Showing papers in "Journal of Finance in 1989"

Why Does Stock Market Volatility Change Over Time

Abstract: This paper analyzes the relation of stock volatility with real and nominal macroeconomic volatility, economic activity, financial leverage, and stock trading activity using monthly data from 1857 to 1987. An important fact, previously noted by Officer (1973), is that stock return variability was unusually high during the 1929-1939 Great Depression. While aggregate leverage is significantly correlated with volatility, it explains a relatively small part of the movements in stock volatility. The amplitude of the fluctuations in aggregate stock volatility is difficult to explain using simple models of stock valuation, especially during the Great Depression. ESTIMATES OF THE STANDARD deviation of monthly stock returns vary from two to twenty percent per month during the 1857-1987 period. Tests for whether differences this large could be attributable to estimation error strongly reject the hypothesis of constant variance. Large changes in the ex ante volatility of market returns have important negative effects on risk-averse investors. Moreover, changes in the level of market volatility can have important effects on capital investment, consumption, and other business cycle variables. This raises the question of why stock volatility changes so much over time. Many researchers have studied movements in aggregate stock market volatility. Officer (1973) relates these changes to the volatility of macroeconomic variables. Black (1976) and Christie (1982) argue that financial leverage partly explains this phenomenon. Recently, there have been many attempts to relate changes in stock market volatility to changes in expected returns to stocks, including Merton (1980), Pindyck (1984), Poterba and Summers (1986), French, Schwert, and Stambaugh (1987), Bollerslev, Engle, and Wooldridge (1988), and Abel (1988). Mascaro and Meltzer (1983) and Lauterbach (1989) find that macroeconomic volatility is related to interest rates. Shiller (1981a,b) argues that the level of stock market volatility is too high relative to the ex post variability of dividends. In present value models such as Shiller's, a change in the volatility of either future cash flows or discount rates

Dynamic Capital Structure Choice: Theory and Tests

Abstract: This paper develops a model of dynamic capital structure choice in the presence of recapitalization costs. The theory provides the optimal dynamic recapitalization policy as a function of firm-specific characteristics. We find that even small recapitalization costs lead to wide swings in a firm's debt ratio over time. Rather than static leverage measures, we use the observed debt ratio range of a firm as an empirical measure of capital structure relevance. The results of empirical tests relating firms' debt ratio ranges to firm-specific features strongly support the theoretical model of relevant capital structure choice in a dynamic setting.

Seasoned Offerings, Imitation Costs, and the Underpricing of Initial Public Offerings

Abstract: This paper presents a signalling model in which high-quality firms underprice at the initial public offering (IPO) in order to obtain a higher price at a seasoned offering. The main assumptions are that low-quality firms must invest in imitation expenses to appear to be high-quality firms, and that with some probability this imitation is discovered between offerings. Underpricing by high-quality firms at the IPO can then add sufficient signalling costs to these imitation expenses to induce low-quality firms to reveal their quality voluntarily. The model is consistent with several documented empirical regularities and offers new testable implications. In addition, the paper provides empirical evidence that many firms raise substantial amounts of additional equity capital in the years after their IPO. EVER SINCE IBBOTSON (1975) FIRST rigorously documented the large underpricing of initial public offerings (IPOs), it has puzzled researchers. Rock (1986) has offered an equilibrium model for this phenomenon in which uninformed investors face a winner's curse when they submit an order for IPO shares. Since informed investors withdraw from the market when the issue is priced above its value, uninformed investors are more likely to receive a full allocation of shares if the offering is overpriced and a rationed allocation if it is not. Firms are forced to underprice their IPOs in order to compensate uninformed investors for this adverse selection. Beatty and Ritter (1986) extend the model to show that the value of information and, thus, both the bias against uninformed investors and the necessary underpricing are higher for issues for which there is greater uncertainty about their value. One problem with the winner's curse explanation of underpricing is that it could be easily avoided. For example, underwriters could reduce the adverse selection problem by offering IPOs only in pools or by agreeing to withdraw an issue or compensate uninformed investors if demand from informed investors is not forthcoming (see also Ritter (1987)). Alternatively, venture capitalists could provide the expertise and capital funding to reduce or avoid IPO underpricing. Yet Barry, Muscarella, Peavy, and Vetsuypens (1988) find that venture-capitalbacked IPOs are even more underpriced than non-venture-capital-backed issues.

Free Cash Flow and Stockholder Gains in Going Private Transactions

Abstract: We investigate the source of stockholder gains in going private transactions. We find support for the hypothesis advanced by Jensen that a major source of these gains is the mitigation of agency problems associated with free cash flow. Using a sample of 263 going private transactions from 1980 through 1987, our results indicate a significant relationship between undistributed cash flow and a firm's decision to go private. In addition, we find that premiums paid to stockholders are significantly related to undistributed cash flow. These results are especially strong for firms that went private between 1984 and 1987 and also for firms whose managers owned relatively little equity before the going private transaction.

