Knowledge that Transforms

Empirical tests are reported for Ross' arbitrage pricing theory using monthly data for U.S. Treasury securities during the 1960–1979 period. We find that mean returns on bond portfolios are linearly related to at least two factor loadings. Multivariate test results, however, are not consistent with the APT. Our sample data in the U.S. Treasury securities market are also not consistent with either version of the CAPM. One‐month‐ahead forecasts of excess returns using factor‐generating models are compared with corresponding naive predictions or predictions using the “market model” with various market portfolios.

We propose a theory of information gathering agencies in a world of informational asymmetries and moral hazard. In a setting in which true firm values are certified by screening agents whose payoffs depend on noisy ex post monitors of information quality, the formation of information gathering agencies (groups of screening agents) is justified on two grounds. First, it enables screening agents to diversify their risky payoffs. Second, it allows information sharing. The first effect itself is insufficient despite the risk aversion of screening agents and the stochastic independence of the monitors used to compensate them.

Recent work demonstrates serious statistical problems with standard volatility tests. This paper proposes new tests that are unbiased in small samples and that do not require assumptions of stationarity. The new tests continue to find evidence against the model positing rational expectations and a constant required rate of return on equity.

Many investors occasionally receive what they believe to be nonpublic information about a security. Others feel that by applying superior analytical skills to public information, they are able to arrive at valuable insights that are not generally appreciated. In either case, there is a substantial opportunity for profit if the investor is correct. The investor must be correct on two counts. First, the estimate of the worth of the information must be reasonably accurate in terms of its impact on the price of the stock, and second, the investor must make a realistic assessment of the likelihood that the market already has received the information or insight in question. This paper is concerned only with the latter problem. The probability distribution of the date on which the market receives information already in the hands of the investor is calculated for a simple model of information propagation. It is then shown how this probability distribution can be brought to bear on the management of a portfolio.

This paper develops a model of bond prices and yield spreads that incorporates the effect of both taxes and differences in default probabilities. The tax loss consequences of default are recognized. Traditionally, tax‐free (municipal) bond yields have been viewed as linearly related to taxable yields with a slope coefficient equal to one minus the tax rate and the intercept representing differences in default risk. While our model supports the linearity assumption, it implies that the slope and intercept are both functions of both the break‐even tax rate and the default probability(ies). Clientele effects among both municipal and taxable bonds are demonstrated. Finally, the implied marginal tax rates and the implied default probabilities are estimated for different categories of municipal bonds.

This paper models an individual's trading decision, given: (1) his/her demand function to hold shares of an asset, (2) his/her expectation on what the market clearing price will be, and (3) the design of the market which determines how orders will be translated into trades. The particular market design we consider is the batched trading (periodic call) regime. Assuming investors are distributed according to their propensities to hold shares, we model the aggregation of orders to obtain market clearing values of price and volume and to show the way in which, with trading friction, these solutions differ from Pareto efficient values. The importance of this analysis for various issues concerning market design is noted.

This paper examines the effect of the moral hazard problem in an agency relationship where the principal cannot observe the level of service provided by the agent. Using data from laboratory markets, we demonstrate that the presence of moral hazard leads to shirking by agents. However, this “lemons” phenomenon occurs only about one‐half of the time. While there is evidence of reputation effects in these markets, seemingly reputable agents are often able to use opportunities for false advertising to their advantage and “ripoff” principals.

This paper examines the daily stock market returns for four foreign countries. We find a so-called “week-end effect” in each country. In addition, the lowest mean returns for the Japanese and Australian stock markets occur on Tuesday. The remainder of the paper answers four questions. Are seasonal patterns in foreign stock markets independent of those previously reported in the U.S.? Do Japan and Australia exhibit a seasonal one day out of phase due to different time zones? Do settlement procedures across countries bias week-end effects? Does the seasonal pattern in foreign exchange offset the week-end effect in stocks for Americans investing overseas?

We develop an analytical model to address the question of optimal deposit insurance policy and to examine the impact of deregulation on depositors' welfare and the soundness of the insurance system. We find that the optimal level of regulation depends critically on the functional relationship between risk and return. We show that in general deregulation of bank activities and/or of deposit rate ceilings will in volve tradeoff between depositors' welfare and the soundness of the insurance system. Our analysis also indicates that risk‐sensitive premium and capital requirement schedules may not be efficient in managing the risk of banks.