Showing papers in "Journal of Financial and Quantitative Analysis in 1993"
TL;DR: In this article, a bivariate error correction model with a GARCH error structure was proposed to estimate the risk-minimizing futures hedge ratios for several currencies and a dynamic hedging strategy was proposed in which the potential risk reduction is more than enough to offset the transactions costs for most investors.
Abstract: Most research on hedging has disregarded both the long-run cointegrating relationship between financial assets and the dynamic nature of the distributions of the assets. This study argues that neglecting these affects the hedging performance of the existing models and proposes an alternative model that accounts for both of them. Using a bivariate error correction model with a GARCH error structure, the risk-minimizing futures hedge ratios for several currencies are estimated. Both within-sample comparisons and out-of-sample comparisons reveal that the proposed model provides greater risk reduction than the conventional models. Furthermore, a dynamic hedging strategy is proposed in which the potential risk reduction is more than enough to offset the transactions costs for most investors.
1,182 citations
TL;DR: In this article, the authors examined the relation between volume, volatility, and market depth in eight physical and financial futures markets and found that unexpected volume shocks have a larger effect on volatility.
Abstract: The relations between volume, volatility, and market depth in eight physical and financial futures markets are examined. Evidence suggests that linking volatility to total volume does not extract all information. When volume is partitioned into expected and unexpected components, the paper finds that unexpected volume shocks have a larger effect on volatility. Further, the relation is asymmetric; the impact of positive unexpected volume shocks on volatility is larger than the impact of negative shocks. Finally, consistent with theories of market depth, the study shows large open interest mitigates volatility.
709 citations
TL;DR: In this article, the authors show that synergy is the primary motive in takeovers with positive total gains even though the evidence is consistent with the simultaneous existence of hubris in any sample of takeovers.
Abstract: Three major motives have been suggested for takeovers: synergy, agency, and hubris. Existing empirical evidence is unable to clearly distinguish among these motives probably due to the simultaneous existence of all three in any sample of takeovers. This paper suggests a way of distinguishing among these competing hypotheses by looking at the correlation between target and total gains. It is argued that this correlation should be positive if synergy is the motive, negative if agency is the motive, and zero if hubris is the motive. The empirical results show that synergy is the primary motive in takeovers with positive total gains even though the evidence is consistent with the simultaneous existence of hubris in this sample. It is also found that agency is the primary motive in takeovers with negative total gains. Three major motives for takeovers have been advanced in the literature: the synergy motive, the agency motive, and hubris. The synergy motive suggests that takeovers occur because of economic gains that result by merging the resources of the two firms. The agency motive suggests that takeovers occur because they enhance the acquirer management's welfare at the expense of acquirer shareholders. The hubris hypothesis suggests that managers make mistakes in evaluating target firms, and engage in acquisitions even when there is no synergy. The existing empirical evidence has not been able to clearly distinguish among the different motives. For example, Bradley, Desai, and Kim (1988) argue that takeovers are value increasing transactions because total gains are positive in their sample of takeovers. However, the returns to acquiring firm stockholders are negative for about half the cases, and the average return is also negative, at least in the 1980s.1 Since synergy motive implies that acquisitions take place only if there are gains to acquirer shareholders, this finding suggests that hubris or agency
591 citations
TL;DR: In this article, the authors deal with the nature of option interactions and the valuation of capital budgeting projects possessing flexibility in the form of multiple real options and identify situations where option interactions can be small or large, negative or positive.
Abstract: This paper deals with the nature of option interactions and the valuation of capital budgeting projects possessing flexibility in the form of multiple real options. It identifies situations where option interactions can be small or large, negative or positive. Interactions generally depend on the type, separation, degree of being "in the money," and the order ofthe options involved. The paper illustrates, through a generic example, the importance of properly accounting for interactions among the options to defer, abandon, contract or expand in? vestment, and switch use. It is shown that the incremental value of an additional option, in the presence of other options, is generally less than its value in isolation, and declines as more options are present. Therefore, valuation errors from ignoring a particular option may be small. However, configurations of real options exhibiting precisely the opposite behavior are identified. Comparative statics results confirm that the value of flexibility, despite interactions, manifests familiar option properties.
