Abstract: ORGANIZED FUTURES MARKETS in financial securities were first established in the U.S. on October 20, 1975 when the Chicago Board of Trade opened a futures market in Government National Mortgage Association 8% Pass-Through Certificates. This was followed in January, 1976 by a 90 day Treasury Bill futures market on the International Monetary Market of the Chicago Mercantile Exchange. In terms of trading volume both have been clear commercial successes and this has led to the establishment, in 1977, of futures markets in Long Term Government Bonds and 90-day Commercial Paper and, in 1978, of a market in One-Year Treasury notes and new GNMA markets. The classic economic rationale for futures markets is, of course, that they facilitate hedging-that they allow those who deal in a commodity to transfer the risk of price changes in that commodity to speculators more willing to bear such risks. The primary purpose of the present paper is to evaluate the GNMA and TBill futures markets as instruments for such hedging. Obviously it is possible to hedge by entering into forward contracts outside a futures market, but, as Telser and Higinbotham [19] point out, an organized futures market facilitates such transactions by providing a standardized contract and by substituting the trustworthiness of the exchange for that of the individual trader. In the futures market, price change risk can be eliminated entirely by making or taking delivery on futures sold or bought, but few hedges are concluded in this manner.' The major problem with making or taking delivery is that there are only four delivery periods per year for financial security futures so it is often

Abstract: Published financial statements of corporations are supposed to provide relevant information to a variety of users. Empirical studies indicate that earnings numbers of corporations are included in the information set of investors when setting security prices of a firm's common shares (see Kaplan [1978] for a survey of these studies). No generally accepted formal models exist, however, to show how to use the information in a firm's financial statements to determine what "good" investments might be. The efficient market theory implies that one cannot use publicly available financial data to choose common stocks which will outperform the stock market after controlling for risk effects. Financial statement analysis, which traditionally has consisted of extensive computations of a myriad of ratios and statistics to detect underor overvalued securities, is presently in a less than satisfying state. What helpful information can be gleaned from systematic examination of firms' financial statements? Practitioners emphasize the complex and subjective nature of their analysis which cannot be reduced to mathematical formulas. Nevertheless, research has indicated that formal analysis of accounting and Previously developed models for predicting bond ratings are summarized and criticized. A statistical procedure appropriate to the ordinal nature of a bond rating is applied to a recent sample of seasoned and newly issued bonds. A simple linear model using a subordination dummy variable, total assets, the long-term debt to total-assets ratio, and the common stock systematic risk measure can correctly classify two-thirds of a holdout sample of newly issued bonds. Further analysis reveals that the model may be predicting the actual risk of a bond better than the rating agency in about half of the "misclassifications."

Abstract: A NUMBER OF INVESTIGATORS have considered reasons why various options are included when bonds are issued Most attention centers on the almost invariable inclusion in corporate bonds of a call or redemption option that enables the borrowing corporation to buy back the bond at a stated price prior to maturity Such an option provides the borrower with considerable financial flexibilityl particularly the opportunity to replace the bonds with a lower-cost issue should rates fall2 To obtain this flexibility, the borrower must pay an interest rate premium While corporations have almost always been willing to pay this premium, the Federal government has not3 Since calls are primarily exercised to take advantage of lower interest rates, most arguments for the existence of the call options have emphasized differences between the borrowers' and lenders' predictions and attitudes about interest rate changes (see [8]) But although these might justify the existence of some call options, they do not explain why virtually all the corporate bonds would have this feature, or conversely why "puttable" bonds, which the holder could present for redemption at his option at pre-set price, would be so rare The published justifications for the existence of call options are so unconvincing that many authorities have held that there are no valid reasons, in particular that in an efficient market the interest rate premium demanded for the call

Abstract: Long-term corporate bonds have traditionally been issued with a call option, whereby the issuing company reserves the right to call the bond, that is, to redeem or buy back the bond prior to maturity. Usually the purpose of calling the bond is to be able to refund it, that is, replace it with one having a lower interest rate, or coupon. During 1976--77, when interest rates had dropped significantly from the rates of 1969--70 and 1974--75, Bell System companies called or refunded over $2 billion of long-term debt. This paper describes how analytical techniques developed at Bell Labs and AT&T played a significant role in these refundings.

