Michael J. Brennan

Evaluating Natural Resource Investments

Notwithstanding impressive advances in the theory of finance over the past 2 decades, practical procedures for capital budgeting have evolved only slowly. The standard technique, which has remained unchanged in essentials since it was originally proposed (see Dean 1951; Bierman and Smidt 1960), derives from a simple adaptation of the Fisher (1907) model of valuation under certainty: under this technique, expected cash flows from an investment project are discounted at a rate deemed appropriate to their risk, and the resulting present value is compared with the cost of the project. This standard textbook technique reflects modern theoretical developments only insofar as estimates of the discount rate may be obtained from crude application of single period asset pricing theory (but see Brennan 1973; Bogue and Roll 1974; Turnbull 1977; Constantinides 1978). The inadequacy of this approach to capital budgeting is widely acknowledged, although not widely discussed. Its obvious deficiency is its The evaluation of mining and other natural resource projects is made particularly difficult by the high degree of uncertainty attaching to output prices. It is shown that the techniques of continuous time arbitrage and stochastic control theory may be used not only to value such projects but also to determine the optimal policies for developing, managing, and abandoning them. The approach may be adapted to a wide variety of contexts outside the natural resource sector where uncertainty about future project revenues is a paramount concern.

Market microstructure and asset pricing: On the compensation for illiquidity in stock returns

Models of price formation in securities markets suggest that privately informed investors are a significant source of market illiquidity. Since illiquidity increases the round-trip trading cost of an investor, this implies that uninformed investors will demand higher rates of return from securities in which informational asymmetries are more severe. In this paper we derive a simple relationship between expected stock returns and market illiquidity in a model with a single representative investor. Using CRSP data for the period 1984-1992, and ISSM intraday data for the year 1988, we investigate the empirical relation between stock returns and measures of market illiquidity. We find a significant relation between required rates of return and our measure of market illiquidity using two types of test. First, following Amihud and Mendelson (1986), we control for the effects of firm size and systematic risk, as well as the quoted spread; and secondly, following Fama and French (1993), we adjust for risk factors related to the overall market, firm size, and the book-to-market ratio.

Alternative factor specifications, security characteristics, and the cross-section of expected stock returns

Abstract We examine the relation between stock returns, measures of risk, and several non-risk security characteristics, including the book-to-market ratio, firm size, the stock price, the dividend yield, and lagged returns. Our primary objective is to determine whether non-risk characteristics have marginal explanatory power relative to the arbitrage pricing theory benchmark, with factors determined using, in turn, the Connor and Korajczyk (CK; 1988) and the Fama and French (FF; 1993b) approaches. Fama–MacBeth-type regressions using risk adjusted returns provide evidence of return momentum, size, and book-to-market effects, together with a significant and negative relation between returns and trading volume, even after accounting for the CK factors. When the analysis is repeated using the FF factors, we find that the size and book-to-market effects are attenuated, while the momentum and trading volume effects persist. In addition, Nasdaq stocks show significant underperformance after adjusting for risk using either method.

Strategic asset allocation

Abstract This paper analyzes the portfolio problem of an investor who can invest in bonds, stock, and cash when there is time variation in expected returns on the asset classes. The time variation is assumed to be driven by three state variables, the short-term interest rate, the rate on long-term bonds, and the dividend yield on a stock portfolio, which are all assumed to follow a joint Markov process. The process is estimated from empirical data and the investors optimal control problem is solved numerically for the resulting parameter values. The optimal portfolio proportions of an investor with a long horizon are compared with those of an investor with a short horizon such as is typically assumed in ‘tactical asset allocation’ models: they are found to be significantly different. Out of sample simulation results provide encouraging evidence that the predictability of asset returns is sufficient for strategies that take it into account to yield significant improvements in portfolio returns.

Investment Analysis and Price Formation in Securities Markets

This paper investigates empirically the relation between the number of analysts following a security and the cost of transacting in the security, using intraday data for the year 1988. Using single and simultaneous equation specifications, it is found that the quoted bid-ask spreads on a large sample of securities are positively related to the number analysts following the security. On the other hand, estimates of the measure of market illiquidity introduced by Kyle (1985) are negatively related to analyst following. The former result is consistent with the model of Glosten and Milgrom (1985), while the latter is consistent with that of Admati and Pfleiderer (1988). Estimates of structural parameters of a model of endogenous information acquisition developed by Admati and Pfleiderer (1988) provide limited support for the model.

Underpricing, ownership and control in initial public offerings of equity securities in the UK

In this paper we examine how separation of ownership and control evolves as a result of an initial public offering (IPO) and how the underpricing of the issue can be used by insiders to retain control. Using data from a sample of 69 IPOs in the United Kingdom, we argue that IPO underpricing is used to ensure over-subscription and rationing in the share allocation process so as to allow owners to discriminate between applicants for shares and reduce the block size of new shareholdings. We find that of the pre-IPO shareholders in a firm, directors sell only a small fraction of their shares at the time of the offering and in the seven subsequent years; in contrast, holdings of non-directors are virtually eliminated during the same period. As a result, in less than seven years almost two-thirds of the offering companys shares have been sold to outside shareholders, thereby substantially advancing the process of separation of ownership and control. Additional evidence in the paper suggests that rationing in the IPO discriminates against applicants who apply for large blocks, and that the greater the underpricing, the smaller the size of new blocks assembled after the IPO.

Analyzing Convertible Bonds

The convertible bond is a hybrid security which, while retaining most of the characteristics of straight debt, offers, in addition, the upside potential associated with theunderlying common stock. As a quid pro quo for the upside potential the convertible bond is typically subordinated to other corporate debt and carries a lower coupon rate than would an otherwise equivalent straight bond.

Finite Difference Methods and Jump Processes Arising in the Pricing of Contingent Claims: A Synthesis

Since the seminal article by Black and Scholes on the pricing of corporate liabilities, the importance in finance of contingent claims has become widely recognized. The key to the valuation of such claims has been found to lie in the solution to certain partial differential equations, the best known of which is that derived by Black and Scholes in their original article from the assumption that the value of the asset underlying the contingent claim follows a geometric Brownian motion.

An Equilibrium Model of Bond Pricing and a Test of Market Efficiency

In two previous and related papers ([3], [4]), the authors have reported the results of estimating a particular equilibrium model of bond pricing using quarterly data on Canadian government bonds for the period 1964 to 1979. This paper reports the results of applying a similar model to the pricing of U.S. government bonds for the period 1958–1979 using data from the CRSP Government Bond File. The paper also extends the previous empirical analysis by evaluating the ability of the pricing model to detect underpriced and overpriced bonds: the data reveal a strong relation between price prediction errors and subsequent bond returns.

The Role of Learning in Dynamic Portfolio Decisions

This paper analyzes the effect of uncertainty about the mean return on the risky asset on the portfolio decisions of an investor who has a long investment horizon. Building on the earlier work of Detemple (1986), Dothan and Feldman (1986), and Gennotte (1986), it is shown that the possibility of future learning about the mean return on the risky asset induces the investor to take a larger or smaller position in the risky asset than she would if there were no learning, the direction of the effect depending on whether the investor is more or less risk tolerant than the logarithmic investor whose portfolio decisions are unaffected by the possibility of future learning. Numerical calculations show that uncertainty about the mean return on the market portfolio has a significant effect on the portfolio decision of an investor with a 20 year horizon if her assessment of the market risk premium is based solely on the Ibbotson and Sinquefield (1995) data.