This paper studies the binomial approximation to the continuous trading term structure model of Heath, Jarrow, and Morton (1987). The discrete time approximation makes the original methodology accessible to a wider audience, and provides a computational procedure necessary for calculating the contingent claim values derived in the continuous time paper. This paper also extends and generalizes Ho and Lee's (1986) model to include multiple random shocks to the forward rate process and to include an analysis of continuous time limits. The generalization provides insights into the limitations of the existing empirical implementation of Ho and Lee's model.

We analyze the optimal mix of debt, common equity, and preferred equity in a model with an investment opportunity and asymmetric information about its quality, and show that an all-equity financed firm will overinvest. Issuing the appropriate amount of debt before the project becomes available resolves this overinvestment problem. Introducing a second motive for debt, such as taxes, leads to a role for preferred stock as a means of enhancing the firm's “debt capacity,” by creating additional incentives to invest. We derive an optimal capital structure involving debt, preferred stock, and common stock.

This paper examines the role of large shareholders in monitoring managers when they propose antitakeover charter amendments. We attempt to distinguish between two competing hypotheses: the “active monitoring hypothesis” and the “passive voting hypothesis.” We find a statistically significant positive relation between institutional ownership and the stockholder wealth effects of various types of amendments, after controlling for ownership concentration among institutions, managerial ownership, and firm size. Our empirical evidence lends support to the “active monitoring hypothesis” proposed by Demsetz (1983) and Shleifer and Vishny (1986) that the existence of large shareholders leads to better monitoring of managers.

Stock price discreteness adds noise to price series. The noise increases return variances and adds negative serial correlation to return series. Standard variance and serial covariance estimators therefore overestimate the variance and serial covariance of the underlying stock values. Discreteness-induced variance and serial covariance depend on underlying volatility and on the size of the bid/ask spread. Simple formulas for approximating the effects of discreteness on variance and serial correlation are derived and presented. The approximations, which are accurate in daily data, can be used to adjust the standard variance and serial covariance estimators.

This paper examines multiperiod corporate financial policy in a world where the only market imperfection is taxation. The optimal financial policy determines the firm's capital structure and debt maturity structure. Two implications of this policy are: (1) there can be a set of debt-asset ratios that is consistent with firm value maximization, and (2) debt maturity structure is irrelevant to firm value.

This paper examines estimation issues associated with multivariate tests of asset pricing. Two issues are considered: (1) the constraint that the sample size (N) must be less than the time series (T), and (2) the relative effect on power of using the multivariate statistic versus a univariate counterpart. We find that an alternative statistic that allows for large N does not dominate the usual portfolio tests. More notably, we find that the power of a simple diagonal statistic usually dominates the multivariate statistic for cases considered in this study.

In rational, efficiently functioning markets, the returns on stock index and stock index futures contracts should be perfectly, contemporaneously correlated. This study investigates the time series properties of 5-minute, intraday returns of stock index and stock index futures contracts, and finds that S&P 500 and MM index futures returns tend to lead stock market returns by about five minutes, on average, but occasionally as long as 10 minutes or more, even after stock index returns have been purged of infrequent trading effects; however, the effect is not completely unidirectional, with lagged stock index returns having a mild positive predictive impact on futures returns.

This paper analyzes the impact of changes in monetary policy regimes on the relation between stock returns and changes in expected inflation. Post-war evidence from four countries reveals a direct link between these relations and the central banks' operating targets (i.e., money supply or interest rates). Specifically, the post-war negative relations between stock returns and changes in expected inflation are significantly stronger during interest rate regimes.

This paper examines the effects of the delivery basis risk embedded in nearly all futures contracts on efficiency tests of these markets. Examining soybean futures contracts, we show that delivery basis risk has important implications for market efficiency tests. Assuming no delivery basis risk, the market efficiency hypothesis is rejected. However, futures prices contain significant time-varying expected delivery basis and time-varying expected delivery risk premiums. Once these expected delivery basis and delivery risk premiums are accounted for, the apparent inefficiency is eliminated. Equilibrium spot prices also contain significant time-varying expected delivery risk premiums.

In a credit market characterized by a priori asymmetric information, collateral not only can identify credit applicants but also can result in moral hazard involving the borrower's use of pledged assets. The borrower's other alternatives are to apply for unsecured bank credit and be priced as “average,” or to acquire financing by selling an asset and subsequently renting it for continued use. The optimal secured loan contract for higher quality firms is shown to involve overcollateralization. There is underinvestment relative to first best in maintenance of the pledged assets but overinvestment relative to the level that would be chosen without bank monitoring. Self-financing and unsecured credit are chosen by the intermediate and lowest quality groups, respectively.

