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Showing papers in "Journal of Finance in 1986"


Journal ArticleDOI
TL;DR: This article found that stocks newly included into the Standard and Poor's 500 Index have a significant positive abnormal return at the announcement of the inclusion, and this return does not disappear for at least ten days after the inclusion.
Abstract: Since September, 1976, stocks newly included into the Standard and Poor's 500 Index have earned a significant positive abnormal return at the announcement of the inclusion. This return does not disappear for at least ten days after the inclusion. The returns are positively related to measures of buying by index funds, consistent with the hypothesis that demand curves for stocks slope down. The returns are not related to S & P's bond ratings, which is inconsistent with a plausible version of the hypothesis that inclusion is a certification of the quality of the stock.

1,452 citations


Journal ArticleDOI
TL;DR: The authors examined the power of statistical tests commonly used to evaluate the efficiency of speculative markets and showed that these tests have very low power. But they did not consider the fact that market valuations can differ substantially and persistently from the rational expectation of the present value of cash flows without leaving statistically discernible traces in the pattern of ex-post returns.
Abstract: This paper examines the power of statistical tests commonly used to evaluate the efficiency of speculative markets. It shows that these tests have very low power. Market valuations can differ substantially and persistently from the rational expectation of the present value of cash flows without leaving statistically discernible traces in the pattern of ex-post returns. This observation implies that speculation is unlikely to ensure rational valuations, since similar problems of identification plague both financial economists and would be speculators. THE PROPOSITION THAT securities markets are efficient forms the basis for most research in financial economics. A voluminous literature has developed supporting this hypothesis. Jensen [10] calls it the best established empirical fact in economics.1 Indeed, apparent anomalies such as the discounts on closed end mutual funds and the success of trading rules based on earnings announcements are treated as indications of the failures of models specifying equilibrium returns, rather than as evidence against the hypothesis of market efficiency.2 Recently the Efficient Markets Hypothesis and the notions connected with it have provided the basis for a great deal of research in macroeconomics. This research has typically assumed that asset prices are in some sense rationally related to economic realities. Despite the widespread allegiance to the notion of market efficiency, a number of authors have suggested that certain asset prices are not rationally related to economic realities. Modigliani and Cohn [14] suggest that the stock market is very substantially undervalued because of inflation illusion. A similar claim regarding bond prices is put forward in Summers [20]. Brainard, Shoven and Weiss [4] find that the currently low level of the stock market could not be rationally related to economic realities. Shiller [16, 17] concludes that both bond and stock prices are far more volatile than can be justified on the basis of real economic events. Arrow [2] has suggested that psychological models of "irrational decision making" of the type suggested by Tversky and Kahneman [22] can help to explain behavior in speculative markets. These types of claims are frequently

1,197 citations


Journal ArticleDOI
TL;DR: In this paper, an arbitrage-free interest rate movements model (AR model) is proposed to price interest rate contingent claims relative to the observed complete term structure of interest rates.
Abstract: This paper derives an arbitrage-free interest rate movements model (AR model). This model takes the complete term structure as given and derives the subsequent stochastic movement of the term structure such that the movement is arbitrage free. We then show that the AR model can be used to price interest rate contingent claims relative to the observed complete term structure of interest rates. This paper also studies the behavior and the economics of the model. Our approach can be used to price a broad range of interest rate contingent claims, including bond options and callable bonds.

1,174 citations


Journal ArticleDOI
TL;DR: In this paper, the authors evaluate the extent to which a firm's choice of risky debt maturity can signal insiders' information about firm quality and show that high-quality firms can sometimes effectively signal their true quality to the market.
Abstract: When capital market investors and firm insiders possess the same information about a company's prospects, its liabilities will be priced in a way that makes the firm indifferent to the composition of its financial liabilities (at least under certain, well-known circumstances). However, if firm insiders are systematically better informed than outside investors, they will choose to issue those types of securities that the market appears to overvalue most. Knowing this, rational investors will try to infer the insiders' information from the firm's financial structure. This paper evaluates the extent to which a firm's choice of risky debt maturity can signal insiders' information about firm quality. If financial market transactions are costless, a firm's financial structure cannot provide a valid signal. With positive transaction costs, however, high-quality firms can sometimes effectively signal their true quality to the market. The existence of a signalling equilibrium is shown to depend on the (exogenous) distribution of firms' quality and the magnitude of underwriting costs for corporate debt. THE CONDITIONS UNDER WHICH financing decisions are irrelevant to a firm's market value and real investment incentives are now well-established. Most of the literature in this area has assumed, inter alia, that firm insiders and the market fully share all available information about the distribution of returns accruing to real investment opportunities. In this situation, insiders and outsiders agree about the value of possible financing changes, and equilibrium security prices make the firm indifferent among alternative financing plans. However, if the market's information is less accurate than insiders' information, firms with different "intrinsic" (or insider's) values will be indistinguishable to outsiders. Insiders may then prefer one type of financing plan over another even in equilibrium. Stiglitz [16] first showed how differences between owners' and potential lenders' bankruptcy assessments will lead to an optimal debt-equity ratio. Subsequently, Leland and Pyle [7] and Ross [14] evaluated the signalling implications of asymmetric information for capital market equilibrium, demonstrating that insiders could-and would-adjust the firm's financial structure to signal their assessment of true firm quality. (Downes and Heinkel [4] have provided empirical evidence supporting Leland and Pyle's main hypothesis about market valuation, although Ritter [13] questions the robustness of their results.) Campbell and Kracaw [3] described how relatively high-quality firms would willingly pay

