The Journal of Finance

Municipal Debt and Marginal Tax Rates: Is There a Tax Premium in Asset Prices?

Published: 05/23/2011   |   DOI: 10.1111/j.1540-6261.2011.01650.x

FRANCIS A. LONGSTAFF

We study the marginal tax rate incorporated into short‐term municipal rates using municipal swap market data. Using an affine model, we identify the marginal tax rate and the credit/liquidity spread in 1‐week tax‐exempt rates, as well as their associated risk premia. The marginal tax rate averages 38.0% and is related to stock, bond, and commodity returns. The tax risk premium is negative, consistent with the strong countercyclical nature of after‐tax fixed‐income cash flows. These results demonstrate that tax risk is a systematic asset pricing factor and help resolve the muni‐bond puzzle.

Arbitrage and the Expectations Hypothesis

Published: 12/17/2002   |   DOI: 10.1111/0022-1082.00234

Francis A. Longstaff

This paper shows that all traditional forms of the expectations hypothesis can be consistent with the absence of arbitrage if markets are incomplete. A key implication is that the validity of the expectations hypothesis is purely an empirical issue; the expectations hypothesis cannot be ruled out on a priori theoretical grounds.

Pricing Options with Extendible Maturities: Analysis and Applications

Published: 07/01/1990   |   DOI: 10.1111/j.1540-6261.1990.tb05113.x

FRANCIS A. LONGSTAFF

Many common types of financial contracts incorporate options with extendible maturities. This paper derives closed‐form expressions for options that can be extended by the optionholder and presents a number of applications including the valuation of American options with stochastic dividends, junk bonds, and shared‐equity mortgages. We also derive closed‐form expressions for writer‐extendible options and discuss the writer's economic incentives for extending an out‐of‐the‐money option. We apply these results to show that corporate debtholders have a strong incentive to extend the maturity of defaulting debt if there are liquidation costs. We model and solve the debtholders' optimal extension problem and show that the possibility of an extension can induce shareholders in highly levered firms to accept negative NPV projects.

Temporal Aggregation and the Continuous‐Time Capital Asset Pricing Model

Published: 09/01/1989   |   DOI: 10.1111/j.1540-6261.1989.tb02628.x

FRANCIS A. LONGSTAFF

We examine how the empirical implications of the Capital Asset Pricing Model (CAPM) are affected by the length of the period over which returns are measured. We show that the continuous‐time CAPM becomes a multifactor model when the asset pricing relation is aggregated temporally. We use Hansen's Generalized Method of Moments (GMM) approach to test the continuous‐time CAPM at an unconditional level using size portfolio returns. The results indicate that the continuous‐time CAPM cannot be rejected. In contrast, the discrete‐time CAPM is easily rejected by the tests. These results have a number of important implications for the interpretation of tests of the CAPM which have appeared in the literature.

Time Varying Term Premia and Traditional Hypotheses about the Term Structure

Published: 09/01/1990   |   DOI: 10.1111/j.1540-6261.1990.tb02439.x

FRANCIS A. LONGSTAFF

Empirical evidence of time varying term premia in bond returns is frequently interpreted as evidence against the Expectations Hypothesis. This paper shows that the Expectations Hypothesis can actually imply time varying term premia if the time frame for which the Expectations Hypothesis holds differs from the return measurement period. Furthermore, many of the properties of these term premia are consistent with those of observed term premia. These results are important because they imply that the case against the Expectations Hypothesis is weaker than claimed in the empirical literature.

How Much Can Marketability Affect Security Values?

Published: 12/01/1995   |   DOI: 10.1111/j.1540-6261.1995.tb05197.x

FRANCIS A. LONGSTAFF

How marketability affects security prices is one of the most important issues in finance. We derive a simple analytical upper bound on the value of marketability using option‐pricing theory. We show that discounts for lack of marketability can potentially be large even when the illiquidity period is very short. This analysis also provides a benchmark for assessing the potential costs of exchange rules and regulatory requirements restricting the ability of investors to trade when desired. Furthermore, these results provide new insights into the relation between discounts for lack of marketability and the length of the marketability restriction.

Small Business Equity Returns: Empirical Evidence from the Business Credit Card Securitization Market

Published: 12/20/2022   |   DOI: 10.1111/jofi.13200

MATTHIAS FLECKENSTEIN, FRANCIS A. LONGSTAFF

We present a new approach for estimating small business equity returns. This approach applies the Merton (1974) credit model to the returns on entrepreneurial business credit card debt securitizations and solves for the implied equity returns for the small businesses owned by the cardholders. The estimated small business equity premium is 10.74%. The standard deviation of small business equity returns is 56.37%. We validate the methodology by applying it to investment‐grade corporate bonds and recovering a public equity premium of 6.17%.

