Knowledge that Transforms

The design of managerial incentive contracts is examined in a setting in which economic agents are risk averse, and the actions of managers can affect asset returns which contain both systematic and idiosyncratic risks. It is shown that in the absence of moral hazard, owners of assets will insure managers against idiosyncratic risks, but with moral hazard, contracts will depend on both systematic and idiosyncratic risks. The traditional recommendation of asset pricing models, namely, to focus only on systematic risks, is thus proved to be valid only when there is no moral hazard. The major empirically testable predictions of the model are (1) managerial incentive contracts will generally depend on systematic as well as idiosyncratic risks, (2) idiosyncratic risks will generally be important in investment decisions, (3) the managers of firms with relatively high levels of idiosyncratic risks will have compensations that are less dependent on their firms' excess returns, and (4) the compensations of managers of larger firms will be relatively more dependent on the excess returns of their firms.

This paper examines the relationship between commodity consumption betas and realized commodity futures contract risk premiums. A linear relationship between risk premiums and consumption betas is developed based on a consumption oriented CAPM. The parameters of this linear model are estimated using fourteen commodities.

The design of managerial incentive contracts is examined in a setting in which economic agents are risk averse, and the actions of managers can affect asset returns which contain both systematic and idiosyncratic risks. It is shown that in the absence of moral hazard, owners of assets will insure managers against idiosyncratic risks, but with moral hazard, contracts will depend on both systematic and idiosyncratic risks. The traditional recommendation of asset pricing models, namely, to focus only on systematic risks, is thus proved to be valid only when there is no moral hazard. The major empirically testable predictions of the model are (1) managerial incentive contracts will generally depend on systematic as well as idiosyncratic risks, (2) idiosyncratic risks will generally be important in investment decisions, (3) the managers of firms with relatively high levels of idiosyncratic risks will have compensations that are less dependent on their firms' excess returns, and (4) the compensations of managers of larger firms will be relatively more dependent on the excess returns of their firms.

Under conditions consistent with the Black‐Scholes formula, a simple formula is developed for the expected rate of return of an option over a finite holding period possibly less than the time to expiration of the option. Under these conditions, surprisingly, the expected future value of a European option, even prior to expiration , is shown equal to the current Black‐Scholes value of the option, except that the expected future value of the stock at the end of the holding period replaces the current stock price in the Black‐Scholes formula and the future value of a riskless invesment of the striking price replaces the striking price. An extension of this result is used to approximate moments of the distribution of returns from an option portfolio.

The paper by Dhrymes, Friend, and Gultekin (DFG) in this issie criticizes empirical work on the the Arbitrage Pricing Theory (APT) conducted by ourselves, (RR [3]), and by a number of others. We are honored that such eminent professors as DFG have taken an interest in our work. Unfortunately, the DFG paper contains analysis which might foster misconceptions in the casual reader. Our purpose here is to present a brief, nontechnical comment. We are confident that those who are inclined to study the DFG paper in detail will be able to discern its merit for themselves.

It is shown that coupon bonds alone are not sufficient to span time‐dated claims on ordinary income, capital gains, and non‐taxable wealth. In an incomplete bond market where the pure dated claims are not spanned by existing bonds, marginal rates of substitution between present consumption and pure dated claims on ordinary income, capital gains income, and non‐taxable wealth, respectively, can differ across bondholders. However, the relative pricing of coupon bonds in each of these countries is shown to be consistent with the tax status of the major (non‐tax‐exempt) holders of government debt.