This paper makes contributions in two directions. First, the paper presents a model in which value-maximizing firms pursue active hedging policies. Second, the paper derives optimal hedging policies for risk-averse agents. Whereas the methodology used and the results provided are quite general, this paper deliberately focuses the analysis on hedging foreign exchange exposure through forward contracts on foreign currencies. This emphasis is explained by the fact that hedging foreign currency exposure through forward contracts has been a topic of considerable interest in recent years.

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.

The purpose of this paper is to analyze the errors made by professional forecasters (analysts) in estimating earnings per share for a large number of firms over a number of years. We have demonstrated in a previous paper that consensus (average) estimates of earnings per share play a key role in share price determination. In this paper, we examine consensus estimates with respect to the following questions: (1) What is the size and pattern of analysts' errors? (2) What is the source of errors? (3) Are some firms more difficult to predict than others? (4) Is there an association between errors in forecasts and divergence of analysts' estimates?

The purpose of this study is to extend the analysis of estimation of the term structure. The ability of the exponential/polynomial present-value function of equation (5) to approximate the theoretical present-value function is analyzed empirically. This study confirms previous results that indicate that the function does not provide an acceptable fit using least squares regression. In most samples, the near end of the estimated term structure appears substantially in error. Lengthening the polynomial tends to improve the fit only at the far end. Since the data appear to be subject to maturity-related heteroschedasticity, we have generalized the disturbance variance specification to allow for this possibility.

Our correction permits determination of sample-specific degrees of heteroschedasticity. The reason is that the intensity of the heteroschedasticity appears to change from period to period. Although previous studies have attempted heteroschedasticity corrections (see [4]), the same specification was imposed on each sample in such studies. Maximum likelihood estimation was proposed and implemented in this paper. The results indicate that the difficulties of providing a good fit using the exponential/polynomial function are substantially eliminated.

Recent literature regarding term structure estimation emphasizes the selection of more sophisticated estimating functions to provide a reasonable fit throughout the entire maturity range. This study emphasizes more careful modeling of the pricing disturbances. The prior approach involves somewhat complicated estimating functions and a potential loss of efficiency due to the lack of influence that each portion of the term structure is able to exert on other portions (with spline functions, for example.) Our maximum likelihood approach is somewhat difficult to implement and computationally burdensome. Nevertheless, it appears to provide a useful term structure estimation procedure.

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 interest rate term structure refers to the array of discount rates on a collection of pure discount bonds that differ one from another only by the timing of their redemption. The most common approximation to the term structure is, of course, the yield to maturity curve, which is usually depicted as a smooth curve that relates rates of return on such bonds held to maturity to their term to maturity. Other expressions of the term structure also could be constructed, but underlying them all is the discount or present value function that we may denote δ(t). δ is the discount applied to a unitary payment to be made t periods hence. Expressing the term structure in this way does not necessarily imply that the term structure is itself driven by t, payment timings. Most economists would generally agree, however, that it is possible to draw smooth discount curves over the time axis. It is necessary to assume only that yield curves are continuous and smooth. By resort to arbitrage arguments implicit in equilibrium theories of the term structure, many economists are willing to live with these assumptions.

This paper demonstrates the strong linkages that exist between currency risk, represented by inflation risk and exchange rate changes, and relative price risk. These linkages affect the optional quantities of forward exchange contracts, nominal debt, and fixed price sales (purchase) contracts to use in hedging against these risks. It is shown that the existence of as many hedging mechanisms as there are forms of price risk allows for the precise targeting of specific price risks with specific hedging instruments. Moreover, even though each hedging mechanism specializes in protecting against a particular form of price risk, the optimal quantitiy of each influences and is influenced by the optimal quantities of the others.

The group of issues that falls under the heading of bank capital adequacy has received a great deal of attention from academics, regulators, and bankers in recent years and is likely to continue as a subject for debate for many years to come. Although the traditional questions debated in the literature on capital adequacy are important and remain unresolved, this paper is not directed at them. Instead, the approach here is to examine how bank regulators operating within the existing legal structure of regulation can pursue optimal policies with respect to the regulation of bank capital.

One of the main principles of corporate finance is that managers should maximize the market value of the outstanding securities. While it is realized that managers and security holders may have divergent objectives, it is generally assumed that various market forces keep managerial and shareholders' goals in line. Out of the extensive literature on this issue, three such market forces emerge. First, non-value-maximizing firms are prime targets for take-over bids (e.g., see [14]): bidding firms could acquire control over the shares of the target firm, replace the management, follow a value-maximizing strategy, and realize a profit from the resulting appeciation of the target shares. Second, outside shareholders may charge managers-owners ex ante by discounting stock prices for expected managerial expropriation, which may induce managers to accept various restrictions on their behavior (e.g., see [11]). Third, shareholders may charge managers ex post, indirectly via the discipline imposed by a competitive managerial labor market (e.g., [8]). Note the difference from the previous mechanism: Jensen and Meckling [11] assume that managerial wages are fixed so that all the adjustment for expected expropriation is reflected in stock prices (and, ultimately, in costly monitoring and bonding devices). In Fama's [8] model, all the adjustment occurs in the managerial labor market, so that the value of the firm remains unaffected by expected managerial expropriation.

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.