Financial Innovation and the Role of Derivative Securities: An Empirical Analysis of the Treasury STRIPS Program

Published: 12/17/2002   |   DOI: 10.1111/0022-1082.00252

Mark Grinblatt, Francis A. Longstaff

The role that financial innovation plays in financial markets is very controversial. To provide insight into this role, we examine how market participants use the highly successful Treasury STRIPS program. We find that investors use the option to create Treasury‐derivative STRIPS primarily to make markets more complete and take advantage of tax and accounting asymmetries. Although liquidity‐related factors help explain differences in the prices of Treasury bonds and STRIPS, we find little evidence that the option to strip and reconstitute securities is used for speculative or arbitrage‐related purposes.

An Empirical Analysis of the Pricing of Collateralized Debt Obligations

Published: 04/01/2008   |   DOI: 10.1111/j.1540-6261.2008.01330.x

FRANCIS A. LONGSTAFF, ARVIND RAJAN

We use the information in collateralized debt obligations (CDO) prices to study market expectations about how corporate defaults cluster. A three‐factor portfolio credit model explains virtually all of the time‐series and cross‐sectional variation in an extensive data set of CDX index tranche prices. Tranches are priced as if losses of 0.4%, 6%, and 35% of the portfolio occur with expected frequencies of 1.2, 41.5, and 763 years, respectively. On average, 65% of the CDX spread is due to firm‐specific default risk, 27% to clustered industry or sector default risk, and 8% to catastrophic or systemic default risk.

Electricity Forward Prices: A High‐Frequency Empirical Analysis

Published: 11/27/2005   |   DOI: 10.1111/j.1540-6261.2004.00682.x

Francis A. Longstaff, Ashley W. Wang

We conduct an empirical analysis of forward prices in the PJM electricity market using a high‐frequency data set of hourly spot and day‐ahead forward prices. We find that there are significant risk premia in electricity forward prices. These premia vary systematically throughout the day and are directly related to economic risk factors, such as the volatility of unexpected changes in demand, spot prices, and total revenues. These results support the hypothesis that electricity forward prices in the Pennsylvania, New Jersey, and Maryland market are determined rationally by risk‐averse economic agents.

A Simple Approach to Valuing Risky Fixed and Floating Rate Debt

Published: 07/01/1995   |   DOI: 10.1111/j.1540-6261.1995.tb04037.x

FRANCIS A. LONGSTAFF, EDUARDO S. SCHWARTZ

We develop a simple approach to valuing risky corporate debt that incorporates both default and interest rate risk. We use this approach to derive simple closed‐form valuation expressions for fixed and floating rate debt. The model provides a number of interesting new insights about pricing and hedging corporate debt securities. For example, we find that the correlation between default risk and the interest rate has a significant effect on the properties of the credit spread. Using Moody's corporate bond yield data, we find that credit spreads are negatively related to interest rates and that durations of risky bonds depend on the correlation with interest rates. This empirical evidence is consistent with the implications of the valuation model.

Interest Rate Volatility and the Term Structure: A Two‐Factor General Equilibrium Model

Published: 09/01/1992   |   DOI: 10.1111/j.1540-6261.1992.tb04657.x

FRANCIS A. LONGSTAFF, EDUARDO S. SCHWARTZ

We develop a two‐factor general equilibrium model of the term structure. The factors are the short‐term interest rate and the volatility of the short‐term interest rate. We derive closed‐form expressions for discount bonds and study the properties of the term structure implied by the model. The dependence of yields on volatility allows the model to capture many observed properties of the term structure. We also derive closed‐form expressions for discount bond options. We use Hansen's generalized method of moments framework to test the cross‐sectional restrictions imposed by the model. The tests support the two‐factor model.

Corporate Yield Spreads: Default Risk or Liquidity? New Evidence from the Credit Default Swap Market

Published: 09/16/2005   |   DOI: 10.1111/j.1540-6261.2005.00797.x

FRANCIS A. LONGSTAFF, SANJAY MITHAL, ERIC NEIS

We use the information in credit default swaps to obtain direct measures of the size of the default and nondefault components in corporate spreads. We find that the majority of the corporate spread is due to default risk. This result holds for all rating categories and is robust to the definition of the riskless curve. We also find that the nondefault component is time varying and strongly related to measures of bond‐specific illiquidity as well as to macroeconomic measures of bond market liquidity.

The U.S. Treasury Buyback Auctions: The Cost of Retiring Illiquid Bonds

Published: 11/28/2007   |   DOI: 10.1111/j.1540-6261.2007.01289.x

BING HAN, FRANCIS A. LONGSTAFF, CRAIG MERRILL

We study an important recent series of buyback auctions conducted by the U.S. Treasury in retiring $67.5 billion of its illiquid off‐the‐run debt. The Treasury was successful in buying back large amounts of illiquid debt while suffering only a small market‐impact cost. The Treasury included the most‐illiquid bonds more frequently in the auctions, but tended to buy back the least‐illiquid of these bonds. Although the Treasury had the option to cherry pick from among the bonds offered, we find that the Treasury was actually penalized for being spread too thinly in the buybacks.

