Knowledge that Transforms

Edward J. Kane, Technological and Regulatory Forces in the Developing Fusion of Financial- Services Competition, The Journal of Finance, Vol. 39, No. 3, Papers and Proceedings, Forty-Second Annual Meeting, American Finance Association, San Francisco, CA, December 28-30, 1983 (Jul., 1984), pp. 759-772

ABSTRACT Short‐term interest rates in the United States have been “too high” since October 1979 in the sense that both unconditional and conditional forecasts, based on an estimated vector autoregression model summarizing the prior experience, underpredict short‐term interest rates during this period. Although a nonstructural model cannot directly answer the question of why this has been so, comparisons of alternative conditional forecasts point to the post‐October 1979 relationship between the growth of real income and the growth of real money balances as closely connected to the level and pattern of short‐term interest rates. This finding is consistent with the authors' earlier conclusion, based on analysis of a small structural macroeconometric model, that the high average level of interest rates has been due to a combination of slow growth of (nominal) money supply and continuing price inflation, which together have kept real balances small in relation to prevailing levels of economic activity.

The design of managerial incentive contracts is examined in a setting in which economic agents are risk averse, and the actions of managers can affect asset returns which contain both systematic and idiosyncratic risks. It is shown that in the absence of moral hazard, owners of assets will insure managers against idiosyncratic risks, but with moral hazard, contracts will depend on both systematic and idiosyncratic risks. The traditional recommendation of asset pricing models, namely, to focus only on systematic risks, is thus proved to be valid only when there is no moral hazard. The major empirically testable predictions of the model are (1) managerial incentive contracts will generally depend on systematic as well as idiosyncratic risks, (2) idiosyncratic risks will generally be important in investment decisions, (3) the managers of firms with relatively high levels of idiosyncratic risks will have compensations that are less dependent on their firms' excess returns, and (4) the compensations of managers of larger firms will be relatively more dependent on the excess returns of their firms.

ABSTRACT This paper examines the impact of the money supply and inflation rate announcements on interest rates. Survey data on expectations of the money supply and consumer and producer price indexes are used to distinguish anticipated and unanticipated components of the announcements. This distinction is used to test for the efficiency of the financial market response to the announcements of new information. The results indicate that the unanticipated components of the announced changes in the Producers Price Index and in the money supply have an immediate positive effect on short‐term interest rates. The Consumer Price Index announcement has no apparent effect. There is no evidence of a delayed announcement effect. However, there is some indication of a liquidity effect of the money supply change on interest rates. This takes place when reserves are changing and several weeks prior to the information announcement.

ABSTRACT Changes in six‐month bill rates over semiannual periods in the 1960s and 1970s are successfully related to expected changes and to surprises. The latter include unanticipated changes in expected inflation, in the growth of industrial production and base money, and in inflation uncertainty. Estimation of the basic equation through the middle of 1983 does not suggest any change in structure. Moreover the equation “explains” 60 percent of the extraordinarily high level of real rates since late 1980, largely owing to an excess of unexpected net increases in anticipated inflation over actual increases. Our estimates provide some support for the expectations theory; there appears to be information content in six–month forward rates. While this content is swamped by the impact of surprises in equations explaining rate changes in terms of forward rates alone, the content is clear when proxies for the surprises are included in the equations.

ABSTRACT This paper uses an option valuation model of the firm to answer the question, “What magnitude tax advantage to debt is consistent with the range of observed corporate debt ratios?” We incorporate into the model differential personal tax rates on capital gains and ordinary income. We conclude that variations in the magnitude of bankruptcy costs across firms can not by itself account for the simultaneous existence of levered and unlevered firms. When it is possible for the value of the underlying assets to jump discretely to zero, differences across firms in the probability of this jump can account for the simultaneous existence of levered and unlevered firms. Moreover, if the tax advantage to debt is small, the annual rate of return advantage offered by optimal leverage may be so small as to make the firm indifferent about debt policy over a wide range of debt‐to‐firm value ratios.

ABSTRACT This paper presents the mean‐Gini (MG) approach to analyze risky prospects and construct optimum portfolios. The proposed method has the simplicity of a mean‐variance model and the main features of stochastic dominance efficiency. Since mean‐Gini is consistent with investor behavior under uncertainty for a wide class of probability distributions, Gini's mean difference is shown to be more adequate than the variance for evaluating the variability of a prospect. The MG approach is then applied to capital markets and the security valuation theorem is derived as a general relationship between average return and risk. This is further extended to include a degree of risk aversion that can be estimated from capital market data. The analysis is concluded with the concentration ratio to allow for the classification of different securities with respect to their relative riskiness.

ABSTRACT This paper conducts empirical tests of the equality of real interest rates across countries. The empirical evidence strongly rejects the hypothesis of real rate equality and the joint hypotheses of uncovered interest parity and ex ante relative PPP, or the unbiasedness of forward rate forecasts and ex ante relative PPP. The evidence suggests that it is worth studying open economy macroeconomic models which allow: 1) domestic real rates to differ from world rates, 2) time varying risk premiums in the forward market, or 3) deviations from ex ante relative PPP.