Signalling and the Pricing of New Issues

Abstract: This paper develops a signalling model with two signals, two attributes, and a continuum of signal levels and attribute types to explain new issue underpricing. Both the fraction of the new issue retained by the issuer and its offering price convey to investors the unobservable “intrinsic” value of the firm and the variance of its cash flows. Many of the model's comparative statics results are novel, empirically testable, and consistent with the existing empirical evidence on new issues. In particular, the degree of underpricing, which can be inferred from observable variables, is positively related to the firm's post-issue share price.

Information and Volatility: The No-Arbitrage Martingale Approach to Timing and Resolution Irrelevancy

Abstract: The no-arbitrage martingale analysis is used to study the effect on asset prices of changes in the rate of information flow. The analysis is first used to develop some simple tools for asset pricing in a continuous-time setting. These tools are then applied to determine the effect of information on prices and price volatility, to extend Samuelson's theorem on prices fluctuating randomly, and to study the impact on prices of the resolution of uncertainty. The conditions under which uncertainty resolution is irrelevant for asset pricing are shown to be similar to those which support the MM irrelevance theorems.

Inferring the Components of the Bid-Ask Spread: Theory and Empirical Tests

Abstract: The relation between the square of the quoted bid-ask spread and two serial covariances-the serial covariance of transaction returns and the serial covariance of quoted returns-is modeled as a function of the probability of a price reversal, 7r, and the magnitude of a price change, a, where a is stated as a fraction of the quoted spread. Different models of the spread are contrasted in terms of the parameters, 7r and a. Using data on the transaction prices and price quotations for NASDAQ/NMS stocks, 7r and a are estimated and the relative importance of the components of the quoted spreadadverse information costs, order processing costs, and inventory holding costs-is determined. THE QUOTED BID-ASK spread is the difference between the ask price quoted by a dealer and the bid price quoted by a dealer at a point in time. The realized bidask spread is the average difference between the price at which a dealer sells at one point in time and the price at which a dealer buys at an earlier point in time. Theories of the spread are theories of the quoted spread. The current literature implies that the quoted spread must cover three costs faced by a dealer: order processing costs, inventory holding costs, and adverse information costs. Order processing costs receive a greater emphasis in the early literature of Demsetz [5] and Tinic [19], but all researchers on the bid-ask spread recognize the importance of these costs. Inventory holding costs arising from the risk assumed by a dealer are modeled in Stoll [17] and Ho and Stoll [13], and Amihud and Mendelson [1] model the effect of constraints on inventory size. The role of adverse information costs is emphasized by Copeland and Galai [4], Glosten and Milgrom [7], and Easley and O'Hara [6]. Empirical studies have shown that the quoted spread is related to characteristics of securities such as the volume of trading, the stock price, the number of market makers, the risk of the security, and other factors. However, these results are roughly consistent with several theories of the spread and do not give much insight into the evolution of the spread over time or the relative importance of the cost components of the quoted spread. An implication of both the inventory cost model and the adverse information cost model is that the realized spread earned by a dealer is less than the spread * Owen Graduate School of Management, Vanderbilt University. This research was supported by grants from the Financial Markets Research Center and the Dean's Fund for Faculty Research at

Empirical Tests of the Consumption-Oriented CAPM

Abstract: The empirical implications of the consumption-oriented capital asset pricing model (CCAPM) are examined, and its performance is compared with a model based on the market portfolio. The CCAPM is estimated after adjusting for measurement problems associated with reported consumption data. The CCAPM is tested using betas based on both consumption and the portfolio having the maximum correlation with consumption. As predicted by the CCAPM, the market price of risk is significantly positive, and the estimate of the real interest rate is close to zero. The performances of the traditional CAPM and the CCAPM are about the same.

An Exact Bond Option Formula

Abstract: This paper derives a closed-form solution for European options on pure discount bonds, assuming a mean-reverting Gaussian interest rate model as in Vasicek [8]. The formula is extended to European options on discount bond portfolios.

