The recent experience of increased volatility of exchange rates among major currencies coupled with highly unstable price levels necessitates a more fundamental understanding of exchange risk. This necessity is further enhanced by the increased internationalization of consumption, investment, and other aspects of economic activity.

Analysis of the growth record of many economies indicates that foreign capital is an important factor in the process of economic development. For many developing countries, a continuing flow of foreign funds is necessary if desired growth targets are to be achieved. These funds are most likely to be in the form of loans rather than grants. This link between economicdevelopment and debt accumulation manifested itself in the enormous growth of less developed countries’ (LDCs) external indebtedness in recent years, especially after the oil crisis of 1973.

The coefficient of variation (CV) in investment returns is often presented in introductory finance texts as a measure of project risk [7, 9, 13, 15]. Curiously, the resulting mean-coefficient of variation (MCV) efficiency criterion is usually casually proposed as an alternative to the more widely recommended mean-standard deviation (MSD) definition of efficiency, as if MCV possessed an obvious intuitive appeal for some investors or some investment situations. The pervasiveness of references to CV as a risk measure is perplexing in light of the absence of utility theoretic underpinnings, especially by contrast with the substantial theoretical effort underlying the MSD notion of efficiency [3, 6, 8, 10, 11, 12].

In recent years much research has centered upon whether yield differentials between bonds which differ in default risk vary systematically over the business cycle. Theory suggests that during a cyclical upswing the yield differential (or risk premium) narrows, while during a downswing the differential widens. The cyclical behavior of yield spreads is well documented in the corporate bond market [4, 8, 12, 16]. This effect has only recently been given attention in the tax-exempt bond market [1, 11]. In addition, the municipal bond market may be segmented. If tax-exempt borrowers and investors are unable to substitute between tax-exempt securities of varying default risk, changes in the relative supply of and demand for these classes of securities could produce systematic fluctuations in tax-exempt yield differentials. These effects could be produced by regulatory statutes which require that banks purchase high-grade securities and the fixed nature of bond ratings.

Markets for exchange typically evolve over time, and the organized security exchanges in the United States have evolved in such a manner as to give specialists a major role as market makers. Specialists are responsible for maintaining a fair and orderly market in the securities listed on an exchange. They specify prices to reflect supply and demand and adjust these prices in response to shifts in supply and demand.

The idea that various characteristics of financial contracts and institutions can be explained as a rational response to problems created by information asymmetries has received a great deal of attention recently. A central theme of the literature in this area is that while moral hazard may hamper the direct transfer of information between market participants, information may be conveyed indirectly through the actions of market participants. For example, the characteristics of the insurance contract purchased may convey information as to riskiness of the insured. Recognition of the possible effects of information asymmetries has provided valuable insights into the role of financial intermediaries and the characteristics of the contracts they offer. In this paper we apply this literature to an analysis of the market for bank loan commitments. Through our analysis we are able to explain the use of various payment options such as fees and compensating balance requirements associated with loan commitments. Extensions of our analysis into the pricing of other bank services are also explored.

The stationarity of beta factors has received considerable attention in the financial economics literature. One particular area of study has been to investigate how the measured stationarity of beta factors changes over data sets of varying lengths. By increasing the length of the estimation period, sampling fluctuations may be reduced; however, the probability of beta factors having changed will increase. The optimal data set length, then, involves a trade-off between these two opposing phenomena. Baesel [2] reported the empirical finding that the stationarity of beta was, indeed, dependent upon the estimation period length over which beta factors were estimated. He found, using transition matrices that beta stationarity was an increasing function of the calendar period used for beta estimation. In this paper, analytic expressions will be derived to explain how and when this empirical phenomenon arises. Conditions will be presented for beta stationarity to increase with calendar period length, and it will be demonstrated that beta stationarity will not increase indefinitely with estimation period length. An identical condition is required for beta stationarity to be an increasing function of the subsequent calendar period length. This phenomenon was empirically investigated by Roenfeldt, Griepentrog, and Pflaum [6], and the analysis presented here explains, in part, their findings.

The measures of risk proposed by Vinso are properly motivated with a concern for the dynamic nature of a firm's operations. The measures are subject to restrictions in application and interpretation, however. Some of these restrictions were caused by the choice of the Cornish-Fisher expansion to incorporate the adjustment for skewness and the resulting quadratic equation. The problems created by the existence of multiple real or imaginary roots to this equation are unresolved in the paper.

Apart from these problems, the measures do not represent probabilities of ruin; they often significantly understate the true probability. We have shown that the measures related to εrp are applicable only to firms with positive-drift processes and argue that they should be evaluated in a multivariate context.

To sum up, Emery and Cogger [5] have raised several interesting questions concerning the derivation of the safety index (as well as the related risk of ruin) and the interpretation of that index which needed to be addressed. While the potential limitations discussed are theoretically possible, closer examination reveals that most of the concerns raised are unlikely to occur in practical applications, although certain of the procedures utilized were in need of further explanation. Several of these issues also provide extensions of the present work to make the estimation of the risk of ruin an even more robust measure of the potential for corporate failure.

In a recent paper [3], Livingston analyzes the relationship between bond prices and market discount rates in a market with taxes, but which is otherwise frictionless. Two main cases are addressed. In the first, all investors are assumed to be in the same tax bracket and a relationship [17] is derived between the price of a bond, the rates of tax on income and capital gains, and the aftertax term structure. In a subsequent section, it is claimed that, when the assumption of a common tax bracket is removed, but maintaining the frictionless market assumption, the analysis is more or less unchanged:

”..there must still be a unique price of an annuity of maturity j and a unique price of a discount note of maturity j. There will be implicit tax rates in these annuities and discount notes for each maturity.… The bond pricing equation is the same except that TP and TG are replaced by TPj. and TGj., implicit marginal tax rates for each maturity” [3, p. 20].

Models of security markets invariably assume that market participants act intelligently since any other assumption generally leads to absurd results. Schaefer's Comment makes the incorrect assumption that one market participant, namely the government, acts unintelligently by allowing investors to reap tax arbitrage profits. Consequently, the conclusions in the Comment are erroneous. As I will show below, a government can (and the U.S. Government does) prevent tax arbitrage and any resulting disequilibrium in the bond market through two simple tax rules. My earlier paper [1] primarily showed that bond price must be a linear function of coupon for any maturity under the assumption of constant tax brackets for all investors, and then suggested that a linear relationship will also hold with investors in different tax brackets. I will prove this last result below.