Showing papers in "Journal of Finance in 1996"

Multifactor Explanations of Asset Pricing Anomalies

Abstract: Previous work shows that average returns on common stocks are related to firm characteristics like size, earnings/price, cash flow/price, book-to-market equity, past sales growth, long-term past return, and short-term past return. Because these patterns in average returns apparently are not explained by the CAPM, they are called anomalies. We find that, except for the continuation of short-term returns, the anomalies largely disappear in a three-factor model. Our results are consistent with rational ICAPM or APT asset pricing, but we also consider irrational pricing and data problems as possible explanations. RESEARCHERS HAVE IDENTIFIED MANY patterns in average stock returns. For example, DeBondt and Thaler (1985) find a reversal in long-term returns; stocks with low long-term past returns tend to have higher future returns. In contrast, Jegadeesh and Titman (1993) find that short-term returns tend to continue; stocks with higher returns in the previous twelve months tend to have higher future returns. Others show that a firm's average stock return is related to its size (ME, stock price times number of shares), book-to-marketequity (BE/ME, the ratio of the book value of common equity to its market value), earnings/price (E/P), cash flow/price (C/P), and past sales growth. (Banz (1981), Basu (1983), Rosenberg, Reid, and Lanstein (1985), and Lakonishok, Shleifer and Vishny (1994).) Because these patterns in average stock returns are not explained by the capital asset pricing model (CAPM) of Sharpe (1964) and Lintner (1965), they are typically called anomalies. This paper argues that many of the CAPM average-return anomalies are related, and they are captured by the three-factor model in Fama and French (FF 1993). The model says that the expected return on a portfolio in excess of the risk-free rate [E(Ri) - Rf] is explained by the sensitivity of its return to three factors: (i) the excess return on a broad market portfolio (RM - Rf); (ii) the difference between the return on a portfolio of small stocks and the return on a portfolio of large stocks (SMB, small minus big); and (iii) the difference between the return on a portfolio of high-book-to-market stocks and the return on a portfolio of low-book-to-market stocks (HML, high minus low). Specifically, the expected excess return on portfolio i is,

Another Puzzle: The Growth in Actively Managed Mutual Funds

Abstract: Mutual funds represent one of the fastest growing type of financial intermediary in the American economy. The question remains as to why mutual funds and in particular actively managed mutual funds have grown so fast, when their performance on average has been inferior to that of index funds. One possible explanation of why investors buy actively managed open end funds lies in the fact that they are bought and sold at net asset value, and thus management ability may not be priced. If management ability exists and it is not included in the price of open end funds, then performance should be predictable. If performance is predictable and at least some investors are aware of this, then cash flows into and out of funds should be predictable by the very same metrics that predict performance. Finally, if predictors exist and at least some investors act on these predictors in investing in mutual funds, the return on new cash flows should be better than the average return for all investors in these funds. This article presents empirical evidence on all of these issues and shows that investors in actively managed mutual funds may have been more rational than we have assumed.

Optimal Capital Structure, Endogenous Bankruptcy, and the Term Structure of Credit Spreads

Abstract: This article examines the optimal capital structure of a firm that can choose both the amount and maturity of its debt. Bankruptcy is determined endogenously rather than by the imposition of a positive net worth condition or by a cash flow constraint. The results extend Leland's (1994a) closed-form results to a much richer class of possible debt structures and permit study of the optimal maturity of debt as well as the optimal amount of debt. The model predicts leverage, credit spreads, default rates, and writedowns, which accord quite closely with historical averages. While short term debt does not exploit tax benefits as completely as long term debt, it is more likely to provide incentive compatibility between debt holders and equity holders. Short term debt reduces or eliminates "asset substitution" agency costs. The tax advantage of debt must be balanced against bankruptcy and agency costs in determining the optimal maturity of the capital structure. The model predicts differently shaped term structures of credit spreads for different levels of risk. These term structures are similar to those found empirically by Sarig and Warga (1989). Our results have important implications for bond portfolio management. In general, Macaulay duration dramatically overstates true duration of risky debt, which may be negative for "junk" bonds. Furthermore, the "convexity" of bond prices can become "concavity." IN AN EARLIER ARTICLE, LELAND (1994a) considered optimal capital structure and the pricing of debt with credit risk. His assumption of infinite life debtconsistent with Modigliani-Miller (1958)-permitted closed form solutions for debt values and equity values with endogenous bankruptcy. But the assumption of infinite life debt is clearly restrictive. Firms must choose the maturity as well as the amount of debt.1

