Showing papers in "Journal of Finance in 1988"

The Determinants of Capital Structure Choice

Abstract: This paper analyzes the explanatory power of some of the recent theories of optimal capital structure. The study extends empirical work on capital structure theory in three ways. First, it examines a much broader set of capital structure theories, many of which have not previously been analyzed empirically. Second, since the theories have different empirical implications in regard to different types of debt instruments, the authors analyze measures of short-term, long-term, and convertible debt rather than an aggregate measure of total debt. Third, the study uses a factor-analytic technique that mitigates the measurement problems encountered when working with proxy variables.

Corporate Finance and Corporate Governance

Abstract: A combined treatment of corporate finance and corporate governance is herein proposed. Debt and equity are treated not mainly as alternative financial instruments, but rather as alternative governance structures. Debt governance works mainly out of rules, while equity governance allows much greater discretion. A project-financing approach is adopted. I argue that whether a project should be financed by debt or by equity depends principally on the characteristics of the assets. Transaction-cost reasoning supports the use of debt (rules) to finance redeployable assets, while non-redeployable assets are financed by equity (discretion). Experiences with leasing and leveraged buyouts are used to illustrate the argument. The article also compares and contrasts the transaction-cost approach with the agency approach to the study of economic organization.

Debt/Equity Ratio and Expected Common Stock Returns: Empirical Evidence

Abstract: The expected common stock returns are positively related to the ratio of debt (noncommon equity liabilities) to equity, controlling for the beta and firm size and including as well as excluding January, though the relation is much larger in January. This relationship is not sensitive to variations in the market proxy, estimation technique, etc. The evidence suggests that the “premium” associated with the debt/equity ratio is not likely to be just some kind of “risk premium”.

Compensation and Incentives: Practice vs. Theory

Abstract: A thorough understanding of internal incentive structures is critical to developing a viable theory of the firm, since these incentives determine to a large extent how individuals inside an organization behave. Many common features of organizational incentive systems are not easily explained by traditional economic theory—including egalitarian pay systems in which compensation is largely independent of performance, the overwhelming use of promotion-based incentive systems, the absence of up-front fees for jobs and effective bonding contracts, and the general reluctance of employers to fire, penalize, or give poor performance evaluations to employees. Typical explanations for these practices offered by behaviorists and practitioners are distinctly uneconomic—focusing on notions such as fairness, equity, morale, trust, social responsibility, and culture. The challenge to economists is to provide viable economic explanations for these practices or to integrate these alternative notions into the traditional economic model.

Liquidity and Market Structure

Abstract: Market liquidity is modeled as being determined by the demand and supply of immediacy. Exogenous liquidity events coupled with the risk of delayed trade create a demand for immediacy. Market makers supply immediacy by their continuous presence and willingness to bear risk during the time period between the arrival of final buyers and sellers. In the long run the number of market makers adjusts to equate the supply and demand for immediacy. This determines the equilibrium level of liquidity in the market. The lower is the autocorrelation in rates of return, the higher is the equilibrium level of liquidity. KEYNES ONCE OBSERVED THAT while most of us could surely agree that Queen Victoria was a happier woman but a less successful monarch than Queen Elizabeth I, we would be hard put to restate that notion in precise mathematical terms. Keynes' observation could apply with equal force to the notion of market liquidity. The T-bond Futures pit at the Chicago Board of Trade is surely more liquid than the local market for residential housing. But how much more? What is the decisive difference between them? Is the colorful open-outcry format of the T-bond Futures market the source of its great liquidity? Or does the causation run the other way? Those are some of the issues we propose to consider here. Our purpose is to present a simple model of market structure that captures the essence of market liquidity. A key feature of the model is its finer partitioning of time intervals and of roles for market participants than in standard treatments of the determination of market prices. Much economic theory, in the Walrasian tradition, still proceeds as if prices were set in a gigantic town meeting in which all potential buyers and sellers participate directly. Researchers in the rapidly growing specialty, sometimes dubbed market microstructure theory, have expanded the cast to include market makers in the sense of intermediaries who can fill gaps arising from imperfect synchronization between the arrivals of the buyers and the sellers. The focus of this literature has been on the inventory-management policies of market makers (see, e.g., Stoll [13]) and on their responses to the threat of adverse information trading against them (see, e.g., Glosten and Milgrom [5]). Our intention here, however, is not to expand this important and interesting class of inventory models but to fit these intermediaries and their temporary inventory holdings into a larger framework that also encompasses the ultimate demanders and suppliers.

