The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 limited thrift goodwill that could be counted as regulatory capital. This paper infers the significance of the thrift put option value from the relationship between thrift goodwill and stock returns. The ability to count goodwill as regulatory capital might have resulted in large put option values by allowing many thrifts to hold low capital and risky assets before the legislation. Tightened regulation may have reduced put option values and hence the wealth of thrift shareholders. Goodwill had a large negative effect on stock returns of low capital thrifts in 1989 and the negative effect persisted in the following two years. These findings suggest that many thrifts had large put option values before the FIRREA and the elimination of put option values was largely responsible for the stock price decline.

The paper derives a general form of the term structure of interest rates. The following assumptions are made: (A1) The instantaneous (spot) interest rate follows a diffusion process; (A2) the price of a discount bond depends only on the spot rate over its term; and (A3) the market is efficient. Under these assumptions, it is shown by means of an arbitrage argument that the expected rate of return on any bond in excess of the spot rate is proportional to its standard deviation.

In recent years intensive work has been done applying the Sharpe-Lintner-Mossin Capital Asset Pricing Model to the multiperiod investment decision under uncertainty. The purpose of this paper is to develop a practical working procedure for use by the financial manager. We first develop the multiperiod capital budgeting decision criterion in a form that lends itself to application. Second, we propose a method of implementation, one that we have made operational in computer programs currently on the Columbia University computer system. This makes it possible to extend the evaluation to encompass typical capital budgeting problems which, until now, have been discussed only under certainty. In particular we deal with the case of capital rationing. We employ programming techniques for this analysis and interpret the meanings of the dual variables.

The competitive bidding requirement in the underwriting of public utility securities has come under increasing scrutiny in recent years. The difficulties that utilities have encountered in raising funds at an historically reasonable cost have exacerbated this situation. “Utilities,” as used here, will refer to investor-owned gas and electric public utilities. The combination of reduced capital availability and rapidly expanding financial needs gives rise to a serious inquiry about whether competitive bidding in new utility underwritings can be justified on the basis of cost to the company.

This paper differentiates between country risk--the probability that a country will default on its obiigations--and two forms of international banking risk: (1) the extent to which a bank's foreign activities affect the cost of equity capital; and (2) the extent to which a bank's foreign activities affect the probability of bankruptcy. The paper focuses on the latter form of international banking risk.

Using Chebyshev's Inequality, it is pointed out that the risk of bankruptcy is influenced by the mean as well as the variance of the return distribution. Consequently, restrictions on the (international) composition of a bank's portfolio may increase rather than reduce the probability of bankruptcy.

The valuation of realistically complicated corporate liabilities is arguably one of the most exciting fields in finance today. It is exciting because it seems quite feasible that what was once a somewhat esoteric body of theory may soon be a viable method of valuing actual securities of many kinds. (This promise was, of course, clearly seen at the outset by both Black and Scholes and Merton in their respective seminal papers.)

This paper proposes a model that a dealer or investor may employ in determining

• The potential investment value of a debt instrument,

• The potential gains in net after-tax yield which result from swaps, and

• The trade-off, effective, after-tax yield on a municipal vs a taxable corporate bond of the same quality or rating.

The certainty-equivalent method of evaluating risky investments has been widely discussed in the literature ([2], [5], [14, p. 356], [19], [20]) and consists of applying a multiplicative factor, αt, to each period's expected cash flow, μt, to produce a certainty-equivalent flow, αtμt. The certainty-equivalent flow is then discounted with the riskless rate of interest, αtμt/(l + i)t. Although there has been much discussion of αt, researchers have not derived explicit expressions for αt, relying instead on ad hoc graphs [24, p. 328] or arguments involving mean-variance indifference curves [2] which may not even exist ([4], [12], [22], [23]). In this paper, I will (1) provide a rigorous definition of αt, (2) derive formal expressions for a for αt three special cases, (3) discuss relationships between αt and σt, the standard deviation of the period t cash flow, (4) formally derive the period t risk-adjusted discount rate, kt, from assumptions concerning the decision maker's (d. m.'s) risk preferences and cash flow distribution, and (5) apply the preceding results to a specific problem involving calculation of the risk-adjusted present value of an uncertain cash flow stream.

Much of modern portfolio theory rests on conclusions drawn from the original form of the Capital Asset Pricing Model. Fundamental to the conclusions of this model is the assumption of perfect competition among investors; i.e., all investors possess approximately the same small amount of wealth such that equilibrium price cannot be influenced significantly by the demand of any of the investors. Today's security market, however, is characterized by individuals and large institutional investors such as insurance companies and investment funds. Although institutions represent a very small fraction of all investors in the market, institutional investors in 1977 held 34.3 percent of all outstanding stock. By the very magnitude of the dollar transactions effected by these large investors, prices can and are affected dramatically. Because today's security market is composed of investors exhibiting extreme differences in wealth, the United States securities market probably is not perfectly competitive as assumed in portfolio theory. Consequently, investment theory must be extended to reflect vast wealth differences among investors. To achieve this end, modifications are made to the original Capital Asset Pricing Model. Equilibrium conditions are examined and conclusions are drawn as to how portfolio theory must be altered to include price affecting ability by a segment of the investors in the market.

The use of the expected utility hypothesis and the “portfolio approach” has recently become quite popular by both writers in monetary theory and in financial management. Most discussions are given within what might be called the Tobin-Markowitz framework. One very important result recently discussed at some length is the Tobin “separation theorem.” This theorem essentially says that a quadratic preference function, or a normal distribution of returns on risky assets is a sufficient condition for the proportions of the various risky assets in a portfolio to be independent of the proportion of the portfolio held in a safe asset. The proofs of this theorem are given within a framework of the decision maker who minimizes portfolio variance for a given portfolio return, using variance as a measure of risk of the portfolio.

