W. W. Higgins, B. J. Moore, Market Structure Versus Information Costs as Determinants of Underwriters' Spreads on Municipal Bonds, The Journal of Financial and Quantitative Analysis, Vol. 15, No. 1 (Mar., 1980), pp. 85-97

Dennis W. Draper, James W. Hoag, Financial Intermediation and the Theory of Agency, The Journal of Financial and Quantitative Analysis, Vol. 13, No. 4, Proceedings of Thirteenth Annual Conference of the Western Finance Association, June 20-26, 1978 (Nov., 1978), pp. 595-611

The objective of this paper is to carry out tests of the general hypothesis, most recently urged by Scherer [14, pp. 100–102] and Weston and Brigham [17, p. 689], that the cost-of-equity capital of small industrial corporations is greater than that of large industrial corporations. The paper denotes this cost as ke and defines it as the expected rate of return on the stock of a company when the current price of the stock is in equilibrium. A common designation of ke of course is the equity capitalization rate. It will be noted that this definition of the cost-of-equity capital abstracts from the flotation costs that are usually incurred when companies sell new stock. Archer and Faerber [2] have already shown that these costs are inversely related to the size of companies.

We shall investigate the problem of optimal exercising strategy for option holders for the case in which option holders are averse to risk. A model of stock price changes incorporating the Lognormal random walk assumption will be combined with a class of utility functions containing diminishing marginal utility of money. In general, the strategy of waiting until the last possible day to exercise an option, which maximizes expected value, will not maximize expected utility. The strategy which maximizes expected utility is obtained by a dynamic programming formulation of the decision problem. At each day (or decision stage), the option holder may choose to act (exercise) or wait until the next day. Working backwards from the last day, a series of critical prices are obtained, with the optimal strategy being as follows: act if the stock price on any day is greater than the critical price for that day; otherwise, wait. Using the concept of proportional risk aversion developed by Pratt, we will demonstrate that, under certain conditions, a utility function which exhibits increasing proportional risk aversion is sufficient to create a series of finite critical prices. Moreover, once an option is exercised, the option holder continually faces a tactical decision to hold the stock and wait for capital gains or sell and take profits as ordinary income, thereby avoiding further risk. This decision may also be optimized by a dynamic programming scheme similar to the approach used above.

This paper develops a positive theory of trade credit based on its use as a financial response to deterministic variations in demand. The operating alternatives to trade credit, which include the use of storage or additional capacity, are modeled using results from the peak-load pricing literature. The paper shows that the extension of credit partitions the buyer's inventory cost and permits specialization at incurring the components of this cost. This specialization is economical when the seller has an advantage at incurring the financial cost and does not have an advantage at incurring the operating cost of accommodating variable demand. Conditions that provide these necessary and sufficient cost relationships are described. The paper also shows that a reduction in costs rather than an increase in revenues is the source of both the buyer's and seller's increase in wealth.

This paper provided a pure financial explanation for the existence of trade credit and for the values of the credit terms offered to customers. Two motives for extending trade credit were identified. The pure operating flexibility motive arises because the opportunity to change credit policy provides the seller an efficient way to respond to fluctuations in demand. This motive was eliminated from consideration in this paper by assuming constant demand. The seller must hold a liquid reserve when the financial markets are imperfect and the desire to earn an excess rate of return on this reserve explains the pure financial intermediary motive for trade credit.The pure financial incentive to lend this liquid reserve to customers was examined by viewing a market borrowing rate of interest that exceeds the market lending rate of interest as a hindrance to trade or, equivalently, as a financial market tariff. This tariff imposes a wedge between the market prices paid and received for the product plus a loan and thereby inflicts a loss of surplus on the seller and buyers. Trade credit lending enables the seller and/or the buyers to recapture at least part of this loss when the source of the tariff does not apply to direct loans to customers. Financial market tariffs caused by transactions costs fulfill this requirement because the trade credit lender's familiarity with its customers and product provide it with information and collection cost advantages over financial intermediaries. Tariffs caused by financial intermediary rents fulfill this requirement as well because the parties to a trade credit loan do not employ the services of a financial intermediary.Increasing opportunity costs and financial market imperfections in addition to the ones described above establish the limits of credit policy. The optimal amount of accounts receivable is derived from the condition that the marginal revenue of trade credit lending is equal to the marginal cost. This condition combined with factoring costs produces a unique, finite optimal credit period. Accrual accounting for income tax purposes imposes an additional restriction because the firm is taxed on the recovery of its opportunity costs. These limitations on credit policy were examined separately in this paper for clarity but they are in effect simultaneously in practice.

This paper uses the portfolio theory approach to bank behavior theory in order to examine the effects of two Fed policy variables on bank portfolio riskiness. The policy variables are (1) the level of the reserve requirement against NOW accounts, and (2) the rate of interest paid by the Fed on bank reserves. This second policy variable is currently zero-valued in nominal terms, but in recent years there has been some discussion of raising it, especially now that interest is paid by banks on checkable accounts. (For an early discussion see Tobin [8].)

The familiar two-parameter model for portfolio decisions, attributed to Markowitz [11], has individuals maximizing an objective function, ϕ [E(Y), V(Y)], of mean and variance of end-of-period wealth, subject to a constraint imposed by initial wealth. In the usual version there is an arbitrary number, n, of risky assets with stochastic end-of-period values (price plus dividend) represented by the vector X with exogenously given mean vector μ and nonsingular variance matrix σ. There is also one riskless asset, whose certain end-of-period value per dollar invested is p. Final wealth, as constrained by initial wealth, W, is given by Y = WP + a' (X – OP), where a and P are vectors of risky asset quantities and prices. Assuming ϕE > 0 (wealth preference), ϕV

Dennis W. Draper, Discussion: Information Sets, Macroeconomic Reform, and Stock Prices, The Journal of Financial and Quantitative Analysis, Vol. 16, No. 4, Proceedings of 16th Annual Conference of the Western Finance Association, June 18-20, 1981, Jackson Hole, Wyoming (Nov., 1981), pp. 511-513

Lemma W. Senbet, Discussion: Signaling, Information Content, and the Reluctance to Cut Dividends, The Journal of Financial and Quantitative Analysis, Vol. 15, No. 4, Proceedings of 15th Annual Conference of the Western Finance Association, June 19-21, 1980, San Diego, California (Nov., 1980), pp. 871-873