Abstract: Recent empirical research has demonstrated that increased bidder competition lowers borrowing costs for issuers of municipal bonds [4, 5, 7, 12, 13, 14]. Consequently, the accepted position of many economists is that new issues should be offered by competitive bid. However, this conclusion is unwarranted in the case of lower-quality bonds receiving only one or two bids. The purpose of this paper is to investigate the economic consequences of municipalities selling bonds by negotiation. More specifically, it investigates the hypothesis that in instances when issuers face relatively high demand uncertainty for their new bonds, it is potentially more efficient to sell bonds by negotiation than by competitive bidding. It is shown that, for lower rated bonds having only one or two bids, cost savings are possible by using negotiation.

Abstract: TWO MAJOR REASONS GENERALLY are cited for including sinking fund provisions in corporate bond issues. First, they reduce default risk by providing for an orderly debt service pattern that systematically reduces the principal outstanding. Second, purchases for the sinking fund help provide a liquid market for the bond issue (see [2]). This reasoning suggests that the yield required by investors-and, therefore, the issuer's interest costs-will be lower for debt obligations that carry sinking fund requirements than for those that do not. In their analysis of sinking funds and investor realized yields, Jen and Wert [4] demonstrate that lower yields on bond issues with sinking funds can be explained by the term structure of interest rates. They also point out that this yield effect results in a reduced interest rate to the issuer. The apparent benefits of sinking fund provisions notwithstanding, the incidence of such bonds varies according to the type of issuer. In particular, public utility and finance company obligations often are issued without sinking fund provisions, whereas industrials almost invariably include sinking fund requirements (see [2]). The type, amount, and timing of sinking fund requirements also varies.' This paper examines the effect of sinking funds on the interest cost for a given bond issue and on an issuing firm's total costs in maintaining a given level of debt financing.

Abstract: COMPETITIVE BIDDING RATHER THAN sale by negotiation is the most frequent method of underwriting state and local government bonds. Generally, it is believed that the competition inherent in competitive bidding lowers municipal borrowing costs and provides some protection against connivance on the part of public officials. In recent years, however, the dramatic increase in volume of negotiated sales has rekindled a long-standing controversy in the municipal bond market over which underwriting procedure is least costly to the issuer. This paper examines empirically the comparative costs of competitive and negotiated underwriting arrangements in the municipal bond market in order to document the effects of underwriter procedure on net interest cost, underwriter spread, and reoffering yield. Additionally, attention is given to the role of issue size in determining competitive and negotiated underwriting costs.

Abstract: An open economy portfolio balance model, describing allocation among money, a domestic bond, and a traded foreign currency bond is developed for a world of many countries. A special role is attributed to the dollar, namely that all internationally traded bonds are denominated in that currency. It is shown that in the short run with real variables exogenous and expectations static, stability requires that all countries except the U.S. be net creditors in dollar-denominated bonds. What data are available on inter-country claims suggest that some countries may well be net debtors abroad in foreign currency. In particular, if one excludes direct investment claims, private claims on the rest of the world by Japan and Canada have been negative over the period of floating rates since 1973. However, some preliminary reduced-form regression equations for the dollar exchange rates of these two countries do not support the implications of the portfolio balance model in the debtor case. On the other hand, an equation for a composite of Western European currencies (by our calculations, this group of countries is a net creditor) gives more promising results.