Previous literature documents significant seasonalities in stock market returns. One explanation is seasonality in earnings information. If true, a return index comprised solely of firms reporting earnings should exhibit stronger intertemporal seasonalities than a return index comprised of firms not reporting earnings. Employing all New York and American Stock Exchange firms over six years, this study examines the seasonality of stock returns. Generally, seasonal patterns for reporting returns are found to be similar to or slightly weaker than for nonreporting returns. Thus, it is doubtful that earnings news seasonality induces stock return seasonality.

This paper examines the pricing of exchange-traded long-term corporate bond portfolios. Observable instruments measuring the term structure of interest rates, levels of bond and stock prices, and a January dummy are found to predict excess returns on corporate bonds. An intertemporal asset pricing model with changing expectations and unobservable factors is then estimated for the predictable excess returns using Hansen's Generalized Method of Moments. The results show that a multibeta linear time-vary ing model of conditional expected returns with constant betas can successfully value corporate bonds. Specifically, the tests indicate the presence of two time-varying hedge portfolios. The data, however, support a single latent variable specification when all January observations are excluded. This result suggests the existence of a strong January seasonal in one of the latent variables.

This paper provides empirical evidence that the quality option in T-bond futures is much less valuable than previously indicated. In addition, a dynamic trading strategy involving multiple switches of the cash bonds held in a long cash versus short futures position is shown to produce substantially greater profits than the single exercise of the quality option. These findings suggest that the optimal management of long cash/short futures positions is likely to involve dynamic trading strategies while passive strategies appear more appropriate for short cash/long futures positions. It is also shown that required variation margin payments are frequently large and may impact the profitability and risk of such positions to a greater extent than either of these options. Further, evidence is given indicating that observed T-bond futures prices reflect an imputed value for the options and risks inherent in such positions.

Most asset pricing models postulate a positive relationship between a stock portfolio's expected returns and risk, which is often modeled by the variance of the asset price. This paper uses GARCH in mean models to examine the relationship between mean returns on a stock portfolio and its conditional variance or standard deviation. After estimating a variety of models from daily and monthly portfolio return data, we conclude that any relationship between mean returns and own variance or standard deviation is weak. The results suggest that investors consider some other risk measure to be more important than the variance of portfolio returns.

Previous studies have found that positive abnormal stock returns are associated with corporate spin-offs and divestitures. Using a simplified model of the process of investor tax trading, we show that an improvement in the value of the tax-timing option component of securities prices is a likely contributing factor to those abnormal returns. The analysis indicates that the same phenomenon also may be part of the explanation for the generally higher returns observed for spin-offs than for divestitures, both when leverage is and is not present in the restructuring transactions.

Greenmail payments are widely viewed as actions designed by managers to perpetuate their tenure in office. This view, which suggests that greenmail prohibitions would enhance shareholder wealth, receives mixed empirical support in this paper. The average market reaction to charter amendments prohibiting greenmail payments is weakly negative, suggesting there is a value to maintaining managerial flexibility. Nonlinear maximum likelihood estimation, however, reveals a strong positive correlation between the market reaction and the firm's abnormal stock price runup over the three months just prior to the proxy mailing date. For the subsample of firms with a relatively large prior runup, the precommitment not to pay greenmail is value enhancing. If the prior runup reflects takeover rumors, then this evidence is consistent with the proposition that greenmail payments amidst takeover speculations are value decreasing.

This paper suggests a modification to the explicit finite difference method for valuing derivative securities. The modification ensures that, as smaller time intervals are considered, the calculated values of the derivative security converge to the solution of the underlying differential equation. It can be used to value any derivative security dependent on a single state variable and can be extended to deal with many derivative security pricing problems where there are several state variables. The paper illustrates the approach by using it to value bonds and bond options under two different interest rate processes.

An approximate method is developed for computing the values of European options on the maximum or the minimum of several assets. The method is very fast and is accurate for parameter ranges that are often of the most interest. The approach casts the problem in terms of order statistics and can be used to handle situations where the initial asset prices, the asset variances, and the covariances are all unequal. Numerical values are given to illustrate the accuracy of the method.

This paper generalizes the risk-return relationship implied by the traditional capital asset pricing model with finite investment horizons. It examines the effect of heterogeneous investment horizons on the functional form of capital asset pricing and proposes a translog model for estimating the risk-return relationship. In addition, this paper contends that some empirical findings that are inconsistent with the traditional CAPM have resulted from misspecification of the CAPM by ignoring the discrepancy between the observed data periods and the true investment horizons. Finally, the paper shows that under various conditions, the translog model is a suitable function for estimating the relationship between risk and expected returns.

This paper demonstrates that Black-Scholes option pricing model hedge positions that are risk free when rebalanced continuously will frequently exhibit substantial systematic risk when rebalanced at finite intervals. This systematic risk may have biased important empirical tests of the option pricing model. Moreover, this systematic risk means that the Black-Scholes option pricing model is inherently inconsistent with the discrete time version of the Capital Asset Pricing Model (CAPM).