Knowledge that Transforms

In this article, we suggest an efficient method of approximating a general, multivariate log-normal distribution by a multivariate binomial process. There are two important features of such multivariate distributions. First, the state variables may have volatilities that change over time. Second, the two or more relevant state variables involved may covary with each other in a specified manner, with a time-varying covariance structure. We discuss the asymptotic properties of the resulting processes and show how the methodology can be used to value a complex, multiple exercisable option whose payoff depends on the prices of two assets. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

We develop a measurement theory of market integration, based on two notions of “integrated markets”. First, two markets cannot be perfectly integrated in any sense if one can construct two portfolios, one from each market, that have identical payoffs but different prices. In that case, the law of one price is violated across the markets. Second, they cannot be integrated in a stronger sense if there are cross-market arbitrage opportunities. Two measures of market integration are developed, respectively reflecting these notions. The smaller the measures, the more closely integrated (in the respective senses) the markets. Among other things, they are interpreted as measuring pricing discrepancy between markets.

We develop a model wherein the choice between adjustable- and fixed-rate debt can serve as a signal of firm quality. The nature of the signal depends on expected inflation volatility relative to other risk parameters. Evidence from a matched sample of debt announcements over the period 1978 to 1986 shows a difference of - 2.05 \ \rm percent between stock price reactions to adjustable rate and fixed rate announcements when expected inflation volatility is above an estimated threshold. Below this threshold, the difference is +0.98 \ \rm percent. The evidence supports the hypothesis that the riskier debt choice serves as a favorable signal of firm quality.

We develop an arbitrage-free discrete time model to price American-style claims for which domestic term structure risk, foreign term structure risk, and currency risk are important. This model combines a discrete version of the Heath, Jarrow, and Morton (1992) term structure model with the binomial model of Cox, Ross, and Rubinstein (1979). It converges (weakly) to the continuous time models in Amin and Jarrow (1991, 1992). The general model is “path dependent” and can be implemented with arbitrary volatility functions to value claims with maturity up to five years. The model is illustrated with applications to long-dated American currency warrants and a cross-rate swap from the quanto class.

A Bayesian approach is used to investigate a sample’s information about a portfolio’s degree of inefficiency. With standard diffuse priors, posterior distributions for measures of portfolio inefficiency can concentrate well away from values consistent with efficiency, even when the portfolio is exactly efficient in the sample. The data indicate that the NYSE–AMEX market portfolio is rather inefficient in the presence of a riskless asset, although this conclusion is justified only after an analysis using informative priors. Including a riskless asset significantly reduces any sample’s ability to produce posterior distributions supporting small degrees of inefficiency.

This article examines the effects of portfolio insurance on market and asset price dynamics in a general equilibrium continuous-time model. Portfolio insurers are modeled as expected utility maximizing agents. Martingale methods are employed in solving the individual agents' dynamic consumption-portfolio problems. Comparisons are made between the optimal consumption processes, optimally invested wealth and portfolio strategies of the portfolio insurers and "normal agents." At a general equilibrium level, comparisons across economies reveal that the market volatility and risk premium are decreased, and the asset and market price levels increased, by the presence of portfolio insurance. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

We contend that security design should be approached as a problem of game design. That is, contracts should specify the procedures that govern the behavior of contract participants in determining outcomes as well as the allocations resulting from those outcomes. We characterize optimal contracts in two nested classes: all contracts (including those that depend on the state) and state-independent contracts. We demonstrate that, in situations in which the dependence of contracts on the state is limited, contracts designed as games can improve the allocation of resources relative to nonstrategic allocation rules.

We study insider trading in a dynamic setting. Rational, but uninformed, traders choose between investment projects with different levels of insider trading. Insider trading distorts investment toward assets with less private information. However, when investment is sufficiently information elastic, insider trading can be welfare-enhancing because of more informative prices. When insiders repeatedly receive information, they trade to reveal it when investment is information elastic because good news increases investment and hence future insider profits. Thus, more information is revealed and uninformed agents are exploited less frequently by insiders. Both effects are Pareto-improving. Finally, we consider various insider-trading regulations.

A subgame perfect Nash equilibrium is characterized for an industry with dissipative costs of agency. In sequence, firms can enter the industry, raise capital with external debt and/or equity, invest in a capital-intensive technology or dissipate capital in perquisites, and finally produce output. For plausible values of two critical parameters, some firms forego in equilibrium investments with positive net present values. Although more managers would like their firms to invest in the capital-intensive technology, they cannot raise the required cash in the capital market. In equilibrium, the industry can have both a profitable core of large, secure, capital-intensive firms, with some debt but no unique optimal capital structure, and a competitive fringe of small, risky, labor-intensive firms. Even as the cost of entry converges to zero, capital-intensive firms can earn extraordinary profits, while all labor-intensive firms fail. With costly agency, access to capital can become a barrier to entry.

The classic option pricing model is generalized to a more realistic, imperfect, dynamically incomplete capital market with different interest rates for borrowing and for lending and a return differential between long and short positions in stock. It is found that, in the absence of arbitrage opportunities, the equilibrium price of any contingent claim must lie within an arbitrage-band. The boundaries of an arbitrage-band are computed as solutions to a quasi-linear partial differential equation, and, in general, each end-point of such a band depends on both interest rates for borrowing and for lending. This, in turn, implies that the vector of concurrent equilibrium prices of different contingent claims—even claims that are written on different underlying assets—must lie within a computable arbitrage-oval in the price space.