Showing papers on "Market liquidity published in 1992"

Debt, Liquidity Constraints, and Corporate Investment: Evidence from Panel Data

Abstract: This paper presents evidence supporting the theory that problems of asymmetric information in debt markets affect financially unhealthy firms' ability to obtain outside finance and, consequently, their allocation of real investment expenditure over time. I test this hypothesis by estimating the Euler equation of an optimizing model of investment. Including the effect of a debt constraint greatly improves the Euler equation's performance in comparison to the standard specification. When the sample is split on the basis of two measures of financial distress, the standard Euler equation fits well for the a priori unconstrained groups, but is rejected for the others. Do IMPERFECTIONS IN THE financial system play a role in economic fluctuations? Recent research in empirical macroeconomics has directed this question to the area of investment, asking in particular whether firms with free access to capital markets have different investment behavior from those who do not. Emphasis on this question has resulted in part from the theoretical predictions of a recent surge of work in the economics of imperfect information that has explored how violations of the Modigliani-Miller theorem ascribe a role for finanical factors in the investment process. In addition, interest in the question has been spurred by the poor empirical performance of standard optimizing models of investment. For example, tests of the q-theory of investment have found little explanatory power for q, have implied implausibly slow capital stock adjustment speeds, and have been outperformed by simple ad hoc accelerator models.1 One specific hypothesis has been at the center of recent attempts to explore the connection between finance and investment. If a firm has difficulty obtaining outside finance, its investment should display excess sensitivity to the availability of internal funds.2 Moreover, differences in this sensitivity

Determinants of European bank profitability: A note

Abstract: A recent study by Bourke (1989) on the determinants of international bank profitability, replicated and extended earlier research undertaken by Short (1979), and found support for the view that concentration was positively and moderately related to profitability. The results also provide some evidence for the Edwards-Heggestad-Mingo hypothesis [Edwards and Heggestad (1973) and Heggestad and Mingo (1976)] of risk avoidance by banks with a high degree of market power. Bourke uses a pooled time series approach to estimate a linear equation, regressing performance measures against a variety of internal (staff expenses, capital ratios, liquidity ratios) and external (concentration ratios, government ownership, interest rates, market growth and inflation) determinants of bank profitability. This note replicates Bourke’s methodology in order to evaluate the determinants of European bank profitability. A sample of European banks, 671 for 1986, 1,063 for 1987, 1,371 for 1988 and 1,108 for 1989, are taken across eighteen countries. (The country breakdown is shown in the appendix.) Standardized accounting data for the banks was obtained from International Bank Credit Analysis Ltd (IBCA), a

Insider Trading: Should It Be Prohibited?

Abstract: Insider trading moves forward the resolution of uncertainty. Using a rational expectations model with endogenous investment level, I show that, when insider trading is permitted, (i) stock prices better reflect information and will be higher on average, (ii) expected real investment will rise, (iii) markets are less liquid, (iv) owners of investment projects and insiders will benefit, and (v) outside investors and liquidity traders will be hurt. Total welfare may increase or decrease depending on the economic environment. Factors that favor the prohibition of insider trading are identified.

Market Structure and the Nature of Price Rigidity: Evidence from the Market for Consumer Deposits

Abstract: Panel data on consumer bank deposit interest rates reveal asymmetric impacts of market concentration on the dynamic adjustment of prices to shocks. Banks in concentrated markets are slower to raise interest rates on deposits in response to rising market interest rates, but are faster to reduce them in response to declining market interest rates. Thus, banks with market power skim off surplus on movements in both directions. Since deposit interest rates are inversely related to the price charged by banks for deposits, the results suggest that downward price rigidity and upward price flexibility are a consequence of market concentration.

Liquidity Effects and the Monetary Transmission Mechanism

Abstract: Several recent papers provide strong empirical support for the view that an expansionary monetary policy disturbance generates a persistent decrease in interest rates and a persistent increase in output and employment. Existing quantitative general equilibrium models, which allow for capital accumulation, are inconsistent with this view. There does exist a recently developed class of general equilibrium models which can rationalize the contemporaneous response of interest rates, output, and employment to a money supply shock. However, a key shortcoming of these models is that they cannot rationalize persistent liquidity effects. This paper discusses the basic frictions and mechanisms underlying this new class of models and investigates one avenue for generating persistence. We argue that once a simplified version of the model in Christiano and Eichenbaum (1991) is modified to allow for extremely small costs of adjusting sectoral flow of funds, positive money shocks generate long-lasting, quantitatively significant liquidity effects, as well as persistent increases in aggregate economic activity.