The Conditional CAPM and the Cross-Section of Expected Returns

Abstract: Most empirical studies of the static CAPM assume that betas remain constant over time and that the return on the value-weighted portfolio of all stocks is a proxy for the return on aggregate wealth. The general consensus is that the static CAPM is unable to explain satisfactorily the cross-section of average returns on stocks. We assume that the CAPM holds in a conditional sense, i.e., betas and the market risk premium vary over time. We include the return on human capital when measuring the return on aggregate wealth. Our specification performs well in explaining the cross-section of average returns. A SUBSTANTIAL PART OF the research effort in finance is directed toward improving our understanding of how investors value risky cash flows. It is generally agreed that investors demand a higher expected return for investment in riskier projects, or securities. However, we still do not fully understand how investors assess the risk of the cash flow on a project and how they determine what risk premium to demand. Several capital asset-pricing models have been suggested in the literature that describe how investors assess risk and value risky cash flows. Among them, the Sharpe-Lintner-Black Capital Asset Pricing Model (CAPM)1 is the one that financial managers use most often for assessing the risk of the cash flow from a project and for arriving at the appropriate

Do Brokerage Analysts' Recommendations Have Investment Value?

Abstract: An analysis of new buy and sell recommendations of stocks by security analysts at major U.S. brokerage firms shows significant, systematic discrepancies between prerecommendation prices and eventual values. The initial return at the time of the recommendations is large, even though few recommendations coincide with new public news or provide previously unavailable facts. However, these initial price reactions are incomplete. For buy recommendations, the mean postevent drift is

Measuring Fund Strategy and Performance in Changing Economic Conditions

Abstract: The use of predetermined variables to represent public information and time-variation has produced new insights about asset pricing models, but the literature on mutual fund performance has not exploited these insights This paper advocates conditional performance evaluation in which the relevant expectations are conditioned on public information variables We modify several classical performance measures to this end and find that the predetermined variables are both statistically and economically significant Conditioning on public information controls for biases in traditional market timing models and makes the average performance of the mutual funds in our sample look better

Liquidity, Information, and Infrequently Traded Stocks

Abstract: This article investigates whether differences in information-based trading can explain observed differences in spreads for active and infrequently traded stocks. Using a new empirical technique, we estimate the risk of information-based trading for a sample of New York Stock Exchange (NYSE) listed stocks. We use the information in trade data to determine how frequently new information occurs, the composition of trading when it does, and the depth of the market for different volume-decile stocks. Our most important empirical result is that the probability of information-based trading is lower for high volume stocks. Using regressions, we provide evidence of the economic importance of information-based trading on spreads.

Oil and the stock markets

Abstract: We test whether the reaction of international stock markets to oil shocks can be justified by current and future changes in real cash flows and/or changes in expected returns. We find that in the postwar period, the reaction of United States and Canadian stock prices to oil shocks can be completely accounted for by the impact of these shocks on real cash flows alone. In contrast, in both the United Kingdom and Japan, innovations in oil prices appear to cause larger changes in stock prices than can be justified by subsequent changes in real cash flows or by changing expected returns.