1,165 citations


Journal ArticleDOI
TL;DR: In this paper, the authors examined the effect of price changes in the composition of the S&P 500 on the stock market and found that prices increased by more than 3 percent after an addition is announced and nearly fully reversed after two weeks.
Abstract: Attempts to identify price pressures caused by large transactions may be inconclusive if the transactions convey new information to the market. This problem is addressed in an examination of prices and volume surrounding changes in the composition of the S&P 500. Since these changes cause some investors to adjust their holdings of the affected securities and since it is unlikely that the changes convey information about the future prospects of these securities, they provide an excellent opportunity to study price pressures. The results are consistent with the price-pressure hypothesis: immediately after an addition is announced, prices increase by more than 3 percent. This increase is nearly fully reversed after 2 weeks. THE EFFICIENT MARKET HYPOTHESIS (EMH) predicts that security prices reflect all publicly available information. Therefore, one corollary of the EMH is that "you can sell (or buy) large blocks of stock at close to the market price as long as you can convince other investors that you have no private information."1 This statement assumes that securities are near perfect substitutes for each other. If so, the excess demand for a single security will be very elastic, and the sale or purchase of a large number of shares will have no impact on price. In contrast to the EMH, Scholes [8], Kraus and Stoll [5], Hess and Frost [4], and others propose two hypotheses which predict that a large stock sale (purchase) will cause the price to decrease (increase) even if no new information is associated with the transaction. The imperfect substitutes hypothesis (ISH), also known as the distribution effect hypothesis, assumes that securities are not close substitutes for each other, and hence, that long-term demand is less than perfectly elastic. Under this hypothesis, equilibrium prices change when demand curves shift to eliminate excess demand. Price reversals are not expected because the new price reflects a new equilibrium distribution of security holders. The price-pressure hypothesis (PPH) assumes that investors who accommodate demand shifts must be compensated for the transaction costs and portfolio risks that they bear when they agree to immediately buy or sell securities which they otherwise would not trade. These passive suppliers of liquidity are attracted by immediate price drops (rises) associated with large sales (purchases). They are compensated for their liquidity service when prices rise (drop) to their fullinformation levels. The PPH, like the EMH, assumes that long-run demand is

1,150 citations


Journal ArticleDOI
TL;DR: In this paper, the authors present a methodology for arriving at empirical estimates of deposit insurance premiums from market data by using isomorphic relationships betweeen equity and a call option, and insurance and a put option.
Abstract: This paper presents a methodology for arriving at empirical estimates of deposit insurance premiums from market data by using isomorphic relationships betweeen equity and a call option, and insurance and a put option. The data utilizes the market value of equity to solve for the asset value and its volatility. Market perceptions of FDIC bailout policies are explicitly modeled so as to eliminate the bias in inverted values of assets and their volatility. Sensitivity analyses are performed to show that rank orderings based on premiums are robust to changes in specification, thus facilitating allocation of aggregate premium across banks. WHILE ECONOMISTS HAVE LONG argued in favor of risk-adjusted deposit insurance as both more equitable and more efficient than the current system of flatrate premiums, various recent developments have further contributed to an increasing dissatisfaction with the current system. First, both the banking industry and the government seem to be tending to the view that deregulation of the banking industry would be necessary in order to meet more sophisticated future demands on the industry as well as desirable as a policy means of stimulating greater competition among banks. Moreover, a sudden rise in the incidence of bank failures,1 and the vulnerability of the U.S. banks to the socalled international debt crisis have served to bring to the fore concern about the health of the banking industry. In the absence of deposit insurance, riskier banks will be able to attract deposits only at higher rates, and these higher costs of funding serve as built-in market-regulated incentives to limit excessive risk-taking by banks. As introduction of deposit insurance makes deposits equally risk-free across banks, these incentives disappear, and regulation and close supervision of the banking industry must necessarily replace them as deterrents to excessive risk-taking. Thus, when insurance is offered at a flat premium, regulation is designed to ensure that the risk posed to the insurer-both asset and financial risk-is appropriately uniform

762 citations


Journal ArticleDOI
TL;DR: In this paper, a theory of trading volume is developed based on assumptions that market agents frequently revise their demand prices and randomly encounter potential trading partners, which is consistent with existing empirical evidence and suggests that markets do not immediately clear all orders or investors have demands to recontract.
Abstract: A theory of trading volume is developed based on assumptions that market agents frequently revise their demand prices and randomly encounter potential trading partners. The model describes two distinct ways informational events affect trading volume. One is consistent with conjectures made by empirical researchers that investor disagreement leads to increased trading. But the observation of abnormal trading volume does not necessarily imply disagreement, and volume can increase even if investors interpret the information identically, if they also have had divergent prior expectations. Simulation tests support the model and are used to contrast the random-pairing environment with costless market clearing. Volume is lower in the costly market, and volume increases caused by an informational event persist after the event period. This is consistent with existing empirical evidence and suggests that markets do not immediately clear all orders or that investors have demands to recontract.

