The theoretical desirability of stochastic dominance (SD) as a decision rule is well established [1, 3, 4, 7, and 11]. However, implementation of SD as a decision rule has been hindered seriously by the lack of an optimal search algorithm [8]. An optimal search algorithm is desirable since it takes the distribution of returns for a group of assets and determines the optimal proportion of each asset which should be combined to provide efficient combinations. For example, for a given expected value (variance) the mean-variance (EV) algorithm builds the portfolio with the smallest (largest) variance (expected value). The EV algorithm determines which assets should be combined and the proportion of the total investment that should be invested in each asset. An analogous algorithm does not exist for SD.

Since the formulation of the portfolio selection problem by Markowitz [12] as a parametric quadratic programming problem, considerable effort has been devoted to obtaining operational portfolio management models. Research has involved: (1) characterizing the return generating process in terms of index models; (2) specifying special-purpose algorithms such as the critical-line method of Markowitz [13] or the solution procedure of Jucker and de Faro [11]; (3) using linear programming formulations to approximate solutions to the nonlinear programming problems such as Sharpe [20, 22] and Stone [25]; and (4) converting portfolio selection models into portfolio management models designed to revise an existing protfolio subject to transaction costs using heuristics such as Smith [24] or revision formulations such as Pogue [16, 17] and Stone and Reback [27].

In this study, alternative real and simulated market indexes are examined as proxies for the “common factor” required by the Sharpe portfolio selection model [13]. The ex post performance of efficient and well-diversified portfolios generated by the model based on the different indexes is compared. The results indicate no significant difference in performance between real and simulated indexes, although the degree of diversification is much lower for portfolios based on indexes which relate well to the universe of securities. It is also shown that portfolios which are selected according to the Sharpe model (regardless of the index) outperform strategies which call for investing in the market portfolio.

In his 1976 Presidential Address to the American Finance Association, Merton Miller provided a compelling argument that there currently exists no viable theory of the optimal capital structure of an individual firm. This argument follows from the critique he presented of existing models of capital structure and from the theory he outlined of the optimal aggregate capital structure of the economy as a whole. That theory depends on the existence of different marginal tax rates for individuals and a tax-free security. Professor Miller pointed out that he was motivated to develop his hypothesis by the apparent inadequacy of a (if not the most) popular explanation for capital structure at both the micro and the aggregate level: the tradeoff between the tax advantages of debt and the cost to the firm's security holders of the bankruptcy process. He observed that neither the tax advantage of debt nor the costs of bankruptcy may be quite what they seem at first glance. When the corporate income tax and the differential taxation of regular income and capital gains are taken into account, then the tax advantage of debt is reduced. Moreover, the limited empirical evidence from actual bankruptcies suggests that the real costs to security holders of bankruptcy may be really rather low. And the recent discussion by Haugen and Senbet [6] suggests that most of the costs attributed to bankruptcy are really costs of liquidation of the firm's assets and not relevant to the capital structure decision.

Against the widely accepted view of the nineteenth-century Mexican peon as a hapless individual caught in perpetual debt bondage to the “company store” of the hacienda on which he spent his short life of drudgery, Dr. Cross places some unique hard evidence drawn from the account books of one such hacienda. He finds that, in this case at least, the number of peons in debt at any one time was very small and the debt well within their ability to repay, thanks in no small part to a system of payment of a large part of their wages in kind. The exceptions reflected in most cases debts incurred either to pay the local priest's stiff fees for administering such sacraments as baptism and marriage, or for funds to invest in the peasant's own agricultural enterprises.

Haugen and Senbet address several interesting issues, such as: a costless solution, with the use of options, to the agency problem and the incorporation of informational asymmetry into the agency problem, as well as the use of options to convey information. I'll start my discussion on their paper by providing general comments which are followed by some clarifying comments on the authors' argument for signaling with options.