Infinite Portfolio Strategies

 

Finance models with a finite number of states and dates have properties that may or may not extend to their infinite counterparts, depending on how the extension is implemented.  It is proposed to deal with this situation by appending a date or state called ∞ to the payoff index set, and defining a topology such that the payoff index set is compact.  This allows a simplified mathematical treatment of a number of topics that are unwieldy when modeled in a setting where the payoff index set is noncompact.  Applications discussed include Ponzi schemes, payoff bubbles and the doubling strategy.

 

February 13, 2008

 

download

 

___________________________________________________________________

 

 

The MM Propositions in the Presence of Bubbles

 

The Miller-Modigliani dividend irrelevance proposition states that changes in dividends that are offset one-for-one by changes in proceeds from net new issues of securities---so that investment and earnings are unaffected---do not affect equity valuations. Under conditions, a related proposition extends the irrelevance result to settings that allow investment levels to vary as dividends are changed.

 

Recently these irrelevance propositions have been questioned by DeAngelo and DeAngelo, who asserted that dividend payout rules, like investment plans, can be suboptimal. Therefore, in their view, in general settings there is no valid irrelevance proposition; low dividend payouts give rise to low valuations.  We observe that these assertions can be sensibly evaluated only in settings that allow bubbles, which were excluded in the discussions of Miller-Modigliani and DeAngelo-DeAngelo. 

 

As is well known, in standard settings if bubbles can exist at all, there exists a continuum of equilibrium paths indexed by initial values of the bubble component of asset values. We show that along some of these equilibrium paths the Miller-Modigliani dividend irrelevance result obtains. In other equilibria, however, DeAngelo-DeAngelo's conclusion that dividend decisions are relevant to equity values is correct.

 

March 15, 2008

 

download

--------------------------------------------------------------------------------------------------------

 

 

Dividend Policy and Income Taxation

 

The effects of dividend and capital gains taxes on optimal dividend payout policy are analyzed in the context of a one-good model (so that capital consists of stored units of the consumption good).  The aftertax discount factor is assumed to adjust to taxes to bring about equality between the discounted value of the firm's aftertax dividend stream under the optimal dividend policy and the number of units of capital the firm is operating. A standard result---that the Miller-Modigliani dividend irrelevance proposition applies in the presence of taxes if the dividend tax rate equals the capital gains tax rate (and if capital gains are taxed as they accrue)---is demonstrated.  The analysis is extended to deal with unequal tax rates. The two major results are (1) allocating retained earnings to share repurchases has the same tax implications as allocating retained earnings to new investments, and (2) either of these will be optimal if and only if the tax rate on capital gains is lower than that on dividends.

 

JEL codes G1, G3.

 

May 1, 2008

 

Download

 

----------------------------------------------------------------------------------------------------------------------------

 

Present Value

 

Forthcoming, The New Palgrave Dictionary of Economics, Second Edition

 

May 31, 2006

 

download

 

--------------------------------------------------------------------------------------------------------------------------------------------

 

 

Excess Volatility

 

Forthcoming, The New Palgrave Dictionary of Economics, Second Edition

 

May 31, 2006

 

download

 

------------------------------------------------------------------------------------------------------------------------------------------

 

Bubbles and the Intertemporal Government Budget Constraint

Economics Bulletin, 2004

download
 

---------------------------------------------------------------------------------------------------------------

 Expected Utility:  A Defense

Economics Bulletin, 2004

download
 

-----------------------------------------------------------------------------------------------------------------------------------

Rational Exuberance

Journal of Economic Literature,  2004
download


--------------------------------------------------------------------------------------------------------------------------------------------------------------------------
 
 

Review of Bossaerts, The Paradox of Asset Pricing

International Journal of the Economics of Business, 2003

download

____________________________________________________________________________________________

Liquidity and Liquidation (with David Kelly)


The manager of a firm that is selling an illiquid asset has discretion as to the sale price: if he chooses a high (low) selling price, early sale is unlikely (likely). If the manager has the option to default on the debt that is collateralized by the illiquid asset, the optimal selling price depends on whether the manager acts in the interests of owners or creditors. We model the former case. In the preferred equilibrium, the owner will always offer the illiquid asset for sale at a strictly higher price than he paid, and he will default if he fails to sell. As a result, the illiquid asset changes hands at successively higher prices; the price inflation terminates upon the first failure to sell, which results in a default chain.

We also consider a generalization of the model which permits sellers to finance sales using either debt or preferred stock, or both.  This allows derivation of an optimal capital structure.

Economic Theory, 2006

download

____________________________________________________________________________________________

Liquidation and Fire Sales (with David Kelly)

 

A "fire sale" occurs when the owner of a good offers it for sale at a price strictly below the price that some buyers would willingly pay for the good.   He does so because the advantage of the quick sale made possible by the lower price outweighs the higher price that other potential buyers would pay, given the likely delay in locating these buyers in the latter case.  Fire sales can occur only in illiquid markets.  This paper generalizes earlier treatments of illiquid markets by assuming that the asset can be offered for sale at any time, rather than only after its owner loses his capacity to operate it profitably.  Also, it specifies that profitability follows a random walk.

In  Models and Monetary Policy:  Research in the tradition of Dale Henderson, Richard Porter, and Peter Tinsley, ed. Faust, Orphanides and Reifschneider, 2006

 

download

_______________________________________________________________________________________________
 

Review of Judea Pearl, Causality

Journal of Economic Methodology, 2002

download

________________________________________________________________________________________________

Equilibrium Valuation of Illiquid Assets (with John Krainer)

We develop an equilibrium model of illiquid asset valuation based on search and matching. We propose several measures of illiquidity and show how these measures behave. We also show that the equilibrium amount of search may be less than, equal to or greater than the amount of search that is socially optimal. Finally, we show that excess returns on illiquid assets are fair games if returns are defined to include the appropriate shadow prices (JEL classifications G12, D40, D83). 

 

Economic Theory, 2002

 

download

________________________________________________________________________________________________

Causality in Economics

October 3, 2006


download






























________________________________________________________________________________________________