Knowledge that Transforms

In a recent article in this journal [6], Clement G. Krouse and Wayne Y. Lee (hereafter K-L) presented a model of optimal equity financing of a corporation based on Pontryagin's maximum principle. In this note the basic assumption of a constant internal rate of return of the K-L model is relaxed. As a result, the financial implications of the K-L results remain essentially unchanged, but their applicability is extended considerably, and some undesirable solution characteristics are eliminated.

This paper examined the empirical consequences of explicit consideration of purchasing power risk in portfolio decisions. It was shown that, during a period of significant inflation, the differences between the variance-covariance relations of nominal rates of return and those of real rates of return were sufficiently pronounced to change the composition of investment portfolios. Further, it was shown that the set of real efficient portfolios dominates any investment strategy that ignores purchasing power risk.

William Breen, John Boyd, Classroom Simulation as a Pedagogical Device in Teaching Money and Banking, The Journal of Financial and Quantitative Analysis, Vol. 11, No. 4, 1976 Proceedings (Nov., 1976), pp. 595-606

The rising cost of funds internationally is forcing multinational corporations to pay more attention to effective cash management on a global basis. However, the available literature is preoccupied with cash management in only one currency. This is a serious oversight given the heavy involvement of U.S. firms overseas. In 1970, for example, the ratio of foreign source earnings plus income from abroad (royalties, fees, service charges) to total U.S. corporate after-tax profits was over 25 percent [14]. If export and import activities were included, this statistic would be more impressive yet.

Paul A. Samuelson, Limited Liability, Short Selling, Bounded Utility, and Infinite-Variance Stable Distributions, The Journal of Financial and Quantitative Analysis, Vol. 11, No. 3 (Sep., 1976), pp. 485-503

In this paper, a short-run partial-adjustment model of the demand for credit union shares was specified and estimated with time series data. The estimated results were used to derive long-run, equilibrium demand coefficients and elasticities. The main conclusions are that credit union shares are substitutes for deposits at savings and loan associations, time and savings deposits at commercial banks, and marketable bonds. Moreover, the implications of the statistical results are that credit union and savings and loan shares are more closely related to more liquid assets than to long-term assets. While real income was employed as a constraint variable, it was employed as a maintained hypothesis since the use of a wealth constraint led to perverse results. Also, some evidence was presented that the elasticities of the demand function for credit union shares are different from those of an aggregate savings deposits function. Thus, it is likely that an aggregate demand function will contain aggregation bias.

The analysis has shown that insurer investment performance parallels that of other investors; greater returns are associated with greater variability. However, with the acquisition of higher levels of investment risk insurers generally reduce the level of underwriting risk which is undertaken. Thus, insurer management apparently attempts to keep ruin probabilities within some undefinable but clearly present limits. In the process of trading off between investment and underwriting risk, a higher rate of return to net worth is sacrificed. The sacrifice of potentially higher rates of return to equity, however, does not place the insurer at a disadvantage relative to the capital market or make attractive the alternative of operating as an investment trust. Under reasonable conditions governing the risk and return associated with underwriting activities, the insurer return to net worth is in a more efficient position as the result of underwriting activities than that offered by the capital market alone. For a given risk position, the return to the insurer exceeds that available from the capital market alone. Thus, so long as marginal returns to underwriting are positive, the leveraging afforded by the expansion of premium volume produces a superior return over the traditional leveraging which might be employed by an investor in the capital market.

Cheng F. Lee, William P. Lloyd, The Capital Asset Pricing Model Expressed as a Recursive System: An Empirical Investigation, The Journal of Financial and Quantitative Analysis, Vol. 11, No. 2 (Jun., 1976), pp. 237-249

This paper presented a stochastic discounted cash flow model with which mortgage companies can assess the value of a mortgage servicing contract. The model was illustrated with data provided by a group of eight MBC's. Simulation and sensitivity analysis showed the impact of different mortgage amounts, termination distributions, and expected rates of servicing cost increases on the value of a mortgage servicing portfolio. In general, because servicing contracts are long-term fixed revenue arrangements, high rates of servicing cost increases substantially reduce the value of an MBC's servicing portfolio. To the extent that mortgage prepayments are reduced by high inflation rates, the impact of high cost increases on the value of a servicing portfolio is compounded.

Jensen [6] employed the instantaneous systematic risk concept to eliminate the problem associated with time horizon. Based upon the effective rate of return argument, Cheng and Deets [3] claimed that Jensen instantaneous risk is not independent of the time horizon used in the investment analysis. They have also proposed a so-called Cheng-Deets instantaneous risk to substitute for the Jensen instantaneous risk.Following the log normal distribution assumption, this paper has shown that Cheng-Deets instantaneous risk is identical to Jensen instantaneous risk. The relationship between finite systematic risk and instantaneous risk is also identified. The roles played by the effective and the nominal rate-of-return concepts in the capital asset pricing process are also clarified. It is shown that both Jensen and CD instantaneous risks are biased unless the investment horizon is instantaneous. A testable generalized CAPM is derived to test the instantaneous investment horizon assumption. Finally, 30 securities of the Dow- Jones industrial average were used to test the generalized CAPM derived in this paper.