Abstract: IN RECENT YEARS MUCH debate has arisen over the effect that the defaults of major corporations or municipalities have had upon their respective financial markets. Such cases involve the June, 1970 default of the Penn-Central Corporation and the New York City Fiscal Crisis of 1975. Some contend that efficient markets prevent major financial crisis such as the Penn-Central default from having more than a momentary impact on the strucutre of interest rates, while others argue that interest rates should increase and then return more slowly to normal levels [6, 9, 12, 14]. This study examines the Penn-Central default, the largest single bankruptcy filed in our nation's history and the first default of investment grade bonds (bonds rated BAA or higher) in the post war period. More specifically, it examines the hypothesis that the Penn-Central default by itself caused a re-evaluation of investor risk-perceptions. In a study especially relevant to this question, Jaffee [14] concluded that the Penn-Central default by itself led to a significant increase in the risk structure of interest rates in the corporate bond market, lasting for nearly three years.If these results are correct, there was a major re-evaluation of bond prices by investors. These findings tend to support concerns expressed by govern-ment officials that such "crises" cause a "broad psychological impact" on financial markets resulting in higher than normal new issue borrowing costs. We address this debate by developing a model which explains the cyclical variation in interest rate differentials (hereafter risk spreads) in the corporate bond market over the business cycle, and then testing empirically whether the Penn-Central default affected bond risk spreads. The paper is organized as follows. Section I presents some background information on the risk structure of interest rates and reasons why risk spreads may vary systematically with the level of economic activity. In Section II, aggregate risk spread averages are employed in time series analysis to determine the extent to which variations between Moody's risk categories can be explained by simple cyclical measures and risk spread determinants. In Section III, the model is subjected to statistical pooling tests-both for intercept and slope coefficient changes-to determine whether the Penn-Central default by itself impacted upon the risk spread averages. The results of this testing are then compared with the

Abstract: An open economy portfolio balance model, describing allocation among money, a domestic bond, and a traded foreign currency bond is developed for a world of many countries. A special role is attributed to the dollar, namely that all internationally traded bonds are denominated in that currency. It is shown that in the short run with real variables exogenous and expectations static, stability requires that all countries except the U.S. be net creditors in dollar-denominated bonds. What data are available on inter-country claims suggest that some countries may well be net debtors abroad in foreign currency. In particular, if one excludes direct investment claims, private claims on the rest of the world by Japan and Canada have been negative over the period of floating rates since 1973. However, some preliminary reduced-form regression equations for the dollar exchange rates of these two countries do not support the implications of the portfolio balance model in the debtor case. On the other hand, an equation for a composite of Western European currencies (by our calculations, this group of countries is a net creditor) gives more promising results.

Abstract: considerable uncertainty about just what the final cost of debt will be. Until recently, about the only recourse available to a borrower was to rush the flotation procedure along and to maintain adequate financial flexibility so it would be possible to postpone the debt issue should rates become too high. Recent developments in the commodities markets have opened up an alternative strategy. Since October of 1975, futures contracts on Government National Mortgage Association pass-through certificates (GNMAs) have been traded on the Chicago Board of Trade. More recently, futures contracts have become available in other debt instruments, specifically Treasury bills, Treasury bonds, and commercial paper. In principle, a firm can cross-hedge (hedge a position in one commodity with an offsetting position in a different but presumably related commodity) its constructive long position in its own soon-to-be-issued bonds by going short in a related interest rate futures contract. Such cross-hedging against corporate debt securities has been seriously advanced as a potential use of GNMA futures contracts [1].

Abstract: This paper investigates the effect of inflation uncertainty on the portfolio behavior of households and the equilibrium structure of capitol market rates. The principal findings regarding portfolio behavior are: (1.) In the presence of inflation uncertainty, households will have an inflation-hedging demand for assets other than riskless nominal bonds, which will be directly proportional to the covariance between the rate of inflation and the nominal rates of return on these other assets. (2.) An asset is a perfect inflation hedge if and only if its nominal return is perfectly correlated with the rate of inflation. The principal findings regarding capital market rates are: (1.) The equilibrium real yield spread between any risky security and riskless nominal bonds is directly proportional to the difference between the covariance of the security's nominal rate of return with the market portfolio and its covariance with the rate of inflation. (2.) As long as the net supply of monetary assets in the economy is greater than zero, an increase in inflation uncertainty will lower the risk premia on all real assets. (3.) A preliminary empirical test of the theory using rates of return on common stocks, long-term bonds, real estate and commodity futures contracts yields mixed results. The risk premia on long-term bonds and futures have the "wrong" signs.

