Knowledge that Transforms

Evaluates alternative accrual-based models for detecting earnings management. Comparison of the specification and power of commonly used test statistics; Application of the models to a random sample of firm-years; Importance of controlling for financial performance when investigating earnings management stimuli that are correlated with financial performance.

In this article, we suggest an efficient method of approximating a general, multivariate log-normal distribution by a multivariate binomial process. There are two important features of such multivariate distributions. First, the state variables may have volatilities that change over time. Second, the two or more relevant state variables involved may covary with each other in a specified manner, with a time-varying covariance structure. We discuss the asymptotic properties of the resulting processes and show how the methodology can be used to value a complex, multiple exercisable option whose payoff depends on the prices of two assets. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

We develop a measurement theory of market integration, based on two notions of “integrated markets”. First, two markets cannot be perfectly integrated in any sense if one can construct two portfolios, one from each market, that have identical payoffs but different prices. In that case, the law of one price is violated across the markets. Second, they cannot be integrated in a stronger sense if there are cross-market arbitrage opportunities. Two measures of market integration are developed, respectively reflecting these notions. The smaller the measures, the more closely integrated (in the respective senses) the markets. Among other things, they are interpreted as measuring pricing discrepancy between markets.

We develop a model wherein the choice between adjustable- and fixed-rate debt can serve as a signal of firm quality. The nature of the signal depends on expected inflation volatility relative to other risk parameters. Evidence from a matched sample of debt announcements over the period 1978 to 1986 shows a difference of - 2.05 \ \rm percent between stock price reactions to adjustable rate and fixed rate announcements when expected inflation volatility is above an estimated threshold. Below this threshold, the difference is +0.98 \ \rm percent. The evidence supports the hypothesis that the riskier debt choice serves as a favorable signal of firm quality.

We develop an arbitrage-free discrete time model to price American-style claims for which domestic term structure risk, foreign term structure risk, and currency risk are important. This model combines a discrete version of the Heath, Jarrow, and Morton (1992) term structure model with the binomial model of Cox, Ross, and Rubinstein (1979). It converges (weakly) to the continuous time models in Amin and Jarrow (1991, 1992). The general model is “path dependent” and can be implemented with arbitrary volatility functions to value claims with maturity up to five years. The model is illustrated with applications to long-dated American currency warrants and a cross-rate swap from the quanto class.

A Bayesian approach is used to investigate a sample’s information about a portfolio’s degree of inefficiency. With standard diffuse priors, posterior distributions for measures of portfolio inefficiency can concentrate well away from values consistent with efficiency, even when the portfolio is exactly efficient in the sample. The data indicate that the NYSE–AMEX market portfolio is rather inefficient in the presence of a riskless asset, although this conclusion is justified only after an analysis using informative priors. Including a riskless asset significantly reduces any sample’s ability to produce posterior distributions supporting small degrees of inefficiency.

This article examines the effects of portfolio insurance on market and asset price dynamics in a general equilibrium continuous-time model. Portfolio insurers are modeled as expected utility maximizing agents. Martingale methods are employed in solving the individual agents' dynamic consumption-portfolio problems. Comparisons are made between the optimal consumption processes, optimally invested wealth and portfolio strategies of the portfolio insurers and "normal agents." At a general equilibrium level, comparisons across economies reveal that the market volatility and risk premium are decreased, and the asset and market price levels increased, by the presence of portfolio insurance. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.