This paper explores the optimal consumption and investment behavior of an individual who derives utility from the ratio between his consumption and an endogenous habit. We obtain closed-form policies under general utility functionals and stochastic investment opportunities by developing a nontrivial linearization to the budget constraint. This enables us to explicitly characterize how habit formation affects the marginal propensity to consume and optimal stock–bond investments. We also show that in a setting that combines habit formation with Epstein–Zin utility, consumption no longer grows at unrealistically high rates at high ages and investments in risky assets decrease.

The market for underwriting services provides a valuable opportunity to test two competing hypotheses in monopsony theory. When applied to the area of investment banking, the theory implies that spread behavior ought to be influenced not only by the average costs of providing underwriting services, but also by the extent of vigorous competition. In competitive markets the prices of products and services tend to reflect minimum average costs in the long run. When competition declines, spreads can be expected to widen. A number of empirical studies have established that spread behavior is in fact dependent on the extent of bidding competition [5, 8, 9, 2]. “The intensity of competition in underwriting new issues of tax exempts has the expected effect on underwriters' spreads, that is, the difference between buying and selling prices; spreads decrease as the degree of competition increases” [2, p. 707].

Unfortunately Professors Arditti and Levy (A-L) in their comment published in this issue of this journal did not realize that the determination of the investor optimum in my paper [1] was simultaneous with respect to the three parameters, the mean and the variance and the third moment of portfolio returns. When the nth moment was introduced, it was assumed that the investor chooses on the basis of all n parameters — the mean, second moment, third moment, etc. — through the nth moment.

A perfect capital market is a key assumption in recent theories of security pricing. It is assumed that the costs of transactions, information-gathering, and portfolio management are all zero, and that no investor is so large as to exert an appreciable effect on either the risk-free interest rate or the yield on risky securities. If, in this perfect capital market, investors have identical decision horizons and homogeneous expectations, then there is a unique optimal portfolio of risky securities. Since this unique portfolio must include every security in proportion to its relative valuation in the capital market, it is referred to as the “market” portfolio. When the capital market reaches equilibrium, the expected return of every security will be a linear function of the expected return of the market portfolio. From this relationship Lintner and Mossin have separately derived valuation formulas that express the market price of a security as a function of the security[s end-of-period expected value, its risk as measured by the variance and covariances of this end-of-period value, the market price of risk within the portfolio, and the risk-free rate of interest.

Firms with lower leverage are not only less likely to experience financial distress but are also better positioned to acquire assets from other distressed firms. With endogenous asset sales and values, each firm’s debt choice then depends on the choices of its industry peers. With indivisible assets, otherwise-identical firms may adopt different debt policies, with some choosing highly levered operations (to take advantage of ongoing debt benefits) and others choosing more conservative policies to wait for acquisition opportunities. Our key empirical implication is that the acquisition channel can induce firms to reduce debt when assets become more redeployable.

This article investigates the short-side anomaly trading behavior of alternative mutual funds (AMFs) based on their short positions in U.S. domestic equities. In aggregate, AMFs demonstrate the ability to exploit well-documented stock market anomalies on the short side, and the overpriced stocks sold short by AMFs generate significant negative alpha. Further, AMFs’ short-side trades exhibit significant return predictability, which can at least partially derive from their ability to process public information on firm and anomaly characteristics. Finally, AMFs’ short-side anomaly-based trading activity and profitability appear to be more pronounced among the stocks with higher credit risk or dynamic short-selling risk.

This article analyzes the informative trading of professional money managers within a rational-expectations equilibrium model in which managers care about their performance relative to their peer group. I find that the existence of uninformed managers causes informed managers with relative performance concerns to trade less informatively, engendering less informative prices. When managers are differentially informed, they need to forecast the average performance based on private signals, and each manager may place more weight on the private signal if the signal provides good information about the average performance. The price aggregates those signals and thus becomes more informative.

