Showing papers in "Journal of Finance in 1994"

The Benefits of Lending Relationships: Evidence from Small Business Data

Abstract: This paper empirically examines how ties between a firm and its creditors affect the availability and cost of funds to the firm. We analyze data collected in a survey of small firms by the Small Business Administration. The primary benefit of building close ties with an institutional creditor is that the availability of financing increases. We find smaller effects on the price of credit. Attempts to widen the circle of relationships by borrowing from multiple lenders increases the price and reduces the availability of credit. In sum, relationships are valuable and appear to operate more through quantities rather than prices.

Contrarian Investment, Extrapolation, and Risk

Abstract: For many years, scholars and investment professionals have argued that value strategies outperform the market. These value strategies call for buying stocks that have low prices relative to earnings, dividends, book assets, or other measures of fundamental value. While there is some agreement that value strategies produce higher returns, the interpretation of why they do so is more controversial. This article provides evidence that value strategies yield higher returns because these strategies exploit the suboptimal behavior of the typical investor and not because these strategies are fundamentally riskier. FOR MANY YEARS, SCHOLARS and investment professionals have argued that

Corporate Debt Value, Bond Covenants, and Optimal Capital Structure

Abstract: This article examines corporate debt values and capital structure in a unified analytical framework. It derives closed-form results for the value of long-term risky debt and yield spreads, and for optimal capital structure, when firm asset value follows a diffusion process with constant volatility. Debt values and optimal leverage are explicitly linked to firm risk, taxes, bankruptcy costs, risk-free interest rates, payout rates, and bond covenants. The results elucidate the different behavior of junk bonds versus investment-grade bonds, and aspects of asset substitution, debt repurchase, and debt renegotiation.

Implied Binomial Trees

Abstract: This article develops a new method for inferring risk-neutral probabilities (or state-contingent prices) from the simultaneously observed prices of European options. These probabilities are then used to infer a unique fully specified recombining binomial tree that is consistent with these probabilities (and, hence, consistent with all the observed option prices). A simple backwards recursive procedure solves for the entire tree. From the standpoint of the standard binomial option pricing model, which implies a limiting risk-neutral lognormal distribution for the underlying asset, the approach here provides the natural (and probably the simplest) way to generalize to arbitrary ending risk-neutral probability distributions.

The Financial and Operating Performance of Newly Privatized Firms: An International Empirical Analysis

Abstract: This study compares the pre- and postprivatization financial and operating performance of 61 companies from 18 countries and 32 industries that experience full or partial privatization through public share offerings during the period 1961 to 1990. Our results document strong performance improvements, achieved surprisingly without sacrificing employment security. Specifically, after being privatized, firms increase real sales, become more profitable, increase their capital investment spending, improve their operating efficiency, and increase their work forces. Furthermore, these companies significantly lower their debt levels and increase dividend payout. Finally, we document significant changes in the size and composition of corporate boards of directors after privatization. THE LAST FIFTEEN YEARS have witnessed a significant, global shift away from state socialism towards entrepreneurial capitalism. One of the most important and visible aspects of this trend has been the enthusiasm with which governments of all political persuasions have sold their state-owned enterprises (SOEs) to private investors in hopes that the generally unsatisfactory economic performance of these firms can be improved by the discipline of private ownership. This denationalization process, given its current title of "privatization" by the conservative government of Margaret Thatcher in

Financial Distress and Corporate Performance

Abstract: This study finds that highly leveraged firms lose substantial market share to their more conservatively financed competitors in industry downturns. Specifically, firms in the top leverage decile in industries that experience output contractions see their sales decline by 26 percent more than do firms in the bottom leverage decile. A similar decline takes place in the market value of equity. These findings are consistent with the view that the indirect costs of financial distress are significant and positive. Consistent with the theory that firms with specialized products are especially vulnerable to financial distress, we find that highly leveraged firms that engage in research and development suffer the most in economically distressed periods. We also find that the adverse consequences of leverage are more pronounced in concentrated industries. FINANCIAL ECONOMISTS HAVE NOT reached a consensus on how financial distress affects corporate performance. Traditionally, the financial economics literature has portrayed financial distress as a costly event whose possibility is important in determining firms' optimal capital structures. Financial distress is seen as costly because it creates a tendency for firms to do things that are harmful to debtholders and nonfinancial stakeholders (i.e., customers, suppliers, and employees), impairing access to credit and raising costs of stakeholder relationships.1 In addition, financial distress can be costly if a firm's weakened condition induces an aggressive response by competitors seizing the opportunity to gain market share.2 More recent articles have

