Showing papers in "Review of Financial Studies in 1998"
TL;DR: The authors compare the restrictions imposed by the four most popular multivariate GARCH models, and introduce a set of robust conditional moment tests to detect misspecification, and demonstrate that the choice of a multivariate volatility model can lead to substantially different conclusions in any application that involves forecasting dynamic covariance matrices (like estimating the optimal hedge ratio or deriving the risk minimizing portfolio).
Abstract: Existing time-varying covariance models usually impose strong restrictions on how past shocks affect the forecasted covariance matrix. In this article we compare the restrictions imposed by the four most popular multivariate GARCH models, and introduce a set of robust conditional moment tests to detect misspecification. We demonstrate that the choice of a multivariate volatility model can lead to substantially different conclusions in any application that involves forecasting dynamic covariance matrices (like estimating the optimal hedge ratio or deriving the risk minimizing portfolio). We therefore introduce a general model which nests these four models and their natural 'asymmetric' extensions. The new model is applied to study the dynamic relation between large and small firm returns. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.
1,310 citations
TL;DR: In this paper, the authors use a single unifying framework to analyze the sources of profits to a wide spectrum of return-based trading strategies implemented in the literature and show that less than 50% of the 120 strategies implemented by the authors yield statistically significant profits.
Abstract: In this article we use a single unifying framework to analyze the sources of profits to a wide spectrum of returnbased trading strategies implemented in the literature. We show that less than 50% of the 120 strategies implemented in the article yield statistically significant profits and, unconditionally, momentum and contrarian strategies are equally likely to be successful. However, when we condition on the return horizon (short, medium, or long) of the strategy, or the time period during which it is implemented, two patterns emerge. A momentum strategy is usually profitable at the medium (3to 12-month) horizon, while a contrarian strategy nets statistically significant profits at long horizons, but only during the 19261947 subperiod. More importantly, our results show that the cross-sectional variation in the mean returns of individual securities included in these strategies plays an important role in their profitability. The cross-sectional variation can potentially account for the profitability of momentum strategies and it is also responsible for atten-
947 citations
TL;DR: In this paper, an explicitly dynamic model of the limit order book in a one-tick market is presented, where each trader knows that her order will affect the order placement strategies of those who follow and the execution probability of her limit order is endogenous.
Abstract: This article presents a one-tick dynamic model of a limit order market. Agents choose to submit a limit order or a market order depending on the state of the limit order book. Each trader knows that her order will affect the order placement strategies of those who follow and the execution probability of her limit order is endogenous. All traders take this into account which, in equilibrium, generates systematic patterns in transaction prices and order placement strategies even with no asymmetric information. One of the most common ways in which traders exchange securities is in markets based on a limit order book. In a limit order market investors can post price-contingent orders to buy/sell at preset limit prices. Exchanges which operate in this fashion are the Paris Bourse, Tokyo, Toronto, and Sydney. 1 Despite the prevalence of the limit order system, the dynamic aspects of the limit order book have not been well explored. This article presents an explicitly dynamic model of the limit order book in a one-tick market. Traders with different valuations for an asset arrive randomly at a marketplace and trade either immediately by submitting a market
673 citations
TL;DR: The authors empirically examined whether access to deposits with inelastic rates (core deposits) permits a bank to make contractual agreements with borrowers that are infeasible if the bank must pay market rates for funds.
Abstract: We empirically examine whether access to deposits with inelastic rates (core deposits) permits a bank to make contractual agreements with borrowers that are infeasible if the bank must pay market rates for funds. Such access insulates a bank's costs of funds from exogenous shocks, allowing it to insulate its borrowers against exogenous credit shocks. We find that, controlling for loan market competition, banks funded more heavily with core deposits provide more loan rate smoothing in response to exogenous changes in aggregate credit risk. Thus we provide evidence for a novel channel linking bank liabilities to relationship lending. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.
509 citations
TL;DR: In this article, the authors present evidence on persistence in the relative investment performance of large, institutional equity managers, and find persistent performance concentrated in the managers with poor prior-period performance measures.