615 citations


Journal ArticleDOI
TL;DR: In this article, the authors examine the issue of integration versus segmentation of the Canadian equity market relative to a global North American market, and find that integration, or the mean-variance efficiency of the global market index, is rejected by the data.
Abstract: This paper examines the issue of integration versus segmentation of the Canadian equity market relative to a global North American market. We compare the international and domestic versions of the CAPM, and find that integration, or the mean-variance efficiency of the global market index, is rejected by the data. Segmentation is the preferred model, based on a maximum likelihood procedure correcting for thin trading. We further divide the sample into securities that are interlisted in Canada and the U.S., and those that are not. Integration is rejected for both groups, which indicates that the source of segmentation can be traced to legal barriers based on the nationality of issuing firms. EMPIRICAL STUDIES OF INTERNATIONAL capital markets have left the issue of segmentation versus integration largely unresolved. Yet the question of national or international pricing of assets has crucial implications for financial decisions.' If national stock markets are segmented, then international portfolios should display superior risk-adjusted performance because some of the priced domestic systematic risk is diversifiable. Also, with segmentation, many irrelevance propositions for corporate financial strategy break down: home firms face optimal hedging decisions, as well as optimal foreign versus home borrowing decisions. Finally, criteria for capital budgeting decisions will be quite different under national and international pricing. The purpose of this paper is to shed some light on this integration versus segmentation question for the Canadian equity market vis-a-vis a global North American market. In this paper, integration is defined2 as a situation where investors earn the same risk-adjusted expected return on similar financial instruments in different national markets. The key problem, of course, is the pricing

494 citations


Journal ArticleDOI
TL;DR: Warga et al. as discussed by the authors used the Sharpe-Lintner Capital Asset Pricing Model (CAPM) to analyze the role of risk in such tests and illustrates the logic in a discussion using the CAPM, although a Breeden consumption-based CAPM or an Arbitrage Pricing Model could easily be used.
Abstract: Filter rule profits found in foreign exchange markets in the early days of the current managed float persist in later periods, as shown by statistical tests developed and implemented here. The test is consistent with, but independent of, a wide variety of asset pricing models. The profits found cannot be explained by risk if risk premia are constant over time. Inclusion of the home-foreign interest rate differential in computing profits has little effect on the comparison of filter returns to those of buy-and-hold. IN THE EARLY YEARS of the generalized managed floating that began in March 1973, filter rule profits in excess of buy-and-hold were found for many countries (Logue, Sweeney and Willett [18], Dooley and Shafer [6], Cornell and Dietrich [5]). It was unclear, however, whether such profits indicated inefficiencies. First, it was not clear that risk was adequately handled in such tests, and often risk was ignored. Second, there was no evidence such profits would be available postsample. And third, there was no statistical test of the significance of these profits. This paper uses the logic of risk/return tradeoffs to analyze the role of risk in such tests and illustrates the logic in a discussion using the Sharpe-Lintner Capital Asset Pricing Model (CAPM), although a Breeden consumption-based CAPM, a Merton intertemporal CAPM, or an Arbitrage Pricing Model (APM) could easily be used. The paper develops a test of statistical significance appropriate to foreign exchange markets (Section I), analyzing the rate of return on foreign exchange speculation less the foreign-domestic interest rate differential. The test explicitly assumes that risk premia are constant over the sample. The excess rates of return observable in using filters in going from a risk-free dollar asset to a risk-free Deutsche Mark (DM) asset persist into the 1980's (Section II), and this is true even when taking account of transactions costs. It turns out that these results for the $/DM case do not depend very much on the interestrate differential, but primarily on exchange rate behavior. This is useful to know because it is often quite difficult to find matching, interest-rate data of high quality. For a sample of nine other currencies, using only exchange rates, Section III shows that the excess returns made in the first 610 days of the float persist in the next 1,220 days, into the 1980's. (Dooley and Shafer [7] find similar persistence in experiments that do not use buy-and-hold and have no significance tests.) When filter rule profits have been found in spot exchange markets, it has often been argued that the profits are due to risk. This paper uses the CAPM to analyze rates of return both to buy-and-hold and to filter strategies. It turns out that the * Claremont McKenna College and Claremont Graduate School. Arthur D. Warga, Douglas Joines, and Thomas D. Willett offered helpful comments, and Ning-Ning Koo provided research assistance.

472 citations


Journal ArticleDOI
TL;DR: In this article, the authors examine whether the assumption of observability of expected returns and other relevant state variables causes significant mis-specification in equilibrium models of asset prices and analyze the impact of estimation error on investment choices.
Abstract: Models of asset pricing generally assume that the variables which characterize the state of the economy are observable. However, the distributional properties of asset prices that are relevant for portfolio decisions are in general not observable, and therefore must be estimated. The estimation of expected returns is a particularly difficult problem and estimation errors are likely to be substantial. In this light, it is reasonable to examine whether the assumption of observability of expected returns and other relevant state variables causes significant mis-specification in equilibrium models of asset prices. This paper has three main objectives: first, to derive optimal estimators for the unobservable expected instantaneous returns using observations of past realized returns; second, to establish that estimation and portfolio choice can be solved in two separate steps; third, to analyze the impact of estimation error on investment choices. The estimators of expected returns are in general not consistent, i.e., the estimation error does not tend to disappear asymptotically. The effects of the estimation error, therefore, cannot be ignored even if realized returns are observed continuously over an infinite time period.

