Knowledge that Transforms

Recent theoretical work has argued that a small open economy should use residence-based but not source-based taxes on capital income. Given the ease with which residents can evade domestic taxes on foreign earnings from capital, however, a residence-based tax may not be administratively feasible, leaving no taxes on capital income.

This paper provides a simple proof of a recent theorem presented by In the single-factor case, the theorem asserts that any variable correlated with the factor can serve as the benchmark in an approximate APT expected return relation. The significance of this result is considered and a new direction for empirical work on "arbitrage pricing" is outlined.

ABSTRACT Unit time costs, or holding costs, are incurred in many arbitrage contexts. Examples include losing the use of short sale proceeds and lending funds at below market rates in reverse repurchase agreements. This paper analyzes the investment problem of a risk averse arbitrageur who faces holding costs. The model allows prices to deviate from “fundamental” values without allowing for riskless arbitrage opportunities. After characterizing an arbitrageur's optimal strategy, the model is examined in the context of the Treasury market. The analysis reveals that holding costs are an important friction in this market and that they can significantly affect arbitrageur behavior.

Standard models of informed speculation suggest that traders try to learn information that others do not have. This result implicitly relies on the assumption that speculators have long horizons, i.e, can hold the asset forever. By contrast, we show that if speculators have short horizons, they may herd on the same information, trying to learn what other informed traders also know. There can be multiple herding equilibria, and herding speculators may even choose to study information that is completely unrelated to fundamentals. These equilibria are informationally inefficient.

We estimate and compare a variety of continuous-time models of the short-term riskless rate using the Generalized Method of Moments. We find that the most successful models in capturing the dynamics of the short-term interest rate are those that allow the volatility of interest rate changes to be highly sensitive to the level of the riskless rate. A number of well-known models perform poorly in the comparisons because of their implicit restrictions on term structure volatility. We show that these results have important implications for the use of different term structure models in valuing interest rate contingent claims and in hedging interest rate risk.

We explore the determinants of liquidation values of assets, particularly focusing on the potential buyers of assets. When a firm in financial distress needs to sell assets, its industry peers are likely to be experiencing problems themselves, leading to asset sales at prices below value in best use. Such illiquidity makes assets cheap in bad times, and so ex ante is a significant private cost of leverage. We use this focus on asset buyers to explain variation in debt capacity across industries and over the business cycle, as well as the rise in U.S. corporate leverage in the 1980s.

ABSTRACT This paper uses the predictability of monthly excess returns on U.S. and Japanese equity portfolios over the U.S. Treasury bill rate to study the integration of long‐term capital markets in these two countries. During the period 1971–1990 similar variables, including the dividend‐price ratio and interest rate variables, help to forecast excess returns in each country. In addition, in the 1980's U.S. variables help to forecast excess Japanese stock returns. There is some evidence of common movement in expected excess returns across the two countries, which is suggestive of integration of long‐term capital markets.