Knowledge that Transforms

In this paper we utilize White's Reality Check bootstrap methodology (White (1999)) to evaluate simple technical trading rules while quantifying the data‐snooping bias and fully adjusting for its effect in the context of the full universe from which the trading rules were drawn. Hence, for the first time, the paper presents a comprehensive test of performance across all technical trading rules examined. We consider the study of Brock, Lakonishok, and LeBaron (1992), expand their universe of 26 trading rules, apply the rules to 100 years of daily data on the Dow Jones Industrial Average, and determine the effects of data‐snooping.

Hedge funds display several interesting characteristics that may influence performance, including: flexible investment strategies, strong managerial incentives, substantial managerial investment, sophisticated investors, and limited government oversight. Using a large sample of hedge fund data from 1988–1995, we find that hedge funds consistently outperform mutual funds, but not standard market indices. Hedge funds, however, are more volatile than both mutual funds and market indices. Incentive fees explain some of the higher performance, but not the increased total risk. The impact of six data‐conditioning biases is explored. We find evidence that positive and negative survival‐related biases offset each other.

An extensive empirical literature in finance has documented not only the presence of anamolies in the Black-Scholes model, but also the "term-structures" of these anamolies (for instance, the behavior of the volatility smile or of unconditional returns at different maturities). Theoretical efforts in the literature at addressing these anamolies have largely focussed on two extensions of the Black-Scholes model: introducing jumps into the return process, and allowing volatility to be stochastic. This paper employs commonly-used versions of these two classes of models to examine the extent to which the models are theoretically capable of resolving the observed anamolies. We find that each model exhibits some "term-structure" patterns that are fundamentally inconsistent with those observed in the data. As a consequence, neither class of models constitutes an adequate explanation of the empirical evidence, although stochastic volatility models fare better than jumps in this regard.

Scott W. Barnhart, Robert McNown, Myles S. Wallace, Non-Informative Tests of the Unbiased Forward Exchange Rate, The Journal of Financial and Quantitative Analysis, Vol. 34, No. 2 (Jun., 1999), pp. 265-291

In this study I use a principal‐agent framework to analyze optimal contracting under two accounting standards, referred to as historical cost (HC) and market value (MV), and under differing asset market assumptions. I distinguish HC from MV by the way revenue is recognized and in the reporting discretion allowed. The MV standard recognizes both realized and unrealized holding gains; HC recognizes only realized holding gains. MV allows the manager reporting discretion; the HC standard does not. Also, distinguishing an asset's value‐in‐use (VIU) from its net realizable value (NRV), I consider markets where the asset's VIU and NRV are always equal as well as markets where VIU and NRV differ. I show the following. If an asset's NRV and VIU are equal and if the manager's available reporting discretion is known, the principal prefers the MV standard because it provides better information about the manager's effort. However, the principal may prefer the HC standard if sufficiently uncertain about the manager's reporting discretion or if the asset's NRV exceeds its VIU, so that expected revenue is sufficiently enhanced by selling the asset earlier. Using an example (normal distribution and mean/variance preferences with linear contracts), I provide a case where the principal prefers the HC standard. Also, I compare the optimal effort and contract under each standard, and provide comparative static results that show how expected revenue, cost, and net income change due to changes in certain model parameters.

We present a model of oligopolistic commodity speculation, in which a limited number of speculators practice non-cooperative storage in an infinite-horizon game. A significant technical difficulty due to the non-negative stock constraint is overcome, and a tractable sub-game perfect equilibrium is presented, in which it is shown that less is stored and prices are more volatile than under perfect competition. It turns out that a tax on consumption of the good would increase storage, stabilize prices, increase welfare and raise speculative profits; the oligopolists would thus lobby for a tariff raised against their own shipments.

We examine the proposition that competitive firms must behave as if they were maximizing profits; otherwise they would go bankrupt, or even fail to be financed in a competitive capital market. We investigate a model in which an entrepreneur raises funds for a risky enterprise on a competitive capital market, by offering a “dividend policy” based on the realized (stochastic) flow of earnings. We show that an entrepreneur who maximizes the expected sum of discounted dividends is sure to fail in finite time. On the other hand, many other behaviours yield positive expected profits and are able to attract investment funds, and yet result in a positive probability of surviving forever. As a consequence, if new firms have sufficiently diverse behaviours, then even if there is a constant stream of new entrants, after a long time practically all of the surviving firms will not have been maximizing profits.

“… I suppose there exists an extremely powerful, and, if I may so speak, malignant being, whose whole endeavours are directed toward deceiving me.” Rene Descartes, Meditations, II.1

We compare the performance of markets and tournaments as allocative mechanisms in an economy with borrowing constraints. The economy consists of a continuum of individuals who differ in their initial wealth and ability level. These must be assigned to a continuum of investment opportunities or inputs of different productivity. With perfect capital markets matching is efficient under both mechanisms. Markets, however, generate higher aggregate consumption because of the waste associated with the production of signals under tournaments. When borrowing constraints are present, tournaments dominate markets in terms of matching efficiency and, for sufficiently powerful signalling technologies, also in terms of aggregate consumption.