435 citations


Journal ArticleDOI
TL;DR: In this article, the authors derived a closed-form valuation model in a two-country world in which the domestic investors are constrained to own at most a fraction, δ, of the number of shares outstanding of the foreign firms.
Abstract: This paper derives a closed-form valuation model in a two-country world in which the domestic investors are constrained to own at most a fraction, δ, of the number of shares outstanding of the foreign firms. When the “δ constraint” is binding, two different prices rule in the foreign securities market, reflecting the premium offered by the domestic investors over the price under no constraints and the discount demanded by the foreign investors. The premium is shown to be a multiple of the discount, the multiple being the ratio of the aggregate risk aversion of the domestic and foreign investors. Given the aggregate risk-aversion parameters, the equilibrium premium and discount are determined by the severity of the δ constraint and the “pure” foreign market risk.

Journal ArticleDOI
TL;DR: In this paper, it is shown that for Gaussian information structures under incomplete observations, the consumer's problem can be transformed into an equivalent program with a completely observed state: the conditional expectation of the underlying unobservable state variables.
Abstract: This paper analyzes an economy in which investors operate under partial information about technology-relevant state variables. It is shown that for Gaussian information structures under incomplete observations, the consumer's problem can be transformed into an equivalent program with a completely observed state: the conditional expectation of the underlying unobservable state variables. A consequence of this transformation is that classic results in finance remain valid under an appropriate reinterpretation of the state variables. THE STATIC CAPITAL ASSET Pricing Model (CAPM) of Sharpe [24], Lintner [16], and Mossin [20] states that the expected premium on any risky asset is proportional to the premium on the market as a whole. This theoretical linear relationship, however, is subject to criticisms on two grounds. First, it does not seem to be supported by the empirical evidence.' Second, it is based on the premises of a constant opportunity set. Merton [19] subsequently relaxes this assumption, and shows that when the opportunity set fluctuates over time due to changes in the state of the economy, individual securities are also priced with respect to selected portfolios (funds), providing a hedge against unanticipated fluctuations.2 More recently, Breeden [3] has extended Merton's results by emphasizing the role of aggregate consumption in pricing relationships. In this paper, we seek to further our understanding of asset pricing by relaxing the assumption that investors observe the state of the economy. In the MertonBreeden framework, observed state variables affect the means and variances of asset returns, implying deformations of the opportunity set over time. From a practical point of view, it seems that this complete information assumption is violated. Investors in financial markets operate under partial knowledge of the microvariables which influence production and the returns on assets. Their decisions rely mostly on information through noisy channels such as newspapers, technical reviews, or weather reports. In this paper, we attempt to model such

Journal ArticleDOI
TL;DR: In this paper, the authors use past price patterns as a proxy to measure the incentives to sell or avoid selling a stock and observe trading volumes to estimate the extent to which investors respond to these incentives.
Abstract: Capital gains taxes create incentives to trade. Our major finding is that turnover is higher for winners (stocks, the prices of which have increased) than for losers, which is not consistent with the tax prediction. However, the turnover in December and January is evidence of tax-motivated trading; there is a relatively high turnover for losers in December and for winners in January. We conclude that taxes influence turnover, but other motives for trading are more important. We were unable to find evidence that changing the length of the holding period required to qualify for long-term capital gains treatment affected turnover. INVESTORS RESPONDING TO THE tax incentives in the capital gains laws should produce predictable patterns in the volume of trading in a stock, but not necessarily in its price. This study uses past price patterns as a proxy to measure the incentives to sell or avoid selling a stock and observes trading volumes to estimate the extent to which investors respond to these incentives. Past price patterns may influence trading volumes for other (non-tax related) reasons as well. These are also considered. We find that past prices influence current incentives to trade through both tax and non-tax motives. Winners tend to have higher abnormal volumes than losers. This would be expected if non-tax-related motives were predominant. However, the influence of tax-related motives on trading volume is shown by seasonal variations in the relationship between past price changes and turnover. As predicted by tax-induced trading theories, the volume of losers is higher than normal in December, and the volume of winners is higher than normal in January. We found no evidence that trading volume was affected by changes in the length of the holding period required to qualify for long-term capital gains. Investors' reactions to capital gains taxes are important for several reasons. First, a comprehensive understanding of investor behavior would include both price and volume. Understanding the relationship between taxes and volume is a fruitful and convenient method of contributing to this subject. The resource allocation consequences of capital gains taxes are controversial in part because

Journal ArticleDOI
TL;DR: In this paper, the authors compare results from the standard COMPUSTAT data base with those from a data base which suffers from neither look-ahead bias nor ex-post-selection bias.
Abstract: Studies relating accounting and price data often use the COMPUSTAT or related PDE data base as the source for the accounting data. This practice may introduce a look-ahead bias and an ex-post-selection bias into the study. We examine this problem by comparing results from the standard COMPUSTAT data base with those from a data base which suffers from neither bias. We find that rates of return from portfolios chosen on the basis of accounting data from the two data bases differ significantly. Further, we find that these differences imply different conclusions when we test a specific hypothesis relating accounting and price data. Finally, we propose a number of remedies which may reduce the bias when the standard COMPUSTAT data base is used.