Who Manages Risk? An Empirical Examination of Risk Management Practices in the Gold Mining Industry

Abstract: This article examines a new database that details corporate risk management activity in the North American gold mining industry. I find little empirical support for the predictive power of theories that view risk management as a means to maximize shareholder value. However, firms whose managers hold more options manage less gold price risk, and firms whose managers hold more stock manage more gold price risk, suggesting that managerial risk aversion may affect corporate risk management policy. Further, risk management is negatively associated with the tenure of firms' CFOs, perhaps reflecting managerial interests, skills, or preferences.

Of Tournaments and Temptations: An Analysis of Managerial Incentives in the Mutual Fund Industry

Abstract: We test the hypothesis that when their compensation is linked to relative performance, managers of investment portfolios likely to end up as “losers” will manipulate fund risk differently than those managing portfolios likely to be “winners.” An empirical investigation of the performance of 334 growth-oriented mutual funds during 1976 to 1991 demonstrates that mid-year losers tend to increase fund volatility in the latter part of an annual assessment period to a greater extent than mid-year winners. Furthermore, we show that this effect became stronger as industry growth and investor awareness of fund performance increased over time.

Shareholder Activism by Institutional Investors: Evidence from CalPERS

Abstract: This study examines firm characteristics that lead to shareholder activism and analyzes the effects of activism on target firm governance structure, shareholder wealth, and operating performance for the 51 firms targeted by CalPERS over the 1987-93 period. Firm size and level of institutional holdings are found to be positively related to the probability of being targeted, and 72 percent of firms targeted after 1988 adopt proposed changes or make changes resulting in a settlement with CalPERS. Shareholder wealth increases for firms that adopt or settle and decreases for firms that resist. No statistically significant change in operating performance is found. INSTITUTIONAL OWNERSHIP OF DOMESTIC equities has grown rapidly in recent years and in 1992 surpassed the 50 percent level of aggregate ownership.1 At the same time, the market for corporate control that was active in the 1970s and 1980s, and that served effectively to discipline managers, has weakened substantially.2 The rise in institutional holdings and corresponding decline of the market for corporate control have focused attention on the role and importance of institutional investors as monitors of corporate management. The recent increase in monitoring by traditionally passive institutional investors has been described as "shareholder activism." For this study, shareholder activism is defined to include monitoring and attempting to bring about changes in the organizational control structure of firms (targets) not perceived to be pursuing shareholder-wealth-maximizing goals. The emergence of shareholder activism raises questions about the practices of activist institutional investors and particularly whether activism is beneficial for shareholders of targeted firms and possibly firms that are not targeted

Recovering Probability Distributions from Option Prices

Abstract: This article derives underlying asset risk-neutral probability distributions of European options on the S&P 500 index. Nonparametric methods are used to choose probabilities that minimize an objective function subject to requiring that the probabilities are consistent with observed option and underlying asset prices. Alternative optimization specifications produce approximately the same implied distributions. A new and fast optimization technique for estimating probability distributions based on maximizing the smoothness of the resulting distribution is proposed. Since the crash, the risk-neutral probability of a three (four) standard deviation decline in the index (about -36 percent (-46 percent) over a year) is about 10 (100) times more likely than under the assumption of lognormality. RECENTLY, THE INCREASING POPULARITY of derivatives and some highly publicized failures to control risk have led to increased efforts to find reasonable methods to measure the sensitivity of large institutional derivatives portfolios to extreme events. Merely because such events are rare is not sufficient to ignore them, since on the few occasions when they do occur, significant amounts of money can change hands, potentially wiping out profits accumulated over long prior periods. A key assumption behind methods of estimation is the joint probability distribution of constituent underlying asset returns. This has long been a concern of financial economists, since probability assumptions are critical to much of their research during the last quarter century. Heretofore, probability distributions of stock market returns have typically been estimated from historical time series. Unfortunately, common hypotheses may not capture the probability of extreme events, and the events of interest are rare or may not be present in the historical record, even though they are clearly possible.

