Showing papers in "Review of Financial Studies in 1990"
TL;DR: In this paper, the extended Vasicek model is shown to be very tracta-ble analytically, and option prices are compared with those obtained using a number of other models.
Abstract: This article shows that the one-state-variableinterest-rate models of Vasicek (1977) and Cox,Ingersoll, and Ross (1985b) can be extended sothat they are consistent with both the current termstructure of interest rates and either the currentvolatilities of all spot interest rates or the currentvolatilities of all forward interest rates. Theextended Vasicek model is shown to be very tracta-ble analytically. The article compares option pricesobtained using the extended Vasicek model withthose obtained using a number of other models.
2,132 citations
TL;DR: In this paper, the short run interdependence of prices and price volatility across three major international stock markets is studied using the autoregressive conditionally heteroskedastic (ARCH) family of statistical models.
Abstract: The short-run interdependence of prices and price volatility across three major international stock markets is studied Daily opening and closing prices of major stock indexes for the Tokyo, London, and New York stock markets are examined The analysis utilizes the autoregressive conditionally heteroskedastic (ARCH) family of statistical models to explore these pricing relationships Evidence of price volatility spillovers from New York to Tokyo, London to Tokyo, and New York to London is observed, but no price volatility spillover effects in other directions are found for the pre-October 1987 period Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies
1,599 citations
TL;DR: In this article, the authors investigated why almost all stock markets fell together despite widely differing economic circumstances and found that "contagion" between markets occurs as the result of attempts by rational agents to infer information from price changes in other markets.
Abstract: This paper investigates why, in October 1987, almost all stock markets fell together despite widely differing economic circumstances. The idea is that "contagion" between markets occurs as the result of attempts by rational agents to infer information from price changes in other markets. This provides a channel through which a "mistake" in one market can be transmitted to other markets. Hourly stock price data from New York, Tokyo and London during an eight month period around the crash offer support for the contagion model. In addition, the magnitude of the contagion coefficients are found to increase with volatility.
1,546 citations
TL;DR: In this article, the authors show that despite negative autocorrelation in individual stock returns, weekly portfolio returns are strongly positively auto-correlated and are the result of important cross-autocorrelations.
Abstract: If returns on some stocks systematically lead or lag those of others, a portfolio strategy that sells "winners" and buys "losers" can produce positive expected returns, even if no stock's returns are negatively autocorrelated as virtually all models of overreaction imply. Using a particular contrarian strategy, the authors show that, despite negative autocorrelation in individual stock returns, weekly portfolio returns are strongly positively autocorrelated and are the result of important cross-autocorrelations. The authors find that the returns of large stocks lead those of smaller stocks, and present evidence against overreaction as the only source of contrarian profits. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.
1,351 citations
TL;DR: In this paper, the authors show that the effects of data snooping can be substantial, and two empirical examples demonstrate that the effect of this type of data-snooping on the performance of financial asset pricing models is substantial.
Abstract: Tests of financial asset pricing models may yield misleading inferences when properties of the data are used to construct the test statistics. In particular, such tests are often based on returns to portfolios of common stock, where portfolios are constructed by sorting on some empirically motivated characteristic of the securities such as market value of equity. Analytical calculations, Monte Carlo simulations, and two empirical examples show that the effects of this type of data snooping can be substantial. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.
983 citations
TL;DR: In an adverse selection model of a securities market with one informed trader and several liquidity traders, this paper study the implications of the assumption that the informed trader has more information on Monday than on other days.
Abstract: In an adverse selection model of a securities market with one informed trader and several liquidity traders, we study the implications of the assumption that the informed trader has more information on Monday than on other days. We examine the interday variables in volume, variance, and adverse selection costs, and find that on Monday the trading costs and the variance of price changes are highest, and the volume is lower than on Tuesday. These effects are stronger for firms with better public reporting and for firms with more discretionary liquidity trading.
827 citations
TL;DR: In this paper, the authors analyzed the behavior of stock return volatility using daily data from 1885 through 1988 using call option prices and estimates of volatility from futures contracts on stock indexes.
Abstract: This article analyzes the behavior of stock return volatility using daily data from 1885 through 1988. The October 1987 stock market crash was unusual in many ways. October 19 was the largest percentage change in market value in over 29,000 days. Stock volatility jumped dramatically during and after the crash. Nevertheless, it returned to lower, more normal levels more quickly than past experience predicted. The author uses data on implied volatilities from call option prices and estimates of volatility from futures contracts on stock indexes to confirm this result. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.
810 citations
TL;DR: In this article, the authors derived valuation formulas for American options and analyzed the properties associated with the optimal exercise boundary, and a numerical technique to implement the valuation formulas was presented to evaluate the performance of these formulas.
