Knowledge that Transforms

Subsequent to the October 1979 shift in monetary policy in the United States, interest rates in North America not only reached unprecedented levels but also exhibited unprecedented volatility. Using Canadian data, the authors show that anticipated quarterly changes in long‐term rates associated with the rational‐expectations model have remained small during this post‐shift period. The authors examine three sets of recorded forecasts of long‐term interest rates in Canada and note their failure to improve upon the no‐change prediction. The “perverse” relationship between the slope of the yield curve and the subsequent movement in long‐term rates exists in the Canadian data but is of only modest value in a forecasting context. The excess returns on long‐term bonds implicit in the recorded forecasts of the level of interest rates vary sharply, yet there is little evidence that forecasters have identified a predictable component of time‐varying term premia.

In this paper, we extend earlier work on hedging models so that uncertainty about both deposit supply and loan demand is incorporated as well as random rates of return on loans and CD's. Our model suggests that the optimal forward position is the sum of three ratios that should be estimated simultaneously. Using bank-specific data, the optimal hedge ratios are estimated in both the pre-deregulation and deregulation subperiods. Our results show that previous studies of bank hedging with interest rate futures have greatly overstated (a) the volume of short futures positions that banks should take and (b) the degree of homogeneity of optimal hedge ratios across the banking system. Similarly, deregulation has not uniformly affected the interest rate risk borne by different institutions.

Examined in this paper is the choice between private and public incorporation of an asset for an entrepreneur (asset owner) who hires a manager with superior information about the asset's return distribution. Public sale of equity is shown to be the preferred alternative when (a) capital market issue costs are low or (b) the assest's idiosyncratic risk is high and the owner is either sufficiently risk averse or sufficiently “optimistic” about the asset's expected return. Thus, those assets deemed most valuable by their owners will tend to be publicly incorporated. The paper also explores the impact of incorporation mode—private versus public—and information structure on the firm's investment policy and ownership distribution.

This article generalizes the single-period linear-programming bounds on option prices by allowing for a finite number of revision opportunities. It is shown that, in an incomplete market, the bounds on option prices can be derived using a modified binomial option-pricing model. Tighter bounds are developed under more restrictive assumptions on probabilities and risk aversion. For this case the upper bounds are shown to coincide with the upper bounds derived by Perrakis, while the lower bounds are shown to be tighter.

Commonly, equilibrium security prices are modeled by continuous-state stochastic processes, while observed prices are rounded into discrete units. This paper models the rounding mechanism and examines the probabilistic structure of the resultant rounded process. We provide accurate and simple estimates of the inflation in estimated variance and kurtosis induced by ignoring rounding. In particular, the maximum-likelihood estimate of security price volatility using rounded prices is developed, and a simulation analysis is performed to examine the small-sample properties of this estimator. For many practical applications, a simple correction for rounding becomes available.