The implications for portfolio behavior and asset prices of transaction costs are central to the analysis of numerous issues in economics. For example, questions involving the demand for the financial contracts issued by financial intermediaries are intimately tied to the existence of transaction costs. Thus the analysis of questions involving the nature of the demand for mutual fund shares, insurance contracts, mortgage loans, etc., and the form those contracts take require the explicit inclusion of transaction costs.

During the past decade considerable empirical evidence has been accumulated suggesting the stock market adjusts to the arrival of new information in an efficient manner. The studies providing this evidence consist of announcement tests of new publicly available information (such as earnings, stock splits, accounting changes, etc.) on the risk-adjusted return of securities. The specific methodology employed is crucial since it directly affects the results of a test for market efficiency. Following the pioneering work of Ball and Brown [1] and Fama, et al. [15], many researchers [6, 12, 21, 22, 27] have employed a similar methodology in order to test for market efficiency. This cumulative average residual (CAR) methodology consists of: (1) estimating the parameters of the market model based on data in a time period prior (and sometimes subsequent) to an announcement, and (2) analyzing the residuals derived from applying this model to a time period which includes the announcement date.

The decomposition of a security risk into diversifiable (or unsystematic) and nondiversifiable (or systematic) risks has emerged from the portfolio approach of capital investment and has culminated in the well-known Capital Asset Pricing Model (CAPM), developed by Sharpe [4], Lintner [3] and others. In this framework, the diversifiable risk is the risk that can be “washed out” by diversification and the nondiversifiable risk is the risk which cannot be diversified away. It appears to us that the decomposition of risk into its components is in some cases vague and in most cases imprecise. We define the diversifiable and nondiversifiable risk measures as two complementary components of the standard deviation of a security's rate of return. Furthermore, we require thatthe nondiversifiable risk measure will completely determine its equilibrium market price. We shall see that the definition presented is appealing for all securities and particularly for those with negative Beta. To be more specific, recall that a security's β is given by the slope of the following time series regression:

Sharpe's market model [29] is widely used both by academic researchers and practitioners in finance, but it cannot be accepted with complete confidence until some of its basic assumptions are tested more thoroughly. The applicability, usefulness, and reliability of the model are functions of its conformity to real data, which in turn depends partly on the unresolved question of heteroscedasticity.

There have been a large number of tests assessing the performance of U.S. mutual funds. Most of the performance measures have been either explicitly or implicitly based on only two moments of the distribution of returns: the mean and variance. For example, the performance measure suggested and employed by Sharpe [10] is the fund's ex-post reward (return) to variability ratio, while the capital asset pricing measures employed by Treynor [11], Jensen [4] and others relate the fund's returns to those expected, given its level of systematic risk [β]. The risk [β] and excess return [α] measures themselves are directly derived from an underlying mean-variance model of asset choice. When these performance measures are used to compare fund performance vis a vis the market (index), no consensus of opinion appears to have materialized, although most studies find that funds in general perform worse than the market. Indeed, as Carlson ([2, p. 22]) notes in the conclusion of an article reviewing a number of U.S. mutual fund studies, “The issue of whether mutual funds outperform ‘the market’ depends in large degree on the selection of both the time period and market proxy.”

In a recent paper in this Journal Francis [3] has examined the intertemporal systematic cross dependence between the monthly returns of securities and those of a market index. Based on the monthly price behavior of a sample of 770 common stocks listed continuously on the New York Stock Exchange (NYSE) from 1958 to 1967 he concludes that, relative to the general market movement, there is no consistent pattern of leads or lags for securities' monthly returns. In other words, the monthlyreturns of securities do not precede or follow the monthly returns on the market index.

The question of stock market efficiency has received considerable play in the financial press in recent years and understandably so. Not only is this a topic of interest to national policymakers charged with monitoring and promoting market efficiency, but answers to this question have rather important implications for the management of market participants' portfolios. Our interest in this subject focuses on a subsegment of the larger question of market efficiency, in particular on so-called technical theories of stock market behavior.

Where rates of return are perfectly correlated, risk reduction through diversification cannot be achieved. Where rates of return are less than perfectly correlated, however, then, to the extent that these interrelationships can be known, modern portfolio theory provides a framework in which risk reduction through diversification can be achieved. Markowitz was the first to give rigorous content to the concept of portfolio diversification [14], and to introduce a formulation for treating portfolio selection as a mathematical optimization problem. In order to facilitate application of his own covariance approach, Markowitz first suggested [15, pp. 96–101], and Sharpe later developed a market model formulation according to which it is assumed that the rates of return on various securities “are related only through common relationships with some basic underlying factor” [18, p. 281]. More than 25 years have passed since Markowitz introduced his original formulation, and the literature dealing with the portfolio selection problem that he identified has grown considerably since then. Unfortunately, many problems remain which prevent full and effective implementation of this framework for investment analysis.

