Knowledge that Transforms

This paper examines estimation issues associated with multivariate tests of asset pricing. Two issues are considered: (1) the constraint that the sample size (N) must be less than the time series (T), and (2) the relative effect on power of using the multivariate statistic versus a univariate counterpart. We find that an alternative statistic that allows for large N does not dominate the usual portfolio tests. More notably, we find that the power of a simple diagonal statistic usually dominates the multivariate statistic for cases considered in this study.

Cheng F. Lee, Chunchi Wu, K. C. John Wei, The Heterogeneous Investment Horizon and the Capital Asset Pricing Model: Theory and Implications, The Journal of Financial and Quantitative Analysis, Vol. 25, No. 3 (Sep., 1990), pp. 361-376

An approximate method is developed for computing the values of European options on the maximum or the minimum of several assets. The method is very fast and is accurate for parameter ranges that are often of the most interest. The approach casts the problem in terms of order statistics and can be used to handle situations where the initial asset prices, the asset variances, and the covariances are all unequal. Numerical values are given to illustrate the accuracy of the method.

Ofer and Natarajan (1987) report negative, statistically significant cumulative average abnormal returns over five years following convertible bond calls. We show that these results are obtained only if returns preceding the call dates are used for market model parameter estimation. Returns preceding calls tend to be positive and unusually large. This means that predicted post-call returns, based on pre-call parameter estimates, are biased upward. Consequently, the corresponding abnormal returns are biased downward. We also discuss a corrected test statistic. We conclude that the evidence does not indicate market inefficiency in the stock price reaction to convertible calls.

This paper examines the effects of the delivery basis risk embedded in nearly all futures contracts on efficiency tests of these markets. Examining soybean futures contracts, we show that delivery basis risk has important implications for market efficiency tests. Assuming no delivery basis risk, the market efficiency hypothesis is rejected. However, futures prices contain significant time-varying expected delivery basis and time-varying expected delivery risk premiums. Once these expected delivery basis and delivery risk premiums are accounted for, the apparent inefficiency is eliminated. Equilibrium spot prices also contain significant time-varying expected delivery risk premiums.

Previous literature documents significant seasonalities in stock market returns. One explanation is seasonality in earnings information. If true, a return index comprised solely of firms reporting earnings should exhibit stronger intertemporal seasonalities than a return index comprised of firms not reporting earnings. Employing all New York and American Stock Exchange firms over six years, this study examines the seasonality of stock returns. Generally, seasonal patterns for reporting returns are found to be similar to or slightly weaker than for nonreporting returns. Thus, it is doubtful that earnings news seasonality induces stock return seasonality.

The paper uses a signalling equilibrium to explain the market's reaction to the announcement of a firm's financing decision. In our model, a firm can issue one of the following securities: convertible debt with a different conversion ratio, straight debt, and stock. We identify conditions under which the conversion ratio of a convertible debt issue serves as a credible signal of a firm's private information, given the continuous distribution of attributes (information) across firms. In this signalling equilibrium, we find that the lower the expected future earnings, the higher the conversion ratio of a convertible debt issue. At the limit, firms that expect the highest earnings will use straight debt financing, and firms that expect the lowest earnings will use equity financing. Based on the signalling equilibrium, we predict that at announcement of a convertible debt issue, negative abnormal common stock return increases in absolute value with the conversion ratio.

We examine empirically the existence of speculative bubbles in U.S. stock prices and, by building on West's procedure, propose direct and computationally simple tests of the “nobubble” hypothesis. These tests are likely to be close to their nominal size in small samples and to have small sample power against a wide class of bubbles including those orthogonal to the dividend process. We apply the tests to long-term annual U.S. stock market data for the 1871–1981 and 1871–1988 periods. Contrary to West, we do not reject the “no-bubble” hypothesis. We offer an explanation as to the cause of discrepancy between the two results.

In a credit market characterized by a priori asymmetric information, collateral not only can identify credit applicants but also can result in moral hazard involving the borrower's use of pledged assets. The borrower's other alternatives are to apply for unsecured bank credit and be priced as “average, ” or to acquire financing by selling an asset and subsequently renting it for continued use. The optimal secured loan contract for higher quality firms is shown to involve overcollateralization. There is underinvestment relative to first best in maintenance of the pledged assets but overinvestment relative to the level that would be chosen without bank monitoring. Self-financing and unsecured credit are chosen by the intermediate and lowest quality groups, respectively.

This paper examines multiperiod corporate financial policy in a world where the only market imperfection is taxation. The optimal financial policy determines the firm's capital structure and debt maturity structure. Two implications of this policy are: (1) there can be a set of debt-asset ratios that is consistent with firm value maximization, and (2) debt maturity structure is irrelevant to firm value.