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Working Paper
Price reactions to public announcements
We employ a parametric rational expectations equilibrium model to study the impact of public information releases on private information acquisition and asset prices in a large economy. We demonstrate that investors treat public information as a substitute for privately acquired information. Their attempts to substitute public for private information can amplify or even reverse the effect of public information releases on price volatility. The direction of the resulting change in price volatility is dependent on the level of public information regarding asset payoffs, the variance of asset ...
Working Paper
Pricing S&P 500 index options using a Hilbert space basis
This paper tests the approach of Madan and Milne (1994) and its extension in Abken, Madan, and Ramamurtie (1996) for pricing contingent claims as elements of a separable Hilbert space. We specialize the Hilbert space basis to the family of Hermite polynomials and test the model on S&P 500 index options. Restrictions on the prices of Hermite polynomial risk are imposed that allow all option maturity classes to be used in estimation. These restrictions are rejected by our empirical tests of a four-parameter specification of the model. Nevertheless, the unrestricted four-parameter model, based ...
Working Paper
Rational expectations equilibrium in an economy with segmented capital asset markets
We develop a model of noisy rational expectations equilibrium in segmented markets. The noise emerges endogenously through intermarket effects rather than through exogenous supply noise from liquidity or naive trading as in standard noisy rational expectations equilibrium of the Hellwig type. Existence of and persistence of segmentation in equilibrium is established. A metric to determine welfare effects of the degree of segmentation is also derived. This metric is structurally different from the metric derived in the standard models and includes the latter as a special case. Empirical ...
Working Paper
Specifying a consistent joint maximum-likelihood (JMLE) approach to testing bond models
In this paper we extend the results derived in our earlier work to develop a methodology to employ the maximum-likelihood estimation technique for the pricing of interest rate instruments. In order to price bonds and their derivative assets, researchers must identify a preference parameter in addition to the dynamics for the interest rate process. There are two approaches to obtaining estimators for both preference and dynamics parameters: (1) a two-stage approach and (2) a single-stage joint maximum-likelihood (JMLE) approach. The first approach, while tractable, suffers from serious ...
Working Paper
MLE is alive and well in the financial markets
In this paper we specify the basic set of economic criteria that any diffusion-driven interest rate or FX rate process must satisfy. We also develop the methodology that is implementable to test the validity of a proposed process insofar as it satisfies the basic criteria as well as the actual estimation of the parameters of an acceptable candidate process. In this paper we focus on processes such as the overnight repo rate process or the FX rate process, each of which is directly observable. We develop what we call the marginal maximum-likelihood estimation (MMLE) technique to distinguish it ...
Working Paper
Off-farm income and risk reduction in agriculture: when does it matter?
Investment behavior is analyzed using a dynamic portfolio model including off-farm income. The correlation structure of off-farm income and asset returns and the ratio of off-farm income to wealth is shown to affect portfolio choice. Empirical analysis indicates that off-farm income tends to increase farm assets.
Working Paper
Applying economic restrictions to foreign exchange rate dynamics: spot rates, futures, and options
Extant models of exchange rate behavior have typically relied on statistical rather than economic considerations. The approach has been to employ a variant of the generalized central limit theorem to develop tests for the models proposed. ; We propose a minimal set of simple economic restrictions symmetry, invariance, and non-negativity that must be satisfied by an exchange rate process. By symmetry, we mean that both the direct and indirect exchange rate processes must belong to the same class of distributions. By invariance, we mean that the distribution for an exchange rate must be ...
Working Paper
Information quality, performance measurement, and security demand in rational expectations economies
The relationship between asset demand and information quality in rational expectations economies is analyzed. First we derive a number of new summary descriptive statistics that measure four basic characteristics of investment style: asset selection, market timing, aggressiveness, and specialization. Then we relate these statistics to the divergence between a given investor's information structure and the market average information structure. Finally, we demonstrate that informational differentials can be identified, and consistently estimated, using OLS from the time series of observed asset ...
Working Paper
Estimation of risk-neutral and statistical densities by Hermite polynomial approximation: with an application to Eurodollar futures options
This paper expands and tests the approach of Madan and Milne (1994) for pricing contingent claims as elements of a separable Hilbert space. We specialize the Hilbert space basis to the family of Hermite polynomials and use the model to price options on Eurodollar futures. Restrictions on the prices of Hermite polynomial risk for contingent claims with different times to maturity are derived. These restrictions are rejected by our empirical tests of a four-parameter model. The unrestricted results indicate skewness and excess kurtosis in the implied risk-neutral density. These characteristics ...
Working Paper
An intertemporal model of consumption and portfolio allocation
We develop an infinite time horizon, continuous time model of portfolio choice and consumption allocation for an investor seeking to maximize the expected utility of his life-time consumption. In this model, the investor is endowed with capital that can be invested in long-lived capital assets and has, in addition, a stochastic stream of cash flows that could be interpreted as either a wage income stream or a stochastic endowment flow. We obtain a complete and original solution to the consumption-portfolio choice problem for the negative exponential and quadratic utility functions and special ...