An Empirical Test of the Impact of Managerial Self-interest on Corporate Capital Structure

Abstract: This paper provides a test of whether capital structure decisions are at least in part motivated by managerial self-interest. It is shown that the debt ratio is negatively related to management's shareholding, reflecting the greater nondiversifiable risk of debt to management than to public investors for maintaining a low debt ratio. Unless there is a nonmanagerial principal stockholder, no substantial increase of debt can be realized, which may suggest that the existence of large nonmanagerial stockholders might make the interests of managers and public investors coincide. A RECENT PAPER BY Friend and Hasbrouck (F-H) [7] used data on holdings of stock owned by managerial insiders (officers and directors) to test the hypothesis that the corporate capital structure is determined at least in part by optimization of management interests even when these interests conflict with stockholders' interests. The value of the stock held by corporate insiders (MV) and the ratio of their holdings to the total value of their stock outstanding (FR) were used in that study as measures of the greater incentive to management than to other stockholders for maintaining a low debt ratio to avoid bankruptcy possibility. The regression results were supportive of the hypothesized inverse relationship between unscaled MV and debt, but a less satisfactory result was obtained when MV was scaled by logarithm or FR was used as a second measure of the relevant risk. The result less satisfactory than expected seems to question the ability of management in adjusting debt ratio by its own interests, especially when these conflict with stockholders' interests. To effectively test the managerial-optimization hypothesis raised by F-H, this paper intends to address the effect of various constraints on management's ability or desire to reduce the specific risks to them implicit in a higher debt ratio that might otherwise be desired by public investors in view of the tax shield on interest paid on corporate debt or for other reasons. A simple theory was presented in Lang [15] that illustrates that, if management also loses its stake at bankruptcy, it may desire to use an amount of debt that is less than optimum (which maximizes firm's value) to reduce its bankruptcy risks implicit in a higher debt

Risk in Banking and Capital Regulation

Abstract: This paper investigates the role of bank capital regulation in risk control. It is known that banks choose portfolios of higher risk because of inefficiently priced deposit insurance. Bank capital regulation is a way to redress this bias toward risk. Utilizing the mean-variance model, the following results are shown: (a) the use of simple capital ratios in regulation is an ineffective means to bound the insolvency risk of banks; (b) as a solution to problems of the capital ratio regulation, the "theoretically correct" risk weights under the risk-based capital plan are explicitly derived; and (c) the "theoretically correct" risk weights are restrictions on asset composition, which alters the optimal portfolio choice of banking firms. THE RECENT INCREASE in bank failures, especially after the 1980 and 1982 Deregulatory Acts, has again ignited a controversy over the risk portfolio of the banking industry. Given the importance of this sector, there has been increased scrutiny of the industry's motives for risk taking and possible regulatory changes to improve its stability. These investigations have centered around two rather complementary areas. The first of these is the role of deposit insurance and how its current pricing procedure encourages risk taking and justifies current bank regulations. The works of Buser, Chen, and Kane [4], Kane [9], and Benston et al. [2] have made substantive contributions. The authors demonstrates the way in which our current fixed-rate insurance system rewards risk taking by the firm and insulates it through deposit insurance from the market discipline that needs to exist to ensure proper risk evaluation. This realization has led these authors to propose a series of regulatory changes to encourage proper portfolio choice within the industry. These include a shift to, market value accounting, risk-based deposit insurance premiums, and additional capital regulation. The last of these serves as a method of coinsurance whereby higher capital levels require the bank to absorb greater losses in the event of failure and encourage additional prudence in management. In essense it is one method of risk reduction that may offset the risk preference imposed on the industry due to the inappropriate insurance pricing. Because the amount of capital influences the probability of bank insolvency and thus the soundness of the entire banking system, the regulators, ceteris paribus, prefer more capital to

Was It Real? The Exchange Rate‐Interest Differential Relation over the Modern Floating‐Rate Period

