Knowledge that Transforms

We value American options on bonds using a generalization of the Geske–Johnson (Geske, R., Johnson, H., 1984. Journal of Finance 39, 1151–1542) (GJ) technique. The method requires the valuation of European options, and options with multiple exercise dates. It is shown that a risk-neutral valuation relationship (RNVR) along the lines of Black–Scholes (Black, F., Scholes, M., 1973. Journal of Political Economy 81, 637–659) model holds for options exercisable on multiple dates, even under stochastic interest rates, when the price of the underlying asset is lognormally distributed. The proposed computational procedure uses the maximized value of these options, where the maximization is over all possible exercise dates. The value of the American option is then computed by Richardson extrapolation. The volatility of the underlying default-free bond is modeled using a two-factor model, with a short-term and a long-term interest rate factor. We report the results of simulations of American option values using our method and show how they vary with the key parameter inputs, such as the maturity of the bond, its volatility, and the option strike price.

A model of mean reversion of exchange rates to purchasing power parity is developed and tested where exchange rates are assumed to follow a mean reverting elastic random walk toward a stochastic PPP rate. The model recognizes the possibility that mean reversion towards PPP may be nonlinear which allows greater flexibility in the adjustment process. Regression equations consistent with the theoretical model are derived. The model is tested using long- and short-term data for six countries. While the results are generally consistent with the findings of previous studies, evidence is presented which demonstrates that the mean reversion process is not linear for some countries.

This paper traces developments in the credit risk measurement literature over the last 20 years. The paper is essentially divided into two parts. In the first part the evolution of the literature on the credit-risk measurement of individual loans and portfolios of loans is traced by way of reference to articles appearing in relevant issues of the Journal of Banking and Finance and other publications. In the second part, a new approach built around a mortality risk framework to measuring the risk and returns on loans and bonds is presented. This model is shown to offer some promise in analyzing the risk-return structures of portfolios of credit-risk exposed debt instruments.

The last two decades have witnessed a tremendous growth in the volume of assets and liabilities whose cash flows depend, in a variety of ways, on the path of interest rates. Some of these, including floating-rate notes and swap agreements, contractually base cash flows on current and past interest rates and contain caps, floors, and other, more complex features. Others, including mortgages, many corporate bonds, and time deposits, are fixed-rate instruments that contain embedded options, such as those to prepay, call, or withdrawal. The irregular exercise of these options causes cash flows to vary as time proceeds and interest rates rise or fall. This paper develops a state-contingent claims technique for valuing such securities. It is derived from the option-based model of Breeden and Litzenberger (1978) using the transition matrix approach of Banz and Miller (1978). Particular attention is paid to valuing so-called path-dependent securities whose contemporaneous cash flows depend on the historical path of interest rates as well as their current level. A detailed example is provided in which an adjustable-rate mortgage is valued under a variety of economic and security specific assumptions.

Estimates of central bank intervention losses or profits vary widely; some estimates find substantial losses, others profits. In most cases, estimated profits are not risk-adjusted, and risk adjustment can have large effects. Furthermore, profit estimates involve variables integrated of order one, and because of this test-statistics may have nonstandard distributions; few studies take this into account. Estimates of risk-adjusted profits for the US Fed and the Swedish Riksbank, with allowances for possible nonstandard distributions, suggest that neither made losses and might have made significant profits.

Traditional theories of intermediation are based on transaction costs and asymmetric information. They are designed to account for institutions which take deposits or issue insurance policies and channel funds to firms. However, in recent decades there have been significant changes. Although transaction costs and asymmetric information have declined, intermediation has increased. New markets for financial futures and options are mainly markets for intermediaries rather than individuals or firms. These changes are difficult to reconcile with the traditional theories. We discuss the role of intermediation in this new context stressing risk trading and participation costs.

Recent models of IPO underpricing suggest that high-quality firms underprice their IPOs to differentiate themselves from low-quality firms and, thus, receive a more favorable market response to subsequent equity offerings. We test this suggestion for 172 industrial firms that made an initial public offering during 1987–1991 and made a subsequent seasoned equity offering within three years of their IPO. We examine two measures of the impact of the hypothesized underpricing signal net of the cost of employing that signal. Inconsistent with the underpricing signal hypothesis, we find no evidence that firms recover the cost of an underpriced IPO in either higher issue proceeds or in greater wealth for the firm's initial owners.

The purchase of insurance provides a potentially finer informational partition over the distribution of post-loss resolution wealth that may allow favorable adaptation of intermediate consumption, investment, or other decisions. Such a positive informational value does not require consumer risk aversion. Lines of insurance with longer resolution periods should impact relatively more decisions and have higher informational value. Under standard assumptions on preferences, in the absence of informational value, risk premiums paid for insurance by risk averse consumers should not increase as the loss resolution period increases. Empirical tests using data from the property-liability insurance market suggest that the willingness to pay per dollar of coverage (as measured by relative market demand across lines of insurance) is greater for lines of insurance with longer resolution periods consistent with a positive informational value of insurance. The results suggest that other financial assets may also have differential informational value.

The price-earnings relation can be characterized as a system of simultaneous equations. Earnings and prices can behave as if they are both endogenously determined because they are jointly affected by information that is difficult to specify explicitly. Specification tests provide evidence that both earnings changes and price changes are endogenous. The price and earnings coefficients increase from OLS to joint estimation and, under a restrictive set of assumptions, provide increasingly similar estimates of the permanent component of earnings. The evidence is consistent with the contention that a portion of the single-equation bias can be mitigated via joint estimation.

We demonstrate the value-relevance of foreign earnings for US multinational firms by examining the associations between annual abnormal stock performance and changes in firms′ domestic and foreign incomes. For 2570 tirm-year observations between 1985 and 1993, both foreign and domestic earnings changes have significant positive associations with annual excess return measures: however, the association coefficient on foreign income is significantly larger than the association coefficient on domestic income. We demonstrate this larger association coefficient for foreign income is consistent with differences in growth opportunities between domestic and foreign operations.