Knowledge that Transforms

The Arbitrage Pricing Theory (APT) has been proposed as an alternative to the mean‐variance Capital Asset Pricing Model (CAPM). This paper considers the testability of the APT and points out the irrelevance for testing of the approximation error. We refute Shanken's objections, including his assertion that Roll's critique of the CAPM is applicable to the APT. We also explain the testability of the APT on subsets, and we explore the relationship between the APT and the CAPM.

With a graduated personal tax schedule, Miller showed that there could be an equilibrium debt supply for the corporate sector as a whole. In the presence of uncertainty there is also a unique debt/equity ratio for each individual firm, and this ratio is related to the firm's operational risk characteristics. However, if firms merge and spin off in response to tax incentives, the identity of firms is ambiguous and only the corporate sector is a meaningful construct. These arguments are developed in both discrete and continuous models that employ extensions of the arbitrage‐free pricing theory.

Chris C. Carvounis provides the background, the theory and definition, and the analytical tools necessary to understand the scenarios now being played out in the various LDCs. After presenting general issues related to LDC debt from the functionally distinct positions of borrowers, lenders, and negotiators, Carvounis examines in detail the cases of five specific debtor nations--Turkey, Mexico, Brazil, Argentina, and Poland. For each country, a chronology provides background information and a commentary analyzes the key debtor-related matters. The commentaries discuss national economic development strategy, the orchestration of internal and external economies, the role of the central government as investor and regulator, domestic and foreign political factors pertinent to the country's external debts, and other significant factors.

Security market line (SML) analysis, while an important tool, has never been fully justified from a theoretical standpoint. Assuming symmetric information and an inefficient index, we show that SML analysis can be grossly misleading, since, in general, efficient and inefficient portfolios can plot above and below the SML. On a more positive note, if SML analysis uses the return on a marketed riskless asset for the zero-beta rate, efficient portfolios must plot above the SML. Nonetheless, arbitrarily inefficient portfolios also plot above the SML.

This paper tests whether the higher oil prices of the last decade could have been the result of producer collusion. We find little evidence that OPEC influenced oil prices during the years of skyrocketing prices (1974–1980), but there is evidence that it did so during the recent years of softening prices (1981–1983).

In this study a real price index is created for whole life insurance sold in the United States from 1953 to 1979. New purchases of whole life insurance are shown to be negatively related to changes in this cost index, contrary to what has been widely accepted in the insurance literature, but consistent with economic theory. The existence of strong price elasticity of demand for whole life insurance does not ensure, however, that the insurance industry manifests a high degree of price competition.

This study examines whether the information implied by simultaneous levels of option and stock prices (specifically, the implied standard deviation of returns) reflects other contemporaneously available information. The independent contemporaneous measure considered is the observed dispersion (across several financial analysts), at a point in time, in the forecasts of earnings per share for a given firm. The results indicate that implied standard deviations clearly reflect the contemporaneous dispersion in analysts' forecasts incrementally , i.e., beyond the information contained in the historical time series of returns.

This paper examines the optimality of an insurance strategy in which an investor buys a risky asset and a put on that asset. The put's striking price serves as the insurance level. In complete markets, it is highly unlikely that an investor would utilize such a strategy. However, in some types of less complete markets, an investor may wish to purchase a put on the risky asset. Given only a risky asset, a put, and noncontinuous trading, an investor would purchase a put as a way of introducing a risk‐free asset into the portfolio. If, in addition, there is a risk‐free asset and the investor's utility function displays constant proportional risk‐aversion, then the investor would buy the risk‐free asset directly and not buy a put. In sum, only under the most incomplete markets would an investor find an insurance strategy optimal.