Journal ArticleDOI
TL;DR: In this article, a two-factor APT model with the market and changes in the yield on long-term government bonds as factors is employed to evaluate whether firms are required to pay an ex ante premium to investors for bearing the risk of interest-rate changes.
Abstract: This paper addresses the issue of whether firms are required to pay an ex ante premium to investors for bearing the risk of interest-rate changes. A two-factor APT model with the market and changes in the yield on long-term government bonds as factors is employed. The paper shows that, empirically, most of the interest-sensitive stocks are in the utility industries, and that there is reasonable evidence that the interest factor is priced in the sense of the APT. Several sources for the interest sensitivity are considered, and regulatory lags are focused on as a likely candidate. SOME FIRMS EXHIBIT ex post sensitivity in their stock returns to unanticipated changes in interest rates. Are these firms required to pay investors ex ante for bearing this risk of interest-rate changes? The framework for examining pricing of unanticipated interest-rate changes is a two-factor APT model with the market and changes in the yield on long-term government bonds as factors. The issue is whether the interest-rate change premium is significant. To study this, the paper uses full information maximum likelihood (FIML) estimation on groups of twenty-five individual firms, with both cross-equation constraints and withinequation nonlinear constraints on the parameters as mandated by the APT model. Whether the risk of unanticipated changes in interest rates is priced in the market is of particular interest with regard to regulated firms. Regulated firms (especially electric utilities) turn out to comprise the big majority of firms that are sensitive to unanticipated interest-rate changes. After some preliminary investigation, the analysis focuses on electric utilities. Much empirical work on the APT relies on factor analysis, e.g., Roll and Ross [30]. Bower, Bower, and Logue [5] use factor analysis in comparing the APT and the CAPM to explain utilities' returns. The present paper, however, uses observable variables at the macro level. Chan, Chen, and Hsieh (CCH; [7]), and Chen, Roll, and Ross (CRR; [8]) also examine APT models with specific macroeconomic factors. CCH and CRR use a traditional Fama-MacBeth type of cross-sectional estimation approach in the premia calculations rather than a FIML approach. Gibbons and Stambaugh have applied FIML techniques to models using only the market as an explanatory variable. Gibbons [20] used a noniterative algorithm on portfolios of firms, equivalent to a two-step cross-sectional approach. Stam

Journal ArticleDOI
TL;DR: The one-factor version of the Cox, Ingersoll, and Ross model of the term structure is estimated using monthly quotes on U.S. Treasury issues trading from 1952 through 1983 as mentioned in this paper.
Abstract: The one-factor version of the Cox, Ingersoll, and Ross model of the term structure is estimated using monthly quotes on U.S. Treasury issues trading from 1952 through 1983. Using data from a single yield curve, it is possible to estimate implied short and long term zero coupon rates and the implied variance of changes in short rates. Analysis of residuals points to a probable neglected tax effect. THE TERM STRUCTURE of interest rates is important to economists because the relationship among the yields on default free securities that differ in their term to maturity reflects the information available to the market about the future course of events. The Expectations Hypothesis, the Liquidity Preference Hypothesis (Hicks [10]) and the Market Segmentation Hypothesis (Culbertson [6]) are theories of the term structure that predict little more than that the implied forward rate is either equal to or not equal to the expectation of future spot rates. Cox, Ingersoll and Ross [5] (CIR) model the term structure of interest rates in a competitive equilibrium context. Their model has elements in common with the earlier hypotheses of the term structure. However, the CIR model has a rich class of empirical implications, not only for the pricing of default free securities, but also for the pricing of bond options, callable bonds and other types of financial claims. This paper examines the extent to which the model (in its simplest one-factor form) is descriptive of the prices of U.S. Treasury Bills, Bonds and Notes traded from 1952 to 1983. Section I describes the model, and the parsimonious representation of bond prices which it implies. Section II describes the data and Section III outlines the preliminary results obtained by fitting the model to observed data. The final section outlines directions for future research.

Journal ArticleDOI
TL;DR: In this paper, the authors generalize the Myers-Majluf model by allowing the firm to choose not merely whether to issue stock, but also how much stock to issue.
Abstract: This paper characterizes the function relating the number of new shares issued by a firm to the resulting change in the firm's stock price, when insiders are asymmetrically informed. We show that, in equilibrium, the stock price will be a decreasing function of the issue size; moreover, the rate of decrease can be so rapid to cause "equity rationing." We also show that there will be underinvestment relative to the symmetric information case. RECENT EMPIRICAL WORK HAS shown that the announcement of a stock issue is associated with a drop in the corresponding share price1, and Myers and Majluf [9] have explained why one would expect this result under asymmetric information. If management is acting in the interests of the current shareholders, it will be reluctant to issue new stock when it knows the value of the firm's existing assets is high. A stock issue, therefore, signals to the market that the firm's current assets are overvalued and drives down the share price. In this paper, we generalize the Myers-Majluf model by eliminating the assumption that the firm has a single all-or-nothing investment opportunity whose cash requirements are fixed and known by all investors, and by allowing the firm to choose not merely whether to issue stock, but also how much stock to issue2. This generalization allows us to analyze questions about the relationship between the stock price and the issue size, which do not arise in the Myers-Majluf model. Our principal results are, first, that the stock price following the announcement

Journal ArticleDOI
TL;DR: In this article, the authors discuss the conceptual and econometric problems associated with defining and measuring timing and selectivity, and propose two basic modeling approaches, which are termed the portfolio approach and the factor approach.
Abstract: The dichotomy between timing ability and the ability to select individual assets has been widely used in discussing investment performance measurement. This paper discusses the conceptual and econometric problems associated with defining and measuring timing and selectivity. In defining these notions we attempt to capture their intuitive interpretation. We offer two basic modeling approaches, which we term the portfolio approach and the factor approach. We show how the quality of timing and selectivity information can be identified statistically in a number of simple models, and discuss some of the econometric issues associated with these models. In particular, a simple quadratic regression is shown to be valid in measuring timing information.