This paper provided a pure financial explanation for the existence of trade credit and for the values of the credit terms offered to customers. Two motives for extending trade credit were identified. The pure operating flexibility motive arises because the opportunity to change credit policy provides the seller an efficient way to respond to fluctuations in demand. This motive was eliminated from consideration in this paper by assuming constant demand. The seller must hold a liquid reserve when the financial markets are imperfect and the desire to earn an excess rate of return on this reserve explains the pure financial intermediary motive for trade credit.

The pure financial incentive to lend this liquid reserve to customers was examined by viewing a market borrowing rate of interest that exceeds the market lending rate of interest as a hindrance to trade or, equivalently, as a financial market tariff. This tariff imposes a wedge between the market prices paid and received for the product plus a loan and thereby inflicts a loss of surplus on the seller and buyers. Trade credit lending enables the seller and/or the buyers to recapture at least part of this loss when the source of the tariff does not apply to direct loans to customers. Financial market tariffs caused by transactions costs fulfill this requirement because the trade credit lender's familiarity with its customers and product provide it with information and collection cost advantages over financial intermediaries. Tariffs caused by financial intermediary rents fulfill this requirement as well because the parties to a trade credit loan do not employ the services of a financial intermediary.

Increasing opportunity costs and financial market imperfections in addition to the ones described above establish the limits of credit policy. The optimal amount of accounts receivable is derived from the condition that the marginal revenue of trade credit lending is equal to the marginal cost. This condition combined with factoring costs produces a unique, finite optimal credit period. Accrual accounting for income tax purposes imposes an additional restriction because the firm is taxed on the recovery of its opportunity costs. These limitations on credit policy were examined separately in this paper for clarity but they are in effect simultaneously in practice.

In this paper, a general treatment of identifying the set of unbiased estimators of N-period mean returns is advanced and a new unbiased estimator, which promises near-minimum variance and minimal computation, is formulated. The new estimator is also equally applicable to other processes of compound growth.

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.

Previous analyses of market structures characterized by gradual information dissemination presume the equilibrium price existing after all market participants are informed is independent of the order of information dissemination. In these papers, final market clearing price, given the investors' posterior beliefs, is known a priori and is assumed to equal the price that would exist if data were disseminated simultaneously. We demonstrate that final equilibrium price is dependent, in general, on the order of information dissemination. This implies that, if the dissemination sequence is stochastic, price is unknown prior to the complete dissemination of information, even if the investors' posterior beliefs given the information event are known. We derive a necessary and sufficient condition for equilibrium price to be independent of the dissemination sequence in our economy. Our analysis highlights the importance of the wealth redistribution dynamics inherent in the information dissemination process.

Controversy surrounds the Securities and Exchange Commission's (SEC) Rule 415 that went into effect in March 1982 and remained an experiment until it was permanenty adopted for large firms in November 1983. Rule 415allows a company to register all the securities it plans to issue over the next two years and then to sell someor all of the securities whenever it chooses. This procedure is known as a shelf registration. The purposes of Rule 415 are to simplify the registration of new corporate securities and to allow more flexibility in the way issues are underwritten.

Foreign exchange risk and hence the demand for foreign assets depend on the objective and habitat of investors. The investment objective, in turn, is contingent upon how the consumption basket or its price is defined. If the investor is “domestic” in the sense that he or she spends all income on domestic goods, then the domestic price index should be used in defining the investment objective in real terms, regardless of whether returns are generated at home or abroad. However, for an investor who consumes a mix of foreign and home products, or for multinational firms with extensive operations outside their home countries, some sort of world price reflective of the relative importance of home and foreign goods in their consumption basket is the proper deflator.

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.

The Capital Asset Pricing Model has been challenged recently by several studies that point to certain anomalies in the capital market related to firm size. Banz [3] reported a nonlinear relation between the aggregate market value of a firm's common stock and the stock's mean return. He found that firms with small market values had large and positive residual returns over a period of at least 40 years. Reinganum [23] found that high earning-price (E/P) stocks had higher returns than low E/P-ratio stocks and that, after controlling for size, the E/P effect largely disappeared. Although they rejected the hypothesis that the anomalies are due to inefficiency in the capital market, the two authors are not able to identify the economic factors that might explain the effect of firm size on the functioning of the capital market.

The “information content of dividends” hypothesis (which emanates from the early work of Lintner [17] and Miller and Modigliani [18]) states that managers use dividend announcements to signal their beliefs about the prospects of the firm. Thus, an announcement of an increase in the dividend rate reflects management's belief that the firm's cash flows in the foreseeable future will be sufficiently high to sustain payment at the increased rate. Similarly, an announcement of a dividend decrease occurs only when management is extremely pessimistic about the probability that future cash flows will be sufficient to continue dividends at their present rate. The theoretical implication of the “information content” hypothesisis that the announcement of a dividend (or change in dividend) conveys information about management's assessment of the firm's prospects, that this information is different from other information provided by management, and this information may cause an immediate investor reaction, including, but not limited to, price changes.

This paper examines the implied standard deviation (ISD) estimated from transactons data on options, using the Black-Scholes pricing model. It was found that the distribution of the ISD is symmetric, though not normal. Also, the ISD based on the last daily observation deviates significantly from the daily average ISD. It is suggested that the daily average is a more reliable estimate of the standard deviation.