optimal replication of contingent claims under portfolio constraints we determine the minimum cost of superreplicating a nonnegative contingent claim when there are convex constraints on portfolio weights we show that the optimal cost with constraints is equal to the price of a related claim without constraints the related claim is a dominating claim that is a claim whose payoffs are increased in an appropriate way relative to the original claim the results hold for a variety of options including some path dependent options constraints on the gamma of the replicating portfolio constraints on portfolio amounts and constraints on the number of shares are also considered article published by oxford university press on behalf of the society for financial studies in its journal the review of financial studies

tax policy and yardstick voting in flemish municipal elections recent theoretical papers develop political agency models in which voters compare tax policy with that in neighbouring jurisdictions in these yardstick competition models voters judge incumbents by comparing their policy with policy in neighbouring jurisdictions this paper reports an analysis of municipal elections in flanders during the period 1982 to 2000 and finds empirical evidence for yardstick voting incumbents are punished for higher tax rates importantly the electoral punishment also depends on tax rates in neighbouring municipalities higher rates in neighbouring municipalities are favourable for the incumbents

how efficient is the voting market it is by now well established that good macroeconomic conditions benefit the incumbent president and his congressional party confreres at the polls this result is not unanimous see for example stigler or arcelus and meltzer2 and may not be universal 3 however the basic results in kramer 4 the progenitor of the modern literature on the effect of economic conditions on elections seem to have stood the test of time the broad consensus of this literature is that voters in presidential and congressional elections 1 reward income growth and punish unemployment and inflation 2 probably give greater weight to income growth than to unemployment and inflation and 3 myopically ignore any information beyond the recent past say prior to the election year 5 so far however the data have outrun interpretation while economic conditions seem to matter we do not know why they matter or how plausibly to characterize the process by which voters translate information about economic conditions into voting decisions this article tries to fill that gap though it extends the empirical literature to gubernatorial elections its main con

changes in the financial market welfare and price effects and the basic theorems of value conservation this paper analyzes the impact on both welfare and equilibrium prices of changes in the financial market in a general equilibrium two period context previous papers have focussed on the securities effect tending to essentially ignore the equally important endowment effect that arises when market structure changes are implemented two forms of endowment neutrality and market structure changes which either preserve expand or shift allocational feasibility differentiate the main theorems which are based on arbitrary preferences and beliefs and substantially extend and modify extant results in particular earlier statements identified with value conservation are sharply moderated very roughly the paper yields the following implications for some of the more common changes in the market nonsynergistic corporate spinoffs and the opening of option markets have on balance strongly positive welfare effects nonsynergistic mergers tend to have strong negative welfare effects while the welfare effects of alternative risky debt structures tend to be ambiguous all of the preceding however may under plausible conditions be redistributive changes in the structure of the financial market have long been of interest to financial economists while such changes may take many forms it is perhaps surprising that only a few of the more common ones have been systematically studied foremost among these are changes which involve the firm s capital structure the relative amounts of debt and equity mergers and other special recapitalizations this paper analyzes the impact on both welfare and equilibrium prices of changes in the financial market in a two period context it differs from previous studies primarily in that it is based on a fully integrated general equilibrium approach similar to that employed in international trade analysis thus while the resulting mosaic contains previous studies as clearly recognizable fragments such as the classic paper of modigliani and miller 33 it also provides the necessary framework and tools for an evaluation of market structure changes of any type such as changes involving subordinated debt convertibles warrants mergers spinoffs and the opening of option markets

bond pricing and the term structure of interest rates a new methodology for contingent claims valuation this paper presents a unifying theory for valuing contingent claims under a stochastic term structure of interest rates the methodology based on the equivalent martingale measure technique takes as given an initial forward rate curve and a family of potential stochastic processee for its subsequent movements a no arbitrage condition restricts this family of processes yielding valuation formulae for interest rate sensitive contingent claims which do not explicitly depend on the market prices of risk examples are provided to illustrate the key results in relation to the term structure of interest rates arbitrage pricing theory has two purposes the first is to price all zero coupon default free bonds of varying maturities from a finite number of economic fundamentals called state variables the second is to price all interest rate sensitive contingent claims taking as given the prices of the zero coupon bonds this paper presents a general theory and a unifying framework for understanding arbitrage pricing theory in this context of which all existing arbitrage pricing models are special cases in particular vasicek 1977 brennan and schwartz 1979 langetieg 1980 ball and torous 1983 ho and lee 1986 schaefer and schwartz 1987 and artzner and delbaen 1988 the primary contribution of this paper however is a new methodology for solving the second problem i e the pricing of interest rate sensitive contingent claims given the prices of all zero coupon bonds the methodology is new because i it imposes its stochastic structure directly on the evolution of the forward rate curve ii it does not require an inversion of the term structure to eliminate the market prices of risk from contingent claim values and iii it has a stochastic spot rate process with multiple stochastic factors influencing the term structure the model can be used to consistently price and hedge all contingent claims american or european on the term structure and it is derived from necessary and more importantly sufficient conditions for the absence of arbitrage the arbitrage pricing models of vasicek 1977 brennan and schwartz 1979 langetieg 1980 and artzner and delbaen 1988 all require an iformerly titled bond pricing and the term structure of interest rates a new methodology