Journal ArticleDOI
TL;DR: The authors analyzes the market for financial assets in a production and exchange economy with several realized outputs and a single unobservable source of non-consistency risk and shows that, for a large class of diffusion outputs and preferences, optimizing consumers first estimate the realizations of the unobservability factor and then use these estimates to determine portfolio and consumption rules.
Abstract: This paper analyzes the market for financial assets in a production and exchange economy with several realized outputs and a single unobservable source of nondiversifiable risk. The paper demonstrates that, for a large class of diffusion outputs and preferences, optimizing consumers first estimate the realizations of the unobservable factor and then use these estimates to determine portfolio and consumption rules. Moreover, the explicit consideration of this unobservable productivity factor affects equilibrium demands and prices. The equilibrium spot rate of interest emerges as the "best estimate" of the unobservable factor, and multiperiod default-free bonds arise as the optimal hedge for the unobservable changes of the stochastic investment opportunity set. THIS PAPER ANALYZES THE market for financial assets in a production and exchange economy with several realized outputs and a single unobservable source of nondiversifiable risk. The paper poses and answers three questions: 1. How do consumers determine equilibrium demands and prices when their investment opportunities are unobservable? 2. In equilibrium, what financial assets provide an optimal hedge for the

Journal ArticleDOI
TL;DR: In this article, the same authors applied the method to earnings and dividend announcements, which have been documented to be information events, and found a strong increase in information asymmetry only before the second announcement and virtually no increase before the joint and first announcements.
Abstract: Recent theoretical work on the bid-ask spread asserts that the dealer should widen the bid-ask spread when he or she suspects that the information advantage possessed by informed traders has increased. Thus, the dealer's spread can be employed to test for an increase in information asymmetry prior to an anticipated information event. In this paper, the method is applied to earnings and dividend announcements, which have been documented to be information events. The authors study three groups of announcements: (a) joint announcements-i.e., earnings and dividend announcements that are made on the same day, (b) initial (first) announcements-earnings or dividend announcements that were not preceded by another announcement in the prior thirty days, and (c) following (second) announcements-those announcements that follow the first announcement by at least ten days but by no more than thirty days. The authors find a strong increase in information asymmetry only before the second announcements and virtually no increase before the joint and first announcements. This is consistent with the hypothesis that there is, on average, normal information asymmetry before announcements, but that the dealer will suspect a nonroutine announcement (with an attendant increase in information asymmetry) when the second announcement is separated from the first by more than ten days. Other possible explanations for the results are discussed, and suggestions for future research are outlined. IT IS WIDELY ACCEPTED that some traders in securities markets may possess nonpublic information about future events that may affect security prices.' The

Journal ArticleDOI
TL;DR: In this paper, the authors test the arbitrage pricing theory (APT) in an international setting and show that the number of common factors between a pair of countries ranges from one to five and their cross-sectional test results lead them to reject the joint hypothesis that the international capital market is integrated and that the APT is internationally valid.
Abstract: In this paper, we test the arbitrage pricing theory (APT) in an international setting. Inter-battery factor analysis is used to estimate the international common factors and the Chow test is used in testing the validity of the APT. Our inter-battery factor analysis results show that the number of common factors between a pair of countries ranges from one to five, and our cross-sectional test results lead us to reject the joint hypothesis that the international capital market is integrated and that the APT is internationally valid. Our results, however, do not rule out the possibility that the APT holds locally or regionally in segmented capital markets. Finally, the basic results of both the inter­ battery factor analysis and the cross-sectional tests are largely invariant to the nume­ raire currency chosen. NUMEROUS AUTHORS, NOTABLY SOLNIK [21], Grauer, Litzenberger, and Stehle [11], and Stulz [24] have derived various versions of the international asset pricing model (IAPM) under alternative views of the structure of international capital markets. However, only a few serious attempts have been made to test various versions of the IAPM. These tests are largely inconclusive (see Solnik [20] and Stehle [23]). Apart from the problem stressed by Roll [16] of identifying the world market portfolio, previous tests of the IAPMs suffer from the technical problem of aggregating assets of national investors using different numeraire currencies. Differences in the numeraire arise from differences in consumption baskets in an environment characterized by exchange rate uncertainty. In a fruitful attempt to extend the arbitrage pricing theory (APT) of Ross [18] to an international setting, Solnik (22] derives an international arbitrage pricing theory which is largely devoid of the aforementioned difficulties and thus more amenable to empirical testing. 1 As shown by Solnik, testability of the APT in an

Journal ArticleDOI
TL;DR: In this paper, a discrete-time option-pricing model is used to derive the "fair" rate of return for the property-liability insurance firm, where the financial claims of shareholders, policyholders, and tax authorities can be modeled as European options written on the income generated by the insurer's asset portfolio.
Abstract: A discrete-time option-pricing model is used to derive the “fair” rate of return for the property-liability insurance firm. The rationale for the use of this model is that the financial claims of shareholders, policyholders, and tax authorities can be modeled as European options written on the income generated by the insurer’s asset portfolio. This portfolio consists mostly of traded financial assets and is therefore relatively easy to value. By setting the value of the shareholders’ option equal to the initial surplus, an implicit solution for the fair insurance price may be derived. Unlike previous insurance regulatory models, this approach addresses the ruin probability of the insurer, as well as nonlinear tax effects.

