Knowledge that Transforms

This paper develops a new methods for measuring tax effects in bond markets and presents empirical results for British Government Securities. The basic idea is to construct a least cost portfolio which, for investors in a given tax bracket, dominates a given bond. A portfolio is said to dominate a bond if it provides cash flows which are at least as great in every period, and has a lower price. In effect our method calculates an upper bound on the value of a bond to investors in a given tax bracket. The results demonstrate (i) the existence of clientele effects and (ii) the absence of an ‘effective tax rate’.

This study investigates the sensitivity of tests of the CAPM to different sets of asset returns. Tests are conducted with market portfolios that include returns for bonds, real estate, and consumer durables in addition to common stocks. Even when stocks represent only 10% of the portfolio's value, inferences about the CAPM are virtually identical to those obtained with a stocks-only portfolio. In contrast, inferences are sensitive to the set of assets used in the tests.

The performance of Value Line Investment Survey recommendations made between 1965 and 1978 is evaluated by applying a future benchmark technique. The future benchmark technique avoids selection bias problems associated with using historic benchmarks as well as known difficulties of using Capital Asset Pricing Model benchmarks. Potential problems (implicit in the technique) are discussed and resolved within the conduct of the experiment. Results indicate statistically significant abnormal performance when future benchmarks are computed using a market model.

The efficiency of the Canadian Treasury bill market is examined with data on spot and forward rates of return. Over the period from 7/62 to 3/79, the bill market has been efficient in the sense that it correctly uses the information contained in past spot rates in assessing the expected future spot rate and in determining the forward rate. Moreover, the forward rate is found to contain some information about future spot rates above and beyond that in past spot rates.

This paper provides analytical formulas for European put and call options on the minimum or the maximum of two risky assets. The properties of these formulas are discussed in detail. Options on the minimum or the maximum of two risky assets are useful to price a wide variety of contingent claims of interest to financial economists. Applications discussed in this paper include the valuation of foreign currency debt, option-bonds, compensation plans, risk-sharing contracts, secured debt and growth opportunities involving mutually exclusive investments.

This paper examines the relation between the variance of equity returns and several explanatory variables. It is found that equity variances have a strong positive association with both financial leverage and, contrary to the predictions of the options literature, interest rates. To a substantial degree, the negative elasticity of variance with respect to value of equity that is part of market folklore is found to be attributable to financial leverage. A maximum likehood estimator is developed for this elasticity that is substantially more efficient than extant estimation procedures.

Horse racing data permit interesting tests of attitudes toward risk. The present paper studies a new sample of racetrack results from Atlantic City, New Jersey. The questions examined are: (1) Are the market odds the best data for predicting the order of finish? (2) Do horses go off at odds that reflect their true probability of winning? (3) Is there any evidence that late bettors have better information than early bettors? It is found that market odds predict the order of finish well, but that ‘favorites’ are good bets and ‘long shots’ are poor ones. The data suggest that there does exist an ‘informed’ class of bettors and that bettors are on the whole neither risk neutral nor risk averse.

This paper examines the pricing performance of the valuation equation for American call options on stocks with known dividends and compares it with two suggested approximation methods. The approximation obtained by substituting the stock price net of the present value of the escrowed dividends into the Black-Scholes model is shown to induce spurious correlation between prediction error and (1) the standard deviation of stock return, (2) the degree to which the option is in-the-money or out-of-the-money, (3) the probability of early exercise, (4) the time to expiration of the option, and (5) the dividend yield of the stock. A new method of examining option market efficiency is developed and tested.