voters as fiscal conservatives voters penalize federal and state spending growth this is the central result of my analysis of voting behavior in presidential senatorial and gubernatorial elections from 1950 1988 the composition of federal spending growth seems irrelevant the vote loss to the president s party from an extra dollar of defense or nondefense spending is the same however in gubernatorial elections expansion of state welfare spending exacts a disproportionate political price deficit financing of federal or state spending does not appear to matter politically i conclude by discussing the obvious question of why government budgets have grown in the face of this voter hostility

the maximum entropy distribution of an asset inferred from option prices this paper describes the application ofthe principle of maximum entropy to the estimation of the distribution of an underlying asset from a set of option prices the resulting distri bution is least committal with respect to unknown or missing information and is hence the least prejudiced the maximum entropy distribution is the only information about the asset that can be inferred from the price data alone an extension to the principle of mini mum cross entropy allows the inclusion of prior knowledge of the asset distribution we show that the maximum entropy distribution is able to accurately fit a known density given simulated option prices at different strikes

spending cuts or tax increases the composition of fiscal adjustments as a signal abstract this paper shows that the composition of fiscal adjustments spending cuts versus tax increases serves as a signal of the government s degree of collusion with special interests the politico economic model of fiscal policies combining retrospective voting with common agency type lobbying presents undominated separating equilibria and intuitive pooling ones in both of which fiscal adjustments with sufficiently large spending cuts lead to incumbent reappointment whereas those with only tax increases lead to incumbent defeat these findings are consistent with the recent empirical evidence of voters behaving as fiscal conservatives the efficiency enhancing aspects of the signaling mechanism and the effects of imposing a deficit limit are also analyzed

a dynamic model of voter behavior and the demand for public goods among social groups in great britain abstract a dynamic model of voter behavior is discussed explaining transitions in party choice by imputed party responsibilities with respect to public and private consumption possibilities the model uses a group framework to explicitly describe voter interests it allows for an estimation of the relative preference for public goods as determined by the revealed preference mechanism of voting the model is compared to popularity functions in their general form an empirical application to great britain is presented it appears that retired individuals have the highest relative preferences for public goods followed by housewives men manual workers self employed and non manual workers

some results in the theory of arbitrage pricing this paper derives a stronger version of huberman s recent preference free pricing theorem this pricing result relates the expected return on an asset to its factor responses and the covariance structure of the residuals from a linear factor model it must characterize any infinite asset economy in which no arbitrage opportunities are present whether or not the factor model has uncorrelated residuals this result provides the intuition for the role of residual risk in the pricing model and eliminates some classes of arbitrage opportunities still present under huberman s bound some applications to empirical tests and performance measurement are also discussed the arbitrage pricing theory is one of several financial pricing models which attempts to explain the cross sectional variation in expected returns on assets in certain respects it is similar to the capital asset pricing model but there are both substantive and subtle differences one of the key advantages of the apt is that it derives a simple linear pricing relation approximating that in the capm without some of the latter s objectionable assumptions perhaps the key disadvantage of the apt is that it provides no clues as to what might be important factors nor as to how to interpret the factor premiums which appear in the pricing equation this paper serves several purposes after reviewing the linear factor model formulation in section i it derives in section ii a stronger version of huberman s 9 recent preference free pricing theorem this pricing result relates the expected return on an asset to its factor responses and the covariance structure of the residuals this relation must characterize any infinite asset economy in which no arbitrage opportunities are present whether or not a linear factor model with uncorrelated residuals is the appropriate returns generating mechanism section iii specializes this result by eliminating the effects of residual covariances and compares the results here to those of previous apt models when applied to the standard linear factor model with uncorrelated residuals this new pricing bound eliminates arbitrage opportunities which remain under huberman s bound this result also provides for the first time the intuition for the role of residual risk in the approximate pricing relation section v provides an interpretation of the factor premiums and gives a valid asset pricing model interpretation to the apt which is consistent with merton s

taxation and presidential approval separate effects from tax burden and tax structure turbulence previous research has established that taxation may impose significant electoral costs on politicians this literature however focuses exclusively on the effect of the tax burden in this paper we test the hypothesis that both the level of the tax burden and the change in the tax structure affect the us president s approval ratings over the 1959 2006 period our results support this proposition specifically we find a negative impact from the magnitudes of the tax burden and the deficit as well as from changes in the tax structure on presidential approval ratings

optimal security design how should new securities be designed traditional theories have little to say on this the literature on capital structure and general equilibrium theories with incomplete markets take the securities firms issue as exogenous this paper explicitly incorporates the transaction costs of issuing securities and develops a model where the instruments that are traded are chosen optimally and the economy s market structure is endogenous among other things it is shown that the firm s income stream should be split so that in every state all payoffs are allocated to the security held by the group that values them most this abstract was borrowed from another version of this item

the political economy of expenditures by the peruvian social fund foncodes 1991 95 the peruvian social fund foncodes was created by president alberto fujimori in 1991 with the stated objectives of generating employment alleviating poverty and improving access to social services this article uses province level data on monthly expenditures socioeconomic indicators and electoral outcomes to analyze political influences on the timing and geographic distribution of foncodes expenditures between 1991 and 1995 i reach three main conclusions first these expenditures increased significantly before national elections second foncodes projects were directed at provinces in which the marginal political effect of expenditures was likely to be largest third these projects favored the poorest provinces which suggests that the program also had a redistributive function the results are robust to a large number of specifications and controls the peruvian data support predictions made in the literature on political business cycles as well as the literature on political influences on the allocation of discretionary funds