Abstract: This article presents evidence on persistence in the relative investment performance of large, institutional equity managers. Similar to existing evidence for mutual funds, we find persistent performance concentrated in the managers with poor prior-period performance measures. A conditional approach, using time-varying measures of risk and abnormal performance, is better able to detect this persistence and to predict the future performance of the funds than are traditional methods. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.
498 citations
TL;DR: In this article, the authors solve the equilibrium problem in a pure-exchange, continuous-time economy in which some agents face information costs or other types of frictions effectively preventing them from investing in the stock market.
Abstract: This article solves the equilibrium problem in a pure-exchange, continuous-time economy in which some agents face information costs or other types of frictions effectively preventing them from investing in the stock market. Under the assumption that the restricted agents have logarithmic utilities, a complete characterization of equilibrium prices and consumption/investment policies is provided. A simple calibration shows that the model can help resolve some of the empirical asset pricing puzzles. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.
420 citations
TL;DR: In this article, the effects of transaction costs on asset prices were studied in an overlapping generations economy with a riskless, liquid bond, and many risky stocks carrying proportional transaction costs.
Abstract: In this article we study the effects of transaction costs on asset prices. We assume an overlapping generations economy with a riskless, liquid bond, and many risky stocks carrying proportional transaction costs. We obtain stock prices and turnover in closed form. Surprisingly, a stock's price may increase in transaction costs, and a more frequently traded stock may be less adversely affected by an increase in transaction costs. Calculations based on the 'marginal' investor overestimate the effects of transaction costs. For realistic parameter values, transaction costs have very small effects on stock prices but large effects on turnover.
370 citations
TL;DR: In this paper, a semi-explicit approximation for American option values in the Black Scholes model was proposed, based on randomization, which yields an approximation that is both accurate and computationally efficient.
Abstract: While American calls on non-dividend paying stocks may be valued as European, there is no completely explicit exact solution for the values of American puts. We introduce a novel technique called randomization to value American puts and calls on dividend-paying stocks. This technique yields a new semi-explicit approximation for American option values in the Black Scholes model. Numerical results indicate that the approximation is both accurate and computationally efficient.
337 citations
TL;DR: In this article, the authors present a theory of outside equity based on the control rights and the maturity design of equity, and show that outside equity is a tacit agreement between investors and management supported by the equity-holders' right to dismiss management regardless of performance and by the lack of a prespecified expiration date on equity.
Abstract: This article presents a theory of outside equity based on the control rights and the maturity design of equity. I show that outside equity is a tacit agreement between investors and management supported by the equity-holders' right to dismiss management regardless of performance and by the lack of a prespecified expiration date on equity. As a tacit agreement outside equity is sustainable despite management's potential for manipulating the cash flows and regardless of how costly it is for equity-holders to establish a case against managerial wrongdoing. I establish that the only outside equity that investors are willing to hold in equilibrium is that with unlimited life, the very outside equity that corporations issue. Consistent with empirical evidence, this model predicts that debt-equity ratios are higher (lower) in industries with low (high) cash flow variability. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.
246 citations
TL;DR: In this article, the early exercise boundary of an American option is approximated as a multipiece exponential function and closed form formulas are obtained in terms of the bases and exponents of the function.
Abstract: This article proposes to price an American option by approximating its early exercise boundary as a multipiece exponential function. Closed form formulas are obtained in terms of the bases and exponents of the multipiece exponential function. It is demonstrated that a three-point extrapolation scheme has the accuracy of an 800-time-step binomial tree, but is about 130 times faster. An intuitive argument is given to indicate why this seemingly crude approximation works so well. Our method is very simple and easy to implement. Comparisons with other leading competing methods are also included. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.
211 citations
TL;DR: In this paper, a potential acquirer with a toehold bids aggressively and possibly overpays in equilibrium, and the aggressiveness increases further if he is able to renege on his winning bid.