As an operational objective for firm management, the market value maximization criterion derives its theoretical validity from the Fisherian separation principle which states that production decisions for an economy can be made without regard to consumer-investors' preferences for consumption, given perfectly competitive markets. In other words, if the firm's activities do not affect the prices of consumptive goods, then maximizing the wealth of its shareholders will lead to a maximization of each shareholder's utility. Not only does this optimality criterion avoid the ambiguities and vagaries of constructing an aggregate shareholder preference function, but when implemented as a firm decision rule, should result in the same production plan that each investor would select himself, and thereby should represent a Pareto optimal allocation of resources: (Hirshleifer [5, Chapters 1, 9]; Fama and Miller [3, Chapters 2, 7]; and more recently, Ekern and Wilson [2], Merton-Subrahmanyam [7], LeRoy [6]).

In a recent paper the net present value (NPV) accept-reject decision rule, invoking the conventional definition of expected net cash flows of a finite, uneven character along with a weighted average cost of capital, was derived from the condition of shareholder wealth maximization (Beranek [2]). Since the entire textbook-NPV expression was established–its logical form, the content of its variables, and the implied specification of its parameters–this has served as a partial rescue of textbook approaches to capital budgeting, approaches which had heretofore rested on an intuitive basis. But attempts to rescue textbook treatments of mutually exclusive (ME) choices and capital rationing must fail. Explaining why they must fail, and developing what we shall denote as the AB alternative solution, is the object of this paper.

The rapid advancement of technology leading to quicker obsolescence, shorter life cycles, and more intensive competition has resulted in renewed emphasis on the abandonment and replacement decision in the analysis of investment projects. Once an investment was undertaken, many corporations in the past often abandoned a project only when it either suddenly ceased to function, or else when it became so unprofitable that abandonment was literally forced. Several authors have demonstrated that a project could be abandoned well before any of these terminal conditions existed. Robicheck and Van Home, for instance [14], showed that an asset could be abandoned even though it may be expected to generate positive cash flows in subsequent years. Dyl and Long (DL) [6], in a modification to the Robichek and Van Home (RVH) model regarding the year of abandonment, suggested that rather than abandoning a project at the earliest time–whenever the abandonment value exceeded the present value of all subsequent future flows– all possible cases of abandonment over the life of the asset should be considered. In this manner, the procedure is to select the highest net present value of an asset over all cash flow and abandonment possibilities. This result particularly holds when all projects have the same degree of risk and when there are frictionless markets and no capital rationing.

In a recent issue of the Journal of Financial and Quantitative Analysis, Bernhard [2] has pointed out and discussed the seemingly paradoxical possibility that P < 0 even though there is a unique r in the [0, ∞) interval, and that r > it for all t. He showed that this can happen when there are one or more additional values of r in the (−1, 0) interval or when the unique r in the [0, ∞) interval consists of multiple coinciding roots. The further point to be shown here is that it can also happen even when r is unique and simple in the (−1, ∞) interval. Thus the phenomenon is considerably more general than Bernhard had implied.

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).

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.

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.

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.

This study compares the dividend policies of independently owned and bank holding company-affiliated commercial banks. The hypothesis tested is that there exists a significant, positive relationship between the amount of cash dividends paid by a bank and its affiliation with a holding company. The issue is an important one because the distribution of earnings as dividends obviously reduces a bank's ability to generate capital internally, and retained earnings have been the chief source of growth in bank equity capital. For some time the bank supervisory authorities have been concerned over the relative decline in importance of capital in the balance sheet of the average bank, such funds permitting banks to absorb unexpected losses and weather periods of financial crises. Capital adequacy is thus a major consideration in the regulators' assessment of bank dividend policy. Prior research has shown that the banking subsidiaries of bank holding companies have maintained lower capital in relation to assets than have other banks despite achieving greater profitability. Since a bank's capital position is usually positively correlated with its earnings, this implies that affiliated banks have been more generous in paying dividends. Indeed, the statistical evidence of this study indicates that the banking subsidiaries of holding companies paid significantly higher dividends than other banks over the four–year period from 1973 through 1976. Whether or not this has resulted in these firms maintaining less than “adequate” capital is a question that goes far beyond the scope of this paper, but which ultimately must be considered.