Dual Trading in Futures Markets

Published: 06/01/1992   |   DOI: 10.1111/j.1540-6261.1992.tb04404.x

MICHAEL J. FISHMAN, FRANCIS A. LONGSTAFF

With dual trading, brokers trade both for their customers and for their own account. We study dual trading and find that customers who are less likely to be informed have higher expected profits with dual trading while customers who are more likely to be informed have higher expected profits without dual trading. We also examine the effects of frontrunning. We test the major empirical implications of our model. Consistent with the model, dual traders earn higher profits than non‐dual traders, and customers of dual‐trading brokers do better than customers of non‐dual‐trading brokers.

The TIPS‐Treasury Bond Puzzle

Published: 01/30/2013   |   DOI: 10.1111/jofi.12032

MATTHIAS FLECKENSTEIN, FRANCIS A. LONGSTAFF, HANNO LUSTIG

We show that the price of a Treasury bond and an inflation‐swapped Treasury Inflation‐Protected Securities (TIPS) issue exactly replicating the cash flows of the Treasury bond can differ by more than $20 per $100 notional. Treasury bonds are almost always overvalued relative to TIPS. Total TIPS‐Treasury mispricing has exceeded $56 billion, representing nearly 8% of the total amount of TIPS outstanding. We find direct evidence that the mispricing narrows as additional capital flows into the markets. This provides strong support for the slow‐moving‐capital explanation of arbitrage persistence.

Dynamic Asset Allocation with Event Risk

Published: 02/12/2003   |   DOI: 10.1111/1540-6261.00523

Jun Liu, Francis A. Longstaff, Jun Pan

Major events often trigger abrupt changes in stock prices and volatility. We study the implications of jumps in prices and volatility on investment strategies. Using the event‐risk framework of Duffie, Pan, and Singleton (2000), we provide analytical solutions to the optimal portfolio problem. Event risk dramatically affects the optimal strategy. An investor facing event risk is less willing to take leveraged or short positions. The investor acts as if some portion of his wealth may become illiquid and the optimal strategy blends both dynamic and buy‐and‐hold strategies. Jumps in prices and volatility both have important effects.

The Relative Valuation of Caps and Swaptions: Theory and Empirical Evidence

Published: 12/17/2002   |   DOI: 10.1111/0022-1082.00399

Francis A. Longstaff, Pedro Santa‐Clara, Eduardo S. Schwartz

Although traded as distinct products, caps and swaptions are linked by no‐arbitrage relations through the correlation structure of interest rates. Using a string market model, we solve for the correlation matrix implied by swaptions and examine the relative valuation of caps and swaptions. We find that swaption prices are generated by four factors and that implied correlations are lower than historical correlations. Long‐dated swaptions appear mispriced and there were major pricing distortions during the 1998 hedge‐fund crisis. Cap prices periodically deviate significantly from the no‐arbitrage values implied by the swaptions market.

Advance Refundings of Municipal Bonds

Published: 03/18/2017   |   DOI: 10.1111/jofi.12506

ANDREW ANG, RICHARD C. GREEN, FRANCIS A. LONGSTAFF, YUHANG XING

The advance refunding of debt is a widespread practice in municipal finance. In an advance refunding, municipalities retire callable bonds early and refund them with bonds with lower coupon rates. We find that 85% of all advance refundings occur at a net present value loss, and that the aggregate losses over the past 20 years exceed $15 billion. We explore why municipalities advance refund their debt at loss. Financially constrained municipalities may face pressure to advance refund since it allows them to reduce short‐term cash outflows. We find strong evidence that financial constraints are a major driver of advance refunding activity.

An Empirical Comparison of Alternative Models of the Short‐Term Interest Rate

Published: 07/01/1992   |   DOI: 10.1111/j.1540-6261.1992.tb04011.x

K. C. CHAN, G. ANDREW KAROLYI, FRANCIS A. LONGSTAFF, ANTHONY B. SANDERS

We estimate and compare a variety of continuous‐time models of the short‐term riskless rate using the Generalized Method of Moments. We find that the most successful models in capturing the dynamics of the short‐term interest rate are those that allow the volatility of interest rate changes to be highly sensitive to the level of the riskless rate. A number of well‐known models perform poorly in the comparisons because of their implicit restrictions on term structure volatility. We show that these results have important implications for the use of different term structure models in valuing interest rate contingent claims and in hedging interest rate risk.