Knowledge that Transforms

This paper examines rational expectations in the Treasury bill market from 1961 to 1988 with a risk premium specified to be proportional to the volatility of excess returns using instrumental variables. From 1961 to 1972 and from 1972 to 1979, rational expectations cannot be rejected, and both the predictive power of the yield curve and the risk premium are highly significant. By contrast, with just a constant risk premium and with a risk premium proxied by moving averages of absolute interest rate changes, rational expectations are rejected for each subperiod, and the yield curve has significant predictive information only from 1972 to 1979.

February and August peaks in the growth rates of the seasonally unadjusted Industrial Production Index follow the stock market peaks documented by Rozeff and Kinney (1976) by one month. Coefficients on one-month lead growth rates in industrial production for small firms are positive and significant in time-series regressions even in the presence of the market factor. Moreover, whereas returns on large firms' stocks unidirectionally Granger cause (i.e., predict) future growth rates in industrial production at least six months in advance, returns on small firms' stocks reflect one-month lead as well as past growth rates in industrial production. For these reasons, we argue that seasonal real growth provides a partial explanation for the January stock seasonal among small firms.

Focussing on takeover bids whose outcome can be predicted in advance with certainty, Grossman and Hart estsblished the proposition, which subsequent work accepted, that successful bids must be made at or above the expected value of minority shares.This proposition provided the basis for Grossman and Hart's identification of a free-rider problem and became a major premise for the analyaia of takeovers.This paper showa that this important proposition does not always hold once we drop the assumption that the only successful bida are those whose success could have been predicted with certainty.In particular, it is shown that any unconditional bid that is below the expected value of minority shares but above the independent target's per share value will succeed with a certain positive probability; that the bidder's expected payoff from such a bid (not counting the transaction costs of making the bid) is always positive; and that bidders might elect to make such bids.These results have implications for the nature of the free-rider problem and for the operation of takeovers; in particular, it ia shown that, when a raider can increaae the value of a target's assets, the raider might elect to bid even if no dilution of minority shares is possible and it holds no initial stake in the target.

Wilbur Lewellen, Claudio Loderer, Ahron Rosenfeld, Mergers, Executive Risk Reduction, and Stockholder Wealth, The Journal of Financial and Quantitative Analysis, Vol. 24, No. 4 (Dec., 1989), pp. 459-472

In a dynamic framework, the advantage of leverage depends upon the firm's recapitalization policy. We show that if bonds are callable at par, then equityholders have an incentive to recapitalize too early. Call premia and issue discounts, however, mitigate the agency problem of early recapitalization. The model provides the optimal call premium and issue discount as a function of firm-specific characteristics. An analysis of a bond sample supports the model's prediction that the optimal call premium is positively related to firm risk.

This paper provides further empirical evidence on the relation between entrepreneurial ownership retention and the initial value of unseasoned common shares. A Canadian data set is employed to estimate the various empirical specifications used in previous studies and to examine additional variables suggested by recent developments in the theoretical literature. The estimation is carried out using a more general procedure to correct for heteroskedasticity. In contrast to previous findings, the entrepreneurial ownership retention signal does not possess statistical significance in any of the models examined.

This study examines whether stock returns provide forecasts of changes in interest rates and inflation. In contrast to earlier work that indicated that changes in expected inflation negatively affect stock returns, we find a statistically significant positive relation between stock returns and future inflation rate changes as well as a significant positive relation between stock returns and future interest rate changes. Real estate investment trusts, which are particularly interest- and inflation-sensitive securities, provide better forecasts than a broad market index. Finally, we find that most of the evidence supporting the forecasting ability of stock returns occurs in the October 1979 to October 1982 period when the Federal Reserve Board chose not to counteract interest rate changes.

Joyce A. Hall, Wade Brorsen, Scott H. Irwin, The Distribution of Futures Prices: A Test of the Stable Paretian and Mixture of Normals Hypotheses, The Journal of Financial and Quantitative Analysis, Vol. 24, No. 1 (Mar., 1989), pp. 105-116

This paper analyzes the pricing of stock index options in a simple general equilibrium model. In this model, the volatility of the stock index and the spot rate of interest are functions of a stochastic variable. The paper investigates the biases that arise when using the Black-Scholes model with the assumed volatility and interest rate dynamics. It is shown that the model can, in principle, explain the biases observed in empirical work on stock index options.

We derive formulas for the valuation of call options on stocks and bonds when the defaultfree rate is stochastic. The formulas highlight the role of the correlation between the unanticipated returns on the underlying security and the changes in the short-term rate in determining the options value. Our numerical analysis indicates that option prices predicted by the proposed formula differ from those predicted by the Black and Scholes formula when this correlation is relatively large and the short-term rate's instantaneous variance is relatively large as well. Moreover, the proposed formula predicts higher (lower) stock option prices than those predicted by the Black and Scholes formula for correlation values that are lower (higher) than some positive critical value.