Common Stochastic Trends in a System of Exchange Rates

Abstract: Univariate tests reveal strong evidence for the presence of a unit root in the univariate time-series representation for seven daily spot and forward exchange rate series. Furthermore, all seven spot and forward rates appear to be cointegrated; that is, the forward premiums are stationary, and one common unit root, or stochastic trend, is detectable in the multivariate time-series models for the seven spot and forward rates, respectively. This is consistent with the hypothesis that the seven exchange rates possess one longrun relationship and that the disequilibrium error around that relationship partly accounts for subsequent movements in the exchange rates. A GENERAL CONSENSUS HAS emerged in recent years that many macroeconomic time series, such as GNP, consumption expenditures, disposable income, etc., can be characterized by a stochastic trend model. In particular, Nelson and Plosser [22] described this property as one of being "difference stationary" so that the first difference of a time series is stationary. An alternative "trend stationary" model, where a stationary component is added to a deterministic trend term, has generally been found to be less appropriate.1 Similarly, it has long been recognized that many financial time series, such as foreign exchange rates, are nonstationary, e.g., in Meese and Singleton [21]. The issue of nonstationary is not merely a statistical curiosity but has several important implications for the modeling of exchange rates. For instance, many models of exchange rate determination under rational expectations require stationarity assumptions when solving out the expected future values of the fundamentals. Further, there has been some controversy over the appropriate transformations to use when conducting tests of whether the forward rate is an unbiased and efficient predictor of the future spot exchange rate.2 Some authors, e.g., Frenkel [11, 12], have conducted tests in levels, while Geweke and Feige [14]

Economic Significance of Predictable Variations in Stock Index Returns

Abstract: Knowledge of the one-month interest rate is useful in forecasting the sign as well as the variance of the excess return on stocks. The services of a portfolio manager who makes use of the forecasting model to shift funds between bills and stocks would be worth an annual management fee of 2% of the value of the assets managed. During 1954:4 to 1986:12, the variance of monthly returns on the managed portfolio was about 60% of the variance of the returns on the value weighted index, whereas the average return was two basis points higher. A STATISTICALLY SIGNIFICANT NEGATIVE correlation between nominal excess returns on stocks and nominal interest rates has been noted in the financial economics literature. In this paper we examine the economic importance of the ability of nominal interest rates to forecast nominal excess returns on stocks. The qualitative conclusion of the paper is that the forecasting ability of treasury bill rates is economically significant. The evidence suggests that this is true because both the expected value and the variance of the nominal stock excess returns depend in interesting ways on the nominal interest rate.' Our approach to evaluating the economic importance of the negative correlation between the nominal interest rate and stock returns is similar in spirit to Fama and Schwert (1977), who examine whether the statistically significant negative correlation between stock returns and nominal interest rates can be used to forecast times when the expected nominal risk premium on stocks is negative. They conclude that the negative slope coefficient in the regression of stock returns on treasury bill returns is not useful in predicting times when stocks do worse than bills. This is probably too stringent a measure of economic importance-we are able to show economic significance despite the inability of the model to consistently forecast periods with a negative risk premium. Our primary assumption is that the model used to forecast stock index returns is known to sophisticated investors; i.e., the model is predicting (market) expected

An Empirical Investigation of U.S. Firms in Reorganization

Abstract: The purpose of this paper is to understand the institutional features of Chapter 11 from an empirical examination of thirty firms that have emerged from reorganization. We find the recontracting framework of Chapter 11 to be complex, lengthy, and costly. Violations of absolute priority in favor of stockholders are frequently encountered. These deviations may result from the bargaining process of Chapter 11 or from a recontracting process between creditors and stockholders which recognizes the ability of stockholder-oriented management to preserve firm value. An example of such recontracting addresses Myers' underinvestment problem. An investigation of the effects of Chapter 11 on the pricing of risky debt is also provided. THE PURPOSE OF THIS paper is to understand the institutional features of Chapter

Preemptive Bidding and the Role of the Medium of Exchange in Acquisitions

Abstract: The medium of exchange in acquisitions is studied in a model where (i) bidders' offers bring forth potential competition and (ii) targets and bidders are asymmetrically informed. In equilibrium, both securities and cash offers are observed. Securities have the advantage of inducing target management to make an efficient accept/reject decision. Cash has the advantage of serving, in equilibrium, to "preempt" competition by signaling a high valuation for the target. Implications concerning the medium of exchange of an offer, the probability of acceptance, the probability of competing bids, expected profits, and the costs of bidders are derived. IN STRUCTURING ITS OFFER to acquire a firm, an acquirer must, among other things, determine the medium of exchange of the offer. That is, an acquirer must choose whether the payment will be in the form of cash, debt, equity, or some combination. With symmetric information, no transactions costs, and no taxes, the medium of exchange is irrelevant. This is not the case, though, if these assumptions are not satisfied. This paper studies the role of the medium of exchange in acquisitions in a setting in which there is asymmetric information between a target and competing bidders. The focus of the paper is on the role of the medium of exchange in preempting competition. Consider a bidder that studies the profitability of an acquisition. If it makes a bid, other potential bidders will observe the bid, learn of the potentially profitable acquisition, and perhaps compete for it. A preemptive bid may be a way to eliminate this competition. Suppose a competing bidder's expected payoff is decreasing in the initial bidder's valuation for the target. When bidding against an initial bidder with a high valuation, a competitor may face a low probability of winning the bidding and a low expected payoff given that it does win. In this case, if the initial bidder could signal a sufficiently high valuation, it could deter the competition. As Fishman [7] and P'ng [18] have shown, a high bid can signal a high valuation and thus serve to preempt competition. Both studies, however, deal only with cash offers. (See also Giammarino and Heinkel [9] and Khanna [14].) A key difference between a cash offer and a (risky) securities offer is that a security's value depends on the profitability of the acquisition, while the value of cash does not. In the studies cited above, bidders, but not the target, have private