Futures-Trading Activity and Stock Price Volatility

Abstract: We examine whether greater futures-trading activity (volume and open interest) is associated with greater equity volatility. We partition each trading activity series into expected and unexpected components, and document that while equity volatility covaries positively with unexpected futures-trading volume, it is negatively related to forecastable futures-trading activity. Further, though futures-trading activity is systematically related to the futures contract life cycle, we find no evidence of a relation between the futures life cycle and spot equity volatility. These findings are consistent with theories predicting that active futures markets enhance the liquidity and depth of the equity markets.

The Role of Unemployment Insurance in an Economy with Liquidity Constraints and Moral Hazard

Abstract: The potential welfare benefits of unemployment insurance, along with the optimal replacement ratio, are studied using a quantitative dynamic general equilibrium model. To provide a role for unemployment insurance, agents in our economy face exogenous idiosyncratic employment shocks and are unable to borrow or insure themselves through private markets. In the absence of moral hazard, replacement ratios as high as .65 are optimal and the welfare benefits of unemployment insurance are quite large. However, if there is moral hazard and the replacement ratio is not set optimally, but is instead set to an empirically plausible value, the economy can be much worse off than it would be without unemployment insurance.

Liquidity Effects and the Monetary Transmission Mechanism

Abstract: Several recent papers provide strong empirical support for the view that an expansionary monetary policy disturbance generates a persistent decrease in interest rates and a persistent increase in output and employment. Existing quantitative general equilibrium models, which allow for capital accumulation, are inconsistent with this view. There does exist a recently developed class of general equilibrium models which can rationalize the contemporaneous response of interest rates, output, and employment to a money supply shock. However, a key shortcoming of these models is that they cannot rationalize persistent liquidity effects. This paper discusses the basic frictions and mechanisms underlying this new class of models and investigates one avenue for generating persistence. We argue that once a simplified version of the model in Christiano and Eichenbaum (1991) is modified to allow for extremely small costs of adjusting sectoral flow of funds, positive money shocks generate long-lasting, quantitatively significant liquidity effects, as well as persistent increases in aggregate economic activity.

Futures Manipulation with "Cash Settlement"

Abstract: This paper investigates the susceptibility of futures markets to price manipulation in a two-period model with asymmetric information and "cash settlement" futures contracts. Without "physical delivery," strategies based on "corners" or "squeezes" are infeasible. However, uninformed investors still earn positive expected profits by establishing a futures position and then trading in the spot market to manipulate the spot price used to compute the cash settlement at delivery. We also show that as the number of manipulators grows, profits from manipulation fall to zero. However, even in the limit, manipulation still has a nontrivial impact on market liquidity. More broadly, we interpret manipulation as a form of endogenous "noise trading" which can arise in multiperiod security markets. CAN UNINFORMED INVESTORS PROFITABLY manipulate security prices by strategic trading? This question has long intrigued both economists and the general public. For economists, since Keynes (1936) and Friedman (1953) the issue of interest has been whether such manipulation can arise as an equilibrium phenomenon in the presence of rational market makers and other traders.' Prima facie, it might appear that manipulation requires a divergence between a security's price and its "value" which other market participants ought to recognize and profitably counteract, thereby offsetting any incipient manipulation. We show here, however, that this intuition is incorrect. Even if investors are risk-neutral (and hence risk-capacity limits as in De Long, Shleifer, Summers, and Waldmann (1990) are absent), profitable manipulation occurs in our model under a surprisingly weak set of assumptions. Our analysis is conducted in the context of a two-date model in which trade occurs first in a futures market followed by a spot market. The idea is simple. Suppose that an "informed trader" privately learns the value of the underlying asset before delivery, but that this value becomes public only after the

Informed Speculation and Hedging in a Noncompetitive Securities Market

Abstract: The authors examine an adverse selection model of trading in which both informed and uninformed traders are rational, maximizing agents. Replacing the price inelastic "noise" or "liquidity" traders with strategic, utility-maximizing hedgers permits an explicit analysis of the uninformed traders' welfare, and demonstrates that several comparative statics obtained from the standard paradigm of Kyle (1984, 1985) are altered significantly upon endogenizing the trading motives of these agents. In contrast to extant models, market liquidity and price efficiency are both nonmonotonic in the number of uninformed hedgers in the market. Also, the welfare of hedgers monotonically decreases with the number of informed traders, despite greater competition between the informed. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