A number of futures contracts conveys to the short position various delivery options regarding the quality and exact timing of delivery. Moreover, the compensation to the long position is not solely determined by the market value of the delivered asset at the time of delivery. Sometimes, the long position can hedge this delivery risk by holding an appropriate portfolio of the underlying asset. It often has been stated that whenever the long position can form a dynamic hedge against the delivery risk, the delivery option has a zero value. This paper demonstrates the implication of such erroneous intuition to the pricing of options. It is shown that the root of the issue is the property of diffusion processes whereas, within a given time interval, a random variable either will never cross a given boundary or else, cross it an infinite number of times.

The recent studies of Fisher and Lorie [10 and 11], Brigham and Pappas [2], and others have contributed significantly to our knowledge about overall rates of returns on common stocks. There is, in addition, a growing body of empirical evidence investigating the performance of alternative portfolio maintenance strategies [4, 8, 9, and 13]. However, to date, this evidence for rates of return under alternative portfolio strategies has been obtained for a “one-time” investment decision (with allowances for reinvestment of dividends and possible intraportfolio reallocation). In this paper the effects of alternative portfolio accumulation strategies on subsequent portfolio rates of returns are examined.

In “Valuation Under Uncertainty,” which recently appeared in this Journal (September 1967), Houng-Yhi Chen argues [1, pp. 313–314] that “Robichek and Myers' criticism [2, 3] of the use of the risk-adjusted discount rate is unfounded,” and suggests that our “conclusions must be based in part on a misunderstanding of the risk-adjusted discount rate method.” These charges are without foundation, as we will show here.

We evaluate the cross-sectional predictive ability of a forward-looking monetary policy reaction function, or Taylor rule, in both statistical and economic terms. We find that investors require a premium for holding currency portfolios with high implied interest rates while currency portfolios with low implied rates offer negative currency excess returns. Our forward-looking Taylor rule signals are orthogonal to current nominal interest rates and disconnected from carry trade portfolios and other currency investment strategies. The profitability of the Taylor rule portfolio spread is mainly driven by inflation forecasts rather than the output gap and is robust to data snooping and a wide range of robustness checks.

We use the staggered enactment of anti-recharacterization laws as a plausibly exogenous shock to the value of securitizing collateral through special purpose vehicles (SPVs) and test how collateral values impact corporate risk management. Following the laws’ enactment, we find increases in commodity, foreign exchange, and interest rate hedging, especially for firms with exposure to these risks and that rely on SPVs. Supporting the collateral constraints literature, the effect is weaker for firms that likely need the collateral for external financing, such as financially constrained firms. Our findings highlight fluctuations in collateral values as an important consideration in risk management decisions.

We examine the relationship between dividend smoothing and firm valuation across 21 countries using several empirical methods and smoothing measures. Our main results show that dividends are capitalized at significantly larger values for high-smoothing firms than for low-smoothing firms. We also find that dividend-smoothing premiums are higher in countries with weak shareholder protection – suggesting that smoothing serves as a substitute mechanism to reduce agency costs. Overall, our findings support the view that managers use dividend smoothing predominantly as a bonding mechanism to reduce agency costs (Leary and Michaely (2011)), and not as a rent extraction mechanism (Lambrecht and Myers (2012)).

We examine whether superior understanding of technological innovation is a source of mutual fund managers’ ability to garner positive abnormal returns. Consistent with our hypothesis, the inter-quintile annual net Carhart alpha spread for mutual funds sorted on changes in the technological similarity (TS) of their portfolio holdings is 282 basis points. Moreover, because changes in TS are largely orthogonal to other predictors of mutual fund success (e.g., industry concentration, active share, fund R2, and lag fund alpha), changes in TS can be combined with other measures to help identify the best performing funds.