Abstract: This article demonstrates that a potential acquirer with a toehold bids aggressively and possibly overpays in equilibrium. The aggressiveness of a bidder with a toehold increases further if he is able to renege on his winning bid. A bidder without a toehold, however, responds by shading his bids. The target firm can increase competition and the expected sale price if it only entertains nonretractable bids. This article provides testable implications on the probability of bidder success, stock price reactions on bid revisions and on resolution of the contest, and expected gains to bidders and the target firm.
TL;DR: In this article, the authors show that prices increase following the implementation of a leveraged buyout of a major firm in an industry, with the more leveraged firm in the industry charging higher prices on average.
Abstract: Recent empirical evidence indicates that capital structure changes affect pricing strategies. In most cases, prices increase following the implementation of a leveraged buyout of a major firm in an industry, with the more leveraged firm in the industry charging higher prices on average. Notable exceptions exist, however, when the leverage increasing firm's rival is relatively unlevered. The first observation is consistent with a model where firms compete for market share on the basis of price. The second observation can be explained within the context of a Stackelberg model where the relatively unlevered rival acts as the Stackelberg price leader.
TL;DR: In this article, the authors characterize the circumstances under which a mixture of informed and uninformed (market) finance is optimal, and explain why bank debt is typically secured, senior, and tightly held.
Abstract: By identifying the possibility of imposing a credible threat of liquidation as the key role of informed (bank) finance in a moral hazard context, we characterize the circumstances under which a mixture of informed and uninformed (market) finance is optimal, and explain why bank debt is typically secured, senior, and tightly held. We also show that the effectiveness of mixed finance may be impaired by the possibility of collusion between the firms and their informed lenders, and that in the optimal renegotiation-proof contract informed debt capacity will be exhausted before appealing to supplementary uninformed finance. 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, a model that contains both a random supply of risky assets and finitely-lived agents who trade in a multiple security environment is proposed, and the analysis shows there exist 2 K equilibria when K securities trade.
Abstract: A number of empirical studies have reached the conclusion that stock price volatility cannot be fully explained within the standard dividend discount model. This article proposes a resolution based upon a model that contains both a random supply of risky assets and finitely lived agents who trade in a multiple security environment. As the analysis shows there exist 2 K equilibria when K securities trade. The low volatility equilibria have properties analogous to those found in the infinitely lived agent models of Campbell and Kyle (1991) and Wang (1993, 1994). In contrast, the high-volatility equilibria have very different characteristics. Within the high-volatility equilibria very large price variances can be generated with very small supply shocks. Adding securities to the economy further reduces the required supply shocks. Using previously established empirical results the model can reconcile the data with supply shocks that are less than 10% as large as observed return shocks. These results are shown to hold even when the dividend process is mean reverting.
TL;DR: This paper study U.S. government secured municipal bond yields which are effectively default-free and nonmalleable, and conclude that differential default risk and call options do not explain the municipal bond puzzle.
Abstract: Fama (1977) and Miller (1977) predict that one minus the corporate tax rate will equate after-tax yields from comparable taxable and tax-exempt bonds. Empirical evidence shows that long-term tax-exempt yields are higher than theory predicts. Two popular explanations for this empirical puzzle are that, relative to taxable bonds, municipal bonds bear more default risk and include costly call options. I study U.S. government secured municipal bond yields which are effectively default-free and nonmalleable. These municipal yields display the same tendency to be too high. I conclude that differential default risk and call options do not explain the municipal bond puzzle. 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 optimal tick size that maximizes the expected profits of the market maker can be found to be equal to $1/8 for reasonable parameter values, and the optimal size is decreasing in the degree of adverse selection.
