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The Substitutability of Debt and Equity Securities

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  • Benjamin M. Friedman
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    Abstract

    This paper investigates empirically the degree of substitutability between debt and equity securities in the United States during 1960-1980. The analysis first applies fundamental relationships connecting portfolio choices with expected asset returns to infer key asset substitutabilities directly from the observed U.S. asset return experience. It then compares these implied substitutabilities with the observed portfolio behavior of U.S. households. The resulting evidence provides little ground for any conclusion about even the sign, much less the magnitude, of the substitutability of short-term debt and equity. Although the implied optimal behavior indicates that these two assets are substitutes, the observed behavior indicates that households have treated them as complements. By contrast, the evidence consistently indicates that long-term debt and equity are substitutes. Moreover, with a few exceptions the empirical estimates of the associated substitution elasticity are quite closely clustered around the value -.035. The conclusion that long-term debt and equity are substitutes with elasticity -.035 bears mixed implications for broader economic and financial questions. At one level, the finding that the two assets are indeed substitutes validates the standard assumption underlying a variety of familiar models in monetary economics and finance. At the same time, if the elasticity is only -.035, then many of these models' more important substantive conclusions do not follow.

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    Bibliographic Info

    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 1130.

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    Date of creation: May 1983
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    Publication status: published as Friedman, Benjamin M. (ed.) Corporate Capital Structures in the United States, National Bureau of Economic Research Project Report series. Chicago and London: University of Chicago Press, 1985.
    Handle: RePEc:nbr:nberwo:1130

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    1. Friedman, Benjamin M, 1982. "Federal Reserve Policy, Interest Rate Volatility, and the U.S. Capital Raising Mechanism," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 14(4), pages 721-45, November.
    2. Friedman, Benjamin M, 1980. "Price Inflation, Portfolio Choice, and Nominal Interest Rates," American Economic Review, American Economic Association, American Economic Association, vol. 70(1), pages 32-48, March.
    3. Kane, Edward J, 1983. "Nested Tests of Alternative Term-Structure Theories," The Review of Economics and Statistics, MIT Press, vol. 65(1), pages 115-23, February.
    4. William F. Sharpe, 1964. "Capital Asset Prices: A Theory Of Market Equilibrium Under Conditions Of Risk," Journal of Finance, American Finance Association, American Finance Association, vol. 19(3), pages 425-442, 09.
    5. Blanchard, Olivier J & Plantes, Mary Kay, 1977. "A Note on Gross Substitutability of Financial Assets," Econometrica, Econometric Society, Econometric Society, vol. 45(3), pages 769-71, April.
    6. Friedman, Benjamin M, 1977. "Financial Flow Variables and the Short-Run Determination of Long-Term Interest Rates," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 85(4), pages 661-89, August.
    7. Benjamin M. Friedman, 1978. "Price Inflation, Portfolio Choice, and Nominal Interest Rates," NBER Working Papers 0235, National Bureau of Economic Research, Inc.
    8. Barro, Robert J & Santomero, Anthony J, 1972. "Household Money Holdings and The Demand Deposit Rate," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 4(2), pages 397-413, May.
    9. William C. Brainard & James Tobin, 1968. "Pitfalls in Financial Model-Building," Cowles Foundation Discussion Papers, Cowles Foundation for Research in Economics, Yale University 244, Cowles Foundation for Research in Economics, Yale University.
    10. Zvi Bodie, 1982. "Investment Strategy in an Inflationary Environment," NBER Working Papers 0701, National Bureau of Economic Research, Inc.
    11. Fama, Eugene F & MacBeth, James D, 1973. "Risk, Return, and Equilibrium: Empirical Tests," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 81(3), pages 607-36, May-June.
    12. Stephen M. Goldfeld, 1976. "The Case of the Missing Money," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 7(3), pages 683-740.
    13. Klein, Benjamin, 1974. "Competitive Interest Payments on Bank Deposits and the Long-Run Demand for Money," American Economic Review, American Economic Association, American Economic Association, vol. 64(6), pages 931-49, December.
    14. Samuelson, Paul A, 1970. "The Fundamental Approximation Theorem of Portfolio Analysis in terms of Means, Variances, and Higher Moments," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 37(4), pages 537-42, October.
    15. Friend, Irwin & Blume, Marshall E, 1975. "The Demand for Risky Assets," American Economic Review, American Economic Association, American Economic Association, vol. 65(5), pages 900-922, December.
    16. S. Grossman & R. Shiller, . "The Determinants of the Variability of Stock Market Price," Rodney L. White Center for Financial Research Working Papers, Wharton School Rodney L. White Center for Financial Research 18-80, Wharton School Rodney L. White Center for Financial Research.
    17. Cass, David & Stiglitz, Joseph E., 1970. "The structure of investor preferences and asset returns, and separability in portfolio allocation: A contribution to the pure theory of mutual funds," Journal of Economic Theory, Elsevier, Elsevier, vol. 2(2), pages 122-160, June.
    18. Friedman, Benjamin Morton, 1977. "Financial Flow Variables and the Short-Run Determination of Long-Term Interest Rates," Scholarly Articles 4554309, Harvard University Department of Economics.
    19. Fama, Eugene F. & Schwert, G. William, 1977. "Asset returns and inflation," Journal of Financial Economics, Elsevier, Elsevier, vol. 5(2), pages 115-146, November.
    20. Roley, V Vance, 1983. "Symmetry Restrictions in a System of Financial Asset Demands: Theoretical and Empirical Results," The Review of Economics and Statistics, MIT Press, vol. 65(1), pages 124-30, February.
    21. Feldstein, Martin & Dicks-Mireaux, Louis & Poterba, James, 1983. "The effective tax rate and the pretax rate of return," Journal of Public Economics, Elsevier, Elsevier, vol. 21(2), pages 129-158, July.
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    Cited by:
    1. Arturo Estrella & Jeffrey C. Fuhrer, 1983. "Average Marginal Tax Rates U.S. Household Interest and Dividend Income 1954-80," NBER Working Papers 1201, National Bureau of Economic Research, Inc.
    2. Sahoo, Ganeswar, 2010. "International Capital Flows: An empirical study of the relationship between equity and debt investments," MPRA Paper 24797, University Library of Munich, Germany.

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