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This paper is concerned with the behavior of the risk premium on the market portfolio of risky assets. The paper provides a characterization of the evolution of the market risk prem ium in economies where the variance of the return on the market has constant variance and market index options can be priced using the 1 973 Black Scholes model. It is shown that the risk premium satisfies a n on linear partial differential equation called Burgers' equation. The analysis has potentially important implications for empirical work, where for example, it is undecided whether observed mean reversion i n stock prices can be explained by time varying risk premia within an efficient market. Copyright 1993 by Royal Economic Society.
The CME Nikkei 225 "Quanto" futures contract settles against the Nikkei Index but taken to refer to US dollars. In contrast, the corresponding "Vanilla" instruments trading in Singapore and Osaka, settle in Yen. We show that the returns to the Quanto future are correlated with returns to the US market, as represented by the CME S&P500 future, even after controlling for the returns to the Vanilla contract, translated into dollars, and the dollar/Yen returns. This correlation is partially reversed the next day. This result goes against the usual analysis of Quanto instruments, which asserts that they can be hedged via the corresponding vanilla instrument, and a currency position. In fact, we show that our Quanto and Vanilla investment strategies should not differ in their currency exposure, and this is reflected in the significance of th...
capital structure; dynamic corporate finance; liquidity
contingent claims; corporate finance; dividend policy; liquidity
We solve for a firm's optimal cash holding policy within a continuous time, contingent claims framework using dividends, short-term borrowing, and equity issues as controls assuming mean reversion of earnings. Optimal cash is non-monotone in business conditions and increasing in the level of long-term debt. The model matches closely a wide range of empirical benchmarks and predicts cash and leverage dynamics in line with the empirical literature. Firm value is quite insensitive to changes in the level of long-term debt. The model has interesting implications for asset substitution, hedging, and pecking order. Growth opportunities do not greatly affect cash holding policy.
We solve for a firm's optimal cash holding policy within a continuous time, contingent claims framework using dividends, short-term borrowing, and equity issues as controls assuming mean reversion of earnings. Optimal cash is non-monotone in business conditions and increasing in the level of long-term debt. The model matches closely a wide range of empirical benchmarks and predicts cash and leverage dynamics in line with the empirical literature. Firm value is quite insensitive to changes in the level of long-term debt. The model has interesting implications for asset substitution, hedging, and pecking order. Growth opportunities do not greatly affect cash holding policy.
This paper solves for a firm's optimal cash holding policy within a continuous time, contingent claims framework that has been extended to incorporate most of the significant contracting frictions that have been identified in the corporate finance literature. Under the optimal policy the firm targets a level of cash holding that is a non-monotonic function of business conditions and an increasing function of the amount of long-term debt outstanding. By allowing firms to either issue equity or to borrow short-term, we show how share issue and dividends on the one hand and cash accumulation and bank borrowing on the other are all mutually interlinked. We calibrate the model and show that it matches closely a wide range of empirical benchmarks including cash holdings, leverage, equity volatility, yield spreads, default probabilities and r...
We study a continuous time model of a levered firm with fixed assets generating a cash flow which fluctuates with business conditions. Since external finance is costly, the firm holds a liquid (cash) reserve to help survive periods of poor business conditions. Holding liquid assets inside the firm is costly as some of the return on such assets is dissipated due to agency problems. We solve for the firms optimal dividend, share issuance, and liquid asset holding policies. The firm optimally targets a level of liquid assets which is a non-monotonic function of business conditions. In good times, the firm does not need a high liquidity reserve, but as conditions deteriorate, it will target higher reserve. In very poor conditions, the firm will declare bankruptcy, usually after it has depleted its liquidity reserve. Our model can predict l...
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