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Economic Review

Economic Review
November/December 1995, Volume 80, Number 6

To Call or Not to Call? Optimal Call Policies for Callable U.S. Treasury Bonds
Robert R. Bliss and Ehud I. Ronn

Until 1984, the U.S. Treasury typically issued its long-term bonds in callable form. A number of these securities, totaling $93.8 billion in face value, remain outstanding. After a call protection period, usually five years prior to maturity, the Treasury can call the bonds but must give prior notification of intent to call. This article develops a decision rule, which takes account of the prior notification requirement, when it is optimal to call such bonds.

The decision of whether to call is based on the current level of interest rates and their volatility. For a call to be optimal for the Treasury, interest rates must be sufficiently low (relative to the bond's coupon) and the potential benefits of waiting--on the chance of even lower interest rates--should be insufficient to compensate for the costs of continuing to pay the higher coupon rate for another six months. After developing these ideas, the authors use a numerical example to demonstrate their application. They conclude that, at least in recent years, the Treasury has called bonds optimally. The model they use, which is also applicable to agency, corporate, and municipal callable bonds, specifies conditions under which the Treasury should call outstanding callable bonds in the future.

Mergers and Acquisitions in China
Jie Lin Dong and Jie Hu

Mergers and acquisitions are an integral part of any market economy, enhancing an economy's efficiency by reallocating and recombining production resources for better use. In China, the development of mergers and acquisitions activity has played a positive role in privatizing and revitalizing the country's inefficient state enterprises, attracting foreign investment, and rationalizing the industrial structure. The authors of this article discuss this development in the context of China's market-oriented economic reform and provide an outline of the advantages and disadvantages of the country's approach to mergers and acquisitions.

Three reasons emerge as forces driving mergers and acquisitions activity in China, reasons that are likely to continue fueling its growth: the government's need to restructure and revitalize the state-owned enterprises; the growing needs of enterprises; and the market's potential for attracting more international capital. Because of the importance of the mergers and acquisitions market in restructuring and modernizing the industry of China, the authors expect its development to continue, but they observe that careful handling of many institutional deficiencies and social problems as well as political obstacles will be required to avoid major setbacks.

FYI -- Monetary Aggregates, Payments Technology, and Institutional Factors
David J. Petersen

Economic theory implies that the quantity of money in the economy is linked both to the Federal Reserve's policy-making instruments and its ultimate objectives and should therefore be useful in formulating policy decisions. The Federal Reserve defines monetary aggregates, composed of financial assets like cash and demand deposits, expressly for this purpose.

Over time, substantial changes have been observed in the close relationships between monetary aggregates and economic activity. Between 1990 and 1994, growth in the Federal Reserve's M2 monetary aggregate was much slower than expected, a development that several academic studies attribute to the proliferation of financial assets that serve as alternatives to M2 components. As a result, the current composition of M2 no longer completely reflects the choice of financial assets available as means of payment or close substitutes. Thus, the aggregate's relationship with expenditure on goods and services may no longer be direct or predictable, and M2 may not now serve as a reliable link between policy instruments and policy goals. In addition, unforeseen instability in the macroeconomic relationships between monetary aggregates and the Federal Reserve's goals raises broader questions about the role of aggregates in policy making.

This article explores how the composition and character of payments assets can change in a dynamic financial system, ultimately influencing the relationships between monetary aggregates and economic activity.

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