Knowledge that Transforms

The API metric, as initially formulated by Ball and Brown [1], has been used to examine the relationship between stock prices and accounting numbers. Its use in this manner has raised at least three difficulties: (1) the metric does not utilize all of the information portentially available from accounting numbers, (2) the statistical significance of the API metric and of differences between API's has not always been satisfactorily considered, and (3) the meaning of the metric has been questioned. This paper will attempt to resolve these difficulties by reformulating the API approach. Two nonparametric statistical procedures are considered, both of which provide a test of the statistical significance of the relationship between accounting income numbers and stock prices. The first procedure is particularly appropriate when alternative accounting income numbers are considered. Both procedures provide a conventional unambiguous interpretation of the results.

Paul H. Cootner, The Theorems of Modern Finance in a General Equilibrium Setting: Paradoxes Resolved, The Journal of Financial and Quantitative Analysis, Vol. 12, No. 4, Proceedings of the 1977 Western Finance Association Meeting (Nov., 1977), pp. 553-562

In recent years a substantial number of empirical studies have been conducted concerning aggregate commercial bank behavior [2, 8, 11, 14, 15, 17, 18]. Although the scope of these studies has varied widely, none has included an adequate treatment of the relationship between commercial bank liability management and earning asset adjustments. The importance of the relationship between liability management and commercial bank asset behavior has been alluded to in the literature [3, 5, 6, 13, 18]; but there has been very little empirical investigation of the subject. Moreover, little is known about which assets and liabilities are primarily involved. By increasing or decreasing earning assets, the commercial banking system can create or eliminate deposits, thus affecting the supply of both money and bank credit. Since liability management and asset behavior are very closely related, it seems that an adequate understanding of this relationship is essential to understanding the money supply process.

We have formulated the mean-variance models of portfolio selection with stochastic cash demand. The results of the general model have indicated that the characteristic of the investor's stochastic cash demand, the liquidity risks of assets (measured by the covariance between an asset's return and the cash demand), and the structure of transfer costs also play important roles in the determination of the investor's optimal portfolio. We have also shown that the model of portfolio selection with stochastic cash demand can be greatly simplified if the assumption of symmetric transfer costs is invoked. Furthermore, it has been shown that the simplified model can be reformulated and solved by the LP techniques. Thus, LP formulation of portfolio selection with stochastic cash demand should have practical usefulness.Finally, along the line of works by Chen, Jen and Zionts [3, 4], Pogue [14, 15] and Stone and Reback [20], one can extend the analysis in this paper to the problem of dynamic portfolio management with stochastic cash demand and transfer costs.

In equilibrium, each new capital asset must be priced properly relative to other assets. If an investor can also buy and sell assets in his portfolio costlessly and quickly, then the new asset will be accepted immediately and fully into the market and it will immediately behave as though it were a seasoned or previously available asset. However, it is often argued that recently issued bonds and seasoned or fully distributed bonds behave differently due to the frictions and risks associated with distributing a new security in the market. And it is also argued that recently issued bonds undergo a behavioral transformation as they become seasoned bonds. According to this argument there are significant empirical behavioral differences between recently issued bonds and seasoned bonds [4, 5, 7, 9, 13]. These differences disappear as the market gradually absorbs the new bond issue and the bond becomes “seasoned.”

In recent financial literature a large volume of the articles dealt with asset leasing. This author and his colleagues [6] and others [7] developed the conditions under which asset leasing cannot increase the overall firm's value over normal debt leverage. Many others [2, 3, 11] analyzed the “lease-buy” decision using a variety of models and assumptions. None, however, considered the effect of asset leasing on the firm's capitalization rate. While asset leasing per se would not affect the firm's unlevered cost of capital, it should affect its estimation. This paper developed the adjustment factor to obtain the firm's corresponding unlevered cost of capital with leasing leverage. Basically, Modigliani and Miller's methodology [9] was adjusted for the different tax situation with asset leasing. The effective benefit of leasing on the firm's average cost of funds was shown to be not nearly as effective as an equivalent amount of ordinary debt.

The general framework employed in analyzing diversification among securities involves the mean-variance theory of portfolio selection described by Markowitz [8]. Observation of the securities comprising the efficient set indicates which financial sssets possess attributes (i.e., expected return and covariances) making them worthwhile components of an optimally diversified portfolio. This paper will be concerned with forming an efficient set from four security classes—common stocks, preferred stocks, corporate bonds, and U.S. government bonds (hereafter denoted CS, PS, CB, and GB, respectively). The first objective will be to derive and analyze an efficient set from a sample of these securities in order to determine which securities have potential benefits for diversification.

Consider a productive investment project (or financial security), which would yield a stream of cash flows, positive and negative, over time. A major index of the acceptability of such a project is its internal rate of return, i.e., that rate of interest which discounts all the cash flows from the project to a present worth of zero. Soper [8] has developed a sufficient condition for the internal rate to be unique in the interval, (−1, ∞), along the real line. Then, if the project requires an initial outlay, if Soper's condition holds, and if the unique internal rate exceeds the market rate of interest in each period of the project's life, the project's present worth is positive, and hence, other things being equal, it is worth undertaking.

Nestor Gonzalez, Robert Litzenberger, Jacques Rolfo, On Mean Variance Models of Capital Structure and the Absurdity of their Predictions, The Journal of Financial and Quantitative Analysis, Vol. 12, No. 2 (Jun., 1977), pp. 165-179

R. G. Vickson, M. Altmann, On the Relative Effectiveness of Stochastic Dominance Rules: Extension to Decreasingly Risk-Averse Utility Functions, The Journal of Financial and Quantitative Analysis, Vol. 12, No. 1 (Mar., 1977), pp. 73-84