Abstract: In this paper, we explore the relationship between real exchange rates and real interest rate differentials in the United States, Germany, Japan, and the United Kingdom. Contrary to theories based on the joint hypothesis that domestic prices are sticky and monetary disturbances are predominant, we find little evidence of a stable relationship between real interest rates and real exchange rates. We consider both in-sample and out-of-sample tests. One hypothesis that is consistent with our findings is that real disturbances (such as productivity shocks) may be a major source of exchange rate volatility. THIS PAPER INVESTIGATES THE empirical relationship between major currency real exchange rates and real interest rates over the modern (post-March 1973) flexible rate experience. The exchange rates examined here include the dollar/ mark, dollar/yen, and dollar/pound rates. Our two major findings are as follows. First, the data do not indicate a strong correspondence between real interest rate differentials (short-term or long-term) and real exchange rates. This finding appears to conflict with the predictions of most monetary and portfolio balance models of exchange rate determination, though the conflict can be substantially reconciled if aggregate disturbances are primarily real in nature (i.e., changes in productivity, tastes, etc.). It is true that in many cases the sign of the estimated exchange rate-interest rate differential relationship is consistent with the possible predominance of financial market disturbances, but the relationship is not stable enough to be statistically significant. Second, although one does find some evidence of a unit root in both real exchange rates and long-term (but not shortterm) real interest differentials, these two series do not appear to be linearly cointegrated. Hence, the nonstationarity (or near nonstationarity) in the two series cannot be attributed to the same factor. In Section I, we briefly describe a class of small-scale monetary models of exchange rate determination. The importance of this class of models for empirical work derives from its strong predictions about how the exchange rate will move

Anatomy of Initial Public Offerings of Common Stock

Abstract: Initial public offerings of common stocks (IPOs) are typically underpriced. In this paper, the author develops and tests the hypothesis that underpricing serves as a form of insurance against legal liability and the associated damages to the reputations of investment bankers. The empirical results based on samples of IPOs that were brought to the market before and after the Securities Act of 1933 provide considerable support for the implicit insurance hypothesis. Specifically, gross underpricing and market segmentation between prestigious and fringe investment bankers in originating unseasoned new issues appear to be peculiar to the post-1933 era. A NUMBER OF STUDIES have documented that unseasoned common stocks typically garner large positive abnormal returns during a short period following the initial offering. In his recent review of the empirical evidence on the initial returns of common stock offerings, Smith [36] concluded that the returns from offer price to after-market price have exceeded fifteen percent. His calculations did not include some of the earlier results obtained by McDonald and Fisher [23] and Logue [20]. When their samples are combined with those in Smith's review, the initial returns of unseasoned equity offerings appear even larger-over seventeen percent. These results imply that underwriters consistently offer the securities at substantial discounts from their values that are set in the after market. In other words, initial public offerings (IPOs) appear to be underpriced. What is even more puzzling is the fact that, in some time periods, underpricing appears to be systematically larger than in other periods. Ibbotson and Jaffe [15] and Ritter [29] have documented that, during the postwar era, there have been a number of periods in which the initial returns of common stocks have been extremely high. Ritter, for example, reported that the average return from the offer price to the first after-market price was over forty-eight percent for IPOs in 1980 and 1981.1 Similarly, the initial returns of unseasoned issues of common stock brought to the market in 1950, 1951, 1961, and 1968 were unusually large. These periods in which IPOs were grossly underpriced are referred to as the "hotissue" markets. Why do investment bankers underprice IPOs? Why do issuers

Banking Panics, Information, and Rational Expectations Equilibrium

Abstract: This paper shows that bank runs can be modeled as an equilibrium phenomenon. We demonstrate that some aspects of the intuitive "story" that bank runs start with fears of insolvency of banks can be rigorously modeled. If individuals observe long "lines" at the bank, they correctly infer that there is a possibility that the bank is about to fail and precipitate a bank run. However, bank runs occur even when no one has any adverse information. Extra market constraints such as suspension of convertibility can prevent bank runs and result in superior allocations. BANKING PANICS WERE A recurrent phenomenon in the United States until the 1930s. They have re-emerged as a source of public concern and much theoretical research recently. In this paper, we provide an information-theoretic rationale for bank runs. The traditional "story" is that contagion is an important aspect of bank runs. The idea seems to be that when the general public observes large withdrawals from the banking system, fears of insolvency grow resulting in even larger withdrawals of deposits. In our model, some individuals withdraw because they get information that future returns are likely to be low. Uninformed individuals observing this also have an incentive to liquidate their investments. In addition, some individuals need to withdraw deposits for other than informationally based reasons. Thus, if the random realization of such a group of individuals is unusually large, then the uninformed individuals will be misled and will precipitate a run on the bank. The technology is such that a large volume of withdrawals involves liquidation costs. Consequently, runs on the bank do impose social costs. A mechanism that may reduce these costs in our model is to suspend convertibility if withdrawals are high. However, those individuals who need to withdraw their assets for liquidity reasons are worse off ex post. Our model provides a rationalization for restrictions in demand deposits that were widespread prior to 1929. Friedman and Schwartz [7] suggest that restrictions of payments ensured