Testing for Linear and Nonlinear Granger Causality in the Stock Price-Volume Relation

Abstract: Linear and nonlinear Granger causality tests are used to examine the dynamic relation between daily Dow Jones stock returns and percentage changes in New York Stock Exchange trading volume. We find evidence of significant bidirectional nonlinear causality between returns and volume. We also examine whether the nonlinear causality from volume to returns can be explained by volume serving as a proxy for information flow in the stochastic process generating stock return variance as suggested by Clark's (1973) latent common-factor model. After controlling for volatility persistence in returns, we continue to find evidence of nonlinear causality from volume to returns.

Market Statistics and Technical Analysis: The Role of Volume

Abstract: We investigate the informational role of volume and its applicability for technical analysis We develop a new equilibrium model in which aggregate supply is fixed and traders receive signals with differing quality We show that volume provides information on information quality that cannot be deduced from the price statistic We show how volume, information precision, and price movements relate, and demonstrate how sequences of volume and prices can be informative We also show that traders who use information contained in market statistics do better than traders who do not Technical analysis thus arises as a natural component of the agents' learning process TECHNICAL ANALYSIS OF MARKET data has long been a pervasive activity in both security and futures markets Technical analysts believe that price and volume data provide indicators of future price movements, and that by examining these data, information may be extracted on the fundamentals driving returns1 If markets are efficient in the sense that the current price impounds all information, then such activity is clearly pointless But if the process by which prices adjust to information is not immediate, then market statistics may impound information that is not yet incorporated into the current market price In particular, volume may be informative about the process of security returns In this paper we investigate the informational role of volume That volume may play an important role in markets has long been a subject of empirical research (see, for example, Gallant, Rossi, and Tauchen (1992); Karpoff (1987) provides an excellent review of previous research) This research has documented a remarkably strong relation between volume and the absolute

The Post-Issue Operating Performance of IPO Firms.

Abstract: This article investigates the change in operating performance of firms as they make the transition from private to public ownership. A significant decline in operating performance subsequent to the initial public offering (IPO) is found. Additionally, there is a significant positive relation between post-IPO operating performance and equity retention by the original entrepreneurs, but no relation between post-IPO operating performance and the level of initial underpricing. Post-issue declines in the market-to-book ratio, price/earnings ratio, and earnings per share are also documented.

Is the Electronic Open Limit Order Book Inevitable

Abstract: Under fairly general conditions, the article derives the equilibrium price schedule determined by the bids and offers in an open limit order book. The analysis shows: (1) the order book has a small-trade positive bid-ask spread, and limit orders profit from small trades; (2) the electronic exchange provides as much liquidity as possible in extreme situations; (3) the limit order book does not invite competition from third market dealers, while other trading institutions do; (4) If an entering exchange earns nonnegative trading profits, the consolidated price schedule matches the limit order book price schedule. THIS ARTICLE PROVIDES AN analysis of an idealized electronic open limit order book. The focus of the article is the nature of equilibrium in such a market and how an open limit order book fares against competition from other methods of exchanging securities. The analysis suggests that an electronic open limit order book mimics competition among anonymous exchanges. As a result, there is no incentive to set up a competing anonymous dealer market. On the other hand, any other anonymous exchange will invite "third market" competition. These conclusions suggest that an electronic open limit order book of the sort considered here has a chance of being a center of significant trading volume. The analysis does not imply that an electronic limit order book will be, or should be the only trading institution. It does suggest some of the characteristics that an alternative institution should have in ord'er to successfully compete with an electronic exchange. The results are obtained in a fairly general environment, and hence would appear to be robust. The motivation for the article lies in recent developments in information processing technology, the interest in institutional innovation in the securities industry, and the uncertainty about future developments in trading

Why do NASDAQ Market Makers Avoid Odd‐Eighth Quotes?

Abstract: The NASDAQ multiple dealer market is designed to produce narrow bid-ask spreads through the competition for order flow among individual dealers. However, we find that odd-eighth quotes are virtually nonexistent for 70 of 100 actively traded NASDAQ securities, including Apple Computer and Lotus Development. The lack of odd-eighth quotes cannot be explained by the negotiation hypothesis of Harris (1991), trading activity, or other variables thought to impact spreads. This result implies that the inside spread for a large number of NASDAQ stocks is at least $0.25 and raises the question of whether NASDAQ dealers implicitly collude to maintain wide spreads.

