Knowledge that Transforms

The authors previously had extended the theoretical put-call parity models developed by Stoll (1969) and Merton (1973) to include a dividend term. Ex post tests of the models were generally consistent with market efficiency, but a sufficient number of hedges had high enough returns to warrant analysis of ex ante results. The purpose of this study was to construct hedges 5 and 15 minutes after they were initially identified as having an ex post return in excess of $20 per hedge. The results indicate that mispriced options adjust and that economic profit is sensitive to the level of transaction costs and unlikely even for member firms.

The equilibrium value of a levered firm facing growth opportunities is shown to involve the valuation of a lottery over (cooperative) games rather than a lottery over specific monetary outcomes. In the absence of assumptions about negotiating risk, the value of the firm's claims is seen to be ambiguous even with zero transactions costs. This ambiguity is compounded if the core of the game is empty. This paper rationalizes specific financial instruments and institutions as means for attenuating negotiation costs and core existence problems. Furthermore, the valuation of these instruments requires determining the certainty-equivalent of a lottery over games.

We embed the Sharpe-Lintner, two-parameter asset pricing theory in an intertemporal general equilibrium model. The investment opportunity set changes stochastically over time; in general the short-term and long-term interest rates and the distribution of the rate of return of the market portfolio are non-stationary. This non-stationarity, which is admissible in the Sharpe-Lintner model, has two implications: First, it may bias econometric methods which fail to explicitly take into account the non-stationarity. Second, the sequential application of the Sharpe-Lintner model in the discounting of stochastic cash flows becomes computationally complex and of little practical use.

Event studies focus on the impact of particular types of firm-specific events on the prices of the affected firms' securities. In this paper, observed stock return data are employed to examine various methodologies which are used in event studies to measure security price performance. Abnormal performance is introduced into this data. We find that a simple methodology based on the market model performs well under a wide variety of conditions. In some situations, even simpler methods which do not explicitly adjust for marketwide factors or for risk perform no worse than the market model. We also show how misuse of any of the methodologies can result in false inferences about the presence of abnormal performance.

This paper analyses the distribution of returns on a hedged portfolio, consisting of a European call option and its associated stock, when the portfolio is rebalanced at discrete time intervals. Under the assumptions of the Black-Scholes model this distribution is particularly skew. In tests of the average return on a hedged portfolio this skewness leads to biased t-statistics. The paper explores the nature and extent of this bias and suggests procedures for overcoming it. Other aspects of discrete hedging are also discussed.

This paper examines two alternative models of the process generating stock returns. Under the calendar time hypothesis, the process operates continuously and the expected return for Monday is three times the expected return for other days of the week. Under the trading time hypothesis, returns are generated only during active trading and the expected return is the same for each day of the week. During most of the period studied, from 1953 through 1977, the daily returns to the Standard and Poor's composite portfolio are inconsistent with both models. Although the average return for the other four days of the week was positive, the average for Monday was significantly negative during each of five-year subperiods.

In this paper, a model of corporate leverage choice is formulated in which corporate and differential personal taxes exist and supply side adjustments by firms enter into the determination of equilibrium relative prices of debt and equity. The presence of corporate tax shield substitutes for debt such as accounting depreciation, depletion allowances, and investment tax credits is shown to imply a market equilibrium in which each firm has a unique interior optimum leverage decision (with or without leverage-related costs). The optimal leverage model yields a number of interesting predictions regarding cross-sectional and time-series properties of firms' capital structures. Extant evidence bearing on these predictions is examined.

This paper provides evidence on the daily market reaction to the announcement and subsequent acceptance or rejection of merger proposals. There is a swift and large positive market reaction to the first public announcement of the merger proposal. Subsequently, there is a positive reaction to the approval of completed proposals and a negative reaction to cancelled proposals. Where proposals are vetoed by incumbent target management, there is a negative market reaction to the veto, but this does not eliminate the earlier positive reaction to the first announcement. In these proposals there is a permanent revaluation of the target shares. This is in contrast to cancelled proposals that incumbent managements do not veto, where the target stock price falls back, on average, to the preproposal level.

The expected market return is a number frequently required for the solution of many investment and corporate finance problems, but by comparison with other financial variables, there has been little research on estimating this expected return. Current practice for estimating the expected market return adds the historical average realized excess market returns to the current observed interest rate. While this model explicitly reflects the dependence of the market return on the interest rate, it fails to account for the effect of changes in the level of market risk. Three models of equilibrium expected market returns which reflect this dependence are analyzed in this paper. Estimation procedures which incorporate the prior restriction that equilibrium expected excess returns on the market must be positive are derived and applied to return data for the period 1926–1978. The principal conclusions from this exploratory investigation are: (1) in estimating models of the expected market return, the non-negativity restriction of the expected excess return should be explicity included as part of the specification: (2) estimators which use realized returns should be adjusted for heteroscedasticity.