Abstract: No analytic solutions exists for the valuation of American options written on futures contracts and foreign currencies for which early exercise may be optimal. This article formulates the American option valuation problem in economically and mathematically meaningful ways. This enables us to derive valuation formulas for American options. The properties associated with the optimal exercise boundary are examined, and a numerical technique to implement the valuation formulas is presented. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.
598 citations
TL;DR: In this paper, an analytical framework for assessing the magnitude of the structurally induced volatility is presented, and the ratio of variance of open-to-open returns to closeto-close returns is consistently greater than one for NYSE common stocks during the period 1982 through 1986.
Abstract: The procedure for opening stocks on the NYSE appears to affect price volatility. An analytical framework for assessing the magnitude of the structurally induced volatility is presented. The ratio of variance of open-to-open returns to closeto-close returns is shown to be consistently greater than one for NYSE common stocks during the period 1982 through 1986. Tbe greater volatility at the open is not attributable to the way in which public information is released since both the opento-open return and the close-to-close return span the same period of time. Instead, the greater volatility appears to be attributable to private information revealed in trading and to temporaryprice deviations induced by specialist and other traders. The implied cost of immediacy at the open is significantly higher than at the close. Other empirical evidence in this article documents the volume of trading at the open, the time delays between the exchange opening and the first transaction in a stock, the difference in daytime volatility versus overnight volatility, and the extent to which volatility is related to trading volume.
583 citations
TL;DR: This paper showed that the stock market dramatically out-performs a standard q-variable because the market-equity component of this variable is only a rough proxy for stock market value.
Abstract: Changes in stock prices have substantial explanatory power for U.S. investment, especially for long-term samples, and even in the presence of cash flow variables. The stock market dramatically out-performs a standard q-variable because the market-equity component of this variable is only a rough proxy for stock market value. Although the stock market did not predict accurately after the crash of October 1987, the errors were not statistically significant. Parallel relationships for Canada raise the puzzle that Canadian investment appears to react more to the U.S. stock market than to the Canadian market. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.
511 citations
TL;DR: In this article, the authors test whether banks' investment and financing policies can be explained by tax status and find that banks apparently trade off these costs against tax-planning benefits.
Abstract: We test whether banks' investment and financing policies can be explained by tax status. We document changes in bank holdings of municipal bonds in response to changes in tax rules relating to deductibility of interest expense. We also document an association between banks' marginal tax rates and their investment and financing decisions, which is consistent with the existence of tax clienteles. However, banks do not sort themselves perfectly into investment and financing clienteles because of adjustment costs. We posit specific types of transaction-cost impediments to tax planning, and document that banks apparently trade off these costs against tax-planning benefits. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.
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TL;DR: In this paper, the authors derive and analyze option prices when the underlying asset is the market portfolio with discontinuous returns, and study the cost and risk implications of such dynamic hedging plans.
Abstract: When the price process for a long-lived asset is of a mixed jump-diffusion type, pricing of options on that asset by arbitrage is not possible if trading is allowed only in the underlaying asset and a risk-less bond. Using a general equilibrium framework, we derive and analyze option prices when the underlying asset is the market portfolio with discontinuous returns. The premium for the risk of jumps and the diffusion risks forms a significant part of the prices of the options. In this economy, an attempted replication of call and put options by the Black-Scholes type of trading strategies may require substantial infusion of funds when jumps occur. We study the cost and risk implications of such dynamic hedging plans. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.
TL;DR: A binomial approximation to a diffusion is defined as " computationally simple" if the number of nodes grows at most linearly in a number of time intervals as discussed by the authors, and the convergence of the sequence of bond and European option prices from these processes to the corresponding values in the diffusion limit is also demonstrated.
Abstract: A binomial approximation to a diffusion is defined as " computationally simple" if the number of nodes grows at most linearly in the number of time intervals. It is shown how to construct computationally simple binomial processes that converge weakly to commonly employed diffusions in financial models. The convergence of the sequence of bond and European option prices from these processes to the corresponding values in the diffusion limit is also demonstrated. Numerical examples from the constant elasticity of variance stock price and the Cox, Ingersoll, and Ross (1985) discount bond price are provided. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.
TL;DR: In this article, the determinants of stock-return variances were investigated and the overall results were consistent with the predictions of private-information-based rational trading models, but inconsistent with both the irrational trading noise and public-information hypotheses.
Abstract: New evidence is provided on the determinants of stock-return variances. First, when the Tokyo Stock Exchange is open on Saturday, the weekend variance increases; weekly variance is unaffected, however, despite an increase in weekly volume. Second, the listing of U.S. stocks in Tokyo substantially increases the number of trading hours, but Tokyo volume is negligible for these U.S. stocks and their 24-hour variance is unaffected. The overall results are consistent with the predictions of private-information-based rational trading models, but inconsistent with both the irrational trading noise and public-information hypotheses.