Firm Valuation, Earnings Expectations, and the Exchange‐Rate Exposure Effect

Abstract: Consistent with previous research, we fail to find a significant correlation between the abnormal returns of our sample firms with international activities and changes in the dollar. We investigate the possibility that this failure is due to mispricing. Lagged changes in the dollar are a significant variable in explaining current abnormal returns of our sample firms, suggesting that mispricing does occur. A simple trading strategy based upon these results generates significant abnormal returns. Corroborating evidence from returns around earnings announcements as well as errors in analysts' forecasts of earnings is also provided. IT IS A WIDELY held view that exchange rate movement should affect the value of a firm. Standard economic analysis implies that the profitability and value of most U.S. firms with foreign sales or operations abroad should increase (decrease) with an unexpected depreciation (appreciation) of the dollar as expected foreign currency cash flows translate into larger (smaller) U.S.

Investment Bank Reputation, Information Production, and Financial Intermediation

Abstract: We model reputation acquisition by investment banks in the equity market Entrepreneurs sell shares in an asymmetrically informed equity market, either directly, or using an investment bank Investment banks, who interact repeatedly with the equity market, evaluate entrepreneurs' projects and report to investors, in return for a fee Setting strict evaluation standards (unobservable to investors) is costly for investment banks, inducing moral hazard Investment banks' credibility therefore depends on their equity-marketing history Investment banks' evaluation standards, their reputations, underwriter compensation, the market value of equity sold, and entrepreneurs' choice between underwritten and nonunderwritten equity issues emerge endogenously

Robust Financial Contracting and the Role of Venture Capitalists

Abstract: We derive a role for inside investors, such as venture capitalists, in resolving various agency problems that arise in a multistage financial contracting problem. Absent an inside investor, the choice of securities is unlikely to reveal all private information, and overinvestment may occur. An inside investor, however, always makes optimal investment decisions if and only if he holds a fixed-fraction contract, where he always receives a fixed fraction of the project's payoff and finances that same fraction of future investments. This contract also eliminates any incentives of the venture capitalist to misprice securities issued in later financing rounds. IN THIS ARTICLE WE develop a model of financial contracting with multiple investment decisions and show how conflicts of interest and informational asymmetries can be effectively resolved by an inside investor, i.e., an investor who not only provides capital but also works closely with the firm, monitors it frequently, and is generally very well informed about the firm's prospects and investment opportunities. Venture capitalists are obvious examples of inside investors, and their function has been an important motivation for this article. Banks, especially in Japan and Germany, are also involved in monitoring and can be viewed as playing the role of inside investors. In this article we examine the potential benefits of inside investors in a context where there are no restrictions beyond limited liability on the type of financial contracts that can be written. We address a basic financial contracting problem involving an entrepreneur who has an idea for a project but does not have sufficient capital to fund it. An important assumption is that there are several stages in the project's development and that a decision must be made at each stage whether the project should be continued or abandoned. If the project is continued, the amount of additional capital to be invested must also be determined. We assume that the entrepreneur, as an insider, observes private information about the project's profitability at each stage. This information is not

Security Analysis and Trading Patterns When Some Investors Receive Information Before Others

Abstract: In existing models of information acquisition, all informed investors receive their information at the same time. This article analyzes trading behavior and equilibrium information acquisition when some investors receive common private information before others. The model implies that, under some conditions, investors will focus only on a subset of securities ("herding"), while neglecting other securities with identical exogenous characteristics. In addition, the model is consistent with empirical correlations that are suggestive of oft-cited trading strategies such as profit taking (short-term position reversal) and following the leader (mimicking earlier trades). IN EXISTING MODELS OF information acquisition, all informed investors receive their information at the same time. While these models provide many important insights, in reality some investors, either fortuitously or owing to superior skill, acquire pertinent information before others. By being first, an investor can exploit this information to great advantage. Information that is uncovered only slightly later is less valuable even if it has not yet been publicly revealed. We show in this article that the sequential nature of information arrival has a significant effect on both the trading decisions and the types of information collected by investors. The model we develop describes the investment choices of a set of competitive, risk-averse investors who investigate the long-term prospects of firms. Lucky or high-ability investors uncover the

A Nonparametric Approach to Pricing and Hedging Derivative Securities Via Learning Networks

Abstract: We propose a nonparametric method for estimating derivative financial asset pricing formulae using learning networks. To demonstrate feasibility, we first simulate Black-Scholes option prices and show that learning networks can recover the Black-Scholes formula from a two-year training set of daily options prices, and that the resulting network formula can be used successfully to both price and delta-hedge options out-of-sample. For comparison, we estimate models using four popular methods: ordinary least squares, radial basis functions, multilayer perceptrons, and projection pursuit. To illustrate practical relevance, we also apply our approach to S\&P 500 futures options data from 1987 to 1991.