Abstract: Exchange-mandated discrete pricing restrictions create a wedge between the underlying equilibrium price and the observed price. This wedge permits a competitive market maker to realize economic profits that could help recoup fixed costs. The optimal tick size that maximizes the expected profits of the market maker can be equal to $1/8 for reasonable parameter values. The optimal tick size is decreasing in the degree of adverse selection. Discreteness per se can cause time-varying bid-ask spreads, asymmetric commissions, and market breakdowns. Discreteness, which imposes additional transaction costs, reduces the value of private information. Liquidity traders can benefit under certain conditions. 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 determine the minimum cost of superreplicating a nonnegative contingent claim when there are convex constraints on portfolio weights and show that the optimal cost with constraints is equal to the price of a related claim without constraints.
Abstract: We determine the minimum cost of superreplicating a nonnegative contingent claim when there are convex constraints on portfolio weights. We show that the optimal cost with constraints is equal to the price of a related claim without constraints. The related claim is a dominating claim, that is, a claim whose payoffs are increased in an appropriate way relative to the original claim. The results hold for a variety of options, including some path-dependent options. Constraints on the gamma of the replicating portfolio, constraints on portfolio amounts, and constraints on the number of shares are also considered. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.
TL;DR: This paper examined the relation between two factors affecting stock returns, the bid-ask spread and price discreteness, and the increase in return variance after ex-dates of stock splits and stock dividends.
Abstract: This article examines the relation between two factors affecting stock returns, the bid-ask spread and price discreteness, and the increase in return variance after ex-dates of stock splits and stock dividends. Controlling for these effects, the variance of daily returns still increases significantly. The variance of weekly returns also increases significantly, and the variance of returns for a control sample of nonsplitting firms shows no significant increase. Variance ratio tests show that bid-ask errors are small for these stocks and therefore cannot explain the large increase in variance. Spreads and price discreteness do not explain increased variance after stock distributions. 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 show how rational asset pricing models restrict the regression-based criteria commonly used to measure return predictability and show that the intercept, slope coefficients, and R[superscript 2] in predictive regressions must take specific values.
Abstract: This article shows how rational asset pricing models restrict the regression-based criteria commonly used to measure return predictability. Specifically, it invokes no-arbitrage arguments to show that the intercept, slope coefficients, and R[superscript 2] in predictive regressions must take specific values. These restrictions provide a way to directly assess whether the predictability uncovered using regression analysis is consistent with rational pricing. Empirical tests reveal that the returns on the CRSP size deciles are too predictable to be compatible with a number of well-known pricing models. However, the overall pattern of predictability across these portfolios is reasonably consistent with what we would expect under circumstances where predictability is rational. 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 relative merits of net versus gross settlement of interbank payments are compared. And the authors conclude that net settlement dominates gross, although the optimal net settlement scheme may involve a positive probability of default.
Abstract: In this article, we consider the relative merits of net versus gross settlement of interbank payments. Net settlement economizes on the costs of holding non-interest-bearing reserves, but increases moral hazard problems. The 'put option' value of default under net settlement can also distort banks' investment incentives. Absent these distortions, net settlement dominates gross, although the optimal net settlement scheme may involve a positive probability of default. 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 analyze an overlapping generations model with fixed costs of stock market participation, and show that the endogenous fluctuations of market participation lead to increased volatility of the share price.
Abstract: We analyze an overlapping generations model with fixed costs of stock market participation. Participation in the stock market is determined endogenously and covaries positively with preceding innovations in dividends. The equilibrium share price is positively related to market participation of the same period and to information about future dividends. There is “rational trend chasing” in the sense that, although all agents are rational, market participation rises after an increase of the share price and falls after a decrease. Finally, we show that the endogenous fluctuations of market participation lead to increased volatility of the share price.
TL;DR: In this article, a dynamic model of endogenous entry of traders subject to heterogenous expectational errors was developed to explore the linkage between higher trader participation and exchange rate volatility, and the competitive entry equilibrium is characterized by excessive market entry and excessively volatile prices.