factor analysis and arbitrage pricing in large asset economies abstract the paper develops a framework for factor analysis and arbitrage pricing in a large asset economy modeled as one with a continuum of assets it is shown that the assumptions of absence of arbitrage opportunities and that returns have a strict factor structure imply exact factor pricing for a full measure of assets interpreting finite subsets of assets as random draws from the underlying economy there is probability one that every asset in a finite sample is exactly factor priced it is further shown that approximate factor structures exist in general and that they can be chosen optimally according to a measure of their explanatory power factor structures in the present model are also robust to asset repackaging and to the use of proxies to approximate the true factors journal of economic literatureclassification numbers g1 g12 c14

arbitrage and diversification in a general equilibrium asset economy this paper presents a theory of equilibrium asset pricing that generalizes the recent work of connor the model extends connor s results to more general sets of asset returns and consumer preferences introduces production and provides a framework for analyzing exact and approximate equilibrium asset pricing the other major contribution of the paper is the introduction of geometric arguments that exploit the properties of induced prefer ences over assets this method of analyzing asset pricing provides an intuitively appealing way of analyzing equilibrium asset pricing theories unifies several well known asset pricing models this paper extends connor s finite asset model in a number of directions these extensions are nontrivial because they allow the theory to encompass asset pricing models that were excluded by connor s assumptions the second major contribution of the paper is to introduce a method of argument that exploits the geometric properties of induced preferences over assets and characterizes asset prices using these proper ties this technique provides an intuitively appealing way of analyzing asset pricing theories for a simple geometric exposition of the main ideas in this paper see milne 1987 0 2 to place this paper in the context of the literature it is important to appreciate the development of asset pricing models over the last two decades the first and perhaps the most famous asset pricing model is the capital asset pricing model capm developed by sharpe 1964 and lintner 1965 the model demonstrated a striking result assuming i consumers characterize portfolios in terms of the means and variance of rates of return ii there exists a risk free asset and iii asset market equilibrium then any asset s expected rate of return could be written as a linear function of the riskless interest rate and the expected rate of return on the endowment of risky assets the so called market portfolio the original capm result was derived from a one period model but merton 1973 showed that in a continuous time model where returns could be char acterized by a diffusion process the same mean variance argument could be applied to obtain the capm formula it was well known that if consumers had von neumann morgenstern prefer ences then either quadratic utility and or multivariate normality of returns were

the political costs of taxes and government spending the marginal political costs of different types of taxes and government spending as well as voter preferences over different fiscal variables are examined using two different specifications for political cost one based on the probability of incumbent defeat and the other based on the incumbent s percentage of the vote models associated with these two specifications in which voting behaviour depends on disaggregated taxes and government expenditures are estimated using clata from canadian provincial elections the empirical results which indicate that different types of taxes and expenditures have quite different marginal political costs have important implications for models that incorporate voter pref erences

cost sharing versus block funding in a federal system a demand systems approach this paper employs a maximizing framework consistent with the axioms of consumer preference to analyze local government s choice of spending on different social services within this framework it is possible to include both block funding and cost sharing intergovernment transfer schemes canada s movement to block funding from the cost sharing method of financing provincial expenditures on hospitals medical care and post secondary education is analyzed the results indicate that the provincial governments actions are generally consistent with a significant maximizing model of consumer behavior and that the change to block funding had a significant impact on real provincial funding of some previously cost shared social services

privatization and the british electorate microeconomic policies macroeconomic evaluations and party support despite much scholarly research on the link between macroeconomic evaluations and political behavior relatively little is known about the influence of government economic policy on this process margaret thatcher s recent sales of public assets privatization in britain provide a unique opportunity to examine the link between microeconomic activity measured by privatization macroeconomic evaluations and voting by applying multivariate analysis to data collected during the 1983 and 1987 general elections we show that privatization measured by share purchases and council house ownership stimulates positive judgments about the country s economy however the effect of privatization on the vote is almost entirely indirect via these retrospective judgments about the economy while privatization has undoubtedly benefited the conservatives electorally the evidence on council house purchases suggests that the impact may be temporary

on the theory of inflation and optimal investment policy equilibrium considerations the increase in the rate of inflation in recent years has brought forth a variety of articles concerning the effects of inflation on investment and valuation under conditions of equilibrium numerous authors 2 3 5 9 10 11 12 16 20 have derived an asset pricing model with uncertain inflation nelson 18 and kim 15 have analyzed the effects of inflation on the optimal level of investment in the capital budgeting process nelson under the assumption of perfect net operating income sensitivity states it is clear that the optimal investment will be smaller the higher the anticipated rate of inflation this result also is demonstrated to be a special case of kim s analysis while nelson and kim make important contributions their work should be extended under conditions of equilibrium chen 4 recognizing the need for an equilibrium framework has applied the asset pricing model to examination of optimal investment policy by utilizing the jensen long 15 methodology in a world of uncertain inflation the jensen long methodology is not without controversy james 13 has recently argued extending fama s 8 critique that the capital asset pricing model is inappropriate for analysis without the assumption of a perfectly competitive capital market whereas an imperfectly competitive capital market is explicit in the jensen long methodology on the other hand a competitive capital market

