Knowledge that Transforms

An analysis of the dual problem described by Ronn (1987) reveals that it provides a powerful and easily interpretable test for the hypothesis of a single class of marginal investors, including models of equilibrium based on a “representative tax bracket.” When Ronn's empirical tests are interpreted via the dual, they lend additional support to his conclusions in providing a strong rejection of the representative tax bracket hypothesis. A valid dual LP used to test the hypothesis can be obtained with fewer assumptions than Ronn's primal; in addition, a minor error in Ronn's presentation of the dual is corrected.

comments and suggestions. Working papers of the Federal Reserve Bank of Cleveland are preliminary materials circulated to stimulate discussion and critical comment. The views stated herein are the author's and not necessarily those of the Federal Reserve Bank of Cleveland or of the Board of Governors of the

Thomas J. Finucane, Black-Scholes Approximations of Call Option Prices With Stochastic Volatilities: A Note, The Journal of Financial and Quantitative Analysis, Vol. 24, No. 4 (Dec., 1989), pp. 527-532

Kevin F. McCardle, Robert L. Winkler, All Roads Lead to Risk Preference: A Turnpike Theorem for Conditionally Independent Returns, The Journal of Financial and Quantitative Analysis, Vol. 24, No. 1 (Mar., 1989), pp. 13-28

This paper examines how the progressive personal tax rate affects the equilibrium asset pricing model. In a continuous-time framework with progressive taxation, it can be shown that the expected excess rate of return on a risky asset is an increasing function of (i) the covariance of asset return with aggregate consumption rate changes, and (ii) the covariance of asset return with the aggregation of individual wealth change, weighted by the investor's tax scheme progressivity index. The capital asset pricing model derived in the absence of tax is shown to understate the expected excess rate of return and to have a misspecification error under the progressive tax scheme. Furthermore, the expected excess rate of return can be decomposed as the consumption risk premium and tax premium. The tax premium depends on the tax structure prevailing in the economy.

This paper examines the seasonal behavior of proportional dealer spreads for OTC NASDAQ common stocks. Results indicate there is seasonality in dealer spreads. Spreads tend to be larger in the second half of the calendar year, peaking in December. At the turn-ofthe-year, spreads tend to peak in mid- to late December and then recede during January. The last trading day in December produces the largest daily decline in spreads during the turn-of-the-year period.

Jimmy E. Hilliard, Susan D. Jordan, Hedging Interest Rate Risk with Futures Portfolios Under Full-Rank Assumptions, The Journal of Financial and Quantitative Analysis, Vol. 24, No. 2 (Jun., 1989), pp. 217-240

A majority of corporate zero-coupon bonds includes a call provision, giving the firm the right to call the bond at par value. In this paper, we investigate whether or not it is optimal for the firm to call such a bond for refunding purposes, taking into consideration the effect of corporate taxes. We find that it is not optimal to refund the bond as long as the corporate tax rate is less than 50 percent. We find that a significantly higher proportion of callable zero-coupon bonds, compared to noncallables, has restrictive financing covenants, suggesting that the call feature is included to provide flexibility at a low cost for future recapitalizations as the firm's investment opportunities change.

Shantaram P. Hegde, Robert E. Miller, Market-Making in Initial Public Offerings of Common Stocks: An Empirical Analysis, The Journal of Financial and Quantitative Analysis, Vol. 24, No. 1 (Mar., 1989), pp. 75-90

The first part of this paper presents a general approach to valuing a financial institution's contracts when there is credit risk. The approach uses contingent claims pricing theory and is particularly appropriate for an off-balance sheet contract, such as a swap, that can have either a positive or a negative value to the counterparty. The second part of the paper extends the analysis by considering the problem, faced by bank supervisory authorities, of determining capital requirements for off-balance sheet contracts.