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TL;DR: In this paper, the authors examined the information content in analysts' recommendations which are made on a five-point buy, hold, or sell scale and found that approximately 4.5% extra return can be achieved by purchasing new buys rather than new sells.
Abstract: In this article we examine the information content in analysts' recommendations which are made on a five-point buy, hold, or sell scale. Our data set includes data on 10,000 forecasts per month. Unlike most prior studies, our data set does not suffer from selection or survivorship bias. We find information in analysts' changes in recommendations. Approximately 4.5% extra return can be earned by purchasing new buys rather than new sells.

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TL;DR: In this article, the authors employ a new approach to study the effects of option trading on the behavior of underlying stock prices and find the two samples exhibit different adjustment processes, with the nonoption firms requiring substantially more time to adjust.
Abstract: This paper employs a new approach to study the effects of option trading on the behavior of underlying stock prices. Extant research compares distributional properties of the stock price at two points in time divided by an event in the option market that might affect price behavior. As an alternative, we examine the stock price adjustment to the release of quarterly earnings using samples of firms with and without listed options. We find the two samples exhibit different adjustment processes, with the nonoption firms requiring substantially more time to adjust. SINCE THE ADVENT OF organized stock option trading, the investment community

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TL;DR: In this paper, the authors examined differences in announcement day effects among firms engaged in voluntary sell-offs and found a positive relation between the relative size of the selloff and the announcement day return.
Abstract: This paper examines differences in announcement day effects among firms engaged in voluntary sell-offs. While, on average, an initial sell-off announcement results in a significant positive excess return, not all divestiture announcements are accompanied by positive price movements. Dividing the sample into two subsamples based on whether the transaction price is announced shows that the announcement day effect is significantly positive for the price group but not statistically different from zero for the noprice group. In addition, a positive relation is found between the relative size of the selloff and the announcement day return. RECENT PUBLISHED STUDIES of spin-offs show evidence of positive announcement day and pre-announcement day stock price effects.' However, empirical studies on voluntary sell-offs have not produced uniform positive or negative price movements.2 Instead, they show positive or zero announcement day cumulative average returns (CARS) and mixed (i.e., positive, negative or zero) preand post-announcement day share price changes. The purpose of this paper is to examine the discrepancies in announcement day excess returns for the selling firms engaged in voluntary sell-offs and to isolate factors behind the differences in share price responses. As we show, two such factors are the relative size of the divestiture and whether the sales (transaction) price is initially announced. Examining the samples of recent divestiture event studies support these findings. Previous papers that restrict their samples to initial announcements containing transaction price or relatively large divestitures report significantly positive announcement day returns. Studies that do not discriminate among price or relative size find smaller or insignificant announcement days returns. This, of course, does not imply that price disclosure and size are the sole factors in determining announcement day effects. However, these findings are consistent with the results reported in this paper. This study is divided into six sections. Section I presents the research design.

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TL;DR: This paper reviewed the theory of futures option pricing and tested the valuation principles on transaction prices from the S&P 500 equity futures option market, at least for the sample period January 28, 1983 through December 30, 1983.
Abstract: This paper reviews the theory of futures option pricing and tests the valuation principles on transaction prices from the S&P 500 equity futures option market. The American futures option valuation equations are shown to generate mispricing errors which are systematically related to the degree the option is in-the-money and to the option's time to expiration. The models are also shown to generate abnormal risk-adjusted rates of return after transaction costs. The joint hypothesis that the American futures option pricing models are correctly specified and that the S&P 500 futures option market is efficient is refuted, at least for the sample period January 28, 1983 through December 30, 1983. FUTURES OPTION CONTRACTS NOW trade on every major futures exchange and on a wide variety of underlying futures contracts. The Chicago Mercantile Exchange, the Chicago Board of Trade, the New York Futures Exchange, and the Commodity Exchange now collectively have more than twenty options written on futures contracts, where the underlying spot commodities are financial assets such as stock portfolios, bonds, notes and Eurodollars, foreign currencies such as West German marks, Swiss francs and British pounds, precious metals such as gold and silver, livestock commodities such as cattle and hogs, and agricultural commodities such as corn and soybeans. Moreover, new contract applications are before the Commodity Futures Trading Commission and should be actively trading in the near future. With the markets for these new contingent claims becoming increasingly active, it is appropriate that the fundamentals of futures option valuation be reviewed and tested. Black [5] provides a framework for the analysis of commodity futures options. Although his work is explicitly directed at pricing European options on forward contracts, it applies to European futures contracts as well if the riskless rate of interest is constant during the futures option life.1 The options currently


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TL;DR: In this paper, the authors present and test empirically an analytic model of loan commitment contracts, which helps explain how contract terms are established in the market and will illuminate the institutional framework of commercial lending.
Abstract: This paper analyzes the structure of loan commitment contracts and the interrelationships among their component parameters. Lenders offer borrowers a set of loan "packages," from which the latter may choose that "package" found to be most appealing. Borrowers may "trade off' changes in any loan parameter in exchange for other adjustments. The borrower, at this time, may "purchase" a larger credit ration for a price. Supporting empirical evidence is presented. RECENTLY, RESEARCHERS HAVE BEGUN to study the determinants of loan commitment or line of credit contracts. Such contracts play an extremely important role in bank credit allocation. According to the Federal Reserve Bulletin, over 70% of U.S. commercial and industrial loans are made under loan commitment contracts. Given the central importance of the institution, it is not surprising that it is the subject of a growing literature. Loan commitment contracts have importance both at the micro level, in terms of the bank-customer relationship, and at the marco level, in terms of the channels of operation of monetary policy. In this paper, we seek to present and test empirically an analytic model of loan commitment contracts. Our paper differs from most previous work in that we include empirical analysis of credit allocation. Moreover, most previous theoretical work on the subject has concentrated on the specific issue of pricing of the contracts, often using an approach based on option theory, and not on the quantity allocation of credit and its determinants. We are particularly interested in the determinants of the quantitative allocation of credit to bank customers, and in the composition of and trade-offs among the various parameters comprising such a loan commitment "package." Our model helps explain how contract terms are established in the market and will illuminate the institutional framework of commercial lending. A view of the credit contract as a "package of loan terms" has been implied recently in connection with the credit rationing problem.' Studies by Azzi and Cox [21, Arzac, Schwartz, and Whitcomb [11 and Koskela [81 show that the