economic performance voting and political support a unified approach a presidential vote function and a presidential approval ratings function are jointly estimated for u s postwar observations the estimation technique treats the two equations as seemingly unrelated regressions with unequal numbers of observations cross equation restrictions implying that voters and poll respondents use identical standards in judging the economic performance of incumbents are imposed and tested estimates show that both votes and approval ratings are influenced by gnp growth and inflation the results suggest that poll respondents are more inflation averse than voters however tests of this hypothesis are not conclusive copyright 1990 by mit press

pyramidal groups and debt abstract this paper suggests that debt should be raised by subsidiaries in order to exploit the limited liability of the holding company however when this behavior increases the cost of funds the holding might prefer to raise debt to a point where it would also default when subsidiaries are insolvent after accounting for standard controls we find that holding companies in italian pyramids have higher leverage than subsidiaries and that the cash flow share of the entrepreneur in the subsidiary does not play a significant role these findings are consistent with the implications of our model of group capital structure

pricing and hedging in incomplete markets abstract we present a new approach for positioning pricing and hedging in incomplete markets that bridges standard arbitrage pricing and expected utility maximization our approach for determining whether an investor should undertake a particular position involves specifying a set of probability measures and associated floors which expected payoffs must exceed in order for the investor to consider the hedged and financed investment to be acceptable by assuming that the liquid assets are priced so that each portfolio of assets has negative expected return under at least one measure we derive a counterpart to the first fundamental theorem of asset pricing we also derive a counterpart to the second fundamental theorem which leads to unique derivative security pricing and hedging even though markets are incomplete for products that are not spanned by the liquid assets of the economy we show how our methodology provides more realistic bid ask spreads

bankruptcy limited liability and the modigliani miller theorem this paper examines the validity of the modigliani miller theorem in the presence of bankruptcy the theorem asserts that the value of a firm and the set of return patterns that the capital markets offer to private investors are independent of firm debt equity ratios the usual proof of the theorem is based on the presumption that in perfect capital markets borrowing by firms and borrowing by individuals can be perfect substitutes it is unclear whether this presumption is valid when there is a positive probability that either the firm or the individual who borrows to invest in the firm goes bankrupt on the one hand joseph stiglitz 1969 and robert merton have argued that the modigliani miller theorem remains valid even with bankruptcy if agents who borrow to invest in a firm can limit their liability to the amount of collateral they put up on the other hand vernon smith 1972 has argued that a margin loan which is secured by a pure equity collateral has a different return pattern from a direct loan to the firm and cannot serve as a substitute for the latter see also david baron smith s argument raises a number of issues first it brings out the important fact that return patterns for limited liability borrowing and lending depend on the composition of the portfolio that serves as collateral if a firm goes bankrupt a pure equity collateral is worthless whereas a collateral that contains some bonds may still earn a positive return because the bonds have a privileged claim to the firm s remaining assets in general margin contracts with different collateral compositions will generate different return patterns both for the borrower and the lender given this multiplicity of return patterns on margin loans one would not expect that all margin loans can be used as substitutes for direct loans to the firm this intuition is confirmed by smith s demonstration that a particular margin loan namely the loan on pure equity collateral cannot serve this purpose the question remains open whether this is actually needed for the modiglianimiller theorem it might be enough if some appropriate margin loan could be used as a substitute for lending to the firm in pursuing this problem one finds a gap in the standard proof of the modiglianimiller theorem usually one applies an arbitrage argument to show that as a firm changes its debt equity ratio investors in shares and bonds adjust their portfolios so as to leave their overall return patterns unchanged no such arguments are given for other securities related to the firm in particular for margin investments and for margin loans that serve to finance those margin investments without an analysis of professor of economics university of bonn research on this paper was supported by nsf grant soc 75 13437 at princeton university and by the deutsche forschungsgemeinschaft i have benefited from the advice of dwight jaffee and an anonymous referee in a similar vein stiglitz 1972 asserts the value of the firm decregses because there is a divergence in the estimation of the chances of bankruptcy between the lender and the borrower p 467 this analysis rests upon a form of market segmentation that is without economic merit in his model there are two groups of agents optimists and pessimists the optimists invest all their wealth in the firm s equity valued to make the rate of return equal to that on the riskless asset the pessimists are indifferent between the risky firm s bonds and the riskless asset it follows that the optimists being more optimistic than the pessimists must prefer the risky bond to the riskless asset and hence to the equity yet stiglitz assumes that the optimists invest in the equity and not in the risky bond of course if one group invests all its wealth into one asset that asset need not satisfy a marginal equality condition at all a correct analysis of his model leads to the results of this paper

a positive model of tax structure the model of tax structure developed in this paper is one in which the composition of revenues and the structure of specific taxes arise naturally as the result of self interested political behavior it is assumed that political agents choose tax structure so as to minimize the political costs or expected net loss in votes associated with raising a budget of given size several hypotheses concerning the nature of political cost functions are developed and applied to an explanation of the differences among u s states in their reliance on income taxation the empirical application emphasizes differences in political constraints across jurisdictions in the belief that much can be learned about the choice of policy instruments by studying structural adjustments in response to varying constraints the paper discusses how the proposed approach differs from or is consistent with that adopted by other authors and how the estimating equation relates to other empirical research in the literature