549 citations
TL;DR: In this paper, the authors compare different approaches to developing arbitrage-free models of the term structure and present a numerical procedure that can be used to construct a wide range of one-factor models of short rate that are both Markov and consistent with the initial term structure of interest rates.
Abstract: This paper compares different approaches to developing arbitrage-free models of the term structure. It presents a numerical procedure that can be used to construct a wide range of one-factor models of the short rate that are both Markov and consistent with the initial term structure of interest rates.
491 citations
TL;DR: In this paper, the authors show that there is a separating equilibrium in which the size of the cash discount conveys information about product quality, and the driving forces of this equilibrium outcome are the risk-sharing motives of the producer and buyer as well as asymmetric information about quality.
Abstract: The purpose of this paper is to explain cross-sectional variations in trade credit terms across firms and industries. This study shows that there is a separating equilibrium in which the size of the cash discount conveys information about product quality. The driving forces of this equilibrium outcome are the risk-sharing motives of the producer and buyer as well as asymmetric information about product quality. The empirical implications of the model are derived and discussed in relation to industry practices.
405 citations
TL;DR: In this paper, the authors found that stocks with unexpected increases in short interest are found to generate statistically significant, but small, negative abnormal returns for a short period around the announcement date.
Abstract: According to the Diamond-Verrecchia hypothesis, if increases in short interest are correlated with information that is not yet public, they should precipitate a price adjustment. Stocks with unexpected increases in short interest are found to generate statistically significant, but small, negative abnormal returns for a short period around the announcement date. When the sample is divided into stocks with and without tradable options, nonoptioned stocks closely mimic these results but the optioned stocks do not. In a cross-sectional analysis of individual firms, the short-term negative abnormal returns are found to be 1) more negative, the higher the degree of unexpected short interest and, 2) less negative if the firm has tradable options.
350 citations
TL;DR: In this article, the authors analyzed the effect of second-hand information on the behavior of security prices and volume using analysts' recommendations published in the monthly "Dartboard" column of the Wall Street Journal.
Abstract: This study analyzes the effect of second-hand information on the behavior of security prices and volume using analysts' recommendations published in the monthly "Dartboard" column of the Wall Street Journal. For the two days following the publication of the recommendations, average positive abnormal returns of 4 percent?nearly twice the level of abnormal returns documented in previous research on analyst recommendations?and average volume double normal volume levels on the two days following publication of the recommendations are documented. The positive abnormal return on announcement is partially reversed within 25 trading days. The authors conclude that the positive abnormal return on announcement of the recommendations is a result of naive buying pressure as well as the information content of the analysts' recommendations.
313 citations
TL;DR: In this paper, the authors examined the relation between managerial ownership and the probability of being a target firm, and the impact of managerial ownership on target shareholder returns, and found that targets have lower managerial ownership than either their industry counterparts or randomly selected nontargets.
Abstract: This paper examines the relation between managerial ownership and the probability of being a target firm, and the impact of managerial ownership on target shareholder returns The paper finds that targets have lower managerial ownership than either their industry counterparts or randomly selected nontargets Managerial ownership is significantly lower in contested compared to uncontested offers, and in unsuccessful compared to successful cases Managerial ownership is significantly related to abnormal returns in contested cases that are ultimately successful The results are consistent with a positive impact of managerial ownership where it is used to negotiate, but not ultimately block, an acquisition
273 citations
TL;DR: The authors analyzes the strategy that minimizes the initial cost of replicating a contingent claim in a market with transactions costs and trading constraints, and shows that in the presence of trading frictions, it is no longer optimal to revise one's portfolio in each period.
Abstract: This paper analyzes the strategy that minimizes the initial cost of replicating a contingent claim in a market with transactions costs and trading constraints. The linear programming and two-stage backward recursive models developed are applicable to the replication of convex as well as nonconvex payoffs and to a portfolio of options with different maturities. The paper's formulation conveniently accounts for fixed and variable transactions costs, lot size constraints, and position limits on trading. The article shows that in the presence of trading frictions, it is no longer optimal to revise one's portfolio in each period. At the optimum, cash flows in excess of the desired ones may be generated. The optimal policy trades off the curvature of the payoff that is generated against the terminal slack.
