Knowledge that Transforms

While American calls on non-dividend-paying stocks may be valued as European, there is no completely explicit exact solution for the values of American puts. We use a technique called randomization to value American puts and calls on dividend-paying stocks. This technique yields a new semiexplicit approximation for American option values in the Black-Scholes model. Numerical results indicate that the approximation is both accurate and computationally efficient.

Journal Article Optimal Contracting with Moral Hazard and Cascading Get access Naveen Khanna Naveen Khanna Michigan State University Address correspondence to Naveen Khanna, 315 Eppley, Eli Broad College of Business, Michigan State University, East Lansing, MI 48824-1121, or e-mail: [email protected]. Search for other works by this author on: Oxford Academic Google Scholar The Review of Financial Studies, Volume 11, Issue 3, July 1998, Pages 559–596, https://doi.org/10.1093/rfs/11.3.559 Published: 03 June 2015

We empirically examine the hypothesis that access to deposits with inelastic rates (core deposits) permits a bank to make contractual agreements with borrowers that are infeasible if the bank must pay market rates for its funds. Access to core deposits insulates a bank's costs of funds from exogenous shocks, allowing the bank to insulate its borrowers against exogenous credit shocks. We find that, controlling for competitive conditions in loan markets, banks funded more heavily with core deposits provide more smoothing of loan rates in response to exogenous changes in aggregate credit risk. This suggests that a distinctive feature of bank lending is that firms and banks form multiperiod lending relationships in which loans need not break even period by period. It also partially explains the declining share of bank loans (or near substitutes for bank loans) in credit markets. As banks have increasingly been forced to pay market rates for an increasing share of their funds, multiperiod relationship lending has become increasingly less feasible and bank loans have lost some of their comparative advantage over securities. Our results suggest that access to core deposits is one of the foundations of relationship lending.

We examine the predictive power of equilibrium dominance in experimental markets where firms with investment opportunities have an informational advantage over potential investors and are permitted to purchase a money-burning signal. Equilibrium dominance often fails to predict well when a Pareto-superior sequential equilibrium is also available. Instead, equilibrium selection appears to be related to the potential earnings of a more valuable firm that can signal its type successfully by defecting from the sequential equilibrium. Potential investors formulate their bids for firm equity based primarily on expectations formed adaptively in response to signaling choices made by firms.

Recent evidence shows that higher trader participation increases exchange rate volatility. To explore this linkage, we develop a dynamic model of endogenous entry of traders subject to heterogenous expectational errors. Entry of a marginal trader into the market has two effects: it increases the capacity of the market to absorb exogenous supply risk, and at the same time it adds noise and endogenous trading risk. The competitive entry equilibrium is characterized by excessive market entry and excessively volatile prices. A positive tax on entrants can decrease trader participation and volatility while increasing market efficiency. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

I consider the costs and benefits of introducing a new security in a standard framework where uninformed traders with hedging needs interact with risk-averse informed traders, Opening a new market may make everyboby worse off, even when the new security is traded in equilibrium, This article emphasizes cross-market links between hedging and speculative demands: risk-averse arbitrageurs can use the new market to hedge their positions in the preexisting security, which cart affect liquidity in the old market. More generally, the availability of such hedging opportunities will influence the strategies to which traders will direct resources.

We analyze an overlapping generations model with fixed costs of stock market participation. Participation in the stock market is determined endogenously and covaries positively with preceding innovations in dividends. The equilibrium share price is positively related to market participation of the same period and to information about future dividends. There is "rational trend chasing" in the sense that, although all agents are rational, market participation rises after an increase of the share price and falls after a decrease. Finally, we show that the endogenous fluctuations of market participation lead to increased volatility of the share price.

In this article, we consider the relative merits of net versus gross settlement of interbank payments. Net settlement economizes on the costs of holding non-interest-bearing reserves, but increases moral hazard problems. The "put option" value of default under net settlement can also distort banks' investment incentives. Absent these distortions, net settlement dominates gross, although the optimal net settlement scheme may involve a positive probability of default.

In Market Efficiency: Stock Market Behaviour in Theory and Practice, Andrew W. Lo has collected the major papers, both theoretical and empirical, that have defined the development of the theory of efficient capital markets. The first volume has an introduction by the editor and a foreword by Richard Roll. Both are brief—too brief, in my opinion—but excellent. The papers are grouped into five parts. In Volume I, Part I is “Theoretical Foundations.” The included articles are by Black (1986), Fama (1970), Grossman (1976), Grossman and Stiglitz (1980), LeRoy (1973), Lucas (1978), and Samuelson (1965). Part II is “The Random Walk Hypothesis.” The articles are by Cootner (1962), Cowles and Jones (1937), Fama (1965), Fama and Blume (1966), Fama and French (1988), French and Roll (1986), Jegadeesh (1990), Kim, Nelson, and Startz (1991), Lo (1991), Lo and MacKinlay (1988), Osborne (1959), Porterba and Summers (1988), and Richardson (1993). In Volume II, Part I is “Variance Bounds Tests.” Included articles are by Campbell and Shiller (1989), Flavin (1983), Gilles and LeRoy (1991), Grossman and Shiller (1981), Kleidon (1986), LeRoy and Porter (1981), Marsh and Merton (1986), Merton (1987), Michener (1982), Shiller (1981), and West (1988).