The informational role of prices contributes positively to their variability. In a noisy rational expectations equilibrium, traders rationally respond to price changes by revising their estimates of other traders' private signals and hence their own expectations of future dividends. The resultant shifts in traders' demands amplify any supply shock-induced price changes. We develop an infinite horizon noisy rational expectations model and calibrate, simulate, and test it using U.S. stock market data. The price variability in a heterogeneous information economy is shown to be 20% to 46% higher than in an otherwise equivalent economy in which all signals are publicly announced.

If stocks were severely undervalued in the late 1970s and early 1980s, then the bull market starting in 1982 was partly just a correction to more normal valuation levels. This paper tests the hypothesis that investors suffer from inflation illusion, resulting in the undervaluation of equities in the presence of inflation, with levered firms being undervalued the most. Using firm level data and a residual income/EVA model, we find evidence that errors in the valuation of levered firms during inflationary times result in depressed stock prices. Our misvaluation measure can be used with expected inflation to make statistically reliable predictions for real returns on the Dow during the subsequent year. Our model suggests that stocks were overvalued at the end of the 1990s.

This paper solves, in closed form, the optimal portfolio choice problem for an investor with utility over consumption under mean-reverting returns. Previous solutions either require approximations, numerical methods, or the assumption that the investor does not consume over his lifetime. This paper breaks the impasse by assuming that markets are complete. The solution leads to a new understanding of hedging demand and of the behavior of the approximate log-linear solution. The portfolio allocation takes the form of a weighted average and is shown to be analogous to duration for coupon bonds. Through this analogy, the notion of investment horizon is extended to that of an investor who consumes at multiple points in time.

This article studies the valuation of options written on the average level of a Markov process. The general properties of such options are examined. We propose a closed-form characterization in which the option payoff is contingent on cumulative catastrophe losses. In our framework, the loss rate is a mean-reverting Markov process, with no continuous martingale component. The model supposes that high loss levels have lower arrival rates. We analytically derive the cumulative loss process and its characteristic function. The resulting option model is promising.

American options require numerical methods, namely lattice models, to provide accurate price estimates. The computations can become expensive when more than one state variable is involved. Analytical upper bounds can therefore provide a useful guideline for how high American values can reach. In this paper, we derive analytical (closed-form) upper bounds for American option prices under stochastic interest rates, stochastic volatility, and jumps where American option prices are difficult to compute with accuracy. In a stochastic volatility model (Heston (1993) and Scott (1997)) that has two random factors, we demonstrate that the upper bound only takes a very small fraction of the time that the American option needs to compute.

This study investigates the relation between the method of payment in acquisitions, earnings management, and operating performance for a large sample of firms that conducted acquisitions between 1985 and 1997. Prior to their acquisitions, acquirers exhibit levels of operating performance that exceed that of their respective industry peers. We find no evidence that acquirers manage their earnings prior to acquisitions, despite the possible incentives of managers who plan stock-based acquisitions to temporarily inflate their stock's purchasing power. Subsequent to acquisitions, acquirers continue to exhibit superior performance relative to their industry and experience significantly higher levels of operating performance than control firms with similar pre-event operating performance. Although the extant literature documents significant relations between the form of acquisition payment, announcement returns, and the post-acquisition excess return of acquirers, we find no evidence that the method of payment conveys information about the acquirer's future operating performance.

The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 limited thrift goodwill that could be counted as regulatory capital. This paper infers the significance of the thrift put option value from the relationship between thrift goodwill and stock returns. The ability to count goodwill as regulatory capital might have resulted in large put option values by allowing many thrifts to hold low capital and risky assets before the legislation. Tightened regulation may have reduced put option values and hence the wealth of thrift shareholders. Goodwill had a large negative effect on stock returns of low capital thrifts in 1989 and the negative effect persisted in the following two years. These findings suggest that many thrifts had large put option values before the FIRREA and the elimination of put option values was largely responsible for the stock price decline.