Abstract: This paper develops behavioral relationships explaining investors' demands for longterm bonds, using three alternative hypotheses about investors' expectations of future bond prices (yields). The results, based on U.S. data for six major categories of bond market investors, consistently support an autoregressive expectations model. The results also have implications for further aspects of investors' portfolio behavior, including expectations formation, response to inflation, and speed of adjustment. THE DISTINGUISHING CHARACTERISTIC of a long-term asset, in contrast to a

Abstract: Most bond issues of large utility companies are rated for quality by at least two of the three rating agencies. Bond investors individuals and institutions are concerned not only with original ratings of an issue but also with future ones. Since a rating change will affect prices of the outstanding bonds as well as interest rates and marketability of new issues, it may be a cause of portfolio readjustment for investors as well as a reason for the utility to reconsider its capital budgeting policies. Each rating agency maintains that models based on financial statements or data bases cannot replicate its ratings [4, 7]. Nevertheless, studies have explained bond quality ratings by using financial statement data [9, 19, 21, 25] and related bond quality ratings to systematic risk [15], prices [10], bond yield [26], and market-determined risk measures [22]. Several scholars have examined the impact of rating changes on borrowing cost [11] and on price adjustments [8, 12, 20]. No work has been uncovered, though, that centers upon forecasting rating changes by the various rating agencies. The purpose of this paper, therefore, is to investigate whether or not a multivariate discriminant model that incorporates the recent levels, past trends, and instability of financial ratios can explain and predict the quality rating changes of electric utility bonds. We used 1971 as a starting point because bond rating changes were rare before then. In 1971, there were no quality rating changes announced by Moody's for industrial or utility bonds graded B or above. With rising interest rates and the environmental problems

Abstract: 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.

Abstract: In a recent paper, the author [8] has derived the equilibrium bond pricing equation in a world of uncertain future interest rates assuming that capital gains and losses will be taxed at maturity at capital gains tax rates. In the case of premium bonds (i.e., bonds selling above par), the U.S. tax law allows bondholders to elect to amortize the premium on a straight line basis as a deduction from regular taxable income. For those paying positive tax rates, the amortization option will generally be advantageous compared to taking a capital loss at maturity.

Abstract: With a neutral tax system an increase in observed and anticipated inflation would not be expected to alter either real after-tax yields on bonds and equities or the ratio of the market value of equities to the replacement cost of corporate real capital. In the real world, however, declines in real after-tax bond yields and the relative value of shares have been observed. Feldstein (1976, 1978) has attributed both of these phenonema to the use of historic-cost depreciation, and the taxation of nominal capital gains. Our analysis supports his conjecture regarding the decline in real after-tax debt yields, but rejects his analysis of the cause of the decline in share values. The decline in share values can be attributed to many factors, but the most important is probably the favorable taxation of income from owner-occupied housing (no taxation of either implicit rents nor real capital gains). As a result housing has become more attractive with the acceleration of inflation, and households have substituted housing for equity shares. Other possible sources of the decline in share values are reduced profitability of existing capital, owing to increased regulatory costs and real energy prices, and a greater perceived risk in business operations.

