Showing papers on "Financial market published in 1991"

Multitask Principal–Agent Analyses: Incentive Contracts, Asset Ownership, and Job Design

Abstract: Introduction In the standard economic treatment of the principal–agent problem, compensation systems serve the dual function of allocating risks and rewarding productive work. A tension between these two functions arises when the agent is risk averse, for providing the agent with effective work incentives often forces him to bear unwanted risk. Existing formal models that have analyzed this tension, however, have produced only limited results. It remains a puzzle for this theory that employment contracts so often specify fixed wages and more generally that incentives within firms appear to be so muted, especially compared to those of the market. Also, the models have remained too intractable to effectively address broader organizational issues such as asset ownership, job design, and allocation of authority. In this article, we will analyze a principal–agent model that (i) can account for paying fixed wages even when good, objective output measures are available and agents are highly responsive to incentive pay; (ii) can make recommendations and predictions about ownership patterns even when contracts can take full account of all observable variables and court enforcement is perfect; (iii) can explain why employment is sometimes superior to independent contracting even when there are no productive advantages to specific physical or human capital and no financial market imperfections to limit the agent's borrowings; (iv) can explain bureaucratic constraints; and (v) can shed light on how tasks get allocated to different jobs.

Inferring Trade Direction from Intraday Data

Abstract: This paper evaluates alternative methods for classifying individual trades as market buy or market sell orders using intraday trade and quote data. We document two potential problems with quote-based methods of trade classification: quotes may be recorded ahead of trades that triggered them, and trades inside the spread are not readily classifiable. These problems are analyzed in the context of the interaction between exchange floor agents. We then propose and test relatively simple procedures for improving trade classifications. THE INCREASING AVAILABILITY OF intraday trade and quote data is opening new frontiers for financial market research. The improved ability to discern whether a trade was a buy order or a sell order is of particular importance. In Hasbrouck (1988), the classification of trades as buys or sells is used to test asymmetric-information and inventory-control theories of specialist behavior. In Blume, MacKinlay, and Terker (1989), a buy-sell classification is used to measure order imbalance in tests of breakdowns in the linkage between S&P stocks and non-S&P stocks during the crash of October, 1987. In Harris (1989), an increase in the ratio of buys to sells is used to explain the anomalous behavior of closing prices. In Lee (1990), the imbalance in buy-sell orders is used to measure the market response to an information event. In Holthausen, Leftwich, and Mayers (1987), a buy-sell classification is used to examine the differential effect of buyer-initiated and seller-initiated block trades. Most past studies have classified trades as buys or sells by comparing the trade price to the quote prices in effect at the time of the trade. In this paper, we identify two serious potential problems with this method, namely, that quotes are often recorded ahead of the trade that triggered them, and that

Stock Markets, Growth, and Tax Policy

Abstract: An extensive literature documents the role of financial markets in economic development. To help explain this relationship, this paper constructs an endogenous growth model in which a stock market emerges to allocate risk and explores how the stock market alters investment incentives in ways that change steady state growth rates. The paper demonstrates that stock markets accelerate growth by (1) facilitating the ability to trade ownership of firms without disrupting the productive processes occurring within firms and (2) allowing agents to diversify portfolios. Tax policy affects growth directly by altering investment incentives and indirectly by changing the incentives underlying financial contracts. AN EXTENSIVE LITERATURE DOCUMENTS and discusses the role of financial markets in economic development.1 In an exhaustive study of three dozen developed and developing countries over the period 1860-1963, Goldsmith (1969) provides evidence of a positive relationship between the ratio of financial institutions' assets to GNP and output per person. Goldsmith also presents data showing "that periods of more rapid economic growth have been accompanied, though not without exception, by an above-average rate of financial development" (p. 48). In addition, Romer (1989) and others have shown, using cross-country data sets that range from 20 to over 100 years, that there exist startling differences in per capita output growth rates with no tendency for these growth rates to converge unconditionally.2 This paper helps explain these observations which have not been previously reconciled within the context of a general equilibrium optimizing model. Along with recent work by Bencivenga and Smith (1991), Greenwald and Stigliz (1989), and Greenwood and Jovanovic (1990), this paper constructs a model that links the financial system with the steady state growth rate of per capita output.3 Specifically, the model extends and links two literatures. The

Martingale and duality methods for utility maximization in a incomplete market

Abstract: The problem of maximizing the expected utility from terminal wealth is well understood in the context of a complete financial market. This paper studies the same problem in an incomplete market containing a bond and a finite number of stocks whose prices are driven by a multidimensional Brownian motion process W. The coefficients of the bond and stock processes are adapted to the filtration (history) of W, and incompleteness arises when the number of stocks is strictly smaller than the dimension of W. It is shown that there is a way to complete the market by introducing additional “fictitious” stocks so that the optimal portfolio for the thus completed market coincides with the optimal portfolio for the original incomplete market. The notion of a “least favorable” completion is introduced and is shown to be closely related to the existence question for an optimal portfolio in the incomplete market. This notion is expounded upon using martingale techniques; several equivalent characterizations are provided...