revealed preferences for public goods applying a model of voter behavior most analyses of preferences for government supplied goods disregard the fact that in a democratic society these preferences are revealed by an individual choice the vote in this paper this is taken account of in a model explaining the dynamics in voting behavior in a multi party system the model assumes that voters may be categorized into k groups of individuals pursuing the same interests who remember how parties do in representing these interests given the level to which they are held responsible for government policy the model allows one to estimate party identification sensitiveness to economic performances time preference and relative preferences for public versus private goods all for each of the groups furthermore the model allows for an estimation of the level to which various parties are held responsible for government policies

monitored financial equilibria abstract the financial monitoring system is formalized as an economic primitive in addition to preferences endowments production sets and asset spans new definitions of budget constraints and economic equilibria follow the concept of a general equilibrium is then appropriately revised to accommodate this perspective on the role of a financial monitoring system implications for asset pricing are derived and the relationship of equilibria to risk management considerations is discussed

factor pricing in a finite economy abstract prior theoretical derivations of the arbitrage pricing theory apt bound an aggregate measure of the deviation of mean asset returns from that predicted by a linear pricing equation it is conceivable given this bound that some assets might be badly mispriced by the model in this paper a more intuitive derivation of the factor pricing equation is presented which describes the deviation on an asset by asset basis the deviation is shown to be small for assets in a realistic finite economy and is arbitrarily close to zero for those assets with arbitrarily small size relative to aggregate wealth it follows that the linear pricing equation provides a good approximation for the mean returns of all traded assets

the relevance of financial policy when the asset market is incomplete equilibrium allocations are not invariant to changes in the financial policies of firms in the presence of secondary assets such as options whose payoffs depend nonlinearly on the price of equity the range of attainable reallocations of revenue varies as a firm alters its position in the asset market corporate financial policy is thus relevant when assets are nominal monetary policy implemented through open market operations is also effective

gain loss and asset pricing we develop an approach to asset pricing in incomplete markets that bridges the gap between the two fundamental approaches in finance model based pricing and pricing by no arbitrage we strengthen the absence of arbtrage assumption by precluding investment opportunities whose attractiveness to a benchmark investor exceeds a specified threshold in our framework the attractiveness of an investment opportunity is measured by the gain loss ratio we show that a restriction on the maximum gain loss ratio is equivalent to a restriction on the ratio of the maximum to minimum values of the pricing kernel by limiting the maximum gainloss ratio we can restrict the admissible set of pricing kernels which in turn allows us to restrict the set of prices that can be assigned to assets we illustrate our methodology by computing price bounds for call options in a black scholes economy without intermediate trading when we vary the maximum permitted gainloss ratio these bounds can range from the exact prices implie

coping with collapse a stock flow consistent monetary macrodynamics of global warming abstract this paper presents a macroeconomic model that combines the economic impact of climate change with the pivotal role of private debt using a stock flow consistent approach based on the lotka volterra logic we couple its nonlinear monetary dynamics of underemployment and income distribution with abatement costs a calibration of our model at the scale of the world economy enables us to simulate various planetary scenarios our findings are threefold 1 the 2 c target is already out of reach absent negative emissions 2 the long term resp short term results of climate change on economic fundamentals may lead to severe economic consequences without the implementation resp in case of too rapid an application of proactive climate policies global warming resp too fast transition forces the private sector to leverage in order to compensate for output and capital losses resp to lower carbon emissions thus endangering financial stability 3 implementing an adequate carbon price trajectory as well as increasing the wage share fostering employment and reducing private debt make it easier to avoid unintended degrowth and to reach a 2 5 c target

economic and political foundations of tax structure this paper derives the essential elements of tax systems as the outcome of rational behavior in a model w here government maximizes expected support and where opposition to ta xation depends on the loss in full income the analysis treats the le vel of expenditures as endogenous and integrates the influence of adm inistration costs with that of political and economic factors tax st ructure is shown to be a system of related components in equilibrium a final section compares results to two alternative approaches opti mal taxation and the leviathan model copyright 1988 by american economic association

expected gain loss pricing and hedging of contingent claims in incomplete markets by linear programming abstract we analyze the problem of pricing and hedging contingent claims in the multi period discrete time discrete state case using the concept of a gain loss ratio opportunity pricing results somewhat different from but reminiscent of the arbitrage pricing theorems of mathematical finance are obtained our analysis provides tighter price bounds on the contingent claim in an incomplete market which may converge to a unique price for a specific value of a gain loss preference parameter imposed by the market while the hedging policies may be different for different sides of the same trade the results are obtained in the simpler framework of stochastic linear programming in a multi period setting and have the appealing feature of being very simple to derive and to articulate even for the non specialist they also extend to markets with transaction costs

a unified beta pricing theory abstract this paper derives ross s mutual fund separation theory and a new equilibrium version of ross s arbitrage pricing theory as special cases of a general theory the paper also reveals that the two theories are identical in their predictions of asset prices and portfolio returns the capital asset pricing model a restricted case of the mutual fund separation theory receives special treatment

optimal capital structure and project financing abstract we examine the financing and incorporation modes for new projects there are two objectives the first is to provide a theory of optimal capital structure that links risk leverage and value and is particularly applicable to large firms counter to conventional wisdom we show riskier firms acquire more debt pay higher interest rates and have higher values in equilibrium second we provide an economic rationale for project financing which entails organizing a new project legally distinct from the firm s other assets we explain why project financing involves higher leverage than conventional financing and why highly risky assets are project financed