Abstract: IN RECENT YEARS, an increasing interest has been shown in pure discount bonds. A number of papers [2], [6] have looked at corporate capital structure in an option pricing framework, assuming the issuance of pure discount bonds by corporations. Merton [10] has presented a theoretical discussion of the impact of default risk upon pure discount bonds. Racette and Lewellen [12] have argued that long-term pure discount bond issues could present special tax advantages to corporations. Fisher and Weil [5] have suggested that long-term pure discount bonds would be very attractive to holders of bond portfolios in order to immunize these portfolios against changes in interest rates. A similar position is taken by Caks [3]. In spite of the claimed advantages of pure discount bonds from the viewpoint of both potential bondholders and stockholders, in the United States long-term pure discount bonds are not issued by corporations or governments. This paper will provide an explanation of this non-issuance by showing that the tax treatment of original issue pure discount bonds is highly disadvantageous to potential bondholders and firms. U.S. tax law1 requires the original purchaser of a longterm pure discount bond to amortize as regular income over the bond's life the difference between the purchase price and the face value (to be received at maturity). One purpose of this paper is to show that this tax law implies that, in equilibrium, pure discount bond issue prices would have to be negative for a wide spectrum of tax rates. Corporations would never issue bonds at negative prices, since the corporation would never receive any cash inflows. Secondly, it will be shown that pure discount bonds initially issued at positive prices can subsequently have negative prices if interest rates were to rise. Consequently, such bonds would be very risky to potential purchasers.

Abstract: This paper develops a simple theory of the supply of index bonds by a firm, and uses that model to examine in some detail possible reasons for the non-existence of privately issued index bonds in the United States. The major elements of the theory involve the trade-off between the tax advantages of using debt finance and the increasing risk of bankruptcy debt finance involves. The theory is first used to examine the supply of nominal bonds -- it is thus a theory of the debt-equity ratio. Then the firm's optimal supply of index bonds is examined, and the values of the firm using the alternative debt instruments is compared. In general, there is no reason to think that nominal bonds dominate index bonds -- i.e. the theory cannot explain why firms have not issued index bonds. The paper then turns to a number of other reasons that have been advanced for the non-issue of indexed bonds in the United States, such as the tax treatment of such instruments and the argument that their issue would saddle the firm with open-ended obligations.

Abstract: Forming part of London's Jubilee Line underground railway, a description is given of the design and construction of the running tunnels, step-plate junctions and crossover tunnel between Baker Street and Bond Street, Admiralty Arch and Aldwych, and Baker Street and Charing Cross stations. Tunnel construction and design are detailed as well as the problems associated with keeping stations operational while work was carried out.

Abstract: This paper develops a simple theory of the supply of index bonds by a firm, and uses that model to examine in some detail possible reasons for the non-existence of privately issued index bonds in the United States. The major elements of the theory involve the trade-off between the tax advantages of using debt finance and the increasing risk of bankruptcy debt finance involves. The theory is first used to examine the supply of nominal bonds -- it is thus a theory of the debt-equity ratio. Then the firm's optimal supply of index bonds is examined, and the values of the firm using the alternative debt instruments is compared. In general, there is no reason to think that nominal bonds dominate index bonds -- i.e. the theory cannot explain why firms have not issued index bonds. The paper then turns to a number of other reasons that have been advanced for the non-issue of indexed bonds in the United States, such as the tax treatment of such instruments and the argument that their issue would saddle the firm with open-ended obligations.

Abstract: The concept of a relationship between assumed risk and realized return is intuitively pleasing and has become widely accepted in the field of finance. Until recently this acceptance was anchored largely in what Hirschleifer [11] has called the “notorious fact†that stocks yield more in the long run than bonds and Hickman's finding [10] (since challenged by Fraine [7]) that over the years 1900–1943 the average ex post yield on publicly issued corporate debt was higher the lower the initial quality rating. However, with the advent of the capital asset pricing model of Sharpe [21], Lintner [16], and Mossin [19] the risk-return tradeoff concept has grown in importance and scope. The capital asset pricing model itself has weathered the years well, but has been theoretically and empirically revised, extended, and otherwise altered. Little remains of the original formulation except the proposition that in equilibrium more risk leads to more return--where “risk†for common stocks now means the nondiversified component as measured by the “Beta†coefficient of return volatility vis-A -vis the general market. As Modigliani and Pogue [18] observe after a review of the “more important†empirical tests of the capital asset pricing model: “Obviously, we cannot claim that the CAPM is absolutely right. On the other hand, the empirical tests do support the view that beta is a useful risk measure and that high beta stocks tend to be priced so as to yield correspondingly high rates of return.â€