235 citations
TL;DR: The authors found that sample size and/or error term adjustments render U.S. day-of-the-week effects statistically insignificant. But, in most countries, the effects are statistically significant in not more than two weeks out of the month.
Abstract: Consistent with Connolly's (1989), (1991) evidence, this study finds that sample size and/or error term adjustments render U.S. day-of-the-week effects statistically insignificant. In contrast, day-of-the-week effects in seven European countries and in Canada and Hong Kong are robust to individual sample size or error term adjustments, and day-of-the-week effects in five European countries survive the simultaneous imposition of both types of adjustments. In most countries where day-of-the-week effects are robust, however, the effects are statistically significant in not more than two weeks out of the month. These findings are inconsistent with explanations of the day-of-the-week effect based on institutional differences or on the arrival of new information. Thus, in the absence of other potential explanations already dismissed by Jaffe and Westerfield (1985), evidence in this study further complicates the international day-of-the-week effect puzzle.
TL;DR: This paper showed that when log price changes are not IID, their conditional density may be more accurate than their unconditional density for describing short-term behavior, using the BDS test of independence and identical distribution.
Abstract: This paper demonstrates that when log price changes are not IID, their conditional density may be more accurate than their unconditional density for describing short-term behavior. Using the BDS test of independence and identical distribution, daily log price changes in four currency futures contracts are found to be not IID. While there appear to be no predictable conditional mean changes, conditional variances are predictable, and can be described by an autoregressive volatility model that seems to capture all the departures from independence and identical distribution. Based on this model, daily log price changes are decomposed into a predictable part, which is described parametrically by the autoregressive volatility model, and an unpredictable part, which can be modeled by an empirical density, either parametrically or nonparametrically. This two-step seminonparametric method yields a conditional density for daily log price changes, which has a number of uses in financial risk management.
TL;DR: This article examined the cross-sectional distribution of bid-ask spreads in the S&P 100 index options market and found that traders view call and put options as substitutes, and vice versa.
Abstract: This paper examines the cross-sectional distribution of bid-ask spreads in the S&P 100 index options market. Cross-sectional differences in bid-ask spreads are found to be directly related to differences in market-making costs and trading activity across options. We also examine the relation of an option's bid-ask spread and trading activity to the spread and trading activity in other options. Call option trading activity is inversely related to the call option bid-ask spread but positively related to the spread of the put option having the same strike price and maturity, and vice versa. These findings suggest that traders view call and put options as substitutes.
TL;DR: In this article, the authors considered the Arbitrage Pricing Theory when investors have incomplete information on the parameters generating asset returns and showed that the assigned expected returns are linear in their associated factor betas.
Abstract: This paper considers the Arbitrage Pricing Theory when investors have incomplete information on the parameters generating asset returns. Each asset in the economy may have a different amount of information available on it. Bayesian investors use their prior beliefs in conjunction with the total available information to assign an expected return and a set of factor betas to each asset. The assigned expected returns are shown to be linear in their associated factor betas. However, the factor betas and prices of assets differ from those under complete information. Specifically, risky assets with high (low) information are priced relatively higher (lower). On the other hand, factor betas of high (low) information assets are relatively lower (higher). The analysis has econometric implications for testing the APT. In this paper's framework, maximum likelihood estimates of factor betas, which are based on normality assumptions, are too high (low) for high (low) information assets. In addition, sequentially increasing the sample size by adding new securities to a factor analysis procedure can result in the detection of apparent additional priced factors when they do not really exist.
TL;DR: This paper found that the DJIA's rise and fall is indeed restrained by "support" and "resistance" levels at multiples of 100 (e.g., 2800, 2900, 3000, etc.).