the arbitrage pricing theory and supershares in a single period model with options on the market portfolio linear factor pricing holds if and only if the variance of the market conditional on the factors is zero there is no need for factors other than nonlinear functions of the market for accurate linear pricing of all payoff patterns the factors must be rotationally equivalent to hakansson s supershares in a multiperiod model a similar set of results holds but with consumption replacing the market payoff the methodology of the empirical arbitrage pricing theory literature is not consistent with either the single period model or the multiperiod model linear factor models have been used extensively to analyze security returns predominantly by researchers working with the arbitrage pricing theory apt paradigm 1 a coherent theoretical framework is of course crucial to give direction and interpretation to empirical work as well as to guide applications this paper presents some new basic theoretical results on factor models and security pricing in a single period model with market index options even though the sharpe lintner capm may not hold the market portfolio plays such a central role in pricing that the following condition is necessary and sufficient for a vector of factors to give linear pricing the variance of the market return conditional on the factors must be zero that is the factors must determine the market furthermore there is no need for factors other than potentially nonlinear functions of the market return nonmarket risk in a factor can be eliminated with virtually no loss of linear pricing accuracy in order to get linear pricing of all assets in a complete market the factors must be rotationally equivalent to hakansson s 1977 1978 supershares in an intertemporal model a similar set of results holds with consumption replacing the market return as the pivotal variable for pricing all securities these results are used to highlight some limitations of the existing theoretical apt literature as an interpretive foundation for apt empirical work it is argued that the empirical work is consequently somewhat misdirected so recommendations for redirection are made at the end of the paper section i discusses single period apt models and introduces a completemarkets model six theorems are derived which indicate that the potential role

collateralized borrowing and risk taking at low interest rates abstract empirical evidence suggests financial intermediaries increase risky investments when interest rates are low we develop a model consistent with this observation and ask whether the risks undertaken exceed the social optimum interest rate policy affects risk taking in the model through two opposing channels first low policy rates make riskier assets more attractive than safe bonds second low policy rates reduce the amount of safe bonds available for collateralized borrowing in interbank markets the calibrated model features excessive risk taking at the optimal policy however at low policy rates collateral constraints tighten and risk taking does not exceed the social optimum

partisan cycles in congressional elections and the macroeconomy in the postwar united states the president s party has always done worse in the midterm congressional elections than in the previous congressional election republican administrations exhibit below average and democratic administrations above average economic growth in the first half of each term whereas in the latter halves the two see equal growth our rational expectations model is consistent with these two regularities in presidential elections voters choose between two polarized candidates they then use midterm elections to counterbalance the president s policies by strengthening the opposition in congress since presidents of different parties are associated with different policies our model predicts a spurious correlation between the state of the economy and elections our predictions contrast with those of retrospective voting models in which voters reward the incumbent if the economy is doing well before the election our model performs empirically at least as well as and often better than alternative models

diversification and equilibrium in securities markets abstract diversification is the strategy of investing small fractions of wealth in each of a large number of securities and thereby reducing risk the basic argument in support of diversification is an appeal to the law of large numbers a portfolio in which an investor s wealth is invested in equal fractions in each ofnsecurities with i i d returns has a return that converges to a riskless return asnincreases indefinitely any risk averse investor would prefer the limit riskless return to the return of any portfolio in this paper we use the space ba of all finitely additive signed measures on the set of natural numbers the index set for securities to model the set of portfolios from which an investor may choose this portfolio space contains arbitrary finite portfolios and a nontrivial portfolio which is the limit of the sequence of portfolios having the fraction of wealth 1 ninvested in each ofnsecurities we identify a class of portfolios which we call perfectly diversified these portfolios are described by purely finite additive measures in a perfectly diversified portfolio wealth invested in each individual security is a negligible fraction of the total wealth of the portfolio we show that the return of every perfectly diversified portfolio of securities with uncorrelated returns is riskless it is shown that modeling of the portfolio space as the space ba makes possible a rigorous derivation of a general equilibrium version of the arbitrage pricing theorem apt the apt provides a good illustration of the implications of diversification for equilibrium prices of securities journal of economic literatureclassification numbers d52 g20

incremental risk aversion and diversification preference abstract the class of mean independent incremental risks defined with respect to an initial risk or status quo is shown to coincide with the vector space of incremental risks generated from risks that are individually independent of the status quo using this characterization of mean independence aversion toward independent risk increases together with diversification preference for mean independent risk increases implies aversion toward mean independent risk increases by contrast a nondiversifier who is averse to independent risk increases may nonetheless strictly prefer certain mean preserving increases in risk journal of economic literature classification numbers d80 d81

a simple nonparametric approach to derivative security valuation canonical valuation uses historical time series to predict the probability distribution of the discounted value of primary assets discounted prices plus accumulated dividends at any future date then the axiomatically rationalized maximum entropy principle is used to estimate risk neutral equivalent martingale probabilities that correctly price the primary assets as well as any predesignated subset of derivative securities whose payoffs occur at this date valuation of other derivative securities proceeds by calculation of its discounted risk neutral expected value both simulation and empirical evidence suggest that canonical valuation has merit since the advent of the justly celebrated black scholes option pricing formula intense interest has focused on testing its implications there is consensus

optimal replication of options with transactions costs and trading restrictions this paper analyzes the strategy that minimizes the initial cost of replicating a contingent claim in a market with transactions costs and trading constraints the linear programming and two stage backward recursive models developed are applicable to the replication of convex as well as nonconvex payoffs and to a portfolio of options with different maturities the paper s formulation conveniently accounts for fixed and variable transactions costs lot size constraints and position limits on trading the article shows that in the presence of trading frictions it is no longer optimal to revise one s portfolio in each period at the optimum cash flows in excess of the desired ones may be generated the optimal policy trades off the curvature of the payoff that is generated against the terminal slack

