Knowledge that Transforms

The tests reported here differ in several ways from those of most other papers testing option pricing models: an extremely large sample of observations of both trades and bid-ask quotes is examined, careful consideration is given to discarding misleading records, nonparametric rather than parametric statistical tests are used, reported results are not sensitive to measurement of stock volatility, special care is taken to incorporate the effects of dividends and early exercise, a simple method is developed to test several option pricing formulas simultaneously, and the statistical significance and consistency across subsamples of the most important reported results are unusually high. The three key results are: (1) short-maturity out-of-the-money calls are priced significantly higher relative to other calls than the Black-Scholes model would predict, (2) striking price biases relative to the Black-Scholes model are also statistically significant but have reversed themselves after long periods of time, and (3) no single option pricing model currently developed seems likely to explain this reversal.

This paper demonstrates that, contrary to the results of previous studies, the impact of inflation on the aggregate debt‐asset ratio cannot be determined theoretically. However, it is shown that inflation is likely to increase this ratio when personal income tax schedules are indexed to the price level and/or when leverage‐related costs are relatively high and the personal tax rate on income from holding common stocks is relatively low.

The authors consider the optimal amount of insurance purchased by an individual who behaves according to the Hurwicz criterion of choice under uncertainty. Their results are compared with earlier results obtained in alternative frameworks (expected utility maximization and Savage's regret criterion). It is shown that a positive amount deductible is often suboptimal.

We show that the set of expected return vectors, for which an observed portfolio is mean variance (MV) efficient, is a two‐parameter family. We identify ten ways to specify the time series behavior of the two parameters; the result highlights a number of inconsistencies involved in MV modelling. For each of the cases, it permits the inference of the time series of expected return vectors, as well as all the other Capital Asset Pricing Model (CAPM) variables, compatible with a known covariance matrix and the observed time series of market value weights. The empirical work shows that there are substantial case‐to‐case differences in the time series of mean vectors and many of them are quite different from the constant mean vector envisioned in tests of the CAPM.

In an arbitrage‐free economy, there will always exist a set of linear operators which map future contingent dividends of securities into their current prices. It happens that such operators will also form an “evolution semigroup” as a consequence of intertemporal analysis of the no‐arbitrage restriction. This paper summarizes some of the major implications of the semigroup properties, but avoids almost all of the technical discussion which underlies them. Instead, several practical examples are presented. Some well‐known continuous‐time results are replicated by this alternative method, and certain new developments are explored.

This study investigates the differences in the behaviors between the speculative investors and the conservative investors in two separate experimental markets. Although the market for speculators shows greater price volatility in both bid/ask spread within a trade as well as with intraperiod variances, it exhibits several desirable properties. Specifically, the price patterns tend to converge closer, and at a greater speed to either the prior information equilibrium price or the rational expectation equilibrium price. It also achieves better allocational efficiency. And, it is also less likely to be misled by potentially “false” price information.

This paper focuses on the conditions under which banks are subject to currency and country risks on their dollar‐denominated loans to foreign firms and governments. We conclude that currency risk is a function of the rates of domestic and foreign inflation, deviations from purchasing power parity, and the effect of these deviations on the firm's and the nation's dollar‐equivalent cash flows. Country risk is largely determined by the variability of the nation's terms of trade and the government's willingness to allow the national economy to adjust rapidly to changing economic fortunes.

In this paper, we consider two hypotheses for the recent performance of real estate returns. The first is the random event argument that real estate is positively correlated with unanticipated inflation but that structural change in expected returns due to a change in the perceived sensitivity of returns to unanticipated inflation has not taken place. The second is the hedge demand argument that formulates the structural shift hypothesis. The paucity of real estate and other expectations data as well as the general identification problem make it extremely difficult to distinguish between these hypothesis. Our tests consist of estimates of inflation betas for various asset categories overtime as well as estimates of the hedge vector, . Although some support for the hedge argument is found, the results are not strong enough to reject the random event argument and conclude that a decline in the required return on real estate due to a relative increase in inflation beta drove returns during the 1970's.

Lease cancellation insurance protects the lessor against early termination of a cancellable operating lease. This paper presents a contingent claims model for determining the “fair” premium for this type of insurance policy. Comparative statics are considered, and some numerical examples are presented to illustrate the model. Among other things, the insurance premium is sensitive to the expected rate of economic depreciation of the leased asset and to the leased asset's systematic and nonsystematic risk.