The word revolution is entirely appropriate for describing the changes in financial institutions and instruments that have occurred in the past twenty years. The major impulses to successful financial innovations have come from regulations and taxes. The outlook for the future is for a slowing down of the rate of financial innovation, but much growth and improvement are still in prospect.

Pricing models for American call and put options on futures contracts are derived herein. These models are used to investigate the efficiency of the market for options on Standard & Poor 500 and German Mark futures. The evidence presented here indicates that market prices for these options deviate substantially from their corresponding model prices. In addition, it is shown that a hedging strategy originated at prices that indicate a deviation of market from model is successful in translating the observed mispricing into excess profits after transactions costs. However, these net profits are eliminated if the origination of the strategy is delayed by one trade, or if bid-ask spreads are accounted for.

The following paper presents a general derivation of the jump process option pricing formula. In particular, a general jump process formula is derived via an analysis of the limiting behavior of the binomial option pricing formula. In deriving the formula, a very simple central limit theorem known as Poisson's Limit Theorem is applied. The simplicity of the analysis allows the establishment of precisely the connections between the specification of the underlying binomial stock return process and the specific form of the corresponding continuous-time jump process formula. Several examples are provided to illustrate these connections.

Empirical studies and much marketplace opinion have it that the spread between private money market rates and the U.S. Treasury bill rate of comparable maturity is due to differential default risk, liquidity risk, and relative supplies. This paper presents an argument and empirical evidence that the bulk of the systematic and medium-term differential between privates rates—in this case, domestic CDs, commercial paper, bankers' acceptances, and Eurodollar CDs—and the T-bill rate is due to the exemption of interest on Treasury securities from state and local taxation. In the case of Eurodollar CDs, the additional and major systematic factor explaining the spread (vis a vis T-bills) is the exemption of Eurodollar CDs from the Federal Reserve's “tax” via reserve requirements. An empirical section confirms the role of standard default risk, liquidity risk, and market “absorption” variables in determining short-term deviations from tax-adjusted parity. The taxadjusted parity condition, however, remains the major systematic and medium-term determinant—certainly more important than has been suggested previously in the literature.

This paper examines the influence of risk aversion on the pricing policies of a market maker for securities. It is shown that a market maker's bid-ask spread can be decomposed into a portion for the known limit orders, a risk-neutral adjustment for expected market orders, and a risk adjustment for market order and inventory value uncertainty. It is demonstrated that a risk-averse market maker may set a smaller spread than a risk-neutral specialist. Finally, this paper demonstrates the pervasive role of inventory in affecting both the placement and size of the spread.

Portfolios of stocks issued by small firms are well known to earn rates of return in excess of those commensurate with their market sensitivities. One common explanation for this phenomenon is that small firm stocks are riskier than large firm stocks because less information is available about the former than about the latter. A necessary condition for such an explanation to be valid is that the information effect not be eliminated by combining the individual stocks into portfolios. This paper uses jump-diffusion return models to gauge the impact of information by firm size. The results show that portfolios of small firm stocks are no more prone to information surprises than are portfolios of large firm stocks. However, portfolios of small firm stocks are found to react more severely than portfolios of large firm stocks when surprises do occur.