Preferences for Stock Characteristics As Revealed by Mutual Fund Portfolio Holdings

Abstract: This investigation of the cross-section of mutual fund equity holdings for the years 1991 and 1992 shows that mutual funds have a significant preference towards stocks with high visibility and low transaction costs, and are averse to stocks with low idiosyncratic volatility. These findings are relevant to theories concerning investor recognition, a potential agency problem in mutual funds, tests of trend-following and herd behavior by mutual funds, and corporate finance.

Return Volatility and Trading Volume: An Information Flow Interpretation of Stochastic Volatility

Abstract: The paper develops an empirical return volatility-trading volume model from a microstructure framework in which informational asymmetries and liquidity needs motivate trade in response to information arrivals. The resulting system modifies the so-called “Mixture of Distribution Hypothesis” (MDH). The dynamic features are governed by the information flow, modeled as a stochastic volatility process, and generalize standard ARCH specifications. Specification tests support the modified MDH representation and show that it vastly outperforms the standard MDH. The findings suggest that the model may be useful for analysis of the economic factors behind the observed volatility clustering in returns.

Why Do Markets Move Together? An Investigation of U.S.-Japan Stock Return Comovements

Abstract: This article explores the fundamental factors that affect cross-country stock return correlations. Using transactions data from 1988 to 1992, we construct overnight and intraday returns for a portfolio of Japanese stocks using their NYSE-traded American Depository Receipts (ADRs) and a matched-sample portfolio of U. S. stocks. We find that U. S. macroeconomic announcements, shocks to the Yen/Dollar foreign exchange rate and Treasury bill returns, and industry effects have no measurable influence on U.S. and Japanese return correlations. However, large shocks to broadbased market indices (Nikkei Stock Average and Standard and Poor's 500 Stock Index) positively impact both the magnitude and persistence of the return correlations. STOCK RETURN CROSS-COUNTRY COVARIANCES play a key role in international finance. Changes in these covariances affect the volatility of portfolios and asset prices. As these covariances increase, one expects that: (a) fewer domestic risks are internationally diversifiable, so portfolio volatility increases; (b) the risk premium on the world market portfolio increases;1 (c) the cost of capital increases for individual firms; and, (d) the domestic version of the CAPM becomes increasingly inadequate.2 Despite the important economic consequences of changes in cross-country covariances, the determinants of the levels and dynamics of these covariances have been little studied from an academic

Expectations and the Cross-Section of Stock Returns

Abstract: Previous research has shown that stocks with low prices relative to book value, cash flow, earnings, or dividends (that is, value stocks) earn high returns. Value stocks may earn high returns because they are more risky. Alternatively, systematic errors in expectations may explain the high returns earned by value stocks. I test for the existence of systematic errors using survey data on forecasts by stock market analysts. I show that investment strategies that seek to exploit errors in analysts' forecasts earn superior returns because expectations about future growth in earnings are too extreme. IT IS BECOMING INCREASINGLY accepted that stock returns have a predictable component. Fama and French (FF, 1992) find that size (the market value of a stock's equity) and the ratio of the book value of a firm's common equity to its market value (BM), but not 1B (the slope coefficient in the regression of a security's return on the market's return), capture much of the cross-section of average stock returns.' FF argue that size and BM are proxies for unobservable common risk factors, and that their findings are consistent with rational asset pricing. An alternative interpretation, argue Lakonishok, Shleifer, and Vishny (LSV, 1994), is that financial ratios have predictive power because they capture systematic errors in the way that investors form expectations about future returns, and because the stock market is not fully efficient. Strategies that call for the purchase of stocks with low prices relative to dividends, earnings, and

The Value of Diversification During the Conglomerate Merger Wave

Abstract: The current trend toward corporate focus reverses the diversification trend of the late 1960s and early 1970s. This article examines the value of diversification when many corporations started to diversify. I find no evidence that diversified companies were valued at a premium over single segment firms during the 1960s and 1970s. On the contrary, there was a large diversification discount during the 1960s, but this discount declined to zero during the 1970s. Insider ownership was negatively related to diversification during the 1960s, but when the diversification discount declined, firms with high insider ownership were the first to diversify.