The Effect of Corporate Multinationalism on Shareholders' Wealth: Evidence from International Acquisitions

Abstract: This study presents direct evidence on the effect of international acquisitions on stock prices of U.S. bidding firms. Shareholders of MNCs not operating in the target firm's country experience significant positive abnormal returns at the announcement of international acquisitions. Shareholders of U.S. firms expanding internationally for the first time experience insignificant positive abnormal returns, while shareholders of MNCs operating already in the target firm's country experience insignificant negative abnormal returns. The abnormal returns are larger when firms expand into new industry and geographic markets-especially those less developed than the U.S. economy. The evidence is consistent with the theory of corporate multinationalism, predicting an increase in the firm's market value from the expansion of its existing multinational network. SINCE THE SEMINAL WORK of Grubel [19] on international investment, numerous

Loan Sales and the Cost of Bank Capital

Abstract: This paper considers a model where banks may improve the returns on loans by monitoring borrowers. Bank regulation, together with competitive deposit and equity financing, can give banks an incentive to sell loans, but the extent of their loan selling is limited by a moral-hazard problem. A solution is given for the optimal design of the bank-loan buyer contract that alleviates this moral-hazard problem. An explanation is also given as to why some banks might buy loans and why loan sales volume has recently increased. BANKS' PRACTICE OF MAKING loans and then selling them to other institutions and individuals has grown in popularity. An important example in the development of loan selling has been the increase in banks' mortgage loans that are insured and pooled under the authority of the Government National Mortgage Association (GNMA) and then sold to secondary market investors. Recently, however, there has been a dramatic rise in the volume of other types of loans being sold, especially by money-center banks. Portions of commercial loans originated by these larger banks are being sold to smaller banks, foreign banks, and other financial and nonfinancial institutions. In addition, banks' car loans and credit card receivables have also been pooled and sold to institutions and individuals.' Selling loans that were once considered nonmarketable assets, a process that has been termed "asset securitization", may be signalling the start of a fundamental change in the commercial banking business. The leading banks in loan-selling operations now view themselves more as originators and distributors of loans rather than as institutions holding loans as assets. The potentially large impact of loan sales on the future of commercial banking naturally evokes the question of what incentives exist for banks to sell loans. In this paper, we show that loan sales allow some banks to finance loans less expensively than by traditional deposit or equity issue because bank funds received via loan sales can avoid costs associated with required reserves and

Is the Real Interest Rate Stable

Abstract: Univariate time-series models for consumption, nominal interest rates, and prices each appear to have a single unit root before 1979. If nominal interest rates have a unit root but inflation and inflation forecast errors do not, then ex ante real interest rates have a unit root and are therefore nonstationary. This deduction does not depend on the properties of the unobservable ex post observed real return, which combines the ex ante real interest rate and inflation-forecasting errors. The unit-root characteristic of real interest rates is puzzling from at least two perspectives: many models imply that the growth rate of consumption and the real interest rate should have similar time-series characteristics; also, nominal returns for other assets (e.g., stocks and bonds) appear to have different times-series properties from those of treasury bills. THIS ESSAY IS CONCERNED with the stability of the ex ante short American real interest rate. The paper can be motivated in a number of ways. A number of authors have investigated the question of whether financial markets fluctuate excessively. Insofar as the stationarity of returns is crucial in addressing this issue (Shiller [23]), an assessment of the stationarity of both nominal and real interest rates is potentially valuable. Another group of economists has investigated the question of whether trends in economic time series are deterministic

The Buying and Selling Behavior of Individual Investors at the Turn of the Year

Abstract: The average returns on low-capitalization stocks are unusually high relative to those on large-capitalization stocks in early January, a phenomenon known as the turn-of-the-year effect. This paper finds that the ratio of stock purchases to sales by individual investors displays a seasonal pattern, with individuals having a below-normal buy/sell ratio in late December and an above-normal ratio in early January. Year-to-year variation in the early January buy/sell ratio explains forty-six percent of the year-to-year variation in the turn-of-the-year effect during 1971–1985.