The Impact of New Product Introductions on the Market Value of Firms

Abstract: Although many mechanisms exist for the evaluation of new products, none have specifically examined the role that financial markets can play in measuring the impact of new products on firms. Using traditional event-study methodology, the present research provides a financial market-based analysis of the impact of new product introductions on the market value of firms. Copyright 1991 by University of Chicago Press.

The Survival of Noise Traders in Financial-Markets

Abstract: The authors present a model of portfolio allocation by noise traders with incorrect expectations about return variances. For such misperceptions, noise traders who do not affect prices can earn higher expected returns than rational investors with similar risk aversion. Moreover, such noise traders can come to dominate the market in that the probability that they eventually have a high share of total wealth is close to one. Noise traders come to dominate despite their taking of excessive risk and their higher consumption. The authors conclude that the case against their long-run viability is not as clear-cut as is commonly supposed. Coauthors are Andrei Shleifer, Lawrence H. Summers, and Robert J. Waldmann. Copyright 1991 by University of Chicago Press.

Sunshine Trading and Financial Market Equilibrium

Abstract: In this article, we consider the possibility that some liquidity traders preannounce the size of their orders, a practice that has come to be known as "sunshine trading." Two possible effects preannouncement might have on the equilibrium are examined. First, since it identifies certain trades as informationless, preannouncement changes the nature of any informational asymmetries in the market. Second, preannouncement can coordinate the supply and demand of liquidity in the market. We show that preannouncement typically reduces the trading costs of those who preannounce, but its effects on the trading costs and welfare of other traders are ambiguous. We also examine the implications of preannouncement for the distribution of prices and the amount of information that prices reveal. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

Naive Trading Rules in Financial Markets and Wiener-Kolmogorov Prediction Theory: A Study of “Technical Analysis”.

Abstract: This article attempts a formal study of technical analysis, which is a class of informal prediction rules, often preferred to Wiener-Kolmogorov prediction theory by participants of financial markets. Yet Wiener-Kolmogorov prediction theory provides optimal linear forecasts. This article investigates two issues that may explain this contradiction. First, the article attempts to devise formal algorithms to represent various forms of technical analysis in order to see if these rules are well defined. Second, the article discusses under which conditions (if any) technical analysis might capture those properties of stock prices left unexploited by linear models of Wiener-Kolmogorov theory. Copyright 1991 by University of Chicago Press.

Insiders, Outsiders, and Market Breakdowns

Abstract: A simple classical Walrasian framework is proposed for the study of manipulation among asymmetrically informed risk-averse traders in financial markets, and it is used to analyze the occurrence of a market breakdown in the trading system. Such a phenomenon occurs when the outsiders refuse to trade with the insiders because the informational motive for trade of the insider outweighs her hedging motive. We demonstrate the robustness of our results by proving that the market collapse condition extends not only to the linear strategy function, but to the whole class of feasible nonlinear strategy function, but to the whole class of feasible nonlinear strategy functions. Implications for insider-trading regulation are sketched. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

Anatomy of a Financial Crisis

Abstract: This paper provides an asymmetric information framework for understanding the nature of financial crises. It provides the following precise definition of a financial crisis: A financial crisis is a disruption to financial markets in which adverse selection and moral hazard problems become much worse, so that financial markets are unable to efficiently channel funds to those who have the most productive investment opportunities. As a result, a financial crisis can drive the economy away from an equilibrium with high output in which financial markets perform well to one in which output declines sharply. The asymmetric information framework explains the patterns in the data and many features of these crises which are otherwise hard to explain. It indicates that financial crises have effects over and above those resulting from bank panics and therefore provides a rationale for an expanded lender-of-last resort role for the central bank in which the central bank uses the discount window to provide liquidity to sectors outside of the banking system.

Financial markets and institutions

Abstract: The money study group, David Laidler, Bob Nobay and Michael Parkin the flow of funds - construction and issues, D.G.Barr and K.Cutherton the money supply process, David Cobham financial innovation in theory and practice, D.H.Gowland theory and practice of the banking firm, M.K.Lewis financial regulation in the UK - deregulation and re-regulaiton, Maximilian J.B.Hall structural change in the British financial system, David Llewelyn the London financial markets, Richard Harrington.