Abstract: This study tests the popular claim that the DJIA's movements around key reference points affect "investor sentiment" and thus price behavior. It is found that the DJIA's rise and fall is indeed restrained by "support" and "resistance" levels at multiples of 100 (e.g., 2800, 2900, 3000, etc.) but that, having broken through a 100-level, the DJIA then moves by more than otherwise warranted. A Monte Carlo study and comparisons with other indices confirm the significance of these findings. This suggests that some agents may trade on the basis of the DJIA but does not necessarily suggest that the market is inefficient.
TL;DR: In this paper, the authors examined whether earnings changes convey information in bond markets and found a significant positive (negative) reaction to unexpected earnings increases (decreases), consistent whether earnings announcements precede or follow dividend announcements.
Abstract: This study examines whether earnings changes convey information in bond markets and finds a significant positive (negative) reaction to unexpected earnings increases (decreases). The results are consistent whether earnings announcements precede or follow dividend announcements. Thus, earnings surprises convey information to bond markets and changes in firm value are split among bondholders and stockholders. This is in contrast to evidence from studies examining unexpected dividend announcements where bond price reaction is asymmetric. Cross-sectional analysis reveals that bond excess returns are positively related to earnings surprises.
TL;DR: This article showed that, in a multi-period world, managers of undervalued firms may find it optimal to issue stock, even though cash is available, and the market does not interpret all announcements of equity issues as signals of firm overvaluation.
Abstract: Myers and Majluf (1984) showed that in a world of asymmetric information, managers of overvalued firms issue equity, while managers of undervalued firms use cash, if available. This paper shows that, in a multiperiod world, managers of undervalued firms may find it optimal to issue stock, even though cash is available. Consequently, the market does not interpret all announcements of equity issues as signals of firm overvaluation. The paper also generates predictions regarding the effect of information asymmetry and investment oppor? tunities on i) dividend policy, and ii) the cross-sectional distribution of market reactions when an equity issue is announced.
TL;DR: In this paper, the authors provide a direct test of the hypothesis that large January returns can be attributed to omitted risk factors and show that the presence of stochastic dominance by January returns suggests that the omitted risks are not likely to explain the January effect.
Abstract: This paper provides a direct test of the hypothesis that large January returns can be attributed to omitted risk factors. Data from 1926-1991 show that the January return in the smallest decile of NYSE firms dominates the January returns for all other deciles by the first-order stochastic dominance. Similarly, January returns in all deciles (with the exception of ninth and tenth deciles) dominate non-January returns by first-, second-, or third-order stochastic dominance. The presence of stochastic dominance by January returns suggests that the omitted risk factors are not likely to explain the January effect.
TL;DR: In this paper, the authors present empirical evidence demonstrating that the risk and expected returns of common stocks typically change in the aftermath of large price movements and that subsequent stock returns should be positively correlated with the shift in return volatility.
Abstract: This paper presents empirical evidence demonstrating that the risk and expected returns of common stocks typically change in the aftermath of large price movements. When temporary changes in uncertainty follow major financial events, subsequent stock returns should be positively correlated with the shift in return volatility. This prediction is strongly supported by the data on more than 9,100 daily price change events during 1962-1985. Moreover, the data also suggest that ex ante returns on common stocks may incorporate a premium for increases in parameter uncertainty associated with the events.
TL;DR: In this article, empirical tests of the constant volatility version of the Heath, Jarrow, and Morton model, which is also the continuous time limit of the Ho and Lee model, using a generalized method of moments (GMM) test on three years of daily data for Eurodollar futures and futures options, were presented.
Abstract: This paper presents empirical tests of the constant volatility version of the Heath, Jarrow, and Morton model, which is also the continuous time limit of the Ho and Lee model. Using a generalized method of moments (GMM) test on three years of daily data for Eurodollar futures and futures options, the model can be rejected for most subperiods. Various biases in the fitted option prices relative to the market prices are documented through a regression study. The small sample properties and power of the GMM framework to this setting are also studied through simulations.