Trading Volume and Serial Correlation in Stock Returns

Abstract: This paper investigates the relationship between stock market trading volume and the autocorrelations of daily stock index returns. The paper finds that stock return autocorrelations tend to decline with trading volume. The paper explains this phenomenon using a model in which risk-averse "market makers" accommodate buying or selling pressure from "liquidity" or "non-informational" traders. Changing expected stock returns reward market makers for playing this role. The model implies that a stock price decline on a high-volume day is more likely than a stock price decline on a low-volume day to be associated with an increase in the expected stock return.

Market for information: experimental evidence'

Abstract: Predictions of the noisy rational expectations equilibrium (REE) model are found to be relatively accurate for both asset and information markets in the laboratory. When information about an asset's uncertain dividend is sold to a fixed number of highest bidders, prices, allocations, efficiency, and distribution of profit predictions of the full revelation REE model in the asset market dominate the predictions of the Walrasian model; demand for information shifts to the left and its price declines close to zero. When the price of information is fixed at a relatively high level, the number of informed agents and the informativeness of the asset market tends to adjust to permit the informed agents to recover their investment in information.

The Effects of Splitting on the Ex: A Microstructure Reconciliation

Abstract: Our research investigates stock splits: why they happen, how they affect shareholder wealth, and whether they enhance liquidity for splitting firms. Prior research has not reached a clear-cut answer as to the role of stock splits. While there is definitely a favorable stock price reaction to the announcement of splits, the reason for the positive announcement return is not well-determined. Conventional wisdom suggests that the benefit of splits comes from improved share liquidity; yet empirical evidence has produced ambiguous results on liquidity. More detailed theoretical arguments pose stock splits as part of a strategy used by management to signal value, yet such arguments seem overly complex for such a basic management decision. Moreover, in spite of complex explanations, an anomaly remains: splitting firms also experience positive returns on the split execution day. This event is known well in advance, so any associated favorable information should already be priced into the stock.

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.

Institutional Separation between Supervisory and Monetary Agencies

Abstract: This paper investigates whether monetary policy and banking supervision should be separated, or not. It starts with an account of the historical evolution of the Central Banks micro-function (banking supervision). The role of the lender of last resort and the introduction of deposit insurance is discussed. There is currently a diversity of institutional arrangements, but the differences are found to be greater in appearance than in reality. The main argument of divorcing the monetary from the regulatory authority is that the combination of functions might lead to a conflict of interest. This conflict can arise in different ways. The most important instance is that interest rates are held down because of concern with the ¶health¶ of the banking system, when purely monetary considerations suggest higher rates. It is argued that this conflict between ¶regulatory¶ and ¶monetary¶ objectives depends to some extent on the structure of the banking and financial systems (i.e. whether banks are dependent on wholesale or retail markets for short term funding). A First argument against separation is the role of the Central Bank in the payment system, in particular with respect to preventing systemic risk. The massive intra-day credit exposures in large value payment systems could give rise to settlement failure(s), which in turn could generate a systemic crisis. Settlement risk is therefore increasingly an area of supervisory concern for Central Banks. In so far as the Central Bank as lender of last resort is likely to support a failing participant, it is assuming the risks and effectively becoming the implicit guarantor of the system. Although Central Banks implement risk reduction policies, some risks originate beyond the settlement system, e.g. in foreign exchange trading, securities transactions and interbank transactions. It is argued that Central Banks should have a regulatory and oversight role in the payment system, although it does not follow that they should also operate them. Turning to the broader concern of the Central Bank of systemic stability, it is claimed that the Central Bank usually has to use its lender of last resort function not only in cases of liquidity difficulties, but also where the solvency of banks is uncertain. A cross-country survey of 104 bank failures is assembled in an appendix. We focus on the provision of funding for rescues: central bank, deposit insurance, government or other banking system should lie with the agency which pays if, and when , banks are to be rescued. So long as rescue and insurance is undertaken on an implicit Central Bank basis, then the Central Bank would naturally want to undertake regulation and supervision. However, there is a trend towards using tax-payer money for bank rescues which strengthens the case for separation of the monetary and supervisory functions and establishment of a government agency for the latter. It would, however, be difficult to have a complete division, since the Central Bank would generally remain the only source of immediate funding.

