Knowledge that Transforms

I'd like to begin by thanking the Western Finance Association for the lunch I just consumed …It is only fair that I inform you at the outset that the views you are about to hear can only be described as biased. They are biased because I'll be limiting my remarks to those parts of finance that I think I know something about; secondly, my comments will contain a disproportionate reflection of my own work. The more generous among you might argue that this puts me in good company. A better explanation would recognize that I am really in a monopoly position for the next half hour or so: there are no contemporaneous sessions within commuting distance, your lunch was paid in advance and is not refundable, and for some of you at least there is a certain cost associated with getting up and leaving in full view of the organizers.

The two related problems of agency and informational asymmetry have received increasing attention in finance. In particular, prominent authors in this area (e.g., Jensen and Meckling [7], Ross [15, 16], Leland and Pyle [10], etc.) have demonstrably argued that the financial structure of the firm can be determined in the process of eliminating, or at least reducing, the costs associated with these problems.

Lemma W. Senbet, International Capital Market Equilibrium and the Multinational Firm Financing and Investment Policies, The Journal of Financial and Quantitative Analysis, Vol. 14, No. 3 (Sep., 1979), pp. 455-480

Kalman J. Cohen, Steven F. Maier, Robert A. Schwartz, David K. Whitcomb, Market Makers and the Market Spread: A Review of Recent Literature, The Journal of Financial and Quantitative Analysis, Vol. 14, No. 4, Proceedings of 14th Annual Conference of the Western Finance Association, June 21-23, 1979 (Nov., 1979), pp. 813-814+816-835

In an important article in 1971, Fisher and Weil [4] demonstrated that it is possible to immunize a portfolio of default-free coupon bonds against unexpected interest rate changes so that at the end of the planning period the investor will realize at least the return expected at purchase. Immunization may be achieved by constructing a portfolio whose average duration is equal to the length of the investor's planning period. The computation of duration that produces immunization is dependent on the nature of the assumed stochastic interest rate shocks. Fisher and Weil derive the duration that will produce immunization for additive shifts in the yield curve under instantaneous compounding, e.g., g(t) + λ where g(t) is the instantaneous interest rate at time t and λ is a random shift parameter.

The properties and characteristics of financial ratios have received considerable attention in recent years with interest primarily focused on determining the predictive ability of financial ratios and related financial data. Principal areas of investigation have included the prediction of corporate bond ratings [13, 20, 23, 34], and the anticipation of financial impairment [1, 2, 3, 5, 6, 7, 18, 19, 29, 32, 33, 35]. Related studies have examined the characteristics of merged firms [25, 28], the differencesin financial ratio averages among industries [9, 10], whether firms seek to adjust their financial ratios toward industry averages [15], the relationship between accounting-determined and market-determined risk measures [4, 8, 24], and the influence of financial ratios on analysts' judgments about impending bankruptcy [14, 17]. The general conclusion to emerge from these various research efforts is that a number of financial ratios have predictive and descriptive utility when properly employed.

According to the current state of knowledge in finance, the expected rate of return adjusted for risk is independent of the stock price. The basic proposition of the capital asset pricing model (CAPM) is that the expected rate of return for each security is a function of the “risk” of that security, and that this risk is measured by the contribution of the security to the variability of the market portfolio. The implication of the CAPM is that knowing the price of a security perse will add nothing to predicting its expected rate of return.

The existence of seasonality in security rates of return has implications for both the study of market efficiency and tests involving return models. The existence of seasonal asset returns may be an indicator of market inefficiencies. In an efficient market, investor arbitrage should remove any excess seasonal return an asset receives over a comparable asset of equal risk. The presence of seasonal returns, however, does not necessitate market inefficiency. For example, an expected seasonal return may exist in an efficient market simply because of anticipated seasonal patterns embedded in its underlying determinants. Tax regulations, government monetary policy, seasonal information lags, or risk adjustments have all been advanced as determinants of seasonal movements in return. No matter what the basis for return seasonality or the extent of market efficiency, if seasonality in asset returns exists, then these returns do not follow a strict stationary process within the year. Statistical models analyzing asset returns may use this information to improve model specification. For instance, Kinney and Rozeff [16] have shown that large efficiency gains in estimating portfolio betas can be achieved using time stratified estimates which explicitly incorporate seasonality in 4 stock returns.

Most research in modern portfolio theory and capital market theory is based on investor selection of portfolios that are efficient in the sense that they are not dominated by other portfolios in terms of their risk-expected return characteristics. The most widely used measure of portfolio risk is the variance about the mean of the exante distribution of portfolio returns. The theoretical framework from which this measure of risk is usually derived was initially suggested by Markowitz [12], and is by now well known. Although variance has the attention of most researchers, another measure, semivariance, had some early support from Markowitz himself, and from Quirk and Saposnik [17], Mao [10], and others. Semivariance as a measure of risk can be derived from the same theoretical framework as is variance; it requires only a slightly different utility function. The semivariance of returns of portfolio p below some point h is defined aswhere fp (R) represents the probability density function of returns for portfolio p. Semivariance portfolio theory is enjoying something of a revival in the works of Porter [15, 16], Hogan and Warren [6] and Klemkosky [8], and semivariance capital market models have been developed by Hogan and Warren [7] and Greene [5].

Hans R. Stoll, Commodity Futures and Spot Price Determination and Hedging in Capital Market Equilibrium, The Journal of Financial and Quantitative Analysis, Vol. 14, No. 4, Proceedings of 14th Annual Conference of the Western Finance Association, June 21-23, 1979 (Nov., 1979), pp. 873-894