Knowledge that Transforms

Joseph F. Sinkey, Jr., Identifying Large Problem/Failed Banks: The Case of Franklin National Bank of New York, The Journal of Financial and Quantitative Analysis, Vol. 12, No. 5 (Dec., 1977), pp. 779-800

Edwin J. Elton, Martin J. Gruber, Manfred W. Padberg, Simple Rules for Optimal Portfolio Selection: The Multi Group Case, The Journal of Financial and Quantitative Analysis, Vol. 12, No. 3 (Sep., 1977), pp. 329-345

Robert A. Schwartz, David K. Whitcomb, Evidence on the Presence and Causes of Serial Correlation in Market Model Residuals, The Journal of Financial and Quantitative Analysis, Vol. 12, No. 2 (Jun., 1977), pp. 291-313

This paper is an analytic treatment of the abandonment decision in capital investment analysis. It provides a methodology which has application in obtaining better estimates for project value and risk.

Thomas E. Copeland, A Probability Model of Asset Trading, The Journal of Financial and Quantitative Analysis, Vol. 12, No. 4, Proceedings of the 1977 Western Finance Association Meeting (Nov., 1977), pp. 563-578

The asset and liability portfolios of financial institutions generate patterns of future cash flows that must conform to many restrictions in order to assure solvency and profitability. Many institutions, including insurance companies and pension funds, have definite and certain future commitments of funds. These institutions may wish to invest funds now so that their cash inflows (investment with accumulated earnings) will match their future commitments. In principle, the simplest way to meet future commitments exactly is to purchase single payment notes (or zero coupon bonds) which mature on the commitment dates. For long-term commitments, such instruments are not readily obtainable, at least in the United States. Most available bonds promise coupon payments over time so that these payments would have to be reinvested at unknown future interest rates in order to realize an accumulated sum at any future date when a commitment must be discharged. Since future interest rates are unknown at the initial moment of investment, it is not certain what accumulated earnings will be at future dates. In the absence of default, the risk of not meeting future commitments may be minimized by adopting investment strategies based on the concept of duration. Duration is a measure of the average maturity of an income stream; it is a weighted average of the dates at which the income payments are received, where the weights add to unity and are related to the present value of the income stream. Dating from the initial work of Macaulay [9] and Hicks [6], duration has been shown to be important in constructing portfolios that are hedged or ‘immunized’ from the possible ravages of interest rate uncertainty.

In this paper, possible factors affecting the second-pass regression results in capital asset pricing are investigated in detail. First, the true functional form used to test the risk-return relation is determined by using Box and Cox's [2] generalized functional form technique. Secondly, Box and Cox's residual analysis and transformation technique are used to show the importance of the skewness effect in capital asset pricing. Finally, some other factors affecting the results of second-pass regression coefficient in capital asset pricing also are explored. From these analyses, it is found that the functional form, the skewness effect, and the change of market condition are the most important factors in affecting the empirical conclusions in testing the bias of composite performance measures and the risk-return relation.

The purpose of this paper has been to empirically test Stone's Two-Index Model. The results are mixed, but generally favor the model. Adding a bond index term for the bank sample only marginally improves the model's explanatory power although the index is more important than the equity index. The lack of importance of the bond index for banks is not surprising upon further consideration, however. Banks and their earnings should be more sensitive to short-term rather than long-term rates, and the index reflects primarily long-term rates. To the extent that short- and long-term rates moved in different directions during the sample period, negative correlation is introduced between bank's returns and the index.The bond index improves in performance for the 30 Dow Jones firms and contributes to the explanatory power of the model in 80 percent of the cases. There is some instability in signs and, contrary to Stone's speculations, omission of the bond index does not bias the equity beta estimates.Finally, we caution the reader against generalizing about the long-run value of the two-index model. The short time period used here does not allow us to say anything about the relationship between interest rate movements and the stability of beta. Moreover, during the 1969–1972 period the returns on the bond and equity indexes did not behave as Capital Market Theory would predict. The average monthly return on the bond portfolio was .5 percent and the average return on the equity portfolio was .2 percent. Our findings must, therefore, be interpreted with care, but overall the introduction of interest rate effects into the single-index model looks promising.

Randolph Westerfield, The Distribution of Common Stock Price Changes: An Application of Transactions Time and Subordinated Stochastic Models, The Journal of Financial and Quantitative Analysis, Vol. 12, No. 5 (Dec., 1977), pp. 743-765

J. L. Sharma, Robert E. Kennedy, A Comparative Analysis of Stock Price Behavior on the Bombay, London, and New York Stock Exchanges, The Journal of Financial and Quantitative Analysis, Vol. 12, No. 3 (Sep., 1977), pp. 391-413