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TL;DR: In this paper, the authors derive a rational expectation, partially revealing information equilibrium in which three forms of equity financing are observed: fully underwritten offers, uninsured rights offers, and standby (insured) rights offers.
Abstract: By assuming asymmetric information between investors and firms seeking new equity, we derive a rational expectations, partially revealing information equilibrium in which three forms of equity financing are observed. The highest quality firms employ a standby rights offers, intermediate quality firms signal their true value in the choice of a subscription price in an uninsured rights offer, while low-quality firms remain indistinguishable to investors by making fully underwritten issues. The model offers justification for many firms using apparently more costly underwritten offers, provides a reason why firms using uninsured rights offers do not set arbitrarily low subscription prices to ensure the success of the issue, and explains the simultaneous existence of the three financing vehicles. WHEN FIRMS WISH TO raise new equity capital, they have a variety of alternatives available. These alternatives include fully underwritten offers, uninsured rights offers, and standby (insured) rights offers. The literature provides evidence on the choice of financing methods by firms. Smith [11] examines 578 equity offers in the U.S. over the period 1971-1975; 83% of these offerings were underwritten, 7% were rights offers, and 10% were standby rights offers. Similarly, Bhagat [1] reports the predominant use of underwritten offers in the U.S. In contrast, Marsh [5] states that new equity capital in Europe is raised almost exclusively by rights issues; e.g., over 99% of the new equity issued in the U.K. in 1975 was raised via rights offers. The predominant use of fully underwritten new equity issues in the U.S. rather than the much less costly rights offer has been called an unresolved paradox in finance by Brealey and Myers [2]. Potential explanations have been put forward by several authors. Smith [11] hypothesizes that underwritings provide the managers of the issuing firms with perquisites that are absent in rights offers. Hanson and Pinkerton [3] claim that concern for corporate control influences

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TL;DR: Leavitt et al. as mentioned in this paper showed that one eigenvalue dominates the covariance matrix indicating that a one-factor model may describe security pricing, and they also found that, for values of K larger than one, there is no obvious way to choose the number of factors.
Abstract: Recent theory has demonstrated that the Arbitrage Pricing Model with K factors critically depends on whether K eigenvalues dominate the covariance matrix of returns as the number of securities grows large. The purpose of this paper is to test whether sample covariance matrices can be characterized as having K large eigenvalues. Using all available data on the 1983 CRSP tapes, we compute sample covariance matrices of returns in sequentially larger portfolios of securities. Analyzing their eigenvalues, we find evidence that one eigenvalue dominates the covariance matrix indicating that a one-factor model may describe security pricing. We also find that, for values of K larger than one, there is no obvious way to choose the number of factors. Nevertheless, we find that while only the first eigenvalue dominates the matrix, the first five eigenvalues are growing more distinct. ARBITRAGE PRICING THEORY (APT) as originally developed by Ross [22, 23] is built on the twin assumptions of no arbitrage opportunities in the capital market and a linear relationship between actual returns and K common factors. The principal hypothesis of the model is that expected returns should be linearly related to the weights of the common factors in the assumed linear process. In every test of the model, the focus has been to use factor analysis to extract K factors from sample covariance matrices and then to test the hypothesis by regressing returns or average returns against the factor loadings of the common factors. Most previous tests have either assumed that the number of factors is equal to some predetermined number or have estimated K simultaneously with estimation of the factor loadings. Thus, existing tests of the APT are joint tests of the APT pricing result and an assumed or estimated number of factors. The question of how many factors are important has not been addressed separately from the pricing tests because the APT pricing result is the significant prediction of a theory which has little to say about the value of K. Nevertheless, crosssection linear models have been a central part of financial economics, and it is clearly important to know at least the approximate number of factors which will be significant in such regressions, particularly given the computational difficulties of large-scale factor analysis. Furthermore, Dhrymes, Friend, and Gultekin [6] report that the number of factors needed for standard chi-squared tests increases * University at Buffalo, SUNY. I am in debt to Donald Bosshardt, Gary Chamberlain, Thomas Ho, Richard Roll, Lemma Senbet, Mark Zmijewski, and the participants in finance workshops at the Universities of Michigan, Wisconsin, and Buffalo for their extensive comments. Nevertheless, I am solely responsible for what remains. This paper would not have been started without the unselfish cooperation of Jay Leavitt, Director of Academic Computing, University at Buffalo, SUNY, who designed the eigenvalue algorithm which I used. I am also grateful for partial financial support and lavish computer funds from the School of Management, and for the expert programming assistance provided by Ravi Shukla.