Knowledge that Transforms

This paper presents a test of the theory of rational option exercise. Exercise data from the market for options on Treasury bond futures are used to test the model of rational early exercise developed by Barone-Adesi and Whaley (1987) (BAW). The results show that the BAW model underestimates the futures price that will trigger exercise for calls and overestimates this price for puts. The exercise bias is observed to change across option maturities and the direction of the bias is consistent with the direction of the model-pricing bias observed by Whaley (1986).

This paper extends the default model of yield spreads for bonds by showing that, in general, they are a complex function of maturity and, in particular, are not always monotonically increasing, contrary to what one traditional view suggests. Our results may help explain the apparently conflicting empirical results found in the literature.

A family of jump process models is derived by applying Gauss-Hermite quadrature to the recursive integration problem presented by a compound option model. The result is jump processes of any order with known efficiency properties in valuing options. In addition, these processes arise in the replication of options over finite periods of time with two or more assets where they again have known efficiency properties. A “sharpened” trinomial process is designed that accounts for the first-derivative discontinuity in option valuation functions at critical exercise points. It is shown to have accuracy superior to that of conventional binomial and trinomial processes and is nearly identical to the trinomial process optimized by Boyle (1988) through trial and error.

General equilibrium in the classical two-period mean-variance capital asset pricing model is not unique. Corresponding to one single set of expectations, utility functions, and an initial wealth distribution, there may be several equilibria, and an asset may have different prices, expected rates of return, and betas in different equilibria. However, any equilibrium portfolio is sustained by a unique price system, and if investors have decreasing risk aversion, then any equilibrium allocation of the risky assets is sustained by a unique price system.

This paper analyzes the correspondence between arbitrage sector pricing efficiency and the short-term hedging costs and effectiveness of futures contracts. Reversals of initial contract mispricings by arbitrage sector trading leads to an important mispricing retum component in the total retum to hedge portfolios. The existence of the mispricing retum has implications for initial hedge ratio selection, hedging effectiveness, and expected hedge retum. The analysis is used to interpret the hedge ratio guidance and performance of short-term hedges between the Standard and Poor's 500 stock index futures contract and the underlying S&P 500 cash stock index portfolio over the 1982-1986 period.

The purpose of this paper is to suggest simple procedures designed to cope with the effects of thin trading on event study tests. The procedures are directed at two central problems: (i) missing individual stock returns (i.e., days on which no trading is observed in a security), and (ii) the effect of a bid-ask spread on the time series behavior of daily stock return data. We attack these problems by explicitly incorporating them in the construction of a generating process for observed security returns. First, we develop a procedure for “filling in” missing returns. Then, we model a return-generating process of observed security returns that allows estimation of the variance of unobserved true security returns for use in hypothesis testing.

This paper examines the intertemporal behavior of the short-term rate of interest in a mean-reverting model (Vasicek's elastic random walk model). Using the Goldfeld-Quandt switching regressions technique, we show that the mean-reverting model switched regimes three times over the sample period (March 1959 to December 1985) and that two of these switches coincide with the 1979 and 1982 changes in Federal Reserve monetary policy on interest rates. Parameter estimates prove to be unstable over the sample period. There is evidence of slow mean reversion over the entire sample period; yet significant mean-reversion emerges only in the 1979n1982 regime.

Paul A. Spindt, J. Ronald Hoffmeister, The Micromechanics of the Federal Funds Market: Implications for Day-of-the-Week Effects in Funds Rate Variability, The Journal of Financial and Quantitative Analysis, Vol. 23, No. 4 (Dec., 1988), pp. 401-416

The flattening of yield curves at long-term maturities is proven to be approximately proportional to the reciprocal of the time to maturity under general conditions. This is a consequence of the persistence of earlier forward rates in the averaging process, which produces yields from forward rates. This relationship suggests the use of a “reciprocal maturity yield curve, ” which significantly facilitates the interpretation of the behavior of long-term yields by linearizing them for display over a shorter interval. This is illustrated using a yield curve for U.S. Treasury bills.