Options Trading and the Bid-Ask Spread of the Underlying Stocks

Abstract: This study shows that options listing significantly affects the spreads on the underlying stock. The authors identify a trade-off between the benefits of increased liquidity and the cost of informational externalities. Highly liquid stocks tend to have spread increases, while illiquid stocks experience spread decreases. The effect occurs in concert with nonlisting volatility changes. The spread changes do not appear to be caused by shifts in liquidity between the stock and options market. Often, spread changes are large enough to affect significantly the cost of equity capital. Copyright 1992 by University of Chicago Press.

The Informational Role of Upstairs and Downstairs Trading

Abstract: The author assumes that customers do not continuously participate in all markets and that intermediaries are repositories of information about the ("unexpressed") demands of currently nonparticipating customers. A model of downstairs (i.e., centralized) versus upstairs (i.e., fragmented) markets is developed based on the assumption that upstairs (and not downstairs) dealers may possess information about unexpressed demand. The equilibrium liquidity of both markets is characterized by the trade-off between the benefits of information about unexpressed demand and the cost to the customer of trading in a fragmented market. Copyright 1992 by University of Chicago Press.

Market Making in the Options Markets and the Costs of Discrete Hedge Rebalancing

Abstract: In this paper we provide empirical evidence consistent with the hypothesis that options market makers face risks in managing inventory that are unique to the options markets. In particular, we show that risks associated with the inability to rebalance an option position continuously and uncertainty about the return volatility of the underlying stock each account for a statistically and economically significant proportion of the bid-ask spreads quoted for a sample of Chicago Board Options Exchange options. IT IS WIDELY RECOGNIZED that securities dealers face risk associated with inventory positions taken in the course of their trading activities. For the equity dealer this has been shown both theoretically (e.g., Stoll, 1978a; Ho and Stoll, 1983) and empirically (e.g., Stoll, 1978b) to depend on the stock's return volatility and the expected duration of the risk exposure. In this paper we recognize that option dealers face an additional dimension of risk as a result of the option's stochastic return volatility and demonstrate that this option characteristic contributes to the cost of liquidity in the options market. Ho and Stoll (1983) show that if the stock return volatility is constant, the specialist's risk exposure per dollar of investment is nonstochastic over the interval during which the inventory is held. In contrast, unless the option dealer is able to trade continuously, an option transaction's contribution to the dealer's risk exposure will be stochastic, since the volatility of an option is a function of both its (stochastic) hedge ratio as well as the underlying stock's return volatility. The problem that arises is particularly clear in the context of a dealer attempting to maintain a delta neutral exposure; a strategy common among market makers in the options markets. Imagine a market maker who simultaneously buys 10 option contracts with a hedge ratio of 1/4 and sells 5

Institutional Ownership and the Liquidity of Common Stock Offerings

Abstract: This paper investigates the extent to which institutional ownership of equity affects the market's response to announcements of new issues of common stock. We find that the absolute magnitude of the share price reaction is negatively related to the level of institutional ownership in the announcing firm. These results are consistent with the argument that the information acquisition activities of institutional investors reduce preannouncement information asymmetries between managers and the capital market.

Reforming the World’s Money

Abstract: In The General Theory, Keynes argued that if an economy was operating at less than full employment, then the nation’s central bank, while maintaining the stability of financial markets, should focus primarily on providing all the liquidity that the economy can absorb in order to reach full employment. For more than a quarter century following World War II, the major central banks around the world tried to meet the role that Keynes had prescribed for them in his General Theory.

Testing for credibility effects

Abstract: Recent techniques designed to draw inferences about the credibility of changes in macroeconomic policy regimes are examined. An alternative two-step approach, based on the decomposition between permanent and transitory components of a "credibility variable," is proposed. The methodology is then used to test for the existence of a credibility effect in the cruzado stabilization plan implemented in Brazil in 1986.

