Showing papers by "Marti G. Subrahmanyam published in 2008"

Price Dispersion in OTC Markets: A New Measure of Liquidity

Abstract: In this paper, we model price dispersion effects in over-the-counter (OTC) markets to show that in the presence of inventory risk for dealers and search costs for investors, traded prices may deviate from the expected market valuation of an asset. We interpret this deviation as a liquidity effect and develop a new liquidity measure quantifying the price dispersion in the context of the US corporate bond market. This market offers a unique opportunity to study liquidity effects since, from October 2004 onwards, all OTC transactions in this market have to be reported to a common database known as the Trade Reporting and Compliance Engine (TRACE). Furthermore, market-wide average price quotes are available from Markit Group Limited, a financial information provider. Thus, it is possible, for the first time, to directly observe deviations between transaction prices and the expected market valuation of securities. We quantify and analyze our new liquidity measure for this market and find significant price dispersion effects that cannot be simply captured by bid-ask spreads. We show that our new measure is indeed related to liquidity by regressing it on commonly-used liquidity proxies and find a strong relation between our proposed liquidity measure and bond characteristics, as well as trading activity variables. Furthermore, we evaluate the reliability of end-of-day marks that traders use to value their positions. Our evidence suggests that the price deviations are significantly larger and more volatile than previously assumed. Overall, the results presented here improve our understanding of the drivers of liquidity and are important for many applications in OTC markets, in general.

A tale of two prices: Liquidity and asset prices in multiple markets

Abstract: This paper investigates the liquidity effect in asset pricing by studying the liquidity–premium relationship of an American depositary receipt (ADR) and its underlying share. Using the [Amihud, Yakov, 2002. Illiquidity and stock returns: cross-section and time series effects. Journal of Financial Markets 5, 31–56] measure, the turnover ratio and trading infrequency as proxies for liquidity, we show that a higher ADR premium is associated with higher ADR liquidity and lower home share liquidity, in terms of changes in these variables. We find that the liquidity effects remain strong after we control for firm size and a number of country characteristics, such as the expected change in the foreign exchange rate, the stock market performance, as well as several variables measuring the openness and transparency of the home market.

The economic determinants of interest rate option smiles

Abstract: We address three questions relating to the interest rate options market: What is the shape of the smile? What are the economic determinants of the shape of the smile? Do these determinants have predictive power for the future shape of the smile and vice versa? We investigate these issues using daily bid and ask prices of euro (€) interest rate caps/floors. We find a clear smile pattern in interest rate options. The shape of the smile varies over time and is affected in a dynamic manner by yield curve variables and the future uncertainty in the interest rate markets; it also has information about future aggregate default risk. Our findings are useful for the pricing, hedging and risk management of these derivatives.

Beyond Cash Flow and Voting Rights: Valuation and Performance of Firms in Complex Ownership Structures

Abstract: We propose new measures to describe the ownership structure of family business groups that go beyond the standard measures of cash flow and voting rights. Our measures include the degree of pyramiding in the ownership structure of a group firm, and the centrality of a firm for the group structure (e.g., whether a given firm is used by the family to control other group firms). We use a unique dataset of Korean family business groups (chaebols) to provide evidence that relates these new ownership variables to the performance and valuation of group firms. In particular we show that firms with high investment requirements and/or low profitability are more likely to be set up in pyramids (a selection effect). In addition, central firms appear to have lower market valuations than public group firms that do not hold large equity stakes in other group firms. Our results suggest that cash flow and voting rights are not the only ownership variables that are associated with performance and valuation of group firms. The results also support Almeida and Wolfenzon's (2006) arguments that the family selects pyramidal ownership to take advantage of the cash retained in the central firms of the group, and that pyramidal investments are not beneficial for the minority shareholders of the central firms (who discount the value of their shares accordingly).

Liquidity Effects in Interest Rate Options Markets:Premium or Discount?

Abstract: This paper examines the effects of liquidity on interest rate option prices Using daily bid and ask prices of euro (€) interest rate caps and floors, we find that illiquid options trade at higher prices relative to liquid options, controlling for other effects, implying a liquidity discount This effect is opposite to that found in all studies on other assets such as equities and bonds, but is consistent with the structure of this over-the-counter market and the nature of the demand and supply forces We also identify a systematic factor that drives changes in the liquidity across option maturities and strike rates This common liquidity factor is associated with lagged changes in investor perceptions of uncertainty in the equity and fixed income markets JEL Classification: G10, G12, G13, G15

Back to Basics : The Impact of Financial Leverage on Asset Pricing

Abstract: This paper examines the impact of financial leverage on time-varying betas and on the conditional CAPM using a framework in which a firm’s equity beta is decomposed into the product of financial leverage and its asset beta The unique aspect of this analysis is that a firm’s asset beta is estimated using asset returns constructed from market data not only on equity, but also on corporate bonds and loans Several results emerge The first finding is that leverage alone can explain a substantial portion of the well-documented unconditional alphas of book-to-market–sorted portfolios Second, this improvement is shown to be due to the tight link between book-to-market and leverage, explaining my empirical finding that firms’ asset returns do not increase across book-tomarket–sorted portfolios Third, I document that high book-to-market firms have counter-cyclical asset betas, further improving the fit of the model In summary, high book-to-market firms have both high leverage and high asset betas in economic downturns and, therefore, have high expected equity returns