Knowledge that Transforms

This paper analyzes LDC debt-for-equity swaps under a rational expectations equilibrium. Under full information, the swap can never be strictly preferred by the LDC, the MNC, and the bank. Under the postulated informational asymmetry assumptions the same results obtain, leading to the “lemons” market in reverse. Under rational expectations, the swap can only occur if the loan is correctly valued relative to all private information in the economy. Given that some swaps do occur, future models must reflect the unique features of swaps.

In a single-period model with options on the market portfolio, linear factor pricing holds if and only if the variance of the market conditional on the factors is zero. There is no need for factors other than nonlinear functions of the market. For accurate linear pricing of all payoff patterns the factors must be rotationally equivalent to Hakansson's “supershares.” In a multiperiod model, a similar set of results holds, but with consumption replacing the market payoff. The methodology of the empirical Arbitrage Pricing Theory literature is not consistent with either the single-period model or the multiperiod model.

It has been noted that a certain continuous-time trading strategy, termed the “doubling strategy”, generates a positive net return on borrowed funds, with probability one and within a finite period of time. Since the doubling strategy seems to represent a “free lunch” or arbitrage opportunity, a variety of constraints to render it infeasible have been proposed. In this paper, we show that the doubling strategy generates infinite disutility for a large class of utility functions, and we can think of no utility function for a risk-averse agent which is a counterexample.