Business Cycles and the Behavior of Metals Prices

Abstract: The theory of storage says that the marginal convenience yield on inventory falls at a decreasing rate as inventory increases. The authors test this hypothesis by examining the relative variation of spot and futures prices for metals. As the hypothesis implies, futures prices are less variable than spot prices when inventory is low, but spot and futures prices have similar variability when inventory is high. The theory of storage also explains inversions of "normal" futures-spot price relations around business-cycle peaks. Positive demand shocks around peaks reduce metal inventories and, as the theory predicts, generate large convenience yields and price inversions. and Telser, many tests of the theory use inventory data to test the hypothesis that the marginal convenience yield on inventory falls at a decreasing rate as aggregate inventory increases. Inventory data are always a problem in this approach. It is usually unclear how aggregate inventory should be defined. For example, how should one treat government stocks? Moreover, like the metals we study, many commodities are produced, consumed, and traded internationally, and the accuracy of aggregate inventory data is questionable. Our tests of the theory of storage are also based on the hypothesis that the marginal convenience yield declines at higher inventory levels but at a decreasing rate. Rather than test the hypothesis by examining the inventory-convenience yield relation directly, however, we test its implications about the relative

Bond Covenants and Delegated Monitoring

Abstract: This paper examines alternative contracting arrangements available to a firm seeking to finance an investment project. The authors consider the choice between loan contracts with covenants based on noisy indicators of the firm's financial health and loan contracts enforced by a monitoring specialist. In one interpretation, the specialist is a financial intermediary. The firm's choice is shown to depend upon the firm's credit rating, the accuracy of financial indicators of the firm's condition, the loss from premature liquidation of the firm's project, and the cost of monitoring.

Exchange Rate Uncertainty, Forward Contracts, and International Portfolio Selection

Abstract: In this paper, ex ante efficient portfolio selection strategies are developed to realize potential gains from international diversification under flexible exchange rates. It is shown that exchange rate uncertainty is a largely nondiversiflable factor adversely affecting the performance of international portfolios. Therefore, it is essential to effectively control exchange rate volatility. For that purpose, two methods of exchange risk reduction are simultaneously employed: multicurrency diversification and hedging via forward exchange contracts. The empirical findings show that international portfolio selection strategies designed to control both estimation and exchange risks almost consistently outperform the U.S. domestic portfolio in out-of-sample periods. SINCE GRUBEL [11] APPLIED MODERN portfolio theory (MPT) to international investment, various authors, such as Levy and Sarnat [17], Solnik [20], and Lessard [16], have examined the gains from international diversification of investment portfolios. For the purpose of establishing the gains from international diversification, these studies constructed international portfolios using historical risk and return data from a period of fixed or relatively stable exchange rates and showed that internationally diversified portfolios dominated purely domestic portfolios in terms of mean-variance efficiency. From the standpoint of today's investors, however, the previous studies fail to offer operational guidance for international diversification for two important reasons. First, it is now questionable whether the past findings are still relevant under the current flexible exchange rate regime. Second, by being "ex post" in nature, the past studies ignored the issue of estimation risk, or parameter uncertainty, and therefore may have overstated the realizable portion of the potential gains from international diversification. Fluctuating exchange rates are likely to mitigate the potential gains from international diversification by making investment in foreign securities more risky. As will be shown later, a fluctuating exchange rate contributes to the risk of foreign investment not only through its own variance but also through its "positive" covariances with the local stock market returns. During our sample period of 1980 through 1985, for example, exchange rate volatility is found to account for about fifty percent of the volatility of dollar returns from investment in the stock markets of such major countries as Germany, Japan, and the U.K. Furthermore, the exchange rate changes vis-'a-vis the U.S. dollar are found to be