TL;DR: In this article, a pricing model with fluctuating means and variances of consumption growth provides implications about conditional moments of returns for both short and long investment horizons, and these implications are explored empirically.
Abstract: The authors find that conditional means and variances of consumption growth vary through time, and this variation appears to be associated with the business cycle. A pricing model with fluctuating means and variances of consumption growth provides implications about conditional moments of returns for both short and long investment horizons, and these implications are explored empirically. The U-shaped pattern of first-order autocorrelations of returns, as well as business cycle patterns in the price of risk, appears to be consistent with the model, but the authors' exploration suggests that other implications about conditional return moments are at odds with the data. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.
TL;DR: In this article, the authors identify a separating equilibrium in which the value of the bidder firm is revealed by the mix of cash and securities used as payment for the target, and they find that the average announcement-month bidder abnormal return in mixed offers is large and significant.
Abstract: In a model of takeovers under asymmetric information, we identify a separating equilibrium in which the value of the bidder firm is revealed by the mix of cash and securities used aspaymentfor the target. The model predicts that the revealed bidder value is monotonically increasing and convex in the fraction of the total offer that consists of cash. We examine the model restrictions using data from Canada, where mixed offers are both relatively frequent and free of the confounding tax-related options characterizing mixed offers in the United States. We find that the average announcement-month bidder abnormal return in mixed offers is large and significant. However, maximum likelihood estimates of parameters in both linear and nonlinear cross-sectional regressions fail to support the modelpredictions.
TL;DR: In this paper, the role of the medium of exchange in competition among bidders and its effect on returns to stockholders in corporate takeovers is investigated, and it is shown that stockholders of both acquiring and target firms obtain higher returns when a takeover is financed with cash rather than equity, and that returns to target shareholders increase with competition.
Abstract: The role of the medium of exchange in competition among bidders and its effect on returns to stockholders in corporate takeovers are investigated. Consistent with recent empirical evidence, our model shows that stockholders of both acquiring and target firms obtain higher returns when a takeover is financed with cash rather than equity, and that returns to target shareholders increase with competition. The model predicts that the fraction of synergy captured by the target decreases with the level of synergy. Finally, it is shown that, as competition increases, the cash component of the offer as well as the proportion of cash offered increases. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.
TL;DR: In this paper, the authors generalize the Cox, Ross, and Rubinstein (1979) binomial option-pricing model, and establish a convergence from discrete-time multivariate multinomial models to continuous-time multi-dimensional diffusion models for contigent claims prices.
Abstract: This article generalizes the Cox, Ross, and Rubinstein (1979) binomial option-pricing model, and establishes a convergence from discrete-time multivariate multinomial models to continuous-time multidimensional diffusion models for contigent claims prices. The key to the approach is to approximate the N-dimensional diffusion price process by a sequence of N-variate, (N+1)-nomial processes. It is shown that contingent claims prices and dynamic replicating portfolio strategies derived from the discrete time models converge to their corresponding continuous-time limits. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.
TL;DR: In this article, the authors constructed consistent ML estimators for a cross-sectional model of horizontal mergers relating announcement effects to exgeneous characteristics of firms and industries and found that managers of bidders, but not targets, have valuable private information about the potential synergies from proposed mergers.
Abstract: Event studies often include cross-sectional regressions of announcement effects on exogenous variables. If the event is voluntary and investors are rational, then standard OLS and GLS estimators are inconsistent. Consistent ML estimators are constructed for a cross-sectional model of horizontal mergers relating announcement effects to exgeneous characteristics of firms and industries. The OLS and ML estimates differ dramatically for bidders but not for targets. The evidence suggests that managers of bidders, but not targets, have valuable private information about the potential synergies from proposed mergers. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.
TL;DR: A reexamination of the clearing and settlement process in financial markets (particularly the futures market) and its performance during the 1987 stock market crash is presented in this article. But it is based on the useful analogies that can be drawn between the clearing house and other financial intermediaries, such as banks and insurance companies.
Abstract: This article is a reexamination of the clearing and settlement process in financial markets (particularly the futures market) and its performance during the 1987 stock market crash. It provides both some institutional background and some conceptual perspective on the problems faced by the system during the week of October 19. Much of the discussion is based on the useful analogies that can be drawn between the clearing house and other financial intermediaries, such as banks and insurance companies. A major conclusion is that the Federal Reserve played a vital rob in protecting the integrity of the clearing and settlements system during the crash.
TL;DR: This article examined 41 closed-end fund intial public offerings (IPOs) during the period from January 1986 to June 1987 and found that the mean intial day's return was not significantly different from zero in contrast to previous findings for non-fund IPOs.