revealed preference for public goods the most serious problem for the modern theory of optimal public expenditure is that although it has to be based on some social welfare function individual preferences for public goods which constitute the elements of any individualistic social welfare function are hard to assess it is argued that since every individual can freely participate in the consumption of a public good there is an incentive for him to either underreport or overreport his preferences depending on how the reported preferences are used in the financing process of the public good i this argument will be correct if an individual s preferences for public goods can be expressed only directly in many cases however the consumption of a public good has some technical or objective relationship with the consumption of some private goods thus the benefit an individual derives from free highways depends on how much he spends on a car and gasoline even the benefit an individual derives from the judicial system depends on how much he spends to hire the services of lawyers also an individual can enjoy the same security police provide by hiring private guards and installing locks and so on in these cases if we know the technical relationships between the consumption of private goods and the consumption of public goods then from the market data relating the amounts of private goods bought to prices and the data on the existing amounts of public goods we might be able to infer i the amounts of final goods consumed say the number of trips from one point to another the degree of justice the security from robbery etc and ii their opportunity costs which the individual was willing to pay but if we succeed in this inference then all that remains to be done in order to find the individual s utility function will be to integrate back the relationship between the amounts of final goods consumed and their opportunity costs a trivial example can be provided by assuming that each public good is perfectly substitutable with a private good let yi be the quantity of the ith public good and xi be the quantity of a private good which is a perfect substitute for the ith public good then the benefit derived from the ith public good and its perfect substitute can be measured by xi yi suppose we have ascertained an individual consumer s demand functions for private good when all the yi are zero we know from the revealed preference theory that if these demand functions satisfy a certain condition namely the symmetry of the slutsky matrix then there exists a utility function unique up to a monotone transformation

the effects of campaign spending in house elections new evidence for old arguments the question of how campaign spending affects election results remains open because the simultaneity problem has proven so intractable green and krasno s 1988 recent attempt to solve the problem and to demonstrate that marginal returns on spending are as great for incumbents as for challengers again comes up short a panel feature of the abc newslwashington post congressional district poll conducted during the 1986 elections offers a fresh perspective on the question analysis of changes in voting intentions during the final six weeks of the campaign shows that as the tainted ols studies have invariably suggested the amount spent by the challenger is far more important in accounting for voter s decisions than is the amount spent by the incumbent

spanning and completeness in markets with contingent claims abstract we characterize financial markets that are complete or that contain portfolios which span all measurable functions of a particular asset payoffs either finite and infinite dimensional these results are then employed to describe the extent to which options trading is sufficient to complete markets to investigate the existence of efficient funds and to establish the extent of market completeness required to ensure the unanimity and irrelevance results of modern corporation finance

an explicit bound on individual assets deviations from apt pricing in a finite economy abstract ross s arbitrage pricing theory apt is a tractible and reasonable alternative to the mean variance model nonetheless understanding of the theory has been obscured by the complexity of the sequence economy models used for motivation by contrast we give a simple and direct derivation of the apt in a finite economy using an explicit bound on the deviations from apt prices across assets a coarse calculation shows that theoretical deviations from apt pricing are negligible in our economy

the rationality of economic voting and the macroeconomic regime since voter rationality plays a major role in theories of political economics it is important for political analysts to investigate the extent of voter sophistication a conventional strategy for addressing this question is to determine what decision rule voters appear to use by estimating rival political support models that embody varying assumptions about voter rationality however under some circumstances such a strategy may be incapable of identifying the descriptively superior model due to an observational equivalence problem the paper estimates the competing political support models under alternative macroeconomic regimes and finds evidence favoring the nonrationalist or adaptive model

general equilibrium pricing of options on the market portfolio with discontinuous returns when the price process for a long lived asset is of a mixed jump diffusion type pricing of options on that asset by arbitrage is not possible if trading is allowed only in the underlaying asset and a risk less bond using a general equilibrium framework we derive and analyze option prices when the underlying asset is the market portfolio with discontinuous returns the premium for the risk of jumps and the diffusion risks forms a significant part of the prices of the options in this economy an attempted replication of call and put options by the black scholes type of trading strategies may require substantial infusion of funds when jumps occur we study the cost and risk implications of such dynamic hedging plans article published by oxford university press on behalf of the society for financial studies in its journal the review of financial studies

risk premia and the sources of inflation the process of inflation is associated not only with a rising general price level but also with uncertainty about its rate of change it is the latter aspect of inflation that may give rise to risk premia on nominal assets as compared with a real safe asset a possible framework for analyzing the structure of risk premia under inflationary conditions is the well known capital asset pricing model capm developed by sharpe and lintner indeed a number of papers have recently dealt with these risk premia by means of the capm framework or some close variety of it we may mention the works of roll 9 sarnat 10 fischer 4 chen and boness 1 and friend landskroner and losq 5 1 the capm and its extentions to conditions of inflation use a microeconomic approach in a partial equilibrium analysis of the risk premia a basic feature of the foregoing literature is the implicit treatment of inflation as exogenous alternatively there is no theory to relate the real return on money to be denoted 7r to the other variables in the capm formulation this leads to two important shortcomings first the covariance of 7r with the rates of return appears as completely arbitrary second since x was considered as exogenous the authors did not consider the need to include in their models the government s nominal transfer pay