The Effects of Beta, Bid-Ask Spread, Residual Risk, and Size on Stock Returns

Abstract: Merton's [26] recent extension of the CAPM proposed that asset returns are an increasing function of their beta risk, residual risk, and size and a decreasing function of the public availability of information about them. Associating the latter with asset liquidity and following Amihud and Mendelson's [2] proposition that asset returns increase with their illiquidity (measured by the bid-ask spread), we jointly estimate the effects of these four factors on stock returns. ACCORDING TO THE CAPITAL Asset Pricing Model (CAPM), expected asset returns are determined solely by the systematic (3) risk. Inconsistencies between the dictum of the theory and the empirical findings led Merton [26] to suggest a more general model of asset pricing, assuming that each investor has information only about a subset of the available assets and composes his or her portfolio only of this subset. The resulting portfolio will differ from the CAPM portfolio, and the expected return on each asset will be as follows: (i) an increasing function of its systematic (d) risk; (ii) an increasing function of its residual risk (due to imperfect diversification of this risk);

Earnings Yields, Market Values, and Stock Returns

Abstract: Earlier evidence concerning the relation between stock returns and the effects of size and earnings to price ratio (E/P) is not clear-cut. This paper re-examines these two effects with (a) a substantially longer sample period, 1951-1986, (b) data that are reasonably free of survivor biases, (c) both portfolio and seemingly unrelated regression tests, and (d) an emphasis on the important differences between January and other months. Over the entire period, the earnings yield effect is significant in both January and the other eleven months. Conversely, the size effect is significantly negative only in January. We also find evidence of consistently high returns for firms of all sizes with negative earnings.

Management Buyouts: Evidence on Taxes as a Source of Value

Abstract: This paper estimates the value of tax benefits in 76 management buyouts of public companies completed in the period 1980 to 1986. The median value of tax benefits, estimated at the time the buyout company goes private, has a lower bound of 21% and an upper bound of 143% of the premium paid to pre-buyout shareholders. The estimated value depends on the rate buyout debt is repaid and the tax rate applied to the interest deductions. The paper also presents evidence on the actual taxes paid and debt repayment rates by these companies after the buyout. The results in this paper suggest that tax benefits are an important source of the wealth gains in management buyouts.

Prepayment and the Valuation of Mortgage-Backed Securities

Abstract: This paper puts forward a valuation framework for mortgage-backed securities. Rather than imposing an optimal, value-minimizing call condition, we assume that at each point in time there exists a probability of prepaying; this conditional probability depends upon the prevailing state of the economy. To implement our valuation procedure, we use maximum-likelihood techniques to estimate a prepayment function in light of recent aggregate GNMA prepayment experience. By integrating this empirical prepayment function into our valuation framework, we provide a complete model to value mortgagebacked securities. GIVEN AN OPTIMAL, VALUE-MINIMIZING call policy, a mortgage should never be called when its market value is less than its call price. Similarly, a mortgage should be called if it is worth more than its call price. However, mortgagors often call their loans when the prevailing refinancing rate exceeds the contract rate on the loan (Dunn and McConnell (1981)). In addition, some mortgagors do not call their loans when the loan's contract rate exceeds the prevailing refinancing rate. The purpose of this paper is to put forward a valuation framework for mortgagebacked securities consistent with these stylized facts associated with mortgage prepayments. The mortgagor's prepayment decision is integral to our valuation framework. However, we do not impose an optimal, value-minimizing call condition to price these securities. Rather, we assume that at each point in time there exists a probability of prepaying, this conditional probability depending upon the prevailing state of the economy. By integrating this prepayment function into our valuation framework, we provide a complete model to value mortgage-backed securities. To implement our valuation procedures, we estimate a prepayment function given recent GNMA prepayment experience. We follow Green and Shoven (1986) by using a proportional-hazards model to estimate the influence of various explanatory variables or covariates on the mortgagor's prepayment decision. Distinct from Green and Shoven, we explicitly model the effects of seasoning, as well as investigating the influence of interest cost savings from refinancing. In addition, we also consider the effects of lagged refinancing rates, heterogeneity

