Intermediation, and in particular financial intermediation, is a frequently observed class of activities for which the literature provides little definition. Although intermediaries exist in major proportions of the economy, a precise characterization of an intermediary's function has not appeared. Rather, the academic and pragmatic literature refer to intermediaries by example, generally agreeing that such institutions as banks, insurance companies, etc., are intermediaries. This research addresses the issue of what an intermediary is; that is, what distinguishes the activity of intermediation from other economic activity.

The striking and powerful conclusions of the capital asset pricing model (CAPM) [13,8] arise from imposing the requirement that optimal individual portfolio decisions must be consistent with a market equilibrium for securities. That simple requirement–of market balance–produces the strong results that have been the centerpiece of research in finance in the last fifteen years. But despite the huge payoffs to imposing equilibrium requirements on financial markets, the CAP model remains a partial equilibrium result. The risks which are attributed to securities are strictly exogenous. Securities are risky because their prices fluctuate, but the cause of those price fluctuations is rarely specified. The literature seems to associate “market risk” with the business cycle and individual security risk with either random technological change or demand uncertainty. But whatever attribution is made, such risk remains outside of the model itself. Since the keystone of the CAPM is its important distinction between “real” or nondiversifiable risk and purely financial uncertainty, it is disconcerting to recognize that it is a model in which real quantities do not appear at all.

This paper is a pioneering effort in the examination of the workings of rationality and efficiency in capital markets. The central theme of the paper is the notion of informational efficiency in markets for durable assets. In its broadest terms this imposes a behavioral constraint on the intertemporal development of the asset markets; in a perfect market the development of the equilibrium over time must not be self-contradictory. Individual agents' anticipations of future developments determine their current actions and these, in turn, determine equilibrium prices. But, tomorrow the process will be repeated and it is at this second step that the possibility of conflict enters. The future development need not fulfill precisely people's previous anticipations, but in a perfectly functioning market it would be difficult to accept a blatant contradiction. To believe that prices are lognormally distributed, for example, and to have that belief generate the same equilibrium price period after period is such a contradiction.

The risk inherent in the price fluctuations of bonds has many dimensions. These include default risk, inflation risk, and call risk. The most important single source of risk, particularly for government and high-grade corporate bonds, is basis-risk price fluctuations caused by shifts in interest rates. For a given shift in the yield curve, and holding other factors unchanged, longer term-to-maturity bonds generally suffer greater price changes than shorter maturity bonds. This characterization is not exact because high coupon bonds are less volatile than low coupon bonds. Intuition says that this is to be expected because, other things being equal, high coupon bonds have a greater percentage of their value due to the interim coupons and, hence, have a shorter “effective” maturity. Duration may be interpreted as an attempt to quantify this qualitative statement through the use of a single, numerical measure intended to be used in place of maturity.

These three papers deal with a common subject from three very different attitudes and perspectives. As a result, without challenging such restrictive conventions as the assumption that investor holding periods are fixed and knowable a priori or indeed disagreeing on anything of substance, the respective sets of authors sound three very different themes.

Estimation and control of security risk are subjects of major theoretical and practical importance. Much of the literature in this area has focused on the risk associated with returns over a single holding period. Within this context, a great deal of attention has been devoted to estimation of security betas, which relate to coveriance with “the market,” since the well-known Capital Asset Pricing Model implies that expected returns will, in equilibrium, be related to such values. However, a number of papers [3, 7, 14] have considered “extra-market covariances,” i.e., covariances among security returns not due to common correlations with the market as a whole. Accurate estimates of such covariances are necessary for tailoring portfolios to account for differences in investors' circumstances (e.g., tax brackets) and, a fortiori, for active portfolio management designed to exploit any security mispricing.

Lanstein and Sharpe (LS) attempt to explain residual covariances between stocks on the basis of duration considerations. The results, by admission are mixed. Rather than to focus on these per se, I would like to further the work by making some suggestions with respect to the formal model development and the empirical tests-on the basis that both could be made crisper and thereby increase the value of what already is a contribution.

In recent years, academicians and practitioners have been using the concept of duration more frequently in the analysis of debt securities. Although the use of duration has greatly expanded our insights into the behavior of bond prices and bond risk, it has given rise to a considerable degree of confusion and misunderstanding. The purpose of this review paper is twofold: (1) to clarify the record on what duration is and is not and what it can do and cannot do, and (2) to discuss the appropriate uses of duration in the analysis of security portfolios.

The stated purpose of this review paper by Professors Bierwag, Kaufman, and Khang is (1) to clarify the record on what duration is and is not, and (2) to discuss its usefulness in the analysis of security portfolios. However, the implied, the more important, purpose is to focus the attention of the academic community on a subject that seems to warrant more attention than it has received. Indeed, it seems to me that the whole purpose of this session, which not incidentally is being chaired by coauthor Kaufman, is simply that: to show what can and cannot be done with the concept of duration.

As part of an overall investigation of risk and capital adequacy in banks, we have examined the magnitudes by which Interest rate movements may alter reported rates of costs and returns for a typical commercial bank. At the same time, we have attempted to measure the manner in which banks adjust their loans and costs over time in reaction to shifting markets and rates.