The Impact of Public Information on the Stock Market

Abstract: We study the relation between the number of news announcements reported daily by Dow Jones & Company and aggregate measures of securities market activity including trading volume and market returns. We find that the number of Dow Jones announcements and market activity are directly related and that the results are robust to the addition of factors previously found to influence financial markets such as day-of-the-week dummy variables, news importance as proxied by large New York Times headlines and major macroeconomic announcements, and non-information sources of market activity as measured by dividend capture and triple witching trading. However, the observed relation between news and market activity is not particularly strong and the patterns in news announcements do not explain the day-of-the-week seasonalities in market activity. Our analysis of the Dow Jones database confirms the difficulty of linking volume and volatility to observed measures of information.

Time Variations and Covariations in the Expectation and Volatility of Stock Market Returns

Abstract: This article investigates empirically the comovements of the conditional mean and volatility of stock returns. It extends the results in the literature by demonstrating the role of the commercial paper-Treasury yield spread in predicting time variation in volatility. The conditional mean and volatility exhibit an asymmetric relation, which contrasts with the contemporaneous relation that has been tested previously. The volatility leads the expected return, and this time series relation is documented using offset correlations, short-horizon contemporaneous correlations, and a vector autoregression. These results bring into question the value of modeling expected returns as a constant function of conditional volatility. THE TIME SERIES PROPERTIES of the expectation and volatility of stock returns

The Effect of Market Segmentation and Illiquidity on Asset Prices: Evidence from Exchange Listings

Abstract: This article documents the effect on share value of listing on the New York Stock Exchange and reports the results of a joint test of Merton's (1987) investor recognition factor and Amihud and Mendelson's (1986) liquidity factor as explanations of the change in share value. We find that during the 1980s stocks earned abnormal returns of 5 percent in response to the listing announcement and that listing is associated with an increase in the number of shareholders and a reduction in bid-ask spreads. Cross-sectional regressions provide support for both investor recognition and liquidity as sources of value from exchange listing. THE EFFECT ON SHARE value of listing on the New York Stock Exchange (NYSE) by over-the-counter (OTC) stocks has been the focus of empirical investigation by scholars and practitioners for at least 50 years.' The consensus conclusion is that an NYSE listing is (or at least has been) associated with a significant increase in share price. "Streetlore" has historically attributed this increase in value to the increased investor recognition that is believed to accompany listing on a major exchange. Until recently, this investor recognition explanation has lacked a rigorous analytical foundation. Merton (1987) fills this void with a model of capital market equilibrium with incomplete information. To develop his model, Merton adopts most of the assumptions of the original Sharpe-Lintner-Mossin Capital Asset Pricing Model (CAPM) but relaxes the assumption of equal information across investors. He further assumes that investors invest only in the those securities of which they are aware.2 With this modification to the original CAPM framework, Merton derives a model in which expected returns increase with systematic risk, firm-specific risk, and relative market value and decrease

The Cross-Section of Realized Stock Returns: The Pre-COMPUSTAT Evidence

Abstract: Using a database that is free of survivorship bias, this article finds that book-to-market equity, earnings yield, and cash flow yield have significant explanatory power with respect to the cross-section of realized stock returns during the period from July 1940 through June 1963. There is a strong January seasonal in the explanatory power of these variables, even though small stocks are, by construction, excluded from the sample. Copyright 1994 by American Finance Association.

