Knowledge that Transforms

It is assumed that a collection of market agents can be treated as a statistical ensemble. Their market activities are depicted as the stochastic generation of market orders according to a Poisson process. The objective is to effectively describe the ‘temporal microstructure’, or moment-to-moment trading activities in asset markets. Two basic models, ‘dealership’ vs. ‘auction’ markets (and their variants) are put forth. Implications are drawn from each model. The implications include several testable hypotheses regarding the aggregate behavior of markets and market-makers as well as some qualitative insight into the transaction-to-transaction nature of realistic exchange processes.

International capital market equilibrium is characterized for a world economy in which consumption preferences are defined multiplicatively over many commodities. It is shown that the set of relative asset prices under pure exchange in international capital markets depends on the real purchasing power of nominal payoffs under uncertainty and does not depend on the currency in which the nominal payoffs are denominated. A Sharpe-Lintner type international capital asset pricing model is derived as a special case. Proportional ad valorem commodity taxes and transportation costs are incorporated in the valuation model, interest rate parity and purchasing power parity are reinterpreted under uncertainty, and international differences in borrowing and lending are shown to reflect, in part, differences in risk aversion across countries.

This paper determines the effect of estimation risk on optimal portfolio choice under uncertainty. In most realistic problems, the parameters of return distributions are unknown and are estimated using available economic data. Traditional analysis neglects estimation risk by treating the estimated parameters as if they were the true parameters to determine the optimal choice under uncertainty. We show that for normally distributed returns and ‘non-informative’ or ‘invariant’ priors, the admissible set of portfolios taking the estimation uncertainty into account is identical to that given by traditional analysis. However, as a result of estimation risk, the optimal portfolio choice differs from that obtained by traditional analysis. For other plausible priors, the admissible set, and consequently the optimal choice, is shown to differ from that in traditional analysis.

When adjusted for variation through time in expected premiums, the forward rates of interest that are implicit in Treasury Bill prices contain assessments of expected future spot rates of interest that are about as good as those that can be obtained from the information in past spot rates. Moreover, in setting bill prices and forward rates, the market reacts appropriately to the negative autocorrelation in monthly changes in the spot rate and to changes through time in the degree of this autocorrelation. This evidence is consistent with the market efficiency proposition that in setting bill prices, the market correctly uses the information in past spot rates.

This paper integrates elements from the theory of agency, the theory of property rights and the theory of finance to develop a theory of the ownership structure of the firm. We define the concept of agency costs, show its relationship to the ‘separation and control’ issue, investigate the nature of the agency costs generated by the existence of debt and outside equity, demonstrate who bears these costs and why, and investigate the Pareto optimality of their existence. We also provide a new definition of the firm, and show how our analysis of the factors influencing the creation and issuance of debt and equity claims is a special case of the supply side of the completeness of markets problem. The directors of such [joint-stock] companies, however, being the managers rather of other people's money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master's honour, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company. Adam Smith, The Wealth of Nations, 1776, Cannan Edition (Modern Library, New York, 1937) p. 700.

Recent advances in the general equilibrium pricing of simple put and call options lay the foundation for the development of a general theory of the valuation of contingent claims assets. This paper provides a review of: (1) the development of the general equilibrium option pricing model by Black and Scholes, and the subsequent modifications of this model by Merton and others; (2) the empirical verification of these models; and (3) applications of these models to value other contingent claim assets such as the debt and equity of a levered firm and dual purpose mutual funds.

In this paper a combined capital asset pricing model and option pricing model is considered and then applied to the derivation of equity's value and its systematic risk. In the first section we develop the two models and present some newly found properties of the option pricing model. The second section is concerned with the effects of these properties on the securityholders of firms with less than perfect ‘me first’ rules. We show how unanticipated changes in firm capital and asset structures can differentially affect the firm's debt and equity. In the final section of the paper we consider a number of theoretical and empirical implications of the joint model. These include investment policy as well as the causes and effects of non-stationarity in the systematic risk of levered equity and risky debt.