Roll and Ross [6] have written what has quickly become the classic article on testing the Arbitrage Pricing Theory (APT) originally proposed by Ross [8]. They presented methods both for estimating the return generating process and for testing whether particular elements (factors) in the return generating process were priced in equilibrium. They found that more factors are priced than one would expect to be priced if the Capital Asset Pricing Model (CAPM) were held.

Empirical studies of the behavior of stock returns are important for several reasons. First, the nature of stock return behavior is fundamental to the formulation of the concept of “risk” (or “uncertainty”) in various financial theories and models. Second, the measurement of risk depends heavily on properties (such as the stationarity, long-tailedness, finiteness of the second and higher moments, etc.) of empirical stock return distributions. Third, various tests for the empirical validity of financial models [28] and the applications of these models (e.g., to the evaluation of investment performances [21], [22]) rely to a considerable extent on the steadiness over time of stock return distributions and the constancy of systematic risk. Fourth, several important pricing models for stock options, warrants, convertible debentures, and other similar financial instruments usually require explicit estimates of stock return variances [5]; the usefulness of such models depends largely on the adequacy (e.g., the finiteness, accuracy, etc.) and the stationarity of the variance measurements.

The Arrow-Debreu approach to general equilibrium in an economy has been recognized as one of the most general and conceptually elegant frameworks for the study of financial problems under uncertainty [2], [9]. Equally well known is its elusiveness when it comes to ready application to practical problems (like capital budgeting) or empirical testing. (See [6], [15]–[18].) However, some recent research (see [1], [3], [6], [12]–[16], [18], and [19]) has made a serious attempt to put the state-preference theoretic model in an operational setting. Breeden and Litzenberger [6] have developed an interesting approach to derive constructively the prices of elementary Arrow-Debreu securities from the prices of call options on aggregate consumption. Banz and Miller [3] use a similar technique to value capital budgeting projects based on values for state-contingent claims computed from prices of call options written on the market portfolio. The “supershare” securities proposed by Hakansson [14]–[16] and related work by Garman [13], Ross [24], etc., have also served to give the so-called “state-contingent” approach a practical flavor.

The capital asset pricing model postulates that the equilibrium return on any risky security is equal to the sum of the risk-free rate of return and a risk premium measured by the product of the market price of risk and the security's systematic risk. In the capital asset pricing model, beta as an index of systematic risk is the only security-specific parameter that affects the equilibrium return on a risky security.

The impact of corporate taxes on the leverage decision in a competitive market was analyzed in [8[, [9], and the incorporation of personal taxes into the problem structure was achieved in [4], [1] and [10]. In a more recent paper, Miller [6] suggested that the impacts of both corporate and personal taxation could be studied by simultaneously analyzing the supply of and demand for securities in an overall equilibrium framework. DeAngelo and Masulis [2], [3] formalized and extended the implications of Miller's model, but found that given the U.S. tax code, an equilibrium in which positive dividends were featured was not possible over and above the relatively small dividend exclusion provision.

Since Bowlin's [4] original article on the topic was published, a considerable literature on corporate bond refunding has developed. Most of that literature has concentrated on the question of how to measure the benefit to a company's shareholders of exercising the call provision associated with an outstanding debt issue (see [3], [12], [21], [26], [27], [29], and [31]). Among the related concerns have been the matters of whether there are valuation advantages to the deliberate issuance of discount—including “zero coupon”—bonds (see [9], [22], and [28]), and whether there can be profitable opportunities for refunding prior to maturity debt instruments that were issued at par but later trade at a discount (see [1], [2], [13], [15], [17], [18], and [23]).

In the standard setting in which an individual or firm has preferences for probabilistic monetary outcomes that satisfy the Neumann-Morgenstern [10] assumptions of “rational behavior” and has an exponential utility function for money, a popular index for evaluating any proposed single-period probabilistic project is its “risk-adjusted value” (RAV), i.e., its certainty equivalent, the certain amount of money that has the same utility as the expected utility for the project. Since the exponential function is completely characterized by just a single parameter, its risk aversion level, in comparing mutually exclusive projects one can simply plot their RAVs or their expected utilities as a function of this parameter and then, for any given value or range of values of the parameter, read off which project is best, i.e., has the highest RAV or, equivalently, the highest expected utility. (See, e.g., [7], p. 203 or [2].)

With the formation of a formal market for the trading of financial futures in October 1975, a renewed interest in the futures contract as an investment vehicle has emerged. The traditional approach was to view investing in futures as a way of off setting potential price risk associated with a given spot position. While these descriptive scenarios (see [3], [6], [10], [12], [13], [14], and [19]) adequately illustrate the traditional hedging strategy, their simplifying assumptions introduce a lack of realism into the investment process. The implication drawn from many of these articles is that, if one is interested in risk reduction, one should simply take the opposite position in the appropriate number of futures contracts to totally offset one's existing spot position.

The Standard Fixed Payment Mortgage (SFPM) has been the dominant mortgage instrument in the United States for the last 50 years, and for much of this period it has performed well. However, during periods of high and volatile rates of inflation, the SFPM suffers from severe weaknesses. Foremost among these problems, from the standpoint of the borrower, is the tilt in the stream of real mortgage payments toward the initial years of the mortgage. For consumers unconstrained by capital market imperfections, this tilt is unimportant. However, a consumer is typically unable to borrow against expected higher future income, or against the nominal capital gains that accrue to the owner of a house over the life of the mortgage. In addition, common practices of mortgage lenders often limit mortgage payments to some fraction of income at the time of purchase. Together, these liquidity constraints create a mismatch between the time sequence of mortgage payments and income, a mismatch that reduces the number of borrowers who qualify for financing and that limits the value of the house purchased by those who do obtain financing.