The Determinants of the Maturity of Corporate Debt Issues

Abstract: We document the determinants of the term to maturity of 7,369 bonds and notes issued between 1982 and 1993. Our main finding is that large firms with investment grade credit ratings typically borrow at the short end and at the long end and of the maturity spectrum, while firms with speculative grade credit ratings typically borrow in the middle of the maturity spectrum. This pattern is consistent with the theory that risky firms do not issue short-term debt in order to avoid inefficient liquidation, but are screened out of the long-term debt market because of the prospect of risky asset substitution. TRADITIONALLY, CAPITAL STRUCTURE RESEARCH has focused on how much of a firm's future cash flows should be paid out to debtholders instead of equityholders. An equally important issue is when future cash flows should be paid out to debtholders. A firm that finances its projects with short-term debt risks serious financial difficulty if the debt cannot be extended. Similarly, a firm that finances its activities with long-term debt can sacrifice profits by needlessly risking mismanagement of resources after cash flows are returned from investments, but before they are due to debtholders. This study investigates the factors that firms consider when choosing the maturity of their liabilities. We document the determinants of the maturity of 7,368 public debt issues made by U.S. corporations between 1982 and 1993. Our empirical tests are based on existing theoretical models that relate the maturity of a firm's borrowings to the riskiness of its cash flows, the time until investments pay off, the quality of information held by outsiders, the expected

Bank Information Monopolies and the Mix of Private and Public Debt Claims

Abstract: This article examines the determinants of the mix of private and public debt using detailed information on the debt structure of 250 publicly traded corporations from 1980 through 1990. We find that the relationship between bank borrowing and the importance of growth opportunities depends on the number of banks the firm uses and whether the firm has public debt outstanding. For firms with a single bank relationship, the reliance on bank debt is negatively related to the importance of growth opportunities. In contrast, among firms borrowing from multiple banks, the relationship is positive.

Evidence of Bank Market Discipline in Subordinated Debenture Yields: 1983-1991

Abstract: We examine debenture yields over the period 1983-1991 to evaluate the market's sensitivity to bank-specific risks, and conclude that investors have rationally reflected changes in the government's policy toward absorbing private losses in the event of a bank failure. Although this evidence does not establish that market discipline can effectively control banking firms, it soundly rejects the hypothesis that investors cannot rationally differentiate among the risks undertaken by the major U.S. banking firms. AN INCREASINGLY IMPORTANT ISSUE in the regulation of financial institutions concerns the extent to which market investors can (will) recognize and control the risks of banking firms. Although the Banking Act of 1933 replaced some private risk-bearing with federal deposit insurance, legislators were reluctant to displace market discipline very extensively (Flood (1992)). By the early 1980s, however, U.S. regulators had come to protect virtually all bank liability holders from credit losses-most visibly at large banks which were deemed "too big to fail" (Sprague (1986), O'Hara and Shaw (1990)). This extension of the government safety net largely reflects a skepticism on the part of regulators that "normal" market forces could adequately identify and control bank risks. While U.S. regulators have recently shown an increased willingness to let some bank investors bear default losses, an official suspicion of the efficacy of market discipline remains widespread. By contrast, some prominent academic economists argue that market investors in bank debentures could provide timely and effective control over banking firms' risk exposures, and that the social cost of supervising banks would be lower if regulators ceded greater

The Method of Payment in Corporate Acquisitions, Investment Opportunities, and Management Ownership