Bank financing and investment decisions with asymmetric information about loan quality

Abstract: Banks know more about the quality of their assets than do outside investors. This informational asymmetry can distort investment decisions if the bank must raise funds from uninformed outsiders. We model the effect of asymmetric information about loan quality on the asset and liability decisions of banks and the market valuation of bank liabilities. The existence of a precautionary demand for riskless securities against future liquidity needs depends on both the regulatory environment and the informational structure. If banks are ex ante identical, they prefer issuing risky debt to fund a withdrawal to holding riskless securities ex ante. If banks have partial knowledge of loan quality, however, high-quality banks may hold riskless securities to signal their quality, enabling them to issue risky debt at a lower interest rate. We present new empirical evidence that banks with higher asset quality do in fact hold more cash and securities.

Are Negative Option Prices Possible? The Callable U.S. Treasury-Bond Puzzle

Abstract: Market prices for callable Treasury bonds often imply negative values for the implicit call option. The author considers a variety of possible explanations for these negative values including the Treasury's track record in calling bonds optimally, tax-related effects, tax-timing options, and bond liquidity. None of these factors accounts for the negative values. Although the costs of short selling may explain why these apparent arbitrage opportunities persist over time, why these implicit call values become negative in the first place remains a puzzle. Copyright 1992 by University of Chicago Press.

LIQUIDITY CONSTRAINTS and AGGREGATE CONSUMPTION BEHAVIOR

Abstract: LIQUIDITY CONSTRAINTS AND AGGREGATE CONSUMPTION BEHAVIOR This paper presents time series evidence on the importance of liquidity constraints in aggregate consumption expenditures. In contrast to previous studies, I find the proportion of consumption attributable to liquidity constrained behavior to be large and highly statistically significant. The estimation pays careful attention to the problems of stochastic consumption and temporal aggregation, and the estimates are shown to be robust to alternative specifications involving costly adjustment of consumption, public spending, and to stochastically varying rates of return. I. INTRODUCTION In his seminal contribution to econometric testing of the permanent income hypothesis (PIH) under rational expectations, Hall [1978] showed that optimal saving behavior would make consumption close to a random walk. Hall found only minor departures from a random walk and concluded that there is little reason to doubt the hypothesis. Hall's work stimulated a vast and growing field of research on the econometric implications of optimal consumption behavior. (See Hall [1987] for references and a recent survey.) Econometric testing has taken two distinct approaches. The "Euler equation" approach employed by Hansen and Singleton [1982; 1983], and Nelson [1987] follows Hall by testing the unpredictability of changes in aggregate consumption. The second approach, followed by Hall and Mishkin [1982], West [1988], Deaton [1987], and Quah [1990], focuses on innovations in income and examines the sensitivity or volatility of consumption implied by the permanent income hypothesis. Flavin's [1981] work falls between these two approaches. Her formal work tests the restrictions of the "Euler equation" approach, but she interprets the magnitude of the rejections in terms of the sensitivity of consumption implied by the time-series process on income. The problem with the first approach is that tests of the orthogonality conditions do not yield a meaningful metric with which to assess the size of the departure from the permanent income hypothesis. The results of the second approach are more directly interpretable, but the estimates are sensitive to assumptions on the stochastic structure of labor income and agents' information sets. This paper adopts the Euler equation approach of Hall [1978] but tests the permanent income hypothesis against a tightly parameterized alternative hypothesis. Following Hayashi [1982], I assume a fixed, but unknown, portion of consumption is accounted for by liquidity constrained agents. Estimating the percentage of liquidity constrained consumption provides a statistically powerful and economically meaningful test of the permanent income hypothesis. The basic model in this paper is quite similar to that in the influential papers by Hayashi [1982] and Flavin [1981]. In contrast to those studies, however, I obtain plausible and highly statistically significant estimates of the percentage of liquidity constrained consumption. The results suggest that from 30 percent to 40 percent of U.S. consumption is accounted for by liquidity constrained consumers. Careful attention is given to the problems of stochastic consumption, temporal aggregation and coefficient instability. Further, the estimates are shown to be robust to alternative specifications involving costly adjustment, Aschauer's [1985] public spending hypothesis, and to stochastically varying rates of return. Flavin's basic point is confirmed -- small departures from the random walk predicted by the permanent income hypothesis could be the result of large structural departures from the permanent income hypothesis. The paper is organized as follows. Section II presents Hall's model of the permanent income hypothesis under rational expectations and updates his basic results. Section III develops the model of liquidity constraints and the estimation strategy employed in this paper. …