Knowledge that Transforms

This paper offers a new class of models of the term structure of interest rates. We allow each instantaneous forward rate to be driven by a different stochastic shock, constrained in such a way as to keep the forward rate curve continuous. We term the process followed by the shocks to the forward curve ``stochastic strings'', and construct them as the solution to stochastic partial differential equations, that allow us to offer a variety of interesting parametrizations. The models can produce, with parsimony, any sort of correlation pattern among forward rates of different maturities. This feature makes the models consistent with any panel dataset of bond prices, not requiring the addition of error terms in econometric models. Interest rate options can easily be priced by simulation. However, options can only be perfectly hedged by trading in bonds of all maturities available.

Title Index Get access The Review of Financial Studies, Volume 14, Issue 4, October 2001, Pages 1237–1239, https://doi.org/10.1093/rfs/14.4.1237 Published: 22 June 2015

In this article we examine the effect of the imperfect mobility of goods on international risk sharing and, through that, on the investment in risky projects, welfare, and growth. Our main result is that the welfare gain from integration of financial markets is not greatly reduced by the presence of goods market imperfections, modeled as a cost of transferring goods from one country to the other. We also find that the gain is nonmonotonic with respect to investors' risk aversion and the aggregate volatility of output growth. The policy implication to be drawn is that financial market integration is a worthwhile goal to pursue even when full goods mobility has not been achieved. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

This article studies the security-design problem of a cash-constrained firm facing investors with diverse beliefs. Investor “rational beliefs” are modeled as varying and yet rational in the sense of Kurz (1994a). With two investors, optimal designs are similar under rational beliefs and rational expectations. With many investors, however, optimal securities under rational beliefs maximize investor differences of opinion, while under rational expectations optimal designs minimize disagreements. We demonstrate that the common practice of issuing multiple securities backed by a single asset is optimal under rational beliefs but not under rational expectations. Researching market beliefs can create substantial value for firms.

In this paper we provide a price characterization of efficient consumption bundles in multiperiod economies with market frictions. Efficient consumption bundles are those that are chosen by at least one rational agent with monotonic state-independent and risk-averse preferences and a given future endowment. Frictions include dynamic market incompleteness, proportional transaction costs, short selling costs, borrowing costs, taxes, and others. We characterize the inefficiency cost of a trading strategy -the difference between the investment it requires and the largest amount required by any rational agent to obtain the same utility level - and we propose a measure of portfolio performance based on it. We also show that the arbitrage bounds on a contingent claim to consumption cannot be tightened based on efficiency arguments without restricting preferences or endowments. We examine the efficiency of common investment strategies in economies with borrowing costs due to asymmetric information, short selling costs, or bid-ask spreads. We find that market frictions generally change and typically shrink the set of efficient investment strategies, shifting investors away from well-diversified strategies into low cost ones, and for large frictions into no trading at all. Hence we observe strategies that become inefficient with market frictions, as well as strategies that are rationalized by market frictions.

This study examines whether rates of information flow differ between trading and nontrading periods, and whether the variances of pricing errors differ at the open and close of trading. The approach improves on existing methods by allowing for correlation between pricing errors and information flow, and by conducting inferences at the individual security level. The daytime rate of information flow is about seven times the overnight rate, and the variances of pricing errors at the open are not different from those at the close of trading. This evidence differs from existing results based on return variance ratios. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

Bakshi and Chen (1996) suggest that the spirit of capitalism affects stock prices by increasing society's aversion to risk. In this article, I show that the way in which the spirit of capitalism impinges upon asset prices depends on the interaction of impatience, willingness to substitute over time, and ordinal preferences between consumption and status, in addition to risk aversion. I develop a general model that charts the channels through which the spirit of capitalism affects asset prices. An increase in the capitalist spirit may increase or decrease risk aversion, and may actually decrease the prices of risky assets. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

New York Stock Exchange specialists disseminate information to market participants by displaying price schedules consisting of bid prices, ask prices, bid depths, and ask depths. We examine how specialists update these price schedules in a simultaneous equations model. We find that changes in the best prices and depths on the limit order book have a significant impact on the posted price schedule, while the effects of transactions and order activity are secondary. Furthermore, we show that specialists revise prices and depths differently, but find no evidence that they revise the price schedule in response to changes in inventory.

While folklore in finance holds that split valuation effects are due to dividend increases associated with splits, little is known about magnitudes of dividend and nondividend components of split announcement effects. We find that splits and dividends are indeed informational substitutes, a notion we characterize more precisely, but a significant portion of split valuation effects, 46% according to our estimates, cannot be attributed to dividend information in splits. Our techniques extend the literature on conditional event-study methods and we illustrate their practical value in testing hypotheses and analyzing data not amenable to analysis by standard procedures.

Using a consumption-based asset pricing model with infinite-horizon nonlinear habit formation, Campbell and Cochrane (1999) show that low consumption in surplus of habit should forecast high expected returns. This article argues that the finite-horizon linear habit model also implies an inverse relation between expected returns and surplus consumption. This article also presents empirical evidence, which indicates that expected returns on stocks and bonds vary with surplus consumption implied by the habit models. The volatility of returns and the reward to volatility are also related to surplus consumption. However, less than 30% of the predictable variation of expected returns, using standard lagged information variables, is attributed to surplus consumption. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.