Abstract: This article examines the motives underlying the payment method in corporate acquisitions. The findings support the notion that the higher the acquirer's growth opportunities, the more likely the acquirer is to use stock to finance an acquisition. Acquirer managerial ownership is not related to the probability of stock financing over small and large ranges of ownership, but is negatively related over a middle range. In addition, the likelihood of stock financing increases with higher preacquisition market and acquiring firm stock returns. It decreases with an acquirer's higher cash availability, higher institutional shareholdings and blockholdings, and in tender offers. THE LINK BETWEEN A FIRM'S investment opportunities and its corporate finance activities has long been an interesting subject of corporate finance research. For example, Myers (1977) recognizes the similarity between investment opportunities and call options. He acknowledges that firms with risky debt outstanding may fail to exercise a real investment option if doing so transfers wealth from equityholders to debtholders. His conclusion is that firms whose value depends more on growth options should finance themselves more with equity than with debt. However, the empirical evidence on this topic is somewhat mixed. Titman and Wessels (1988) find no evidence that debt ratios are related to a firm's expected growth, although Smith and Watts (1992) and Bradley, Jarrell, and Kim (1984) report a significantly negative relation between growth opportunities and financial leverage. Whereas these articles focus on the relation between investment opportunities and how firms finance their portfolio of projects, this article examines how firms finance a particular type of investment, namely, a corporate acquisition. How do the characteristics of the acquiring firm, the target firm, and the acquisition itself contribute to the method of financing? In addition, the study of payment methods in corporate acquisitions is intriguing because previous research documents that the acquiring firm's

The Strategic Exercise of Options: Development Cascades and Overbuilding in Real Estate Markets

Abstract: This article develops an equilibrium framework for strategic option exercise games. I focus on a particular example: the timing of real estate development. An analysis of the equilibrium exercise policies of developers provides insights into the forces that shape market behavior. The model isolates the factors that make some markets prone to bursts of concentrated development. The model also provides an explanation for why some markets may experience building booms in the face of declining demand and property values. While such behavior is often regarded as irrational overbuilding, the model provides a rational foundation for such exercise patterns. IN THE CASE OF TRADITIONAL financial options, optimal exercise strategies can be derived without consideration of the strategic interactions across option holders. Most financial options represent widely held side-bets between agents external to the firm, and therefore their exercise does not influence the characteristics of the underlying security or the options themselves. A notable exception is the case of warrants or convertible securities. In the case of warrants, exercise results in the firm issuing new shares of common stock, thereby influencing the underlying stock value as well as the value of the remaining warrants. In this article, I demonstrate that a game-theoretic approach to option exercise can be very useful in explaining real-world investment decisions. I develop an equilibrium framework for solving option exercise strategies. In order to emphasize the applicability of such an approach, I focus on a particular real-world example: the behavior of real estate markets. This analysis of the strategic equilibrium exercise policies of real estate developers (i.e., the exercise of the "option to build") provides a potential explanation for several puzzling real estate market phenomena. For example, some real estate markets have been prone to pronounced bursts of development activity, while others have been characterized by smooth patterns of development over time. Thus, one can use the model to examine the conditions that influence the time between construction starts (i.e., exercise). Similarly, some real estate markets have been prone to lengthy periods of overbuilding, where new development

Capital Requirements, Monetary Policy, and Aggregate Bank Lending: Theory and Empirical Evidence

Abstract: Capital requirements linked solely to credit risk are shown to increase equilibrium credit rationing and lower aggregate lending. The model predicts that the bank's decision to lend will cause an abnormal runup in the borrower's stock price and that this reaction will be greater the more capital-constrained the bank. I provide empirical support for this prediction. The model explains the recent inability of the Federal Reserve to stimulate bank lending by increasing the money supply. I show that increasing the money supply can either raise or lower lending when capital requirements are linked only to credit risk. THE MOTIVATION OF THIS article is first to examine the impact of "risk-based" capital requirements-namely those that link mandatory capital-to-asset ratios for banks to their loans- on aggregate bank lending. These requirements, called the Basle capital rules (or BIS guidelines), went into effect in March 1989 for banks in the leading industrialized nations. These rules initially required banks to maintain capital equal to 7.25 percent of business and most consumer loans, with the requirement increasing to 8 percent by the end of 1992. Secondly, I wish to understand the link between monetary policy and aggregate bank credit in the presence of risk-based capital requirements. My curiosity is sparked in part by two recent phenomena. One is the experience of the U.S. economy, which displayed sluggish growth during 1989-93 despite a monetary policy that attempted to spur bank lending and economic activity.' And the other is the striking decline in loans relative to security holdings (mostly government bonds) in the asset portfolios of U.S.