Measuring Corporate Bond Mortality and Performance

Abstract: This study develops an alternative way to measure default risk and suggests an appropriate method to assess the performance of fixed-income investors over the entire spectrum of credit-quality classes. The approach seeks to measure the expected mortality of bonds and the consequent loss rates in a manner similar to the way actuaries assess mortality of human beings. The results show that all bond ratings outperform riskless Treasuries over a ten-year horizon and that, despite relatively high mortality rates, Brated and CCC-rated securities outperform all other 'rating categories for the first four years after issuance, with BB-rated securities outperforming all others thereafter. THE RECENT EMERGENCE OF the high-yield corporate debt market in the United States has intensified interest in the relation between expected yield spreads of bonds of various credit quality and expected losses from defaults. In addition to default risk, investors also consider the effects of the two other major risk dimensions of investing in fixed-interest instruments, i.e., interest rate risk and liquidity risk. The interaction among the three dimensions of risk has raised the analytic content of fixed-income assessment to an increasingly sophisticated level. The analysis of default risk, however, has probably been the area of most concern and empirical measurement over the years since the initial pioneering work by Hickman (1958). The appropriate measure of default risk and the accuracy of its measurement are critical in the pricing of debt instruments, in the measurement of their performance, and in the assessment of market efficiency. Analysts have concentrated their efforts on measuring the default rate for finite periods of time-for example, one year-and then averaging the annual rates for longer periods. In almost all previous studies, the rate of default has been measured simply as the value of defaulting issues for some specific population of debt compared with the value of bonds outstanding that could have defaulted. Annual default rates are then usually compared with observed promised yield spreads in order to assess the attractiveness of particular bonds or classes of bonds. A corollary approach is to compare default rates with ex post returns to assess whether investors were compensated for the risks they bear.

Disclosure Decisions by Firms and the Competition for Price Efficiency

Abstract: This paper develops a model of the relationship between investment decisions by firms and the efficiency of the market prices of their securities. It is shown that more efficient security prices can lead to more efficient investment decisions. This provides firms with the incentive to increase price efficiency by voluntarily disclosing information about the firm. Disclosure decisions are studied. It is shown that firms may expend more resources on disclosure than is socially optimal. This is in contrast to the concern implicit in mandatory disclosure rules that firms will expend too few resources on disclosure. THIS PAPER DEVELOPS A model of the relationship between firms' investment decisions and the efficiency of the market prices of their securities. It is shown that more efficient security prices can lead to more efficient investment decisions. This provides firms with the incentive to increase price efficiency by voluntarily disclosing information about the firm. Disclosure decisions are studied. The costs of disclosure are twofold. First, there are costs of producing and disseminating the information. Included here are opportunity costs of firms' employees, auditing and legal expenses, costs of printing and distribution, and costs associated with the release of any proprietary information. Second, there are traders' costs of assimilating the information. For instance, while it is not very costly to obtain a firm's 8-K and 10-K (once produced), it is quite costly to understand the implications of their contents. While the former costs have been recognized in the literature on disclosure, the latter costs have not. That is, while traders are sometimes viewed as having access to some costly information, the information contained in firms' disclosures is typically taken to be costlessly observed by all (see for instance Diamond (1985) and Dye (1987)).1 Taking traders' costs of learning the information content of firms' disclosures into account leads to new conclusions regarding incentives to expend resources on disclosure. In particular, it is shown that firms may spend more on disclosure than is socially optimal. This overdisclosure results from firms competing for the attention of traders. This is an interesting result given the public policy concern that firms, on their own, will spend less on disclosure than is socially optimal

Overreactions in the Options Market

Abstract: This paper examines the "term structure" of options' implied volatilities, using data on S&P 100 index options. Because implied volatility is strongly mean reverting, the implied volatility on a longer maturity option should move by less than one percent in response to a one percent move in the implied volatility of a shorter maturity option. Empirically, this elasticity turns out to be larger than suggested by rational expectations theory-long-maturity options tend to "overreact" to changes in the implied volatility of short-maturity options. ARE INVESTORS "RATIONAL"-DO they behave like Bayesian statisticians-when it comes to incorporating new information into asset prices? Proponents of the efficient markets hypothesis would answer this question in the affirmative. Many others, however, believe that Bayesian rationality is a poor description of investor behavior and that, as a consequence, asset prices tend to be informationally inefficient. One way in which inefficiencies might arise is through the overreactions of traders to the arrival of new information.1 This possibility is raised by experimental and survey findings which indicate that people have a systematic tendency to overemphasize recent data at the expense of other information when making projections.2 The objective of this paper is to search for evidence of such overreactive behavior in a semingly peculiar place: the options market. Options may appear to be unlikely candidates for overreaction because, unlike primary securities, their prices are closely tied down by arbitrage considerations. As Black and Scholes (1973) demonstrate, if stock price volatility is known, options prices are completely determined-any deviation from the prescribed value implies a riskless profit opportunity. However, given that volatility is in fact unknown and changing, options do retain something of an independent nature, not wholly redundant with their underlying stocks. Options can be thought of as reflecting a speculative market in volatility-the implied volatility on a given option (obtained by inverting a