The Total Cost of Transactions on the NYSE

Abstract: This paper develops a measure of execution costs (market impact) of transactions on the NYSE. The measure is the volume-weighted average price over the trading day. It yields results that are less biased than measures that use single prices, such as closes. The paper then applies this measure to a data set containing more than 14,000 actual trades. We show that total transaction costs, commission plus market impact costs, average twenty-three basis points of principal value for our sample. Commission costs, averaging eighteen basis points, are considerably higher than execution costs, which average five basis points. They vary slightly across brokers and significantly across money managers. Though brokers do not incur consistently high or low transaction costs, money managers experience persistently high or lost costs. Finally, the paper explores the possible tradeoff between commission expenditures and market impact costs. Paying higher commissions does not yield commensurately lower execution costs, even after adjusting for trade difficulty. We cannot determine whether other valuable brokerage services are being purchased with higher commission payments or whether some money managers really are inefficient consumers of brokerage trading services. RECENT YEARS HAVE WITNESSED an explosion of institutional trading on the nation's stock exchanges. In 1970, only 17,000 trades of blocks of 10,000 or more shares were done on the New York Stock Exchange; these accounted for merely fifteen percent of total volume. In 1984, there were 433,000 such block trades, accounting for fifty percent of volume. These trades are costly and, in an informationally efficient stock market, cannot help but have a deleterious effect on the investment performance of institutional investors.

Risk-Based Premiums for Insurance Guaranty Funds

Abstract: Insurance guaranty funds have been adopted in all states to compensate policyholders for losses resulting from insurance company insolvencies. The guaranty funds charge flat premium rates, usually a percentage of premiums. Flat premiums can induce insurers to adopt high-risk strategies, a problem that can be avoided through the use of risk-based premiums. This article develops risk-based premium formulas for three cases: a) an ongoing insurer with stochastic assets and liabilities, b) an ongoing insurer also subject to jumps in liabilities (catastrophes), and c) a policy cohort, where claims eventually run off to zero. Premium estimates are provided and compared with actual guaranty fund assessment rates.

An Unconditional Asset‐Pricing Test and the Role of Firm Size as an Instrumental Variable for Risk

Abstract: In an intertemporal economy where both risk (stock beta) and expected return are time varying, the authors derive a linear relation between the unconditional beta and the unconditional return under certain stationarity assumptions about the stochastic process of size-portfolio betas. The model suggests the use of long time periods to estimate the unconditional portfolio betas. The authors find that, after controlling for the betas thus estimated, a firm-size proxy, such as the logarithm of the firm size, does not have explanatory power for the averaged returns across the size-ranked portfolios.

The Valuation of Sequential Exchange Opportunities

Abstract: Sequential exchange opportunities are valued using the techniques of modern option-pricing theory. The vehicle for analysis is the concept of a compound exchange option. This security is shown to exist implicitly in several contractual settings. A valuation formula for this option is derived. The formula is shown to generalize much previous work in option pricing. Several applications of the formula are presented.

Bubbles, Fads and Stock Price Volatility Tests: A Partial Evaluation

Abstract: This is a summary and interpretation of some of the literature on stock price volatility that was stimulated by Leroy and Porter [28] and Shiller [40]. It appears that neither small-sample bias, rational bubbles nor some standard models for expected returns adequately explain stock price volatility. This suggests a role for some nonstandard models for expected returns. One possibility is a “fads” model in which noise trading by naive investors is important. At present, however, there is little direct evidence that such fads play a significant role in stock price determination.

Insider Holdings and Perceptions of Information Asymmetry: A Note

Abstract: RESEARCHERS HAVE FOUND THAT trades by corporate insiders yield excess profits (for example, Finnerty [9] and Jaffe [11]). In an efficient capital market, we should expect other market participants to consider this in their investment/ trading decisions. Demsetz [7] notes that, to protect themselves, ordinary (uninformed) investors may adopt a buy-and-hold strategy but incur the "cost of illiquidity" in doing so. Therefore, he argues, the recorded rates of return (measured before losses to insiders) should be higher for stocks more likely to present outsiders with informationally disadvantageous trades. Based on a 159firm sample, he finds that there is a significant positive correlation between the recorded market rates of return and the ratio of insider trading to total trading. In this paper, we study the market's perception of information asymmetry between insiders and outsiders through the behavior of another group of tradersthe dealers/specialists. The degree of information asymmetry is proxied here by the concentration of insider holdings. The dealer/specialist provides the trading public the service of immediacy by standing ready to buy and sell. He or she incurs, in the process, inventory holding costs and information trading costs, which are the expected losses due to transactions with informed traders. Therefore, the dealer/specialist sets the bidask spread (his or her source of revenue) according to the anticipated levels of these costs. In particular, it has been shown that the higher the information trading cost, the wider the spread should be (Jaffe and Winkler [12], Copeland and Galai [6], and Glosten and Milgrom [10]). Thus, ceteris paribus, a higher degree of information asymmetry leads to a larger bid-ask spread. The question, then, is what factors influence the dealer's assessment of information asymmetry. One convenient measure is the extent of insider holdings. Corporate insiders have access to nonpublic firm-specific information and exercise a good deal of corporate control. We use the percentage of ownership by corporate insiders as a proxy for the degree of information asymmetry faced by the dealer. A positive correlation between spreads (net of holding costs and firm-size effects) and insider holdings would imply that dealers perceive a positive relationship between insider holdings and information asymmetry. We also study how the market views institutional holdings through the effect on bid-ask spread. Compared with the typical stockholder, institutions tend to hold larger blocks of a firm's stock; thus, their information acquisition costs are spread over a larger investment, creating an incentive to acquire information.