In this study, alternative real and simulated market indexes are examined as proxies for the “common factor” required by the Sharpe portfolio selection model [13]. The ex post performance of efficient and well-diversified portfolios generated by the model based on the different indexes is compared. The results indicate no significant difference in performance between real and simulated indexes, although the degree of diversification is much lower for portfolios based on indexes which relate well to the universe of securities. It is also shown that portfolios which are selected according to the Sharpe model (regardless of the index) outperform strategies which call for investing in the market portfolio.

A number of recent papers have reported evidence that stock prices are more volatile than is consistent with efficient markets. We argue that the excess volatility tests address a definition of efficient markets that makes an extreme information assumption. We go on to test a weaker definition of efficient markets, due to Jensen (1978). We show the existence of a profitable trading rule that earns a significantly higher rate of return than a buy-and-hold strategy, and so conclude that stock prices are too volatile, even when judged by this weaker definition.

In this paper, a short-run partial-adjustment model of the demand for credit union shares was specified and estimated with time series data. The estimated results were used to derive long-run, equilibrium demand coefficients and elasticities. The main conclusions are that credit union shares are substitutes for deposits at savings and loan associations, time and savings deposits at commercial banks, and marketable bonds. Moreover, the implications of the statistical results are that credit union and savings and loan shares are more closely related to more liquid assets than to long-term assets. While real income was employed as a constraint variable, it was employed as a maintained hypothesis since the use of a wealth constraint led to perverse results. Also, some evidence was presented that the elasticities of the demand function for credit union shares are different from those of an aggregate savings deposits function. Thus, it is likely that an aggregate demand function will contain aggregation bias.

The purpose of this paper is to present a more meaningful interpretation of the empirical finding of a distributed lag relationship between the nominal (market) rate of interest and the rate of inflation than that offered by Irving Fisher [8] and subsequent writers (see e.g., [2], [9], [10], [11], [15], [17]). In Part II we identify a paradox between Fisher's theory and his empirical results and examine previous explanations for the paradox. In III and IV, we offer what appears to be a more satisfactory resolution of the paradox and subject it to empirical test.

We study trading and risk management decisions of banks in over-the-counter markets, accounting for 2 types of risk: payoff risk from loans and counterparty risk from trading activities. Our model provides empirically supported predictions on the structure of the interbank credit default swap (CDS) market: i) banks with high default probabilities either buy or sell CDS contracts; ii) because of the counterparty risk friction, payoff risk is only partially shared; and iii) safe banks act as intermediaries and help diversify counterparty risk. Banks manage their default probabilities to become creditworthy counterparties, but they do so in a socially inefficient way.

This article uses FAS 123R regulation to examine how reduction in CEO compensation incentives affects managerial “playing it safe” behavior. Using proxies reflecting deliberate managerial efforts to change firm risk, difference-in-difference tests show that affected firms drastically reduce both systematic and idiosyncratic risks, leading to an 8% decline in total firm risk. These reductions in risk are achieved by shifting to safer, but low-Q, segments while closing the riskier ones, without significant changes in investment levels. Our findings suggest that decrease in risk-taking incentives provided by option compensation, when not compensated for by alternative incentives or governance mechanisms, exacerbates risk-related agency problem.

I examine whether competition from domestic industry rivals affects firms’ proclivity to undertake foreign direct investment (FDI) and their country location choices. I find that competition affects foreign production decisions and the geography of international investments. While firms enduring stiffer competition are significantly less likely to undertake FDI, this effect is heterogeneous across firms. Competition deters FDI more strongly when costs are heavier, whereas it has weaker effects when efficiency is higher, growth opportunities are valuable, and cash reserves are higher. FDI location models suggest that when going abroad, firms facing stronger competition are more likely to pursue economies of productivity and taxation.

Using a regression-discontinuity design and within lender–borrower variation, we analyze how credit default swaps (CDSs) affect bank incentives and borrower outcomes in renegotiations after covenant violations. While existing studies document an investment decline after covenant violations, we find that covenant-violating firms maintain their investment subsequent to the introduction of CDS trading. Moreover, after CDS introduction, covenant-violating firms are less likely to default. Our results suggest that in the private debt markets, CDSs discipline borrowers, while the empty creditor problem due to CDS is mitigated because of lenders’ reputation concerns and lower coordination frictions.

Most research dealing with portfolio selection under uncertain inflation is carried out by assuming either one of the following two approximations: a linear or a quadratic approximation. In this paper, we analyze the general case, namely assume that the nominal return is the product of the real return and one plus the rate of inflation. We demonstrate that the general analysis leads to the following results that are not found in the two approximations: (1) even if we assume that nominal returns are independent of inflation, the nominal and real efficient sets will not necessarily coincide. Mean-Variance (M-V) analysis leads to a nominal efficient set, that is, a subset of the real M-V efficient set, whereas the opposite holds assuming investors maximize expected utility of real wealth. (2) Similar results are obtained when real returns are independent of inflation (the Fisher hypothesis). Assuming normality of nominal returns, we derive the CAPM in real terms or its zero beta counterpart.

In a previous paper we reviewed the literature on normative stock price models. These models specified the present value of a share of common stock to be equal to the discounted value of dividends accruing to the holder. Using continuous discounting, the present value of a share is(1)

where Dt is the dividend rate at time t and k is the cost of equity capital. Presumably k is a function of both the stockholders' time value of money and the perceived risk or uncertainty associated with the future dividend stream.