Computing the Constant Elasticity of Variance Option Pricing Formula

Abstract: This paper expresses the constant elasticity of variance option pricing formula in terms of the noncentral chi-square distribution. This allows the application of well-known approximation formulas and the derivation of a whole class of closed-form solutions. In addition, a simple and efficient algorithm for computing this distribution is presented. THIS PAPER SHOWS THAT the constant elasticity of variance (CEV) formula can be expressed as a function of the noncentral chi-square distribution. A simple and efficient algorithm for computing this distribution is presented. Approximations to this distribution can be used to estimate accurately the CEV formula when the computation of the exact solution is problematic. Section I discusses theories and some evidence on the association between volatility and price level. Section II presents the particular kind of relationship assumed by the CEV model and reviews empirical evidence on the model. Section III shows that the CEV formula can be expressed in terms of the noncentral chisquare distribution. A simple algorithm for computing this distribution is derived in Section IV. Section V presents some special "closed-form" solutions to this distribution. Finally, Section VI shows that an approximation to the CEV formula can be used when the exact solution converges slowly. I. Relationship between Volatility and Price Level Several theoretical arguments imply an association between stock price and volatility. Geske [11], Black [3], and Christie [5] consider the effects of financial leverage on the variance of the stock. An increase in the stock price reduces the debt-equity ratio of the firm and therefore reduces the variance of the stock's returns. Black hypothesizes that price changes may also affect volatility through their impact on operating leverage. In addition, he proposes a reverse causal relationship whereby an increase in the volatility of stocks causes prices to fall. In Rubinstein's [171 displaced diffusion model, the relation between price and volatility of returns depends on the firm's asset mix and debt-equity ratio. Empirical evidence supports the hypothesis that volatility changes with stock price. Schmalensee and Trippi [19], examining just over a year of weekly data on six stocks, find a strong negative relationship between stock price changes and changes in implied volatility. Black [3], using over ten years of data on thirty stocks, finds that a given proportional increase (decrease) in stock price is

The Price Effect of Option Introduction

Abstract: This paper examines the price effect of option introduction from 1974 to 1980. The introduction of individual options causes a permanent price increase in the underlying security, beginning approximately three days before introduction. The price effect appears to be associated with introduction, and not announcement, throughout the sample period. Excess returns volatility declines with option introduction. Systematic risk is unchanged, there is a positive relation between the price increase and a measure of activity in the options market. Copyright 1989 by American Finance Association.

Some Empirical Estimates of the Risk Structure of Interest Rates

Abstract: This paper investigates the risk structure of interest rates using pure discount bonds. The most striking feature of our estimates of default-risk premia is the resemblance of their time profile to the theoretical time profile obtained by Merton (1974). WHEN A BOND IS issued, a promise to pay certain amounts on predetermined dates is made. The price of such a bond is a function of both the pattern of the promised payments (e.g., the level and periodicity of coupon payments) and the probability that this obligation will be met. Accordingly, there are bond-market studies of both the term structure and the risk structure of interest rates. This is the first paper to investigate the risk structure of interest rates using pure discount bonds. Previous empirical studies of the risk structure of corporate bonds (e.g., Fisher (1959), Johnson (1967), Cohan (1967), Silvers (1973), and Boardman and McEnally (1981)) examine the differences between yields on coupon-paying corporate bonds and yields on coupon-paying government bonds of the same maturity. The use of these data is problematical. First, most corporate bonds promise more than a single payment (i.e., periodical coupon payments are promised). Since the price of a coupon-paying bond is the sum of the values of all of its cash flow components, one cannot estimate the default-risk premium for a single future date. Second, most of these bonds have sinking fund provisions and some of them are callable. (Henceforth, such bonds will be termed "complicated" bonds.) While closed-form solutions exist for some complicated corporate bonds (c.f., Black and Cox (1976)), most analysis of the pricing of such bonds is done via numerical analysis (e.g., Brennan and Schwartz (1977), Mason (1986), Kim, Ramaswamy, and Sundaresan (1987)). Hence, no analytic results are available to which the empirical results can be directly compared. Moreover, the prices (and, consequently, yields) of complicated bonds reflect their sinking fund provisions, callability, etc. Hence, when analyzing the prices of complicated bonds, one cannot empirically isolate the effect of risk alone on the yields of these bonds. Recently, the federal government and corporations have issued increasing numbers of pure discount bonds. This increase, which initially was motivated by

