Sven Grassman's [2] empirical observation that most exports from small open economies are denominated in the currency of the exporter stimulated much theorizing on the currency denomination of international trade contracts. As Rao and Magee [6] note, the problem is nontrivial only if exchange risk exists and the two traditional hedging techniques, forward exchange and international borrowing and lending, are too costly to be employed. With international contracting, both parties typically agree on the quantity to be traded and on a price fixed in one of the two currencies at the time the letter of credit is agreed upon; thus, apart from commercial risk the only source of uncertainty is the real value of the future nominal payment. The degree to which this risk is borne by the importer or the exporter depends, in part, on the currency of denomination.

The well known Sharpe-Lintner-Mossin capital asset pricing model (CAPM) assumes the existence of stability in the price level so that the market price of risk (MPR) measured in nominal terms is the same for all risky assets in an equilibrium market. Friend, Landskroner and Losq [5, hereafter F-L-L] have recently shown that CAPM measured in nominal terms understates the MPR if an uncertain inflation is expected and if a covariance between the rate of return on the market and the rate of inflation is positive (p. 1287).

The existence of default risk is an important characteristic of most lending operations, and many of the studies dealing with lending behavior incorporate default risk considerations. Two basic approaches to the modeling of such behavior can be identified according to their treatment of default probabilities: the first approach assumes that the likelihood of default is independent of the actions of the lender under consideration, namely, the volume of the loan granted by the current lender has no impact on the default probability (e.g., the works by Yawitz [9], Feder and Just [3], and Bierman and Hass [2]). Such an assumption may be quite appropriate in situations where the volume of operations of a single lender is rather small relative to the size of borrower's assets (or previous debt), as is the case with most bond buyers or with banks who lend to sovereign borrowers.

Bradford Cornell's paper develops a small, but important result for the literature on currency of denomination of international trade contracts. The selection of a contract currency determines which party will bear exchange risk in addition to inflation risk. The contract currency problem in international trade is therefore closely related to other contracting issues, such as the pricing of nominal bonds under inflation uncertainty. More graphically, exchange risk can be illustrated by a difference in the units ofaccount of income and consumption streams. For example, if an agent produces only corn and consumes only wheat, he faces an exchange risk if the price of wheat relative to cornis uncertain.

Virtually all new state and local governmental bond issues are purchased initially by an underwriter, or syndicate of underwriters, who in turn resells the bonds to investors. The underwriter attempts to sell the bonds for an amount which exceeds his purchase price. The difference is underwriter spread. Of course the probability that the underwriter will actually receive the planned spread is directly related to the yields at which the reoffering is attempted. The purpose of this study is to test and analyze the relationship between reoffering yields for new municipal bond issues and the spread which the underwriter plans to receive. This study differs from previous studies in method of analysis, and in being the first such study to examine underwriter behavior in the bond market.

In recent issues of the Journal of Financial and Quantitative Analysis, several papers ([7], [1], [4], and [6]) have presented simple sufficient conditions for detecting whether a given pattern of cash flows over time has a unique, simple, nonnegative internal rate of return. One such condition, developed independently by Bernhard [4] and deFaro [6], is easily shown to be the most general of the lot, i.e., to contain the others as special cases. See, e.g., deFaro[6].

Term structure theories and the related specification of estimating equations are properly viewed as part of the complex multiperiod consumptioninvestment decision, a research area which presents many analytical problems (for a review, see Long [4]). Because of both the complexity and analytical difficulties, yield curve estimation has generally utilized rather ad hoc specifications. Thus, the recent article by Echols and Elliot [1] is to be applauded because it attempts to rigorously derive a yield curve specification based upon the pure expectations model of the term structure of interest rates.

A number of articles have recently appeared in the literature dealing with the application of multiple discriminant analysis (MDA) to classification problems in the area of finance [2, 3, 7, 8, 13, 15]. The problem of assessing the importance of individual variables was an issue in these papers. The objective of this paper is to develop a ranking procedure for assessing the relative importance of the individual variables when it cannot be assumed that the group covariance matrices are equal. It is assumed that the analysis is for two groups. The ranking procedure we suggest relies upon the conditional deletion procedure based on a statistic used for solving the multivariate Behrens–Fisher problem.