The Interrelation of Stock and Options Market Trading-Volume Data

Abstract: This research empirically investigates the relation between common stock and call option trading volumes. The paper hyothesizes and tests a sequential flow of information between the stock and option markets. If information trading for CBOE-listed firms is predominantly accomplished through option trading, then existing research methodologies may be biased against finding any significant economic consequences in those instances where option listing is an important variable. Results indicate that trading in call options leads trading in the underlying shares, with a one-day lag. BLACK [2] SUGGESTS THAT INFORMATION traders may prefer trading in options rather than shares due to economic incentives provided by reduced transaction costs, capital requirements, and trading restrictions and due to the greater action afforded by option trading. Manaster and Rendleman [12] empirically support Black's [2] option-information trading preference, finding incremental information content in option prices up to twenty-four hours prior to its reflection in stock prices. Jennings and Starks [10] report that the stock price-adjustment process upon arrival of new information differs for those firms listed on the Chicago Board Option Exchange (CBOE), and they demonstrate that stock price adjustment to new information occurs more rapidly for firms with listed call options. The results in both papers appear to warrant consideration of an optiontrading variable in the design of empirical tests. Both Manaster and Rendleman [12] and Jennings and Starks [10] investigate the price relation between shares and call options; this paper investigates trading volume. Copeland [4] posits the use of trading volume as a proxy for the rate of information arrival. He concludes that the relation between absolute value of price changes and volume is positive and linear if one accepts a sequentialinformation-arrival hypothesis as valid. The present research hypothesizes and tests a sequential flow of information between the stock and option markets. Analyses presented are based on econometric tests for causality1 derived from the works of Granger [6] and Sims [22]. If information trading takes place

Joint Estimation of Factor Sensitivities and Risk Premia for the Arbitrage Pricing Theory

Abstract: The APT is represented as a multivariate regression model with across-equations restrictions. Both observed and unobserved (latent) macroeconomic factors are included, thus generalizing and unifying two previous strands of literature. Large portfolios representing unobserved factors are treated as endogenous, and nonlinear 3SLS estimates are shown to differ sharply from estimates that ignore this endogeneity. Using monthly stock returns and six factors, we cannot reject January effects. The following results are invariant with respect to the inclusioh of January effects: we reject the CAPM in favor of the APT; however, we cannot reject the APT restrictions on the linear factor model. MOST EMPIRICAL WORK ON the arbitrage pricing theory (APT) has followed a factor-analysis approach; papers by Burmeister and Wall [5], Chan, Chen, and Hsieh [7], Chen, Roll, and Ross [9], and McElroy and Burmeister [22] represent some exceptions in which measured macroeconomic factors such as unexpected inflation are used to explain asset prices in an APT or multifactor model. Both the factor-analysis approach and the measured-macroeconomic-factor approach have their merits. The primary advantages of using measured economic factors are: (1) the factors and their APT prices in principle can be given economic interpretations, while with a factor-analysis approach it is unknown what factors are being priced; and (2) rather than using only asset prices to explain asset prices, measured macroeconomic factors introduce additional information, linking asset-price behavior to macroeconomic events. In this exploratory paper we investigate an APT (or multifactor) model in which there are both measured macroeconomic factors and other nonobserved factors. We impose the nonlinear across-equation APT pricing restrictions exactly by using three multivariate estimation methods: iterated nonlinear weighted least squares (ITNLWLS), iterated nonlinear seemingly unrelated regressions (ITNLSUR), and iterated nonlinear three stage least squares (ITNL3SLS); see Gallant [13] and discussion below. The appropriate estimation method depends upon alternative assumptions about the error terms (nonsystematic risk) in the asset-returns equations. The primary objective of this work is to investigate whether or not certain APT tests are sensitive to these alternative error assumptions, the details of which are given in the text. Our focus is on the interrelation

