Knowledge that Transforms

This paper develops a consumption-oriented model of asset prices in a multigood economy that is, in principle, testable even when aggregate consumption of goods and their market prices are only partially observable. Previous studies show that, when there are m consumption goods, equilibrium expected excess returns on securities are functions of their covariances with m + 1 variables—aggregate consumption expenditure and market prices of consumption goods. Without making any further assumptions, the present model shows that a similar equilibrium relationship can be expressed in terms of covariances of asset returns with the following m + 1 variables: market prices of k consumption goods and aggregate consumption of m + 1 − k goods. Because the author's result provides researchers with some flexibility in choosing the set of m + 1 variables that measure riskiness of securities, it should lead to more powerful tests of the model.

The author presents a rapidly convergent algorithm to solve the general portfolio problem of maximizing concave utility functions subject to linear constraints. The algorithm is based on an iterative use of the Markowitz critical line method for solving quadratic programs. A simple example, taken from the theory of state-contingent claims, is worked out in detail. For technical convergence results, the reader is referred to the appropriate mathematical programming literature.

Currency call option transactions data and the Black-Scholes option pricing model, as modified by Merton for continuous dividends and as adapted to currency options by Biger and Hull and by Garman and Kohlhagen, are used to imply spot foreign exchange rates. The proportional deviation between implied and simultaneously observed spot rates is found to be a direct and statistically significant determinant of subsequent returns on foreign currency holdings after controlling for interest rate differentials. Further, an ex ante trading rule reveals that the additional information contained in implied rates often is sufficient to generate significant economic profits.

A new representation of nonmarketable (NM) income is introduced in this essay. Using this representation and continuous trading, there exists a set of individuals who do not participate in the asset market and who consume at the rate of nonmarketable income derived from human capital. Because these individuals remain nonparticipants for a range of stochastic processes governing the NM income, consumption betas are not generally unique in value and the consumption-based CAPM (CCAPM) does not obtain. However, the intertemporal CAPM (ICAPM) of Merton remains valid.

Frank J. Fabozzi, Eileen Moran, Christopher K. Ma, Market Uncertainty and the Least-Cost Offering Method of Public Utility Debt: A Note, The Journal of Finance, Vol. 43, No. 4 (Sep., 1988), pp. 1025-1034

The author examines the relationship between the Arbitrage Pricing Theory of Ross and mean-variance analysis. In particular, conditions are derived on the vector of the factor risk premia that are equivalent to the existence of a strictly positively weighted portfolio on the minimum-variance frontier. Also, a sufficient condition is given under which the existence of a positive minimum-variance portfolio of all the assets in the economy will imply the existence of a positive minimum-variance portfolio on a subset. This means that rejection of the hypothesis of the existence of a positive minimum-variance portfolio on a subset satisfying this condition implies rejection for the whole set.