It is widely thought that incomes risks can be shared by trading in financial assets. But financial assets typically carry some risk idiosyncratic to them, hence, disposing incomes risk using financial assets will involve buying into the inherent idiosyncratic risk. However, standard theory argues that diversification would reduce the inconvenience of idiosyncratic risk to arbitrarily low levels. This paper shows that this argument is not robust: ambiguity aversion can exacerbate the tension between the two kinds of risks to the point that classes of agents may not want to trade some financial assets. Thus, theoretically, the effect of ambiguity aversion on financial markets is to make the risk sharing opportunities offered by financial markets less complete than it would be otherwise.

Balanced growth models are commonly used in macroeconomics because they are consistent with the well-known Kaldor facts regarding economic growth. These models, however, are inconsistent with one of the most striking regularities of the growth process—the massive reallocation of labour from agriculture into manufacturing and services. This paper presents a simple model consistent with both the Kaldor facts and the dynamics of sectoral labour reallocation.

Critics argue that the estate tax prevents the owners of family businesses from passing their enterprises to heirs because it is difficult to pay estate taxes without liquidating the business. Why don't owners purchase enough life insurance to meet their estate tax liabilities? We examine whether and how people use life insurance to deal with the estate tax. We find that, ceteris paribus, business owners purchase more life insurance than do other individuals. However, on the margin, their insurance purchases are less responsive to estate tax considerations, and they are less likely to have the wherewithal to meet estate tax liabilities out of liquid assets plus insurance.

ABSTRACT We study standard mutual fund performance measures, using simulated funds whose characteristics mimic actual funds. We find that performance measures used in previous mutual fund research have little ability to detect economically large magnitudes (e.g., three percent per year) of abnormal fund performance, particularly if a fund's style characteristics differ from those of the value‐weighted market portfolio. Power can be substantially improved, however, using event‐study procedures that analyze a fund's stock trades. These procedures are feasible using time‐series data sets on mutual fund portfolio holdings.

ABSTRACT Most structural models of default preclude the firm from altering its capital structure. In practice, firms adjust outstanding debt levels in response to changes in firm value, thus generating mean‐reverting leverage ratios. We propose a structural model of default with stochastic interest rates that captures this mean reversion. Our model generates credit spreads that are larger for low‐leverage firms, and less sensitive to changes in firm value, both of which are more consistent with empirical findings than predictions of extant models. Further, the term structure of credit spreads can be upward sloping for speculative‐grade debt, consistent with recent empirical findings.

ABSTRACT Using dealer's quotes and transactions prices on straight industrial bonds, we investigate the determinants of credit spread changes. Variables that should in theory determine credit spread changes have rather limited explanatory power. Further, the residuals from this regression are highly cross‐correlated, and principal components analysis implies they are mostly driven by a single common factor. Although we consider several macroeconomic and financial variables as candidate proxies, we cannot explain this common systematic component. Our results suggest that monthly credit spread changes are principally driven by local supply/demand shocks that are independent of both credit‐risk factors and standard proxies for liquidity.

ABSTRACT Although traded as distinct products, caps and swaptions are linked by no‐arbitrage relations through the correlation structure of interest rates. Using a string market model, we solve for the correlation matrix implied by swaptions and examine the relative valuation of caps and swaptions. We find that swaption prices are generated by four factors and that implied correlations are lower than historical correlations. Long‐dated swaptions appear mispriced and there were major pricing distortions during the 1998 hedge‐fund crisis. Cap prices periodically deviate significantly from the no‐arbitrage values implied by the swaptions market.