On the Cross-sectional Relation between Expected Returns and Betas

Abstract: There is an exact linear relation between expected returns and true "betas" when the market portfolio is on the ex ante mean-variance efficient frontier, but empirical research has found little relation between sample mean returns and estimated betas. A possible explanation is that market portfolio proxies are mean-variance inefficient. We categorize proxies that produce particular relations between expected returns and true betas. For the special case of a zero relation, a market portfolio proxy must lie inside the efficient frontier, but it may be close to the frontier. CONTRARY TO THE PREDICTIONS of the Sharpe, Lintner, and Black Capital Asset Pricing Model (hereafter the SLB CAPM or SLB Model; see Sharpe (1964), Lintner (1965), and Black (1972)), a decade of empirical studies has reported little evidence of a significant cross-sectional relation between average returns and betas. Yet it is well known (Roll (1977), Ross (1977)) that a positive and exact cross-sectional relation between ex ante expected returns and betas must hold if the market index against which betas are computed lies on the positively sloped segment of the mean-variance efficient frontier. Not finding a positive cross-sectional relation suggests that the index proxies used in empirical testing are not ex ante mean-variance efficient. Some of the empirical studies have uncovered variables other than beta that have power in explaining the sample cross-sectional variation in mean returns. But the true cross-sectional expected return-beta relation is exact when the index is efficient, so no variable other than beta can explain any part of the true cross-section of expected returns. Conversely, if the index is not efficient, the ex ante cross-sectional relation does not hold exactly and other variables can have explanatory power. Indeed, any variable that happens to be cross-sectionally related to expected returns could have discernible empirical power when the index proxy is ex ante inefficient. Again, the empirical evidence supports an inference that market index proxies used in testing are not on the ex ante efflcient frontier. But the puzzle in the empirical work is not so much that the cross-sectional mean return-beta relation is imperfect nor that other variables have empiri

Exploiting the Conditional Density in Estimating the Term Structure: An Application to the Cox, Ingersoll, and Ross Model

Abstract: We propose an empirical method that utilizes the conditional density of the state variables to estimate and test a term structure model with known price formulae, using data on both discount and coupon bonds The method is applied to an extension of a two-factor model due to Cox, Ingersoll, and Ross (1985; CIR) Our results show that estimates based on only bills imply unreasonably large price errors for longer maturities We reject the original CIR model using a likelihood ratio test, and conclude that the extended CIR model also fails to provide a good description of the Treasury market

Volume and Autocovariances in Short-Horizon Individual Security Returns

Abstract: This article tests for the relations between trading volume and subsequent returns patterns in individual securities' short-horizon returns that are suggested by such articles as Blume, Easley, and O'Hara (1994) and Campbell, Grossman, and Wang (1993). Using a variant of Lehmann's (1990) contrarian trading strategy, we find strong evidence of a relation between trading activity and subsequent autocovariances in weekly returns. Specifically, high-transaction securities experience price reversals, while the returns of low-transactions securities are positively autocovarying. Overall, information on trading activity appears to be an important predictor of the returns of individual securities.

Mean Reversion of Standard & Poor's 500 Index Basis Changes: Arbitrage‐induced or Statistical Illusion?

Abstract: Mean reversion in stock index basis changes has been presumed to be driven by the trading activity of stock index arbitragers. We propose here instead that the observed negative autocorrelation in basis changes is mainly a statistical illusion, arising because many stocks in the index portfolio trade infrequently. Even without formal arbitrage, reported basis changes would appear negatively autocorrelated as lagging stocks eventually trade and get updated. The implications of this study go beyond index arbitrage, however. Our analysis suggests that spurious elements may creep in whenever the price-change or return series of two securities or portfolios of securities are differenced. MEAN REVERSION IN STOCK index basis changes has been amply documented. MacKinlay and Ramaswamy (1988) find significant negative first-order autocorrelation in normalized intraday basis changes of the S&P 500 index futures traded on the Chicago Mercantile Exchange (CME). Yadav and Pope (1990) find similar behavior using Financial Times Stock Exchange (FTSE) 100 index futures data from the London International Financial Futures Exchange (LIFFE), as does Lim (1990) using Nikkei 225 index futures from the Singapore International Monetary Exchange (SIMEX). The trading activity of stock index arbitragers has been presumed to be driving this elastic realignment of stock index and index futures prices. When the basis widens beyond its theoretical level, arbitragers simultaneously sell index futures and buy the index portfolio, pulling the difference between the futures and index

