Corporate Pension Policy and the Value of PBGC Insurance

This paper derives the value of PBGC pension insurance under two scenarios of interest. The first allows for voluntary plan termination, which appears to be legal under current statutes. In the second scenario, termination is prohibited unless the firm is bankrupt. Optimal pension funding strategy under each scenario is examined. Finally,empirical estimates of PBGC liabilities are calculated. These show that a small number of funds account for a large fraction of total prospective PBGC liabilities, that those total liabilities greatly exceed current PBGC reserves for plan terminations, and that PBGC liabilities could be substantially reduced by the prohibition of voluntary termination.

An Equilibrium Theory of Excess Volatility and Mean Reversion in Stock Market Prices

Apparent mean reversion and excess volatility in stock market prices can be reconciled with the Efficient Market Hypothesis by specifying investor preferences that give rise to the demand for portfolio insurance. Therefore, several supposed macro anomalies can be shown to be consistent with a rational market in a simple and parsimonious model of the economy. Unlike other models that have derived equilibrium mean reversion in prices, the model in this paper does not require that the production side of the economy exhibit mean reversion. It also predicts that mean reversion and excess volatility will differ substantially across subperiods.

Valuation and Optimal Exercise of the Wild Card Option in the Treasury Bond Futures Market

The Chicago Board of Trade Treasury Bond Futures Contract allows the short position several delivery options as to when and with which bond the contract will be settled. The timing option allows the short position to choose any business day in the delivery month to make delivery. In addition, the contract settlement price is locked in at 2:00 p.m. when the futures market closes, despite the facts that the short position need not declare an intent to settle the contract until 8:00 p.m. and that trading in Treasury bonds car, occur all day in dealer markets. If bond prices change significantly between 2:00 and 8:00 p.m., the short has the option of settling the contract at a favorable 2:00 p.m. price. This phenomenon, which recurs on every trading day of the delivery month, creates a sequence of 6-hour put options for the short position which has been dubbed the "wild card option." This paper presents avaluation model for the wild card option and computes estimates of the value of that option, as well as rules for its optimal exercise.

Riding the Yield Curve: Reprise

We investigate the efficacy of riding the yield curve. This strategy dictates holding longer-term treasury bills when the yield curve is upwardsloping. We find that the strategy is surprisingly effective. it stochastically dominates buying and holding shorter-term bills for large subperiods, and nearly dominates for the entire sample period, 1949-1988. Our empirical results suggest that abnormal profit opportunities are available from selectively increasing the maturity of a short-term portfolio.

How Big is the Tax Advantage to Debt?

This paper uses an option valuation model of the firm to answer the question, "What magnitude tax advantage to debt is consistent with the range of observed corporate debt ratios?" We incorporate into the model differential personal tax rates on capital gains and ordinary income. We conclude that variations in the magnitude of bankruptcy costs across firms can not by itself account for the simultaneous existence of levered and unlevered firms. When it is possible for the value of the underlying assets to junip discretely to zero, differences across firms in the probability of this jump can account for the simultaneous existence of levered and unlevered firms. Moreover, if the tax advantage to debt is small, the annual rate of return advantage offered by optimal leverage may be so small as to make the firm indifferent about debt policy over a wide range of debt-to-firm value ratios.

Defined Benefit versus Defined Contribution Pension Plans: What are the Real Tradeoffs?

Defined Benefit and Defined Contribution plans have significantly different characteristics with respect to the risks faced by employers and employees, the sensitivity of benefits to inflation, the flexibility of funding, and the importance of governmental supervision. In this paper, we examine some of the main tradeoffs involved in the choice between DB and DC plans. Our most general conclusion is that neither plan type can be said to wholly dominate the other from the perspective of employee welfare.The major advantage of DB plans is the potential they offer to provide a stable replacement rate of final income to workers. If the replacement rate is the relevant variable for worker retirement utility, then DB plans offer some degree of insurance against real wage risk. Of course, protection offered to workers is risk borne by the firm. As real wages change, funding rates must correspondingly adjust. However, to the extent that real wage risk is largely diversifiable to employers, and nondiversifiable to employees, the replacement rate stability should be viewed as an advantage of DB plans. The advantages of DC plans are most apparent during periods of inflation uncertainty. These are: the predictability of the value of pension wealth, the ability to invest in inflation-hedged portfolios rather than nominal DB annuities,and the fully-funded nature of the DC plan. Finally, the DC plan has the advantage that workers can more easily determine the true present value of the pension benefit they earn in any year, although they may have more incertainty about future pension-benefit flows at retirement. Measuring the present value of accruing defined benefits is difficult at best and imposes severe informational requirements on workers. Such difficulties could lead workers to misvalue their total compensation, and result in misinformed behavior.

Earnings and Dividend Announcements is there a Corroboration Effect?

We examine abnormal stock returns surrounding contemporaneous earnings and dividend announcements in order to determine whether investors evaluate the two announcements in relation to each other.We find that there is a statistically significant interaction effect.The abnormal return corresponding to any earnings or dividend announcement depends upon the value of the other announcement. This evidence suggests the existence of a corroborative relationship between the two announcements. Investors give more credence to unanticipated dividend increases or decreases when earnings are also above or below expectations, and vice versa.

Debt Policy and the Rate of Return Premium to Leverage

Equilibrium in the market for real assets requires that the price of those assets be bid up to reflect the tax shields they can offer to levered firms.Thus there must be an equality between the market values of real assets and the values of optimally levered firms. The standard measure of the advantage to leverage compares the values of levered and unlevered assets, and can be misleading and difficult to interpret. We show that a meaningful measure of the advantage to debt is the extra rate of return, net of a market premium for bankruptcy risk, earned by a levered firm relative to an otherwise-identical unlevered firm. We construct an option valuation model to calculate such a measure and present extensive simulation results. We use this model to compute optimal debt maturities, show how this approach can be used for capital budgeting, and discuss its implications for the comparison of bankruptcy costs versus tax shields.