Knowledge that Transforms

The findings, based on price movements alone, are that trading on the assumption that a large (small) proportion of increases in stocks' short ratios is bullish (bearish) produced significantly better than expected results at all Alphas tested above .02. This test-by-predictiveness strongly supports the validity of the assumptions.A test of the components of the short ratio produced no evidence that the success of the ratio as a stock market predictor can be attributed to either of its components singly, i.e., to either changes in short interest or changes in trading volume.A second test of the assumptions incorporated in the SR Expectations Model consisted of a comparison of model results against buy-and-hold results. In all cases except at Alpha .01 model results exceeded buy-and-hold results–and greatly so at Alphas above .02, thus strongly supporting the validity of the assumptions.The test against the buy-and-hold “control” standard was then extended to incorporate dividend and commission considerations. These considerations sharply reduced the model's performance. Therefore, an alternate strategy was tested which markedly reduced commissions, offset the opportunity cost of dividends missed when the portfolio was not long stocks, and avoided the explicit dividend drains caused by short positions. This strategy consisted of substituting Treasury Bill holdings for short positions in the basic model. This policy, consisting of switches between Treasury Bills and SSP “stocks” in accordance with Alpha .05 signals produced a terminal portfolio value greater than the buy-and-hold policy even after the introduction of a 30 percent income-tax consideration. Moreover, this higher return was generated with less risk than that inherent in the buy-and-hold policy.With respect to the optimum filter, it was found that Alpha .11 was best for price predictive purposes, with Alpha .05 a close second, but that once commission considerations are allowed for, Alpha .05 was the optimum filter.In conclusion, the hypothesis of this study is that when speculative expectations become extremely one-sided, a high probability exists that stock prices will reverse towards the unanticipated direction. This view is consistent with the theory that the stock market is generally efficient, but not perfectly so. A test of a model using changes in short ratios as a measure of shifts in investor expectations is consistent with the hypothesis: returns generated by the model significantly outperform random expectations. The test indicates a systematic tendency for investors to over-discount events when an overwhelming majority share the same optimism (pessimism) about future stock prices.

Recent financial literature has discussed how a creditor should determine its investigation and extension policy. Mehta [8, 9] has developed a sequential process for credit extension, and others [1, 2, 4, 7, 10, 12, 14] have used credit-scoring functions to develop decisions rules. Instead of discussing the use of a particular system or the development of a new system, this paper shifts the focus to selection of the best of alternative systems. Different creditors face different profit-loss ratios on loans, business volume, and prior probabilities of good and bad customers. Furthermore, since the alternative systems have different initial costs, effectiveness, and investigation costs per application, no one system is optimal for all creditors. Finally, any credit-scoring alternative declines in effectiveness over time. Measurement of the overall effectiveness of a system requires that the optimal time between updating the system be known.

Ronald W. Melicher, David F. Rush, Daryl N. Winn, Degree of Industry Concentration and Market Risk-Return Performance, The Journal of Financial and Quantitative Analysis, Vol. 11, No. 4, 1976 Proceedings (Nov., 1976), pp. 627-635

This brief paper will show that (a) a theoretical equilibrium state of the world exists in the absence of capital controls and trade barriers when prices for the same goods in different markets are equal, after translation at the spot exchange rate; (b) differences in rates of aggregate price change in different markets eventually cause offsetting exchange rate changes which restore condition (a); (c) returns on equivalent securities denominated in different currencies but covered in the forward market are almost instantaneously equalized; (d) the market's expected rate of change of the exchange rate equals, to a close approximation, the control-free interest rate differential between the two currencies; (e) in the absence of predictable exchange market intervention by central banks, the interest rate differential is the best possible forecaster of the future spot rate; and (f) the forward rate also provides the best forecast of the future spot rate. A final corollary identifies a relationship between inflation rates and international interest rate differentials.

S-L have derived a simultaneous equation CAPM to offer a robust test for the interdependent assumption of the single equation CAPM. However, their empirical results are subject to the multicollinearity problem associated with 2SLS. For improving their results, several alternative estimation methods are used to estimate a seven-equation system for the oil industry. In accordance with both the multicollinearity criterion and residual analysis, it is found the modified 2SLS is the most appropriate method to be used to estimate the S-L model. From the results obtained from the modified 2SLS, it is shown that the market rate of return still is a relatively important factor in predicting the movement of capital market in the simultaneous equation CAPM. After applying a better estimation method to the S-L simultaneous equation CAPM, it is shown that the S-L model has given us the interesting interrelationship of capital asset pricing within a particular risk class.

In recent years a number of papers have been concerned with the determination of necessary and sufficient conditions for portfolio separation and for myopia. As a result of these earlier investigations, it is known that a necessary and sufficient condition both for portfolio separation and for myopia is that the investor's utility function exhibit risk tolerance, that is a linear function of wealth. What is lacking in the existing literature is a clear demonstration of the economic relevance of linear risk tolerance for portfolio separation and myopia. It is hoped that this paper will help to fill the gap by an analysis of separation and myopia using the standard tools of price theory: indifference curves, budget lines, and Engel curves. Viewed in this perspective, a substantial part of the analysis can be amplified and clarified in terms of the geometry of the situation.

Richard H. Pettway, The Effects of Large Bank Failures Upon Investors' Risk Cognizance in the Commercial Banking Industry, The Journal of Financial and Quantitative Analysis, Vol. 11, No. 3 (Sep., 1976), pp. 465-477

George M. Frankfurter, Herbert E. Phillips, John P. Seagle, Performance of the Sharpe Portfolio Selection Model: A Comparison, The Journal of Financial and Quantitative Analysis, Vol. 11, No. 2 (Jun., 1976), pp. 195-204

Investment decision making under conditions of uncertainty, and in particular portfolio selection, is carried out mainly in the Mean-Variance framework which has been developed by Markowitz [29], [30] and Tobin [42]. By assuming the lending and borrowing of money at a given riskless interest rate, Sharpe [39], [40], Lintner [27], [28], Mossin [34], and others derived and extended the Capital Asset Pricing Model, under which an equilibrium price of each risky asset is determined. However, though the mean variance rule is quite convenient to apply, its limitations are well known, i.e., one must assume either normal probability distributions with risk aversion or quadratic utility functions.

Barr Rosenberg, James A. Ohlson, The Stationary Distribution of Returns and Portfolio Separation in Capital Markets: A Fundamental Contradiction, The Journal of Financial and Quantitative Analysis, Vol. 11, No. 3 (Sep., 1976), pp. 393-402