Marshall Sarnat

Safety First — An Expected Utility Principle

The theory of choice under conditions of certainty has been extended by Von Neumann and Morgenstern [8], Friedman and Savage [5], Marschak [13], and others to conditions involving risk by assuming that individuals maximize their expected utility. The application of this theory to portfolio selection, to efficiency criteria, and to the explanation of the well-known phenomenon of diversification of assets has been carried further by Markowitz [11 and 12], Tobin [17], Samuelson [15], Sharpe [16], and Lintner [10], and more recently by Hadar and Russell [5] and Hanoch and Levy [8].

LEASING, BORROWING AND FINANCIAL RISK

The authors present a technique for incorporating the financial risks of leasing into the economic evaluation of the lease vs. buy decision. A numerical example is presented.

A Note on the Implications of Quadratic Utility for Portfolio Theory

The shortcomings of a quadratic utility function are so serious and so widely known that by now one might assume that it would simply have been dropped from consideration. Arrow [1] and Pratt [6] have shown that such a function implies ever increasing absolute risk aversion, that is, reduced risk taking as wealth increases, which contradicts everyday experience. Moreover, the assumption of quadratic utility also implies ultimate satiation with respect to risk taking. This function has a well-defined maximum beyond which the marginal utility of money declines, and as a result the range of admissable returns must be restricted. Wippern [12] has focused attention on the second of the above two shortcomings. Using a rather ingenious device, based on the Sharpe-Lintner market model [8 and 5], Wippern has measured empirically the admissable range of returns implied by the quadratic utility function. Since his empirical findings imply that returns beyond as little as 1.3 standard deviations from the expected return provide negative marginal utility to investors, Wippern concludes that the Sharpe-Lintner market model, and/or the mean-variance portfolio theory upon which it is based, have “inconsistent and implausible properties.â€

The effectiveness of tightening illegal insider trading regulation: the case of corporate takeovers

The impact of tightening the regulation of illegal insider trading in the United States is analysed. It is argued that more effective regulation will reduce the price run-up in target companies prior to takeover announcements. By comparing stock price responses to takeover announcements during two distinct regulatory regimes - a regime of lax regulation, prior to 1985, and a regime of stricter regulation, 1989-1991 - inferences are made about the effectiveness of changes in illegal insider trading regulation. Using this approach, strong evidence is found that stricter regulation was effective in reducing illegal insider trading. Tightening the regulation had a greater impact on negotiated takeovers than on those initiated by bidding. Evidence also indicates that, for negotiated takeovers, but not for takeovers initiated by bidding, insiders associated with acquiring firms sought fewer but more profitable takeovers after the effective tightening of regulation, possibly to compensate them for the reduction in the profit opportunities from illegal insider trading.

The Portfolio Analysis of Multiperiod Capital Investment Under Conditions of Risk

This article applies the Markowitz-Tobin portfolio selection model to problems of multiperiod capital investment, and sets out the theoretical implications for the received doctrine of capital budgeting. Situations in which the use of the mean-variance criterion leads to the inclusion of projects with negative expected net present values in the optimal decision set are analyzed. It is shown that the firm may rationally accept a proposal with negative net present value in the case of low risk projects or even in the case of high risk projects whose negative covariance with other accepted projects is sufficiently strong to produce an efficient combination (portfolio). An analysis of the properties of a proposed measure of risk, the variance of net present value, shows that this measure of dispersion provides an acceptable multiperiod analogue to the measure of risk used in portfolio analysis.

Foreign banks in Japan: A study of a Japanese deregulation process

The deregulation of foreign banks in Japan, although corresponding in broad outline to world-wide trends, has diverged substantially in many particulars from patterns seen elsewhere. It has tended to be excruciatingly slow and piecemeal and to have been of minimal benefit to foreign banks. A review of this process leads to the conclusion that these characteristics result from organisational and political-bureaucratic factors inherent to the Japanese style of government which is, in turn, partially a reflection of Japanese culture. Although these non-economic factors have influenced the specific pattern of change, its overall direction appears to have been consistent with the broader national interest.

Reply: “Safety First – An Expected Utility Principle”

We are grateful for the opportunity which Professors Gressis and Remaleys Comment [1] has afforded us to clarify our analysis of the relationship between Roys Safety First principle and the Mean-Variance expected utility rule, which unfortunately they find misleading. In our original presentation we did not explicitly analyze situations in which Roys criterion leads to an extreme corner solution; and G-R are perfectly correct in noting that if a riskless asset exists, a “Safety-Firster†will not invest in risky securities at all if the risk-free interest rate, r, exceeds the disaster level d. The reason for this is straightforward: such an investment strategy minimizes the risk of disaster. In fact in this particular instance the investor can reduce the probability of disaster to zero.

The Emergence of Israel's Security Market: A Note

Prior to World War I, Palestine was an underdeveloped province of the Turkish Empire, with barely an elementary commercial banking system, let alone an organized long-term capital market. Only thirty years later, however, the new State of Israel was able to confront the economic challenge of statehood with the institutional framework of a formal domestic capital market already in place. This article analyzes the salient economic and social forces which led to the emergence of a viable domestic security market in Palestine during the later years of the British Mandate.