Modern contingent pricing theory (CPT) dates its genesis from the pioneering work of Arrow [1] and Debreu [9] in the context of complete markets. Beja [2, 3] demonstrated the application of contingent pricing concepts to incomplete markets. The approach has been applied to the valuation of options (Cox and Ross [7]; Rubinstein [30]) and a variety of other financial instruments (e.g., Ross [28])- Tne fundamental insight of CPT is that in arbitrage-free markets complex securities may always be viewed as additive combinations of simple “state-claims” having positive value which, in effect, pay off one unit if and only if a given state is attained at a given date. Concurrently, the continuoustime viewpoint pioneered by Black and Scholes [4] and Merton [22] has grown in significance. The basic simplification of the continuous-time approach is that relevant valuation quantities may all be expressed in terms of the first two moments, i.e., mean and variance, of the state variable distributions employed. When CPT adopts a continuous-time format, it has been shown (Garman [13]) that a basic differential equation holds for all securities; that differential equation involves, of course, the state-claim values, the distributional parameters of state variable evolution, and the prices and dividends of securities. Alternatively, somewhat stronger assumptions which lead to the existence of a rational consensus investor allow thedifferential equation to be expressed in terms of marginal utilities (Cox, Ingersoll, and Ross [8]). This paper applies the techniques of continuous-time CPT to the foreign exchange market. Since we wish to substantively treat inflationary and productive sources of risk in two countries, four state variables are necessarily involved. In a sense, therefore, this is an ambitious attempt since the mostcomplex continuous-time models to date (e.g.. Brennan and Schwartz [5]), have substantively treated only two state variables. Such complexity is simplified through the use of some compact notation, but not by the use of ad hoc modeling. Indeed, it should be emphasized that the present treatment is a full-equilibrium approach, and that while the compact quality of the notation might be made to incorporate a significant amount of possible additional structure, nothing here is inconsistent with a complete equilibrium.

Research in the field of international capital markets has grown considerably during the past few years. The growth of this research activity can be explained both in terms of the “need to know” motive, and the “extension of models” motive. The “need to know” motive reflects the changes in the international monetary system, and the international capital market in general since 1973. The introduction of flexible exchange rates among the major currencies, the sharp increase in both the rate and the volatility of world and relative currency inflation, and the radical changesin the relative price of at least one highly traded good—oil—have made it extremely important to gain a better understanding of the risk in the international market. The “extension of models” motive has to do with the natural interest in the field to extend and to test models developed in financial economics on a different, and important, set of problems.

Whether borrowers or lenders gain or lose due to inflation depends upon the nominal rate agreed to, the realized inflation rate and their inflationary expectations when the contract was written. The high rate of inflation in recent years has resulted in the real interest rates on traditional, fixed–rate mortgages being substantially below the nominal, contract rate. This recent experience has stimulated borrowers and lenders to consider the implications of inflation in their contract negotiations.

Bank regulators tend to disagree with the idea that markets can play a role in bank regulation. The markets for bank securities are viewed by regulators as inefficient and lacking the necessary information to demand sufficient risk premiums on bank obligations to affect bank management decisions. On the other hand, bankers who have an active market for their securities tend to place faith in market assessments to determine the cost of management policies; therefore, they tend to think that the market plays an important role in “regulating” bank management decisions. The regulators are perhaps correct about the markets for small and medium–sized banks, but for those banks which have an active market for their securities, do investors adjust rates of return for the presence of increased potential of bankruptcy? If so, when does the adjustment take place?

A currency is not risky because devaluation is highly likely. If the devaluation were certain, there would be no risk at all. A weak currency can be less risky than a strong currency. A strong currency does not become risky because it has been used to denominate a firm's debt.