Asset Pricing in Partially Segmented Markets: Evidence from the Finnish Market

Abstract: This paper analyzes asset pricing in a partially segmented market where citizens of a small country are allowed to hold only their domestic securities, whereas the rest of the investors ("foreigners") are essentially allowed to hold all securities. In this market setting it may occur that the citizens of the small country are willing to pay less for their domestic securities than are the foreign investors. The paper derives equilibrium required rates of return for different investors in this market setting which perfectly occurred in Finland and tests this equilibrium model using data from the Finnish stock market. Empirical results are consistent with the hypotheses derived from the model. SEVERAL STUDIES (SEE, E.G., Solnik (1974a) and Grauer and Hakansson (1987)) have shown that investors should diversify internationally as by so doing they can reduce the risk of their portfolio without lowering the expected return. This implies that, if the citizens of a certain country are by legal restrictions prohibited from holding foreign securities, they may require a higher rate of return on the domestic securities than the foreign investors do. This may happen because the domestic investors cannot diversify away the specific country risk in the same way that the foreign investors can. Thus, if we could observe the prices which the foreign and domestic investors are willing to pay for these domestic securities, we would expect them to differ because of this diversification effect. The Finnish law prohibited Finnish investors from investing in foreign securities until 1986 while simultaneously allowing foreign investors to own up to 20% of the shares of any Finnish company. Moreover, since 1984 the Helsinki Stock Exchange (HSE) has separately quoted the prices for the unrestricted shares which can be owned both by foreign and domestic investors and for the restricted shares owned solely by domestic investors. Thus, the market setting depicted in the previous paragraph occurred perfectly in Finland during the years 1984 and 1985. In this paper our objective is to develop and test an asset pricing model which takes into account the legal restrictions in the Finnish stock market. In Section I we specify the market structure in the Finnish stock market in more detail by explaining the relevant legal restrictions affecting the market. We also present some descriptive statistics on the prices of the restricted and the unrestricted on

Valuing Commercial Mortgages: An Empirical Investigation of the Contingent-Claims Approach to Pricing Risky Debt

Abstract: This paper empirically investigates a contingent-claims model of commercial mortgage pricing. We find that the magnitude of the observed default premia for a sample of nonprepayable fixed rate bullet mortgages can be explained by the contingent-claims model. In addition, the model explains a significant proportion of the period-to-period changes in the default premia. However, given an assumed negative correlation between building value changes and interest rate changes, the model's risk structure tends to increase less steeply with increasing maturity than the observed risk structure. SINCE THE SEMINAL WORK of Black and Scholes (1973), corporate liabilities have been modeled as options on the total value of the firm. This contingent-claims approach to bond pricing was refined by Merton (1974) to allow for cash dispersals prior to the bonds' maturities and by Brennan and Schwartz (1980) and Ingersoll (1987) to allow for interest rate uncertainty. Although variants of these bond pricing models are currently being used extensively on Wall Street, they have not been tested extensively. Moreover, empirical studies have not successfully accounted for the observed spread between the rates on risky and default-free debt. Jones, Mason, and Rosenfeld (1984) empirically investigate a model that assumes a nonstochastic term structure of interest rates, while Ramaswamy and Sundaresan (1986) examine a model with stochastic interest rates to price floating rate notes. In both cases, the models could not explain the observed default premia. The relative lack of empirical analysis is due partly to the complicated nature of corporate bonds. Major corporations generally have a large number of different bond issues outstanding that have different priorities in the event that the firm goes bankrupt. Moreover, the bonds can have a variety of covenants specifying sinking fund provisions, conditions under which technical default will occur, and other restrictions that can have an impact on their value. Although these complications do not preclude pricing various bond issues on a case-by-case basis, they make it difficult to test systematically the accuracy of the pricing model.

The Size and Incidence of the Losses from Noise Trading

Abstract: Recent empirical research has identified a significant amount of volatility in stock prices that cannot easily be explained by changes in fundamentals; one interpretation is that asset prices respond not only to news but also to irrational “noise trading.” We assess the welfare effects and incidence of such noice trading using an overlapping-generations model that gives investors short horizons. We find that the additional risk generated by noise trading can reduce the capital stock and consumption of the economy, and we show that part of that cost may be borne by rational investors. We conclude that the welfare costs of noise trading may be large if the magnitude of noise in aggregate stock prices is as large as suggested by some of the recent empirical litrature on the excess volatility of the market.