Since the first owner of a gold depository discovered that profits could be made by lending some of the gold deposited for safekeeping, there has been a concern for the “capital adequacy” of depository institutions. The idea is simple enough. If the value of an institution's assets may decline in the future, its deposits will generally be safer, the larger the current value of assets in relation to the value of deposits. Defining capital as the difference between assets and deposits, the larger the ratio of capital to assets (or the ratio of capital to deposits) the safer the deposits. At some level capital will be “adequate,” i. e., the deposits will be “safe enough.”

Much of the literature on the adequacy of bank capital is concerned with the role of such factors as default risk and faulty management. These factors are important but they neglect the role that purely stochastic elements can play in affecting the capital of a well-managed bank, even if it is free of default risk. Because banks raise funds by issuing liabilities with different maturities than the assets they acquire, changes in the interest rates paid on these liabilities relative to the interest rates on assets will affect earnings and, hence, bank capital.

This study is concerned with establishing the determinants of banks' exposure to risk and with predicting risk in banking. Using the COMPUSTAT data base, prediction rules have been developed for two aspects of risk: systematic risk (risk that is related to covariance with the market portfolio) and residual risk (the aggregate of specific risk and extra-market covariance). For each type of risk, several models have been estimated: one model employs only measures of the asset and liability characteristics of the bank; a second employs these characteristics and other data taken from annual reports; a third model adds the history of the behavior of the price of the bank's common stock. The central conclusion of the study is that systematic and residual risk in banks can be predicted from predetermined data. Prediction rules estimated in this way can serve a useful function in monitoring bank risk.

The world is still recovering from the shock of radically higher energy prices triggered by the October 1973 war in the Mideast. In the months following the oil embargo and the quadrupled price of petroleum, there seemed to be a very real possibility that the strains imposed on world markets and institutions, and indeed on national economies, would cause a fracture in one or another part of the complex linkages that make up the world economic system.

In recent years the cost of fuel to operate power plants for electric utilities has increased much faster than many utility executives and regulators have anticipated. In the presence of substantial regulatory lag in adjusting rates, stockholders have had to absorb the difference between revenues and unanticipated increases in fuel expenses. In an effort to shorten the time required for increased costs to be reflected in increased prices to consumers, many firms have been allowed to use an automatic fuel adjustment clause (FAC) to pass on increased costs to consumers as they occur. The FAC usually allows the firm to adjust the price of electricity when the price of fuel deviates from some fixed base price. Presently more than 40 of the 50 state regulatory commissions allow some type of FAC.

Recent economic research efforts in rate of return regulation of public utilities have for the most part been couched in a static, steady-state framework, “Averch-Johnson” hypotheses being the most obvious examples [3]. Nevertheless, standard classical microeconomic analysis of rate of return regulation seems to have two important drawbacks: first, it does not address itself to multiperiod relationships; and secondly, it cannot be represented in current-practice financial terms. This paper first outlines rate of return regulation as typically practiced. It then describes the essential features of a model designed to examine intertemporally the financial and capital expansion decision tradeoffs a public utility faces given corporate, institutional, and regulatory constraints. Decision tradeoff questions have assumed substantial policy importance in recent years not only because of the ambiguities in rate of return regulation effects conceptualized in the Averch-Johnson literature but because of the behavioral (occasionally legal) importance of purely financial constraints, such as interest coverage requirements, on corporate investment and financing choices.

Dynamic policies for corporate finance have mostly been studied under conditions of certainty. Financial optimal control models (Davis [3], Krouse [5], Inselbag [4], and Senchack [7]) are characterized by time-varying, state-dependent policy formulations: when and to what extent should earnings retention, borrowing, and debt repayment, new stock issues, and capital investment be varied over an extended planning horizon. Optimal policies generated by these (and other) dynamic deterministic models tend to exhibit a bang-bang phenomenon: switching instantaneously from one extreme to another in a managerially unpalatable way. Dividends are either nonexistent or all of net earnings; borrowing is either absent or at the limit of what banks and the bond market will allow. This sort of policy behavior is acceptable only in a completely deterministic world. Investors would tolerate such extremes since they know that their share, when it finally comes and even after discounting, would still be larger than by any other policy. However, with uncertainty, a balance between dividends now and capital gains later must be struck which will better satisfy investor preferences.

The dynamic behavior of the corporation has been examined in recent literature by a number of authors. These efforts, however, although attempting to characterize the firm's optimal financing program have neglected to incorporate the threat of bankruptcy associated with these decisions. When the threat of default is appropriately considered, the investment and financing strategies are inexorably joined over time so that determination of an optimal policy becomes a multiperiod problem. The thrust of this paper is to address the problem of determining the firm's dynamic investment-financing program explicitly recognizing the uncertainty of financial ruin attributable to the firm's choice of capital structure.

There are seven academic finance associations in the United States; two are considered to be national and five are identified as regional. The national organizations are the American Finance Association (AFA) and the Financial Management Association (FMA), and the regional associations are the Eastern Finance Association (EFA), Midwest Finance Association (MFA), Southern Finance Association (SFA), Southwestern Finance Association (SWFA), and the Western Finance Association (WFA).