Abstract: Recent evidence shows that higher trader participation increases exchange rate volatility. To explore this linkage, we develop a dynamic model of endogenous entry of traders subject to heterogenous expectational errors. Entry of a marginal trader into the market has two effects: it increases the capacity of the market to absorb exogenous supply risk, and at the same time it adds noise and endogenous trading risk. The competitive entry equilibrium is characterized by excessive market entry and excessively volatile prices. A positive tax on entrants can decrease trader participation and volatility while increasing market efficiency. 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 consider the costs and benefits of introducing a new security in a standard framework where uninformed traders with hedging needs interact with risk-averse informed traders.
Abstract: I consider the costs and benefits of introducing a new security in a standard framework where uninformed traders with hedging needs interact with risk-averse informed traders. Opening a new market may make everybody worse off, even when the new security is traded in equilibrium. This article emphasizes cross-market links between hedging and speculative demands: risk-averse arbitrageurs can use the new market to hedge their positions in the preexisting security, which can affect liquidity in the old market. More generally, the availability of such hedging opportunities will influence the strategies to which traders will direct resources. 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, a broker can allocate his time or effort between selling the assets of his multiple clients and searching for new clients in competition with other brokers in a large market in steady state.
Abstract: Brokerage contracts for many categories of real assets are characterized by a common, constant commission rate payable upon sale, exclusive agency, and contractual asking prices. For a large market in steady state, these conventional contracts produce in equilibrium no agency problem between a broker and his clients. Each broker spends the same time or effort selling each client's asset as the broker would spend on his own assets. As in standard agency problems, extra effort by a broker generates first-order stochastically dominant distributions of bids by potential buyers. Unlike standard agency problems, each broker can allocate his time or effort between selling the assets of his multiple clients and searching for new clients in competition with other brokers. Because brokers' time spent searching for new sellers is dissipative, entry by brokers is excessive in equilibrium. 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 apply the evolutionary idea of natural selection to a dynamic futures market and show that the proportion of time that the futures price equals the spot price converges to one with probability 1.
Abstract: While the literature usually justifies informational efficiency in the context of rationality, this article shows informational efficiency by applying the evolutionary idea of natural selection. In a dynamic futures market, speculators are assumed to merely act upon their predetermined trading types (buyer or seller), their predetermined fractions of wealth allocated for speculation, and their inherent abilities to predict the spot price, reflected in their distributions of prediction errors with respect to the spot price. This article shows that the proportion of time that the futures price equals the spot price converges to one with probability 1. 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 examine the predictive power of equilibrium dominance in experimental markets where firms with investment opportunities have an informational advantage over potential investors and are permitted to purchase a money-burning signal.
Abstract: We examine the predictive power of equilibrium dominance in experimental markets where firms with investment opportunities have an informational advantage over potential investors and are permitted to purchase a money-burning signal. Equilibrium dominance often fails to predict well when a Pareto-superior sequential equilibrium is also available. Instead, equilibrium selection appears to be related to the potential earnings of a more valuable firm that can signal its type successfully by defecting from the sequential equilibrium. Potential investors formulate their bids for firm equity based primarily on expectations formed adaptively in response to signaling choices made by firms. 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 identify optimal incentive contracts for managers of firms competing in the product market, and testable implications about which industries may have more convergence in investment choices, greater pay-for-profit sensitivity, larger differences in observed contracts, more innovation, larger-size firms, and potential for overcompensation.
Abstract: In this article I identify optimal incentive contracts for managers of firms competing in the product market. Such firms often confront similar decisions and uncertainties. Managers can improve decision quality by generating private signals through costly effort. However, since signals are likely to be correlated, firms that decide later get additional information from the actions of earlier firms. This impacts effort choice. Decision quality is also affected if later managers disregard their own signals and blindly imitate preceding decisions. In a competitive environment, such cascading hurts profits. Contracts that solve both moral hazard and cascading problems typically put more weight on firm profits, making them expensive. Contacts with more weight on decision quality are less expensive but result in cascades. Shareholders choose contracts that maximize their net surplus. This results in testable implications about which industries may have more convergence in investment choices, greater pay-for-profit sensitivity, larger differences in observed contracts, more innovation, larger-size firms, and potential for overcompensation. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.