TL;DR: In this article, a theoretical analysis of spin-offs is presented, where the authors consider whether and under what circumstances firm value could be enhanced by a spin-off, and they show that a spinoff in which parent company debt is optimally allocated between the post-spin-off firms increases value by reducing agency costs and increasing the value of tax shields when the component firm cash flows are positively correlated.
Abstract: Recent empirical studies have indicated that spin-offs are value enhancing, yet the theoretical aspects of spin-off gains have not been as well explored. This paper presents a theoretical analysis of spin-offs. In the model of the firm presented, outstanding risky debt gives rise to agency costs of underinvestment, which are offset by the benefit of debt-related tax shields. The trade-off specifies the optimal leverage for a firm. Within this framework, the paper considers whether and under what circumstances firm value could be enhanced by a spin-off. It is shown that a spin-off in which parent company debt is optimally allocated between the post-spin-off firms increases value by reducing agency costs and increasing the value of tax shields when the component firm cash flows are positively correlated. The optimal allocation is characterized in terms of the parameters of the technologies of the component firms. When the component cash flows are negatively correlated, under the sufficient conditions developed, a combined firm operation dominates spin-offs. Here, the coinsurance effect on investment incentives dominates the effect of a flexible allocation of
TL;DR: In this paper, a vector autoregressive (VAR) model was used to examine the relation between aggregate insider transactions and stock market returns and found that the degree of mispricing observed by insiders is small.
Abstract: A vector autoregressive (VAR) model is used to examine the relation between aggregate insider transactions and stock market returns Consistent with the extant literature, there is some predictive content associated with aggregate insider transactions, but its magnitude is slight In contrast, market returns have substantial influence on the aggregate purchases and sales of corporate insiders The findings suggest that: 1) the degree of mispricing observed by insiders is small; 2) very little of the mispricing is associated with unanticipated macroeconomic factors; and 3) investors cannot use aggregate insider transactions to profitably predict future market returns over the following eight weeks
TL;DR: In this paper, a new measure of stock return volatility is developed to increase the precision of stock option price estimates, using prior information on the cross-sectional patterns in return volatil? ities for groups of stocks sorted on size, financial leverage, and trading volume.
Abstract: New measures of stock return volatility are developed to increase the precision of stock option price estimates. With Bayesian statistical methods, volatility estimates for a given stock are developed using prior information on the cross-sectional patterns in return volatil? ities for groups of stocks sorted on size, financial leverage, and trading volume. Call option values computed with the Bayesian procedure generally improve prediction accuracy for market prices of call options relative to those computed using implied volatility, standard historical volatility, or even the actual ex post volatility that occurred during each option's life. Although the Bayesian methods produce biased call price estimators, they do reduce the systematic tendency of standard pricing approaches to overprice (underprice) options on high (low) volatility stocks. Little bias improvement is observed with respect to the time to maturity and moneyness of the call options.
TL;DR: In this paper, a simple moment-ordering condition is shown to be necessary and sufficient for stochastic dominance in generalizations of the geometric and harmonic means, and the results have a straightforward and useful interpretation in terms of constant relative and absolute risk aversion utility functions.
Abstract: A simple moment-ordering condition is shown to be necessary for stochastic dominance. Closely related results on generalizations of the geometric and harmonic means are also provided. An ordering of the moment-generating functions is shown to be necessary and sufficient for stochastic dominance. The results have a straightforward and useful interpretation in terms of constant relative and absolute risk aversion utility functions. These results are used to provide necessary and sufficient conditions for optimality of distributions on an important class of utility functions.
TL;DR: In this paper, the equivalence of a no-arbitrage condition to the existence of a pricing operator in markets without transaction costs was established and extended to markets with proportional transaction costs.
Abstract: One of the most fundamental results in finance is the equivalence of a no-arbitrage condition to the existence of a pricing operator in markets without transaction costs (see Ross (1978)). Garman and Ohlson (1981) extended this to markets with proportional transaction costs. The current paper further extends this result to markets with realistic (and nonproportional) transaction costs. These costs include all investors' market-impact and short-borrowing costs, large investors' institutional commissions, and for small investors only the additional cost of retail commissions. They are functions of the value of the trade and have increasing, increasing, constant, and decreasing marginal rates, respectively, in that value. Garman and Ohlson showed that equilibrium prices in their notion of a "corresponding" cost-free market, plus a certain factor, prevail under equilibrium in markets with proportional transaction costs. The current paper extends this to realistic transaction costs and establishes the functional relation between this factor and the form of such costs.
