulation trading strategy is one that generates positive real wealth with no risk. Market manipulation trading strategies are shown to exist under reasonable hypotheses on the equilibrium price process. Sufficient conditions for their nonexistence are also provided.

This paper investigates the forecasting accuracy of bankruptcy hazard rate models for U.S. companies over the time period 1962–1999 using both yearly and monthly observation intervals. The contribution of this paper is multiple-fold. One, using an expanded bankruptcy database we validate the superior forecasting performance of Shumway's (2001) model as opposed to Altman (1968) and Zmijewski (1984). Two, we demonstrate the importance of including industry effects in hazard rate estimation. Industry groupings are shown to significantly affect both the intercept and slope coefficients in the forecasting equations. Three, we extend the hazard rate model to apply to financial firms and monthly observation intervals. Due to data limitations, most of the existing literature employs only yearly observations. We show that bankruptcy prediction is markedly improved using monthly observation intervals. Fourth, consistent with the notion of market efficiency with respect to publicly available information, we demonstrate that accounting variables add little predictive power when market variables are already included in the bankruptcy model.

This article investigates the structure on preferences required to derive Ross's arbitrage pricing theory (APT). It is shown that only ordinal preferences are required. In particular, the APT does not require that agents possess preferences representable as risk-averse expected utility functions. This characteristic of the APT is not shared by the standard equilibrium-based capital asset pricing models.

This article provides a new methodology for pricing and hedging derivative securities involving credit risk. Two types of credit risks are considered. The first is where the asset underlying the derivative security may default. The second is where the writer of the derivative security may default. The authors apply the foreign currency analogy of R. Jarrow and S. Turnbull (1991) to decompose the dollar payoff from a risky security into a certain payoff and a 'spot exchange rate.' Arbitrage-free valuation techniques are then employed. This methodology can be applied to corporate debt and over the counter derivatives, such as swaps and caps.

This paper provides an economic and mathematical characterization of operational risk useful for clarifying the issues related to estimation and the determination of economic capital. The insights for this characterization originate in the corporate finance literature. Operational risk is subdivided into two types, either: (i) the risk of a loss due to the firm’s operating technology, or (ii) the risk of a loss due to agency costs. These two types of operational risks generate loss processes with different economic characteristics. We argue that the current methodology for the determination of economic capital for operational risk is overstated. It is biased high because the computation omits the bank’s net present value (NPV) generating process. We also show that although it is conceptually possible to estimate the operational risk processes’ parameters using only market prices, the non-observability of the firm’s value makes this an unlikely possibility, except in rare cases. Instead, we argue that data internal to the firm, in conjunction with standard hazard rate estimation procedures, provides a more fruitful alternative.