Options Arbitrage in Imperfect Markets

Abstract: Option valuation models are based on an arbitrage strategy-hedging the option against the underlying asset and rebalancing continuously until expiration-that is only possible in a frictionless market. This paper simulates the impact of market imperfections and other problems with the "standard" arbitrage trade, including uncertain volatility, transactions costs, indivisibilities, and rebalancing only at discrete intervals. We find that, in an actual market such as that for stock index options, the standard arbitrage is exposed to such large risk and transactions costs that it can only establish very wide bounds on equilibrium options prices. This has important implications for price determination in options markets, as well as for testing of valuation models. AMONG ALL THEORIES IN finance, the Black-Scholes option pricing model has perhaps had the biggest impact on the real world of securities trading. Virtually all market participants are aware of the model and use it in their decision making. Academics regularly test the model's valuation on actual market prices and typically conclude that, while not every feature is accounted for, the model works very well in explaining observed option prices.' Most option valuation models are based on an arbitrage argument. Under the assumptions of the model, the option can be combined with the underlying asset into a hedged position that is riskless for local changes in the asset's price and in time and must therefore earn the riskless interest rate. This leads to a theoretical value for the option such that profitable arbitrage is ruled out. However, while virtually all options traders are aware of option pricing theory and most use it in some way, the arbitrage mechanism assumed in deriving the theory cannot work in a real options market in the same way that it does in a frictionless market. The disparity between options arbitrage in theory and in practice is the subject of this paper. Some of the important assumptions made in deriving the Black-Scholes model are the following. * The price of the underlying asset follows a logarithmic diffusion process that

S&P 500 Cash Stock Price Volatilities

Abstract: S&P 500 stock return volatilities are compared to the volatilities of a matched set of stocks, after controlling for cross-sectional differences in firm attributes known to affect volatility. No significant difference in volatility is observed between 1975 and 1983before the start of trade in index futures and index options. Since then, S&P 500 stocks have been relatively more volatile. The difference is statistically, but not economically, significant. The relative increase occurs primarily in daily returns and only to a lesser extent in longer interval returns. Other factors besides the start of derivative trade could be responsible for the small increase in volatility. STOCK PRICE VOLATILITY HAS received much attention in the popular press over the last few years, especially since the October 19, 1987 stock market crash. The rise in volatility has alarmed investors, regulators, and the public in general. Some suggest that the start of trade in stock index futures and index options increased speculative activity that in turn destabilized cash markets, causing higher volatility. Large trading activity in the derivative contracts makes the suggestion plausible. Volume in index futures and index options increased dramatically since their introductions in 1982 and 1983. By 1987, the average daily dollar volume in the S&P 500 futures contracts alone exceeded the dollar volume of cash S&P 500 trade by a factor of about two, while the dollar value of the daily net change in total open interest is about 8% of S&P 500 stock dollar volume. Speculative trade in futures and options frequently is accused of destabilizing underlying cash markets. The charge has been made for more than a century in the agricultural, precious metal, and currency markets. Recent evidence by French and Roll (1986) showing stock variance to be strongly related to trading session hours heightens these concerns. Unfortunately, theoretical analyses of whether speculative trade destabilizes cash markets lead to conflicting conclusions, depending on what assumptions are made.1 * School of Business Administration, University of Southern California and Office of Economic Analysis, U.S. Securities and Exchange Commission. I wish to thank Mary (Denny) McSweeny and Steve Hornstein for their valuable research assistance and the referee and editor for their many suggestions and insights. The opinions expressed in this paper do not necessarily reflect those of the U.S. Securities and Exchange Commission or those of the author's colleagues on its staff. 'An increase in well informed speculative trade has two opposite effects on measured volatility. It decreases volatility due to order flow imbalances caused by uninformed traders because informed traders provide liquidity in such events, and it increases volatility due to new fundamental information since the information (which is assumed to be generated at discrete time intervals) is impounded into

Changes in Expected Security Returns, Risk, and the Level of Interest Rates

Abstract: Regressions of security returns on treasury bill rates provide insight about the behavior of risk in rational asset pricing models. The information in one-month bill rates implies time variation in the conditional covariances of portfolios of stocks and fixed-income securities with benchmark pricing variables, over extended samples and within five-year subperiods. There is evidence of changes in conditional “betas” associated with interest rates. Consumption and stock market data are examined as proxies for marginal utility, in a general framework for asset pricing with time-varying conditional covariances.

New Hope for the Expectations Hypothesis of the Term Structure of Interest Rates

Abstract: Survey data on interest rate expectations permit separate testing of the two alternative hypotheses in traditional term structure tests: that the expectations hypothesis fails, and that expected future interest rates are ex post inefficient forecasts. We find that the source of the spread's poor predictions of future interest rates varies with maturity. At short maturities the expectations hypothesis fails. At long maturities, however, changes in the yield curve reflect changes in expected future rates one-for-one, an implication of the expectations hypothesis. This result confirms earlier findings that long rates underreact to short rates, but now it cannot be attributed to term premia. IF THE ATTRACTIVENESS OF an economic hypothesis is measured by the number of papers which statistically reject it, the expectations theory of the term structure is a knockout. Most tests beginning with Macaulay (1938) find no evidence supporting the expectations hypothesis.1 Many cannot even reject statistically the alternative hypothesis that the spread between long and short rates contains no information about future interest-rate changes.2 To make matters worse, in U.S. postwar data, future long rates tend to rise when short rates are above long rates. Since the expectations hypothesis would predict that long rates tend to fall, the theory often does worse than even the naive model that future interest