an extension of the modigliani miller theorem to stochastic economies with incomplete markets and interdependent securities the modigliani miller theorem is shown to hold in a general model of a multiperiod stochastic economy with incomplete markets and perfect foresight in the model firms are allowed to trade all available securities thus share prices and dividends become fully interdependent also several mechanisms of corporate control are considered including value maximization and shareholder voting it is demonstrated that firms have no incentive to trade securities in equilibrium further any such trading does not alter the set of equilibrium allocations this is done by establishing that agents are able to adjust their own portfolios and neutralize corporate policy journal of economic literature classification numbers 021 022 this paper extends the modigliani miller argument on the irrelevance of corporate financial policy to an economy with incomplete markets and fully interdependent securities the approach taken is a general equilibrium model incorporating multiple periods and uncertain states the market is idealized in that there are no transaction costs short sales restrictions or limited liability constraints also agents are assumed to have fully rational expectations regarding future events within this context it is shown that value maximizing firms have no incentive to change the composition of their portfolios and that any such changes have no effect on equilibrium prices and allocations within the economy finally the theory is shown to

beyond arbitrage good deal asset price bounds in incomplete markets one often wants to value a risky payoff by reference to prices of other assets rather than by exploiting full fledged economic models however this approach breaks down if one cannot find a perfect replicating portfolio we impose weak economic restriction to derive usefully tight bounds on asset prices in this situation the bounds assume that investors would want to buy assets with high sharpe ratios good deals as well as pure arbitrage opportunities we show how to calculate the price bounds in one period multiperiod and continuous time contexts we show that the multiperiod problem can be solved recursively as a sequence of one period problems we calculate bounds in option pricing examples including infrequent trading and an option written on a nontraded event and we use the bounds to explore the economic significance of option pricing predictions we find that much variation in s p 500 index option prices over time and across strike prices fits within the bounds

pension plan funding technology choice and the equity risk premium in this paper the impact of lazear contracts with defined benefit pensions on aggregate technology composition and the aggregate risk premium is examined in the presence of capital market constraints affecting workers defined benefit pensions bias the economy towards risk free production leveraging the risky technology relaxes the constraints and results in more risky production and a fall in the aggregate risk premium this effect holds with risky debt and low pension shortfall risk but breaks down with high pension shortfall risk a key prediction is that as lazear contracts become less common risky production will increase and the aggregate risk premium will fall

arbitrage pricing and the stochastic inflation tax in a multisector monetary economy abstract a dynamic general equilibrium multifactor asset pricing model for a monetary economy with capital accumulation and multisector production is constructed equilibrium clower constraints on some investment goods and some consumption goods are imposed an equilibrium apt model is constructed where the covariance between the inflation tax distorted equilibrium investment returns and fundamental forcing processes are important in determining equilibrium risk prices the model is used to address issues concerning the relative importance of real and nominal factors in asset pricing raised in recent papers by chen roll and ross 1986 and cochrane 1991 1992

contingent claims personal loans and the irrelevance of corporate financial structure the modigliani miller m m theorem asserts that in the absence of transaction costs taxes and the possibility of bankruptcy firms market values are independent of their choice of debt equity ratio capital structure the present paper examines the validity of the theorem in a world with bankruptcy this problem has received a lot of attention in the financial economics literature stiglitz and others have noted that in the absence of arrow debreu complete markets or special structures like the capital asset pricing model the theorem may fail the failure occurs because simple portfolio strategies of holding equity common stock of an unlevered firm and default free bonds cannot replicate the return patterns of equity and bonds in a levered firm with limited liability merton i974 i977 used the black scholes i973 option pricing theory to reinstate the validity of the m m theorem even when there is the possibility of bankruptcy however he assumed that borrowing on personal account for security purchase margin loans is default free the principle result of the present paper is to show using the same type of analysis as merton that if individuals can borrow on personal account and create the same limited liability arrangements and the same protective covenants in loan contracts as corporations the m m theorem is valid this result is proved in a multi period context with continuous trading the implications of the possibility of default on short sales are also examined the details of contracts required to replicate the return patterns which corporate leverage creates are set out moral hazard protective covenants and agency problems associated with these contracts are discussed at the end of the paper the analysis in the paper uses the black scholes option pricing theory an important insight of their work is the analogy between certain corporate liabilities and traded options they illustrate the close similarity between a european call option and equity in a levered firm a european call option is the right to buy a particular share at some date the exercise date at a particular price the exercise price the holder will exercise the option if at the exercise date the share is trading at a price above the exercise price equity in a levered firm is the option to buy the firm back from the bondholders if the value of the firm exceeds the face value of the bondholders claim when the bonds mature otherwise given limited liability shareholders will default and the bondholders take over the firm the attractiveness of option pricing analysis is that it does not

pricing interest rate derivative securities this article shows that the one state variableinterest rate models of vasicek 1977 and cox ingersoll and ross 1985b can be extended sothat they are consistent with both the current termstructure of interest rates and either the currentvolatilities of all spot interest rates or the currentvolatilities of all forward interest rates theextended vasicek model is shown to be very tracta ble analytically the article compares option pricesobtained using the extended vasicek model withthose obtained using a number of other models