Abstract: Examination of 41 closed-end fund intial public offerings (IPOs) during the period from January 1986 to June 1987 reveals that the mean intial day's return is not significantly different from zero in contrast to previous findings for nonfund IPOs. New funds also show significant negative after- market returns unlike other new issues. Despite the disparity between our findings and previous results, our results are consistent with existing models. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.
TL;DR: In this article, the authors investigated experimental financial markets in which firms possess more information than do potential investors and the domination of the pooling equilibrium was robust to different experimental experiences by participants.
Abstract: This study investigates experimental financial markets in which firms possess more information than do potential investors. Firms were given opportunities to undertake positive net present value projects which they could either forgo or finance by selling equity. Auctions were conducted among the investors for the right to finance the projects. When the theoretical equilibrium was unique, theory predicted well. When theory permitted pooling, separation, and semiseparation, only the more efficient pooling equilibrium was observed. The domination of the pooling equilibrium was robust to different experimental experiences by participants. When available, signals were used by good firms to distinguish themselves from bad. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.
TL;DR: In this paper, it was shown that the stop-loss start-gain strategy is not self-financing for continuous stock price processes of unbounded variation, leading to a new decomposition of an option's price into its intrinsic and time value, which is mathematically equivalent to the Black-Scholes (1973) formula.
Abstract: The downside risk in a leveraged stock position can be eliminated by using stop-loss orders. The upside potential of such a position can be captured using contingent buy orders. The terminal payoff to this stop-loss start-gain strategy is identical to that of a call option, but the strategy costs less initially. This article resolves this paradox by showing that the strategy is not self-financing for continuous stock- price processes of unbounded variation. The resolution of the paradox leads to a new decomposition of an option's price into its intrinsic and time value. When stock price follows geometric Brownian motion, this decomposition is proven to be mathematically equivalent to the Black-Scholes (1973) formula. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.
TL;DR: In this article, the authors compare tax-loss selling with intertemporal information variation as explanations of the January seasonal in stock returns and conclude that information variation is not a necessary condition for the January effect in stocks.
Abstract: Results of tests contrasting tax-loss selling with intertemporal information variation as explanations of the January seasonal in stock returns are reported. Closed-end fund shares display the typical size-related January seasonal while their net asset values do not. Interpreting the net asset value return as a proxy for information about underlying assets, this result indicates information variation is not a necessary condition for the January effect in stocks. The share returns at the turn of the year are negatively related to their mean preceding year returns and positively related to the standard deviations of their preceding year returns. These results are consistent with tax-loss selling. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.
TL;DR: In this article, the authors characterize economies in which both cash flows and forward prices follow random walks and show that the preferences of the representative investor are of the constant proportional risk-aversion type.
Abstract: In this article, we characterize economies in which both cash flows and forward prices follow random walks. We show in the case of geometric random walks that the preferences of the representative investor are of the constant proportional risk-aversion type. We also show the conditions under which spot prices follow random walks and under which the equivalent martingale measure is non-state-dep endent.
TL;DR: In this paper, a model that allows mean reversion in the sense that the risk premium declines as wealth rises can help explain both the consumption smoothing puzzle and the equity premium puzzle.
Abstract: Most models of the evolution of wealth and consumption assume that wealth volatility and risk premium are constant. But in fact, volatility declines, and risk premium seems to decline, as wealth rises. A model that allows mean reversion in the sense that the risk premium declines as wealth rises can help explain both the "consumption smoothing puzzle" and the "equity premium puzzle." In an example of such a model that gives us an analytic solution, direct and derived risk aversion are both constant, but differ. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.
TL;DR: The stock market crash of October 19, 1987 led to a boom in conferences, commissions, and studies of the stock market as discussed by the authors, and the participants would try to understand the events of October 1987 by a detailed analysis or description of events during the particular days of high volatility.
Abstract: The stock market crash of October 1987 led to a boom in conferences, commissions, and studies of the stock market. In almost each case, the participants would try to understand the events of October 1987 by a detailed analysis or description of events during the particular days of high volatility. Of course, to us economists there was nothing qualitatively unusual about October 19, 1987; the stock market moved, and we have no model that succeeds in explaining the magnitude or sources of daily stock market volatility for that day or any other day. When asked by the National Bureau of Economic Research to organize yet another conference on this subject, I decided that it was time to put these events in a historical perspective and try to understand them in the context of longer time periods and broader models. The papers collected in this symposium issue admirably succeed in broadening our understanding of market volatility and consequently deepening our understanding of the events of a few important days. To develop some perspective for the papers in the symposium and impose my own prejudices on the reader, it is useful to partition the sources of stock price movement.1 First, the price of equity can change for purely informational reasons related to the market receiving news that changes its perception of the payoff stream to holding equity (e.g., the expected dividends or volatility of the dividend may change). Sec-
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