TL;DR: In this article, the authors investigated the warrant pricing abilities of dilution-adjusted versions of the Black-Scholes and Jump-Diffusion option pricing models, and concluded that the Jump-diffusion model generally provides less biased estimates of market value.
Abstract: This paper investigates the warrant pricing abilities of dilution-adjusted versions of the Black-Scholes and Jump-Diffusion option pricing models. Because of the typically long lives of warrants, their pricing is hypothesized to benefit from use of the Jump-Diffusion model, which relaxes the Black-Scholes restriction against stock price jumps. Empirical results indicate that while the Black-Scholes model almost uniformly provides more efficient estimates, the Jump-Diffusion model generally provides less biased estimates of market value. Particularly for the valuation of out-of-the-money warrants and warrants on stocks with a history of large and/or frequent jumps, the Jump-Diffusion model may be preferred.
TL;DR: In this paper, the authors examined the impact on trading profits and on market performance of giving special trading privileges to some traders and not others in call-market experiments and found that the last-mover and orderflow access privileges are both modestly profitable and neither impairs market performance.
Abstract: The 39 experiments reported here examine the impact on trading profits and on market performance of awarding special trading privileges to some traders and not others. In call market experiments, the last-mover and orderflow access privileges are both modestly profitable and neither impairs market performance. In continuous market experiments, quicker access to orderflow information is quite profitable and more detailed access is possibly profitable; both privileges seem to enhance market performance slightly. By contrast, privileged marketmaking is extremely profitable and greatly impairs market performance.
TL;DR: In this paper, the authors present evidence on how the Williams Act affected the corporate acquisitions market, and three hypotheses about the Act's effects are discussed, and the most probable hypothesis implies that the Williams act reduced the expected gross present value of acquisition attempts.
Abstract: This paper presents evidence on how the Williams Act affected the corporate acquisitions market. The acquisition process is modeled and three hypotheses about the Act's effects are discussed. These hypotheses imply differing restrictions on how the Act changes the model's parameters. Parameter changes are estimated but we are unable to reliably discriminate between two of the three hypotheses using the classical statistical testing approach, though the third hypothesis is reliably rejected. Bayesian analysis using a diffuse prior is employed to make formal probability comparisons among the hypotheses. The most probable hypothesis, according to the results, implies that the Williams Act reduced the expected gross present value of acquisition attempts.
TL;DR: The authors used an autoregressive approach to test a multi-factor model with time-varying risk premiums and found that the model is capable of capturing the size effect and the dividend yield effect, but is incapable of explaining the book-to-market effect.
Abstract: This paper uses an autoregressive approach to test a multi-factor model with time-varying risk premiums. A quasi-differencing approach is used to eliminate the unobservable factors in the model. It is found that the model is capable of capturing the “size effect” and the “dividend yield effect,” but is incapable of explaining the “book-to-market effect” and the “earnings-price ratio effect.” Thus, it is concluded that a constant-beta multi-factor model will not be able to explain the cross-sectional variation in expected returns.
TL;DR: In this paper, the authors analyze the effect of organizational change in organizational form, such as the conversion of a corporation, or the spinoff of a unit into a limited partnership, on shareholders' wealth.
Abstract: This paper analyzes the consequence for shareholders of a change in organizational form, the conversion of a corporation, or the spin-off of a unit into a limited partnership. Theory suggests that, prior to the Tax Reform Act of 1986, the tax benefits of conversion to a limited partnership and the creation of a new entity separate from the parent corporation should have a positive effect on shareholder wealth. On the other hand, the increase in agency costs of such an organizational change should decrease the wealth of shareholders. Empirical results lend support to hypotheses that predict an increase in stock price at the announcement of the conversion, but cannot identify the source of the gain.