Stephen A. Buser

Empirical determinants of the relative yields on taxable and tax-exempt securities

Abstract Yields on short-term prime-grade municipals vary through time in relation to after-corporate-tax yields on short-term U.S. Treasury securities. The pattern is not related to the default premium in municipal yields or to the historical ceiling on bank deposit rates (Regulation Q). However, there is a strong link to the default premium in corporate yields and to municipal holdings by large commercial banks. These findings suggest that taxable and tax-exempt markets are linked both by the capital-structure decisions of firms and by the tax-arbitrage activities of banks.

Pricing Life-of-Loan Rate Caps on Default-Free Adjustable-Rate Mortgages

A model is developed and utilized in this paper to value a life-of-loan interest-rate cap on an ARM that reprices monthly. The value of the cap is seen to depend importantly on both the slope of the term structure and the variance of the 1-month rate. However, the cap value is not sensitive to the source of the slope of the term structure - what precise combination of interest-rate expectations and risk aversion determined the slope. This insensitivity is fortunate because of the great difficulty of knowing at any point in time why the term structure is what it is.Given the variation in the slope of the term structure and the variance of the 1-month rate that occurred over the 1979-84 period, the addition to the coupon rate on a 1-month ARM that lenders should have charged for a 5% life-of-loan cap has ranged from 5 to 40 basis points. Copyright American Real Estate and Urban Economics Association.

Determinants of the Value of Call Options of Default-Free Bonds

The fundamental determinants of the value of an option on a bond are the level and slope of the term structure and the level of interest-rate uncertainty. Competing models that have been developed to price bond options produce similar estimates as long as those models are conditioned on similar values for the fundamental determinants. This result is established for simple options with known closed-form solutions and for more complex options that require numerical methods for evaluation. The finding is confirmed for a wide range of economic conditions, and it is shown to be robust with respect to the number and nature of factors that generate interest-rate movements. Copyright 1990 by the University of Chicago.

Life insurance in a portfolio context

Abstract The ownership of life insurance may be modeled as a portfolio problem in which the return on the life insurance contract is negatively correlated with the return on a claim to future wage income. The mean-variance model developed in the paper uses such a framework to express the optimal amount of insurance in terms of two components: the expected value of the wage claim and the risk/return characteristics of the insurance contract. The model thus offers an appealing way to formulate the life insurance problem in a portfolio context. Implications of the model for the functioning of a life insurance market are examined and the existence of accidental death contracts is explained.

Risk Aversion, Insurance Costs and Optimal Property-Liability Coverages

The standard mean-variance portfolio model can be modified to show how individuals select deductibles and face amounts of coverage. Optimal insurance decisions balance the portfolio holders desire for insurance protection against the cost of insurance. This same conclusion has been derived by insurance economists who considered insurance and insurable risks in isolation from other assets. However, the broader portfolio setting allows the portfolio holders behavior towards other risky assets to provide an objective measure of risk tolerance for tile insurance transaction. This setting extends many conclusions from traditional insurance economics into modern portfolio theory. The mean-variance approach also leads to specific predictions about behavior by individuals towards deductibles and amounts of coverage.

Tenure Decisions Under a Progressive Tax Structure

Although certain provisions of the federal tax code provide subsidies to homeowners, others provide subsidies to renters in the form of tax incentives for investments in rental housing. We demonstrate that the renter subsidies dominate for households in low tax brackets whereas homeowner subsidies dominate for households in high tax brackets. Moreover the dollar magnitude involved in the tenure decision can easily push a household across tax brackets. Based on this relation, we identify an upper bound on the value of a dwelling that a household with a given income will prefer to own rather than rent for tax purposes. If the household were to choose a dwelling valued in excess of this household-specific upper bound, the tax effect would reverse and favor renting. This complication provides a possible explanation for apparent tax anomalies in tenure decisions, i.e., high income renters and/or low income homeowners. Copyright American Real Estate and Urban Economics Association.

On the Optimal Mix of Active and Passive Investments

A modified version of the appraisal ratio developed by Treynor and Black in 1973 identifies a unique mix of active and passive investments that is optimal for every investor, regardless of his or her preferences for risk and return. This result suggests that financial advisors can consider recommending specific dollar amounts for clients to allocate to active investment strategies, rather than simply recommending qualitative assessments regarding such opportunities. The article identifies corresponding implications for services that provide estimates of analytic measures that are used to evaluate active investments, as well as for institutions that manage active portfolios on behalf of individuals.

The First Difference Property of the Present Value Operator

The present value of a future cash flow together with derived risk measures like duration and convexity are some of the most fundamental concepts in financial economics. Technological advances have greatly enhanced methods for numerical calculations of such magnitudes. Consequently, analytical expressions have been pushed into the background to the extent that they are rarely, if ever, found in modern textbooks, despite their widespread use in both the classroom and in the real world. This holds, a fortiori, for the derivations leading to these expressions.Analytical solutions are instructive for both students and practitioners as they help understand the qualitative behavior and outcome of numerical calculations and the driving forces behind.This paper derives closed form solutions for the present value and the derived risk measures for a number of commonly used payment streams. The derivations in the paper only use elementary arithmetic operations and avoid cumbersome differentiation operations as well as complicated summation exercises.

New Properties of the Old Present Value Operator

Advances in computing technology have greatly enhanced methods for numerical calculations of present value and related measures such as duration and convexity. Nevertheless, closed form solutions continue to play an important role both in the classroom and in the real world. For example, it is well known that if r is the rate of discount and if C1 denotes the value in period 1 for a cash flow that grows at constant percentage rate, g, then the present value of the future cash flow can be represented as C1 / (r – g). Yet how many students or practitioners, and dare we ask how many finance professors, are aware that the duration of a perpetual cash flow that grows at a uniform geometric rate can be represented as (1 r) / (r –g) ? For that matter, how widely is it known that a simple closed form solution exists for the present value of a cash flow that exhibits cyclical variation over time or a cash flow that grows by a constant dollar amount each period rather than by a constant percentage amount? The objective of this paper is to demonstrate that these results, and countless others, can be derived from one simple but previously under developed property of the traditional present value operator.