Public Information Arrival

Abstract: We develop a measure of public information flow to financial markets and use it to document the patterns of information arrival, with an emphasis on the intraday flows. The measure is the number of news releases by Reuter's News Service per unit of time. We find that public information arrival is nonconstant, displaying seasonalities and distinct intraday patterns. Next we relate our measure of public information to aggregate measures of intraday market activity. Our results suggest a positive, moderate relationship between public information and trading volume, but an insignificant relationship with price volatility. THE LINK BETWEEN INFORMATION and changes in asset prices is central to financial economics. A fundamental tenet of market efficiency is that investors react to new information as it arrives, resulting in price changes that reflect investors' expectations of risk and return. Recent studies in market microstructure explore how price-volume relations are formed in financial markets, with an emphasis on intraday trading. A distinction is often made in the literature between public and private information (French and Roll (1986)). Whereas public information is available to the whole market and hence does not require trading to impact prices, private information is available to a narrow segment of the market and affects prices only through trading. Recent contributions (e.g., Admati and Pfleiderer (1988)) argue that private information plays a dominant role in explaining the time patterns of trading volume and return volatility in securities markets. Public information is relegated to a lesser role, that of an unspecified, exogenous factor. Our purpose is to investigate the rate of public information flow to see whether identifiable patterns exist that shed light on market volume and volatility relationships. We begin by describing the timing and pattern of public information arrival to financial markets. Our database consists of news stories sent via the North American wire by Reuter's News Service in a recent test year, May 1990 through April 1991. We define the rate of public information flow as the number of stories carried over the news wire per unit of time and document the rate of public information flow over various time segments, such as when

Cointegration, Fractional Cointegration, and Exchange Rate Dynamics

Abstract: Multivariate tests due to Johansen (1988, 1991) as implemented by Baillie and Bollerslev (1989a) and Diebold, Gardeazabal, and Yilmaz (1994) reveal mixed evidence on whether a group of exchange rates are cointegrated. Further analysis of the deviations from the cointegrating relationship suggests that it possesses long memory and may possibly be well described as a fractionally integrated process. Hence, the influence of shocks to the equilibrium exchange rates may only vanish at very long horizons. IN THE ARTICLE BY Baillie and Bollerslev (1989a), it is argued that seven different nominal spot and forward exchange rates all contain unit roots in their univariate time series representations. At the same time, however, the spot exchange rates appear to be tied together in the long run through a cointegration-type relationship. The latter finding of Baillie and Bollerslev has attracted particular interest and several studies such as those by Hakkio and Rush (1991) and Sephton and Larsen (1991) have already addressed this issue. Using the same data as the Baillie and Bollerslev article, Sephton and Larsen (1991) describe the evidence for the presence of cointegration as being "fragile" and note that mixed conclusions are reached by truncating the Baillie and Bollerslev sample at different points in time. Diebold, Gardeazabal, and Yilmaz (1994) henceforth Diebold et al., provide interesting evidence that application of the Johansen (1988, 1991) tests with and without an intercept will result in different inferences on the Baillie and Bollerslev data set. Furthermore, Diebold et al. carry out an ex ante forecasting experiment and find that the addition of an error correction term to the martingale model, as implied by the standard cointegration paradigm, fails to reduce the prediction mean square error when compared to a simple martingale model. This therefore leads Diebold et al. to conclude that "there exists substantial uncertainty regarding the existence of cointegration relationships among nominal dollar exchange rates." This article provides some additional evidence on the existence of such a long-run relationship among the same seven nominal spot exchange rates. After further analysis it appears that a form of cointegration does exist between the exchange rates, so that they do not drift apart in the long run. We argue that this form of cointegration is

Interactions of Corporate Financing and Investment Decisions: A Dynamic Framework

Abstract: This article analyzes the interaction between a firm's dynamic investment, operating, and financing decisions in a model with operating adjustment and recapitalization costs. Using numerical analysis, we solve the model for cases that highlight interaction effects. We find that higher production flexibility (due to lower costs of shutting down and reopening a production facility) enhances the firm's debt capacity, thereby increasing the net tax shield value of debt financing. While higher financial flexibility (resulting from lower recapitalization costs) has a similar effect, production flexibility and financial flexibility are, to some extent, substitutes. We find that the impact of debt financing on the firm's investment and operating decisions is economically insignificant.

Why Did NASDAQ Market Makers Stop Avoiding Odd-Eighth Quotes?

