Knowledge that Transforms

Mayers and Rice conjecture that an investor with better information will on average plot above the security market line as drawn by uninformed investors. This paper demonstrates that this conjecture is false in general, by constructing a counterexample. However, the Mayers-Rice conjecture is really part of a much broader hypothesis concerning whether increases in expected returns correspond to increases in expected utilities. It is shown that this latter hypothesis is true when the investor has an exponential or logarithmic utility function.

During the 1970's, mutual fund insurance was sold in the U.S. by the Harleysville and Prudential Insurance Companies. This paper examines the valuation and demand for this insurance. It illustrates that because of its design, for many plausible combinations of model parameters, a competitive premium need not exist for the Harleysville contract. A competitive premium will always exist for the Prudential policy, however the value is directly related to the age of the purchaser. Harleysville charged the same premium to all funds and therefore was subject to adverse selection. Evidence of this effect is provided by illustrating that the demand for the insurance was directly related to its competitive market value.

This study considers the problem of a price-setting monopolistic market-maker in a dealership market where the stochastic demand and supply are depicted by price-dependent Poisson processes [following Garman (1976)]. The crux of the analysis is the dependence of the bid-ask prices on the market-maker's stock inventory position. We derive the optimal policy and its characteristics and compare it to Garman's. The results are shown to be consistent with some conjectures and observed phenomena, like the existence of a ‘preferred’ inventory position and the downward monotonicity of the bid-ask prices. For linear demand and supply functions we derive the behavior of the bid-ask spread and show that the transaction-to-transaction price behavior is intertemporally dependent. However, we prove that it is impossible to make a profit on this price dependence by trading against the market-maker. Thus, in this situation, serially dependent price-changes are consistent with the market efficiency hypothesis.

This paper reexamines the anomalous evidence concerning the efficiency of the listed options exchanges. We focus on the structure of trading costs in that market, and note several costs which generally have been ignored, the largest of which is the bid-ask spread. When we adjust the published trading rules for our estimates of these trading costs, the reported abnormal returns are eliminated.

This study considers the impact of capital structure change announcements on security prices. Statistically significant price adjustments in firms' common stock, preferred stock and debt related to these announcements are documented and alternative causes for these price changes are examined. The evidence is consistent with both corporate tax and wealth redistribution effects. There is also evidence that firms make decisions which do not maximize stockholder wealth. In addition, a new approach to testing the significance of public announcements on security returns is presented.