Knowledge that Transforms

This paper derives the optimal hedge of an uncertain (unknown quantity) future foreign currency cash flow. This more general optimal hedge includes the traditional hedge for a certain (known quantity) future foreign currency cash flow as a special case. The optimal hedge is found to be unbounded and determined by firm-specific conditions, including the variance of the expected cash flow, and the correlation of that future cash flow with actual exchange rate movements. Simulated optimal hedge values are found for U.S.-based multinational firms possessing S/Dm cash flows, using exchange rate data for the 1981–1987 period. Special cases in which the optimal hedge ratio equals zero and one also are identified, and we show that cash flow uncertainty can strongly affect the effectiveness of hedging.

We develop a closed-form general equilibrium model of stock index futures prices in a continuous-time economy with stochastic interest rates and market volatility. We show that futures prices implied by the model have very different properties from those of the cost of carry model. Using NYSE stock index futures data, we examine the restrictions imposed on futures prices by both the equilibrium and cost of carry models. Consistent with the equilibrium model, we find that stock index futures prices are related to market volatility and that their interest-rate sensitivity is a nonlinear function of contract maturity.

We develop a class of discrete, path-independent models to compute prices of American options within the Black-Scholes (1973) framework, including models in which state variables have time-varying volatility functions and models with multiple state variables. Time-varying volatility functions are illustrated with applications to term structure models developed by Vasicek (1977) and Heath, Jarrow, and Morton (1988), (1990). Distinct from previous work in the literature, the multivariate models suggested in this paper are consistent with arbitrarily large, though constant, covariance functions. Finally, we compare and contrast the numerical accuracy of a large number of models with simulation results.

This paper provides an imperfect information explanation for the existence of bank loan commitments when both the bank and the potential borrower are risk neutral. The borrower is assumed to have access to a two-stage investment project wherein the investment required in the second stage is not known at the outset. The unknown investment requirement is revealed to the borrower, but not to the bank, at the beginning of the second stage. If the investor borrows at the beginning of the first stage, the realization at the beginning of the second stage might prompt a default in a situation where the project yields positive net present value. The reason is that the borrower does not regard the first-stage investment as a sunk cost. We show that a two-stage contract resembling a loan commitment can solve this under-investment problem.

Karlyn Mitchell, The Call, Sinking Fund, and Term-to-Maturity Features of Corporate Bonds: An Empirical Investigation, The Journal of Financial and Quantitative Analysis, Vol. 26, No. 2 (Jun., 1991), pp. 201-222

This paper uses a time-state-preference valuation model to examine how the firm's choice of technology and production method affects its equilibrium level of risk and, as a result, the firm's cost of capital. A fixed and flexible method of production is analyzed for a firm using a Cobb-Douglas production function. In both cases, it is found that risk and the cost of capital decrease with the level of capital intensity. Implications are drawn for the specification of empirical tests of the determinants of risk.

This study examines the hypothesis that in the presence of market frictions, relative put and call prices contain information concerning future returns of the underlying asset. A measure of relative prices is derived from the put-call parity relationship for index options and applied to a three-year sample of OEX option transactions. The results show that the measure of relative index option prices leads the stock market by at least 15 minutes.

Elizabeth Tashijan Johnston, William A. Kracaw, John J. McConnell, Day-of-the-Week Effects in Financial Futures: An Analysis of GNMA, T-Bond, T-Note, and T-Bill Contracts, The Journal of Financial and Quantitative Analysis, Vol. 26, No. 1 (Mar., 1991), pp. 23-44

This paper tests whether there is a difference in the stock price reactions to industrial straight debt offerings of different risk. Using bond ratings at the time of announcement as a measure of risk, we find that there is no monotonic relation between stock price impact and rating and no statistically significant difference across risk classes, even though the sample includes low-rated debt issues from recent years. This confirms earlier evidence on straight debt issues, but differs from the evidence on convertible securities. The paper also finds that the results for straight debt are not affected by shelf registrations or by the issuing firms' involvement in merger and acquisition-related activity.

We analyze a model in which firms signal their quality by using financial policies to commit to cash outflows. Two financial policies may be used: dividend and debt-service obligations. We find sufficient conditions for the informational equilibrium to entail concommitant use of both dividends and leverage in the cost-minimizing combination of the commitment signal. In this equilibrium, better firms pay higher dividends and are more highly levered than lower quality firms.