Predicting Contemporary Volume with Historic Volume at Differential Price Levels: Evidence Supporting the Disposition Effect

Abstract: This paper presents empirical evidence comparing two models of trading in equitiesthe well-known tax-loss-selling hypothesis and "the disposition effect." According to the disposition effect, investors are reluctant to realize losses but are eager to realize gains. This paper distinguishes between the two models with a new methodology that examines the relationship between volume at a given point in time and volume that took place in the past at different stock prices. The evidence overwhelmingly supports the disposition effect not only as a determinant of year-end volume, but also as a determinant of volume levels throughout the year. THIS PAPER PRESENTS SOME strong empirical results relating to two competing models of trading volume in equities-the "tax-loss-selling hypothesis" and "the disposition effect."

Jump‐Diffusion Processes and the Term Structure of Interest Rates

Abstract: The authors investigate the term structure of interest rates when the underlying state variables and production technologies follow the jump-diffusion processes. Even in some cases where the traditional expectations theory about the term structure is consistent with general equilibrium under diffusion processes, the traditional theory is not consistent under jump-diffusion processes. It is shown that bond prices are strictly higher under jump risks than otherwise and that consumers with logarithmic utility functions will develop hedge portfolios in the presence of jump diffusion. A NUMBER OF CONTINUOUS-TIME asset-pricing models have been derived under stochastic diffusion processes with continuous sample paths. (See, e.g., Black and Scholes [2], Merton [21], Breeden [3], and Cox, Ingersoll, and Ross [8].) However, recent empirical studies (see, e.g., Brown and Dybvig [4], Feinstone [10], and Jarrow and Rosenfeld [17]) suggest that the underlying processes may follow

The Effect of Taxes and Depreciation on Corporate Investment and Financial Leverage

Abstract: This paper provides an analysis of the effect of corporate and personal taxes on the firm's optimal investment and financing decisions under uncertainty. It extends the DeAngelo aAd Masulis capital structure model by endogenizing the firm's investment decision. The authors' results indicate that, when investment is allowed to adjust optimally, the existing predictions about the relationship between investment-related and debt-related tax shields must be modified. In particular, the authors show that increases in investment-related tax shields due to changes in the corporate tax code are not necessarily associated with reductions in leverage at the individual firm level. In cross-sectional analysis, firms with higher investment-related tax shields (normalized by expected earnings) need not have lower debt-related tax shields (normalized by expected earnings) unless all firms utilize the same production technology. Differences in production technologies across firms may thus explain why the empirical results of recent cross-sectional studies have not conformed to the predictions of DeAngelo and Masulis.

Testing Rationality in the Point Spread Betting Market

Abstract: This paper presents empirical tests of market rationality using data from the point spread betting market on National Football League games. Data from this market avoid many common pitfalls of tests of rationality in conventional financial markets. The authors test for rationality with two types of tests, statistical and economic. Results of the tests reveal that the statistical tests cannot reject market rationality while the economic tests do reject market rationality. MARKET RATIONALITY CAN BE empirically examined with either pure statistical tests or direct economic tests. Statistical tests look at statistical properties of markets, such as price correlations. Economic tests attempt to detect unexploited profit opportunities. This paper compares the results of these two types of rationality tests with data from the point spread betting market on National Football League (NFL) games. We conclude that the statistical tests are too weak to reject rationality in a market where irrationality appears to exist. Our results are strikingly consistent with those of Summers [26], who simulated a model of stock prices incorporating nonrational expectations and then showed that standard statistical tests are too weak to detect the absence of rationally formed expectations. Summers employed simulation because market rationality is difficult to test directly in conventional financial markets: the ongoing nature of securities markets means that there exists no point at which an objective fundamental value can be observed and compared with actual prices.' In contrast, the point spread market offers an objective, though uncertain, game outcome to decide the end-of-horizon payoff. Moreover, once a bet is placed in these markets, the impact of subsequent betting does not affect the odds on the placed bet (unlike pari-mutuel betting). Because of this elementary market