Exchange Rate Expectations: A Survey of Survey Studies

Abstract: The empirical literature on survey-based exchange rate expectations is briefly surveyed. The literature in general supports the presence of a nonzero risk premium and rejects the hypothesis of rational expectations. The crucial result is that, whereas short-run expectations tend to move away from some long-run "normal" values, long-run expectations tend to move back toward them. If this behavior of short-run expectations increases the volatility of exchange rate movements, there may be a basis for an official measure to minimize short-run exchange rate movements.

Stock Price Manipulation, Market Microstructure and Asymetric Information

Abstract: In recent years, there has been a large literature on how stock exchange specialists set prices when there are investors who know more about the stock than they do An important assumption in this literature is that there are *liquidity traders* who are equally likely to buy or sell for exogenous reasons It is plausible that some buyers have cash needs and are forced to sell their stock However, buyers will usually be able to choose the time at which they trade It will be optimal for them to minimize the probability of trading with informed investors by choosing an appropriate time to trade and clustering at that time This asymmetry means that when liquidity buyers are not clustering, purchases are more likely to be by an informed trader than sales so the price movement resulting from a purchase is larger than for a sale As a result, profitable manipulation by uninformed investors may occur A model where the specialist takes account of the possibility of manipulation in equilibrium is presented

Have commercial banks ignored history

Abstract: This paper investigates the impact of past defaults. and of recently acquired sovereignty on the terms of bank loans for developing countries in the 1970s. We control for countries' repayment indicators and for a measure of their political stability. Our findings are that: 1) The repayment difficulties of the period prior to the 1930s do not have a statistically significant impact on the credit terms. In contrast. the defaults of the 1930s and the post war defaults and repayment difficulties do have a statistically significant impact on credit terms. These findings are in contrast to those studies that focused on crises periods in these markets. Our results suggest that countries' repayment behavior influence their later market access. 2) Nations that achieved sovereignty recently were charged higher rates than nations that were sovereign before the 1940s. In fact. recently sovereign borrowers were charged as high rates as the defaulters of the former episodes. This finding suggests that markets attach risk premium for new institutions.

European financial integration: Banking competition and European integration

Abstract: We assess how banking competition will be affected by the process of deregulation and integration in European financial markets, drawing on the lessons of recent research in finance, banking and industrial organization. Our central thesis contends that the main effect of integration will be to change the focus of banks' strategic behaviour from collusion and regulatory capture to competition. Nevertheless, competition will be imperfect due to the presence of significant economic barriers to entry, and this means that the upper bound for the benefits of integration is lower than the competitive benchmark. In consequence, integration will not have an impact as large as that associated with competitive or `contestable' outcomes. The analysis suggests that European banks will seek to offset the increased competition brought about by 1992 by engaging in mergers, acquisitions and cross-participation agreements. Furthermore, different degrees of competition will coexist in a segmented market and the benefits of integration will be unevenly distributed.

Partial Revelation of Information in Experimental Asset Markets

Abstract: We develop a model of market efficiency assuming private information is partially revealed to uninformed traders via the behavior of those who are informed. This partial revelation of information (PRE) model is tested in fourteen computerized double auction laboratory markets. It explains the market value and allocation of purchased information, and asset allocations, better than either a fully revealing information model (FRE strong-form efficiency) or a nonrevealing expectations model; but it takes second place to FRE in explaining asset prices. We conjecture that refined versions of PRE may provide insight into "technical analysis" and minibubbles in securities markets. FROM THE LARGE BODY of literature on informational efficiency beginning with Fama (1970), there now appears to be a general (but not universal) consensus that most important modern securities markets are at least semistrong form efficient but probably less than strong form efficient.1 That is, all public information but probably not all private information is fully reflected in security prices. The question then becomes when and to what extent private information becomes incorporated, or, from the opposite perspective, what is the value of private information to the investor? Furthermore, as Latham (1985) and Rubinstein (1975) point out, theories of efficient markets should explain asset allocations as well as asset prices, and clearly allocations also depend on how the market incorporates private information. The empirical difficulty is that private information by definition is not contemporaneously observable in major financial markets, so further progress using existing market data is problematic. Laboratory asset markets are a natural setting to study the issue of market efficiency because private information can be controlled and allocations can be directly observed. Early laboratory studies (e.g. Plott and Sunder (1982); Forsythe, Palfrey and Plott (1982); Friedman, Harrison, and Salmon (1984)

On the International Use of Currencies: the Case of the Deutsche Mark

Abstract: This paper assesses the role of the deutsche mark as a key international currency. It first investigates the theoretical basis underlying the international use of a currency. Theoretical considerations indicate that several factors relating to the issuing country--including inflation performance, openness of financial markets, and trade patterns--combine to propagate the international use of its currency. The paper then discusses these factors as they relate to the deutsche mark and identifies trends in several of these determinants of international currency use that presage an expanding role for the mark. Finally, data are presented on the extent of the internalization of the deutsche mark during the 1980s which corroborate the theoretical findings.