Abstract: On May 26 and 27, 1994 several national newspapers reported the findings of Christie and Schultz (1994) who cannot reject the hypothesis that market makers of active NASDAQ stocks implicitly colluded to maintain spreads of at least $0.25 by avoiding odd-eighth quotes. On May 27, dealers in Amgen, Cisco Systems, and Microsoft sharply increased their use of odd-eighth quotes, and mean inside and effective spreads fell nearly 50 percent. This pattern was repeated for Apple Computer the following trading day. Using individual dealer quotes for Apple and Microsoft, we find that virtually all dealers moved in unison to adopt odd-eighth quotes. THIS ARTICLE DOCUMENTS A sudden and dramatic narrowing of the inside spreads for Amgen Inc., Apple Computer Inc., Cisco Systems, Intel Corp., and Microsoft Corp. As Table I indicates, each of these stocks is among the 10 most actively traded firms listed on the National Association of Securities Dealers Automated Quotation System (NASDAQ) in 1993. These stocks are traded by at least 40 market makers and are among the largest market capitalization stocks listed on NASDAQ. Despite their high volume and visibility, each of these issues was quoted with spreads of at least $0.25 throughout 1993 and the first five months of 1994. However, the inside spreads for Amgen, Cisco, and Microsoft fell by nearly 50 percent beginning on May 27 and have averaged between $0.151 and $0.175 through July 1994. The inside spread for Apple Computer fell by almost 50 percent on the following trading day, while Intel spreads declined by a smaller amount on June 10. This shift in the width of the inside spreads is remarkable both in its rapidity and its magnitude.'

Stock Returns following Large One‐Day Declines: Evidence on Short‐Term Reversals and Longer‐Term Performance

Abstract: We examine stock returns following large one-day price declines and find that the bid-ask bounce and the degree of market liquidity explain short-term price reversals Further, we do not find evidence consistent with the overreaction hypothesis We observe that securities with large one-day price declines perform poorly over an extended time horizon WHILE THE CONCEPT OF market overreaction has been noted for many years, its formal description and examination is a relatively recent area of study DeBondt and Thaler (1985) define the overreaction hypothesis as the overresponse to new information This hypothesis suggests that extreme movements in stock prices are followed by movements in the opposite direction to "correct" the initial overreaction and that the greater the magnitude of initial price change, the more extreme the offsetting reaction One manner in which the overreaction hypothesis has been studied is the analysis of stock returns following large one-day stock price declines Brown, Harlow, and Tinic (1988) and Atkins and Dyl (1990) find significant reversals for stocks that experience one-day price declines Focusing on extreme price movements, Bremer and Sweeney (1991) examine returns following one-day price declines of 10 percent or more for Fortune 500 firms that are in the Center for Research in Security Prices (CRSP) data files They find significant positive three-day abnormal returns over the period 1962 to 1986 and note that this three-day recovery is inconsistent with stock prices fully and quickly reflecting relevant information They also suggest that market illiquidity may partially explain their findings The purpose of this study is to explain security return behavior following large one-day declines Our primary objective is to explore the role of the bid-ask bounce, market liquidity, and overreaction in explaining price reversals in the three-day period immediately following large one-day declines Large one-day price declines are likely to be associated with substantial selling pressure, enhancing the probability that a closing transaction is at a

Explorations Into Factors Explaining Money Market Returns

Abstract: In this article, we measure and interpret the common "factors" that describe money market returns. Results are presented for both three- and four-factor models. We find that the three-factor model explains, on average, 86 percent of the total variation in most money market returns while the four-factor model explains, on average, 90 percent of this variation. Using mimicking portfolios, we provide an interpretation of the systematic risks represented by these factors. IN THIS ARTICLE, WE attempt to measure and interpret the common "factors" that describe money market returns. The factor approach we employ assumes that the covariance matrix of a set of random variables, in this case excess returns, can be decomposed into common or systematic components and idiosyncratic or nonsystematic components. This decomposition into systematic and nonsystematic components is based on an assumption of a linear relationship between the returns of each security and a set of "common" factors. This is the assumption of linear return-generating models, which form an integral part of the structure of many asset pricing theories-for example, arbitrage pricing theory (APT) as developed by Ross (1976). The interpretation is that the common factors represent sources of systematic or nondiversifiable risk and the idiosyncratic component of returns represents diversifiable risks.' Our focus here is not on testing a particular asset pricing model per se but on developing empirical evidence for the existence of stylized facts regarding money market returns. The stylized facts take the form of the existence, measurement, and interpretation of the common factors that are found in money markets. Our attempt to measure and interpret these sources of systematic risk may eventually lead to the construction of observable eco