Knowledge that Transforms

This paper tests the Arbitrage Pricing Theory (APT) by estimating the factor loadings that are consistent between two industry groups of securities. One of the pitfalls in the study by Roll and Ross is that the factors estimated in one group may not be the same with the factors estimated in another group. This raises some concerns on the acceptability of their conclusions. For our study, we employ inter‐battery factor analysis which enables us to estimate factor loadings by constraining the factors to be the same between two different groups. Our results show that there seem to be five or six inter‐group common factors that generate daily returns for two industry groups of securities, and these inter‐group common factors do not seem to depend on the size of groups. Also, based on our cross‐sectional tests on the risk premia, we conclude that the APT should not be rejected.

This paper presents an analysis of the testability of the mean variance efficiency of a market index when the returns on some components of the index itself are not perfectly observable. The results are basically not supportive of the notion that mean variance efficiency is testable on a subset of the assets. Bounding the market share of the missing asset and its expected return is not sufficient to produce a valid test. When the variance of the missing asset is bounded, and the amount of wealth that might be missing is small, it is possible, in principle, to reject correctly the mean variance efficiency of a market index.

This paper values options on assets whose returns, over a finite interval of time, are generated by a binomial process. It shows that a simple valuation relationship, between the option and the underlying stock, obtains if investors have preference functions that belong to a particular class, even if opportunities to hedge do not exist. One particular application of the theory is in the case where the stock price over a finite interval could increase by an amount, fall by the same amount, or stay at the same level. The results in this paper may be viewed as the foundation of the preference‐based approaches to obtaining a risk neutral valuation relationship.

The marginal performance contribution made by new assets in a portfolio is identified. The maximum change in a portfolio's Sharpe performance from the addition of new assets is a simple function of a generalized Jensen index and the unexplained covariances from a multivariate market model. Deviations from a higher dimension market line may be used to rank the desirability of asset additions to an existing portfolio. Statistical tests for the equality of the performance contributions by new assets is possible.

In this study a simple common algorithm which is applicable to seven models is proposed for optimal portfolio selection disallowing short sales of risky securities. The models considered in the analysis consist of a single index model, four multi‐index models, and two constant correlation models. Unlike the previous approach, the proposed algorithm does not require explicit ranking of securities. Therefore, it is particularly useful for two multi‐index models with orthogonal indices which do not provide any ranking criterion. Also, because of its algorithmic efficiency as demonstrated in a simulation study on models with multiple groups, the approach here can enhance their usefulness in portfolio analysis.

Product lines of traditionally heterogeneous financial institutions are rapidly fusing into a homogeneous blend. Institutions and market structures are reshaping themselves to lower the cost of serving customer demand for financial services. This paper contends that contemporary adaptations exploit scope economies rooted in technological change and deposit‐insurance subsidies to innovative forms of risk‐bearing. As they reorient work flows, financial firms are simultaneously restructuring their organizations to lower net burdens from government regulation. Alternative state and federal regulatory and legislative bodies compete vigorously for the regulatory business of developing institutional hybrids. Evolution of Federal Reserve policy toward “nonbank banks” exemplifies the process.

Short‐term interest rates in the United States have been “too high” since October 1979 in the sense that both unconditional and conditional forecasts, based on an estimated vector autoregression model summarizing the prior experience, underpredict short‐term interest rates during this period. Although a nonstructural model cannot directly answer the question of why this has been so, comparisons of alternative conditional forecasts point to the post‐October 1979 relationship between the growth of real income and the growth of real money balances as closely connected to the level and pattern of short‐term interest rates. This finding is consistent with the authors' earlier conclusion, based on analysis of a small structural macroeconometric model, that the high average level of interest rates has been due to a combination of slow growth of (nominal) money supply and continuing price inflation, which together have kept real balances small in relation to prevailing levels of economic activity.