Knowledge that Transforms

This paper examines the effect of risk differences on the oft-documented negative rela? tionship between stock returns and inflation. We find risk-related patterns of coefficients on our estimates of the level and change in expected inflation and on unexpected inflation. These patterns are consistent with the hypothesis developed in Fama [2] and in Geske and Roll [7] that future real output growth simultaneously helps to determine current stock returns and various measures of inflation.

This paper extends a recent study by Malatesta [14] on measuring abnormal performance using joint generalized least squares. For monthly data and a random sample of securities, Malatesta finds that there is little benefit in using more sophisticated econometric techniques to identify abnormal returns. The current study extends these results using a design that is more amenable to the benefits of the generalized methods and is consistent with actual event studies. Most notably, the study uses a sample of securities experiencing an actual event and tests both monthly and daily data. In addition, iterative techniques are compared to the ordinary least squares and estimated generalized least squares methods. The results of this study support the original conclusions of Malatesta, indicating no measurable gain in using any of the systems methods for event study applications.

David F. Larcker, Short-Term Compensation Contracts and Executive Expenditure Decisions: The Case of Commercial Banks, The Journal of Financial and Quantitative Analysis, Vol. 22, No. 1 (Mar., 1987), pp. 33-50

The primary objective of this paper is to derive a multi-factor equilibrium model using a mean-variance approach. The results of this derivation provide greater insight into the nature of the resulting factors than does APT. There are several important implications for empirical tests of any a priori defined multi-factor model.

This paper derives and tests a new linear programming (LP) approach to bond portfolio management. The model elicits possible tax-clientele effects in the pricing of U.S. Gov? ernment coupon bonds and simultaneously derives the optimal tax-specific bond portfolio. Analytically, the model derives these results by exploiting, for a given tax bracket, the price differential of an after-tax stream of cash flows. It accomplishes this objective by purchasing at the ask price underprieed bonds (for the specific tax bracket), while sim? ultaneously selling at the bid price overpriced bonds. The model requires that the net cash flow, inclusive of purchased and sold bonds, be nonnegative at all future dates; the problem's formulation standardizes the position taken in each bond to a maximum of one unit. One of the model's appealing features is the parsimonious number of required calcu? lations: only one LP program need be run per tax bracket. In addition to obtaining an optimally chosen tax-specific bond portfolio, the model also measures the after-tax term structure of spot U.S. Government interest rates for both tax-exempt and taxable investors. Finally, the superior monthly holding-period rates of return on the optimal taxspecific bond portfolio demonstrate an important property ofthe model's output.

Anthony Saunders, Michael Smirlock, Intra- and Interindustry Effects of Bank Securities Market Activities: The Case of Discount Brokerage, The Journal of Financial and Quantitative Analysis, Vol. 22, No. 4 (Dec., 1987), pp. 467-482

This paper demonstrates that the impact of the existing tax law is not uniform across projects with different variances of payoffs. A bias exists against projects with greater uncertainty of payoffs, which leads to an underinvestment in high risk projects. The bias against higher variance projects offers a theoretical justification for such tax incentives as the research and development tax credit.

This paper points out an error and implications of the error in the model of hedging effectiveness proposed by Howard and D'Antonio (1). The error would lead to ambiguous results if the model were used in practical applications to select the best hedging instrument. This paper proposes a new measure of hedging effectiveness that eliminates the error in the original model and resolves the ambiguity.

In this reply, we point out that Chang and Shankar's measure of hedging performance, which they label HE1, is not an adequate measure. We describe an alternative measure, labeled HBS, which has a number of desirable ex ante and ex post statistical properties.

We construct a simple economy with consumption only at the final date in which we “endogenize” the stochastic behavior of prices assumed in the Black-Scholes model. Certain preferences (constant proportional risk aversion) and beliefs are shown to be sufficient and necessary, in certain respects, for the existence of such an equilibrium. The analysis is then generalized to a continuous-consumption framework, in which we embed the Merton proportional dividend model.