In a recent paper in this Journal Francis [3] has examined the intertemporal systematic cross dependence between the monthly returns of securities and those of a market index. Based on the monthly price behavior of a sample of 770 common stocks listed continuously on the New York Stock Exchange (NYSE) from 1958 to 1967 he concludes that, relative to the general market movement, there is no consistent pattern of leads or lags for securities' monthly returns. In other words, the monthlyreturns of securities do not precede or follow the monthly returns on the market index.

A portfolio frontier superior to the Markowitz one-period buy-and hold efficient frontier does exist. Such a superior frontier can be generated by pursuing a rebalancing policy, even under the conditions of random walk. By rebalancing we mean that an investor maintains a fixed but optimal set of weights among the securities in a portfolio throughout an investment period by buying and selling securities at the end of some predetermined intervals.

Economists generally agree that a basic characteristic of a good tax is economic neutrality. That is, a tax should not influence economic behavior unless it was intentionally designed to produce a specific effect. In this context, the economic effects of the current system of capital gains taxation in the United States have been the subject of considerable concern. Most researchers have concluded that the current system of capital gains taxation has an undesirable and destabilizing effect on the securities markets because the practices of taxing capital gains only when they are realized and, correspondingly, allowing tax deductions for capital losses only upon realization, presumably cause investors to defer the realization of capital gains and to accelerate the realization of capital losses. Based upon this behavioral assumption, many economists infer an effect on the securities markets.

The evolution of corporate capital structure theory in the literature of finance has been marked by the development of an increasingly imaginative rendition of market processes under conditions of uncertainty. Trade-offs between debt and equity sources of financing, and their consequent impact on shareholder wealth, have been the major concern. While the evolution is by no means complete, the notion of an efficient capital market in which investor decisions are focused on security portfolio building activities has provided significant insights into the range of opportunities open to corporate management to enhance share valuation through enlightened financing decisions. One measure of the gap between theory and application, however, can be found in the topics which thus far have not been effectively comprehended in the literature, even though the analytical technology is clearly available. Among those topics is the question of convertible debt financing as a capital structure component. The treatment of such a funds source remains essentially in the realm of folklore, the typical story being that convertibles contain the “best elements” of both equity and straight debt or that they provide a vehicle for issuing equity at a “bonus” price higher than the current price. Closer examination reveals that either view is arrant nonsense, and it is to a demonstration of this point that the present paper is addressed.

This note examines the positive implications of the Latané-Tuttle [5, 6] geometric mean portfolio selection criteria for the determination of stock prices. Recently, Mossin [9] and Lintner [10] have derived the market prices of equities under the respective assumptions that investors have quadratic and exponential utility functions. While it would be presumptuous to suggest that all investors are “long-run wealth” maximizers, this criterion has a certain amount of intuitive appeal. The geometric mean criterion is equivalent to the maximization of a Bernoulli or logarithmic utility function and displays the desirable characteristic of decreasing absolute (i.e., as the investor's wealth increases, he becomes less averse to risk). This contrasts with the exponential utility function which displays constant absolute risk aversion and the quadratic utility function which displays the undesirable characteristic of increasing absolute risk aversion. Another suggested desirable characteristic of the geometric mean criterion is that it emphasizes the avoidance of bankruptcy while maximizing the asymptotic rate of growth of wealth [4, 5] and maximizing the probability of exceeding a given wealth level within a fixed time [3]. This note analyzes the aggregate effect on stock prices of investors using the geometric mean portfolio selection criterion.

When borrowers are delinquent, senior debtholders prefer liquidation, whereas junior debtholders prefer to maintain their option value by delaying resolution or modifying the loan. In the mortgage market, a conflict of interest (“holdup”) arises when servicers of securitized senior liens are also the owners of the junior liens on the same property. We show that holdup servicers are able to delay action on the first-lien mortgage. When they do act, servicers are more likely to choose resolutions that maintain their option value, favoring modification and soft foreclosures over outright foreclosures. Holdup behavior is more likely to result in borrower self-curing.