On the Predictability of Stock Returns: An Asset-Allocation Perspective

Abstract: Sample evidence about the predictability of monthly stock returns is considered from the perspective of a risk-averse Bayesian investor who must allocate funds between stocks and cash. The investor uses the sample evidence to update prior beliefs about the parameters in a regression of stock returns on a set of predictive variables. The regression relation can seem weak when described by usual statistical measures, but the current values of the predictive variables can exert a substantial influence on the investor's portfolio decision, even when the investor's prior beliefs are weighted against predictability. INVESTORS IN THE STOCK market are interested in predicting future stock returns, and the academic literature offers numerous empirical investigations of stockreturn predictability. Many of these investigations report the results of estimating linear time-series regressions of stock returns on one or more predictive variables, and considerable effort has been devoted to assessing the strength and reliability of this regression evidence from a statistical perspective. Given that the regression coefficients are estimated with error, confronting the investor with what is commonly termed "estimation risk," to what extent might the regression evidence influence a rational, risk-averse investor's portfolio decision? Consider an investor who, on December 31, 1993, must allocate funds between the value-weighted portfolio of the New York Stock Exchange (NYSE) and one-month Treasury bills. The investor is given the results of estimating the following regression using monthly data from January 1927 through December 1993,

Cream-Skimming or Profit-Sharing? The Curious Role of Purchased Order Flow

Abstract: Purchased order flow refers to the practice of dealers or trading locales paying brokers for retail order flow. It is alleged that such agreements are used to "cream skim" uninformed liquidity trades, leaving the information-based trades to established markets. We develop a test of this hypothesis, using a model of the stochastic process of trades. We then estimate the model for a sample of stocks known to be used in order purchase agreements that trade on the New York Stock Exchange (NYSE) and the Cincinnati Stock Exchange. Our main empirical result is that there is a significant difference in the information content of orders executed in New York and Cincinnati, and that this difference is consistant with cream-skimming. A STRIKING FEATURE OF global capital markets is the proliferation of trading venues. Whereas established trading centers such as London and New York traditionally controlled the trading volume in securities, new markets have begun to erode that dominance. Frankfurt, Milan, Madrid, and Amsterdam are but a few of the locales now challenging the dominance of the London Stock Exchange for trading in Europe. In the United States, this trend can be seen in the dramatic growth of electronic trading systems such as Instinet and POSIT (the Portfolio System for Institutional Trading), in the increasing volume of the Nasdaq, and in the growth of regional exchanges such as the Cincinnati Stock Exchange (CSE) and the Arizona Stock Exchange. Whether this fragmentation of trading is desirable is debatable. Increased competition could reduce the monopoly power of price-setting agents and thus result in better execution and prices for traders. But this same competition also reduces the liquidity available in any one setting, thereby potentially limiting any market's ability to provide stable prices. Moreover, liquidity facilitates the crucial price discovery role of markets. As order flow fragments, the ability of prices to aggregate information can be reduced, and with it the efficiency of the market. This problem can be exacerbated if markets choose to compete by focusing on particular components of the order flow. By "creamskimming" the order flow, new markets could undermine both the viability of old markets, and of the trading process itself.