A Note On Utility Maximization Under Partial Observations1

Abstract: Using ideas from stochastic filtering theory and a martingale representation result of Jacod, we discuss problems of utility maximization in “dynamically incomplete” financial markets under partial observations.

From Centrally-Planned to Market Economies: The Road from CPE to PCPE

Abstract: This paper deals with the early stages of transformation of centrally-planned economies (CBEs) into market economies during which expectations playa key role. It focuses on the transitional phase during which the economy is not any more a CPE but has not yet become a market economy. During this phase the economy is referred to as a 'previously centrally-planned economy" (PCPE). A simple model is developed to analyze the consequences of expected price liberalization. The model highlights the anticipatory character of economic behavior during the early stages of the transformation process. A major focus is given to credit markets. The CPEs undergoing transformation lack depth and breadth of financial markets. The lack of information necessary to assess risk and creditworthiness complicates the conduct of credit polity. The analysis illustrates the benefits of an early development of such markets, and of finding appropriate ways to "clean" the balance sheets of enterprises and banks from bad loans. It demonstrates the cost of a fine-tuning strategy and the benefits from a quick implementation of price reform. The paper also examines alternative means to reduce 'liquidity overhang," and shows that all involve taxation of one form or another. The consequences of privatization are analyzed and the benefits of an early development of an effective tax system highlighted.

Nonrational actors and financial market behavior

Abstract: The insights of descriptive decision theorists and psychologists, we believe, have much to contribute to our understanding of financial market macrophenomena. We propose an analytic agenda that distinguishes those individual idiosyncrasies that prove consequential at the macro-level from those that are neutralized by market processes such as poaching. We discuss five behavioral traits — barn-door closing, expert/reliance effects, status quo bias, framing, and herding — that we employ in explaining financial flows. Patterns in flows to mutual funds, to new equities, across national boundaries, as well as movements in debt-equity ratios are shown to be consistent with deviations from rationality.

Increasing financial market integration, real exchange rates and macroeconomic adjustment

Abstract: This paper is one of four in this Working Paper Series, focusing on financial liberalisation, along with those of Kupiec, Miller and Weller, and Driscoll. It examines the extent to which international financial markets have become more integrated over the past decade. The finding that financial markets are almost fully integrated, in contrast to goods markets which are not, has important implications for real interest rate differentials, real exchange rate behaviour and external adjustment. In particular, the reduced importance of external imbalance and the increased role of real interest rates in real exchange rate determination can be associated with more prolonged misalignments ...

The effect of the 1987 Stock Crash on international financial integration

Abstract: This paper examines daily open-to-close returns of major stock market indices on the New York Stock Exchange, Tokyo Stock Exchange and the London Stock Exchange over the 1985-1990 period, which encompasses the October 1987 Stock Market Crash. We estimate volatility spillover effects across the 24 hour day using a GARCH-M model. We find evidence that volatility spillover effects emanating from Japan have been gathering strength over time, especially after the 1987 Crash. This may reflect a growing awareness by domestic investors of the economic interdependence of international financial markets since the 1987 Stock Market Crash.

Exchange Rate Changes and the Distribution of Industry Value

Abstract: This article investigates the simple, widely-held hypothesis that an exogenous real home currency depreciation enhances the competitiveness of home country manufacturers vis a vis foreign rivals. The study associates changes in competitiveness with redistributions of value within an industry. Daily and weekly data on redistributions of value are obtained from world financial markets. The study estimates the relationship between changes in exchange rates and redistributions of value within the world automobile and steel industries during the period 1978–87. The data generally do not support the notion that firms benefit competitively from a depreciation of the home currency. On the contrary, for large fractions of both industries, a depreciation of the home currency is associated with a significant decline in their share of industry value.

Government, Financial Markets, and Economic Development

Abstract: Ideological debates on the role of government in development have focused on two contrasting prescriptions: one calling for large scale government interventions to solve problems of massive market failures, the other for the unfettering of markets, with the dynamic forces of capitalism naturally leading to growth and prosperity This paper is part of an exploration of a middle road, focusing in particular on the role of government in financial markets After explaining the importance of, and the limitations on, capital markets, particularly in allocating scarce investment resources, the results are used as a basis of a critique of the two 'extreme' approaches Recognizing the limitations of government intervention as well as of free markets, the 'new view' of capital markets provides new insights into s variety of policy issues, which are addressed in the final section of the paper