Transparency and Liquidity: A Comparison of Auction and Dealer Markets with Informed Trading

Abstract: Trading systems differ in their degree of transparency, here defined as the extent to which market makers can observe the size and direction of the current order flow. We investigate whether greater transparency enhances market liquidity by reducing the opportunities for taking advantage of uninformed participants. We compare the price formation process in several stylized trading systems with different degrees of transparency: various types of auction markets and a stylized dealer market. We find that greater transparency generates lower trading costs for uninformed traders on average, although not necessarily for every size of trade. IT IS A WIDELY HELD BELIEF among economists studying securities markets that greater transparency in the trading process enhances market liquidity by reducing the opportunities for taking advantage of less informed or nonprofessional participants. This has led, particularly in the United States, to a strong regulatory inclination to require as much trading information as possible to be made immediately available to all comers. To some extent, the purpose is to enable ordinary traders to check for themselves whether they have gotten a fair price, but the main idea is that making information visible to a large set of competing professionals improves price formation so greatly that ordinary traders obtain the best possible deal. In Europe, the speed of publication of trade data was a central issue in the drafting of the European Union's Investment Services Directive, implemented in January 1996, imposing a common regime on all securities firms operating in member countries. There was a difference of opinion on transparency between Britain, which favored slow publication of trade data, and most Continental regulators,

Swap Rates and Credit Quality

Abstract: This article presents a model for valuing claims subject to default by both contracting parties, such as swaps and forwards. With counterparties of different default risk, the promised cash flows of a swap are discounted by a switching discount rate that, at any given state and time, is equal to the discount rate of the counterparty for whom the swap is currently out of the money (that is, a liability). The impact of credit-risk asymmetry and of netting is presented through both theory and numerical examples, which include interest rate and currency swaps. THIS ARTICLE PRESENTS A model for valuing claims subject to default by both contracting parties, such as swaps and forwards. This extends the valuation model for defaultable claims proposed by Duffie and Singleton (1994) to cases in which the two counterparties have asymmetric default risk. The extension permits a reexamination of the impact of credit risk on swap rates. While the valuation model applies to all forms of contingent claims in which both contracting parties are at risk to default, such as forward contracts, we focus on swaps for purposes of illustration. For example, consider a 5-year interest rate swap between a given party paying a floating rate such as the London Inter Bank Offered Rate (LIBOR) and another counterparty paying a fixed rate. Replacing the given fixed-rate counterparty with a "lower-quality" counterparty, whose bond yields are 100 basis points higher, increases the swap rate by roughly 1 basis point, using our model and typical parameters for LIBOR rate processes. This credit impact on swap rates is approximately linear within the range of normally encountered credit quality. For a 5-year currency swap, given a foreign exchange rate with 15 percent volatility, our model shows the impact of credit risk asymmetry on the market swap rate to be roughly 10-fold greater than that for interest rate swaps; that is, approximately 10 basis points in swap rate per 100 basis points in bond yield credit spread. The main goal of this article is to provide a simple and theoretically consistent model allowing such computations.

Strategic Trading When Agents Forecast the Forecasts of Others

Abstract: We analyze a multi-period model of trading with differentially informed traders, liquidity traders, and a market maker. Each informed trader's initial information is a noisy estimate of the long-term value of the asset, and the different signals received by informed traders can have a variety of correlation structures. With this setup, informed traders not only compete with each other for trading profits, they also learn about other traders' signals from the observed order flow. Our work suggests that the initial correlation among the informed traders' signals has a significant effect on the informed traders' profits and the informativeness of prices.

The CAPM is Wanted, Dead or Alive

Abstract: Kothari, Shanken, and Sloan (1995) claim that βs from annual returns produce a stronger positive relation between β and average return than βs from monthly returns. They also contend that the relation between average return and book-to-market equity (BE/ME) is seriously exaggerated by survivor bias. We argue that survivor bias does not explain the relation between BE/ME and average return. We also show that annual and monthly βs produce the same inferences about the β premium. Our main point on the β premium is, however, more basic. It cannot save the Capital asset pricing model (CAPM), given the evidence that β alone cannot explain expected return.