Working Paper Abstracts – 1994

Working Paper Abstracts – 1994


The Capital Asset Pricing Model implies (i) the market portfolio is efficient and (ii) expected returns are linearly related to betas. Many do not view these implications as separate, since either implies the other, but we demonstrate that either can hold nearly perfectly while the other fails grossly. If the index portfolio is inefficient, then the coefficients and R-squared from an ordinary-least-squares regression of expected returns on betas can equal essentially any values and bear no relation to the index portfolio’s mean-variance location. That location does determine the outcome of a mean-beta regression fitted by generalized least squares.


Over the years, scholars from several different fields, including corporate finance, transaction cost economics, and law, have challenged the famous Modigliani & Miller Irrelevance Hypothesis. Under what conditions, they have inquired, does the choice between debt and equity finance affect the firm’s average cost of capital? Although these scholars have made substantial progress in selected areas, no unified theory of corporate finance has yet emerged. This paper proposes a new theory based on what Oliver Williamson has described as the “measurement branch” of transaction cost economics. The valuation hypothesis, as I characterize it, asserts that debt and equity finance reflect the value of the corporate enterprise in various alternative uses. By defining property rights — and residual claimancy — to these value flows, corporate financial claims provide their holders with the incentive to specialize in gathering accurate information about the value of the firm’s intangible assets and thus to avoid the pricing errors that can distort ex ante investment. The resulting improvement in resource allocation maximizes the net value of the firm, or, what amounts to the same thing, minimizes its average cost of capital. According to the valuation hypothesis, moreover, the corporation’s hierarchy of financial claims identifies an overall quasi-rent structure that serves as a real-world proxy for asset specificity that promises to operationalize the specific assets hypothesis. As thus conceived, the valuation hypothesis resolves a number of anomalies in the literature on security, bankruptcy, and corporate reorganizations, and sheds considerable light on the optimal choice of business form.


We present evidence on the objective function of bank management – that is, are they risk neutral and minimize expected profits or are they risk-averse and trade off profit for risk reduction? We extend the model of Hughes and Mester (1993) to allow a bank’s choice of its financial capital level to reflect its preference for return versus risk. A multiproduct cost function, which incorporates asset quality and the risk faced by a bank’s uninsured depositors, is derived from a model of utility maximization. The utility function represents the bank management’s preferences defined over asset levels, asset quality, capital level, and profit. Endogenizing the bank’s choice of capital level in this way permits the demand for financial capital to deviate from its cost-minimizing level. The model consists of the cost function, share equations, and demand for financial capital to deviate from its cost-minimizing level. The model consists of the cost function, share equations, and demand for financial capital equation, which are estimated jointly. We then are able to explicitly test whether bank managers are acting in shareholders’ interest and maximizing expected profits, or whether they are maximizing a utility function that exhibits risk aversion. We believe this is the first such test.


Analyzing data from the 1989 Survey of Consumer Finances, we find credit card borrowing is inversely correlated with a household’s willingness to comparison shop for loans and deposits. Households with larger balances have higher disutility of search, ceteris paribus. In addition, these households are more likely to be rejected or to be granted a lower-than-desired credit limit when applying for new credit, and so may find it difficult to switch from one card issuer to another. This partly explains the stickiness of card interest rates and why issuers enjoy above-average returns despite the industry’s competitive structure.


I use the stochastic econometric cost frontier approach to investigate efficiency of banks operating in the Third Federal Reserve District, which comprises the eastern two-thirds of Pennsylvania, the southern half of New Jersey, and Delaware. The results indicate that, in general, banks in the district are operating at cost-efficient output levels and production mixes. Thus, there appears to be little potential cost savings from banks’ changing their scale or scope of operations. However, I find a significant level of X-inefficiency at the banks, indicating potential cost savings from more efficient use of inputs. The second part of the article relates the inefficiency measures to several correlates.


This paper examines the effects of portfolio insurance on market and asset price dynamics in a general equilibrium continuous-time model. Portfolio insurers are modeled as expected utility maximizing agents in two alternative ways. Martingale methods are employed in solving the individual agents’ dynamic consumption-portfolio problems. Comparisons are made between the optimal consumption processes, optimally invested wealth and portfolio strategies of the portfolio insurers and “normal agents”. At a general equilibrium level, comparisons across economies reveal that the market volatility and risk premium are decreased, and the asset and market price levels increased, by the presence of portfolio insurance.


The U.S. financial markets have been structurally designed to benefit market intermediaries — especially market makers — rather than investors. By limiting the use of technological advancement, these intermediaries have succeeded in perpetuating demand for certain of their services and have thus increased the cost of trade execution. In 1975 Congress charged the SEC with the task of “facilitating” the development of a national market system. What they have created instead is a set of fragmented market centers which are overly costly and technologically obsolescent.

The most critical aspect of fragmentation are the costs that are incurred by the market centers and must be paid by the investor. Some of the associated costs which are inevitable when a number of market centers trade the same securities at the same time include: information system expense; market selection system expense; lobbying and advertising expense; and increased regulatory expense.

To improve the structural soundness of the equity markets we make the following recommendation: First, establish a price/time priority rule in which best bid, first-entered into the trading arena would always have the opportunity to meet the best offer, first-entered. Secondly, issuers would be prohibited from listing their securities on more than one market center at the same time. Instead, all listing contracts would be renegotiable at least every other year. Finally, rules that artificially inflate minimum trading price increments — such as the NYSE’s Rule 62, which mandates minimum price differentials of 12 1/2 cents — should be prohibited. Smaller price differentials, such as those as small as one cent, would maximize price competition, reduce trading costs and eliminate pricing artificialities which make such practices as payment for order flow economic.

The result of these simple changes would be a global, low-cost, electronic auction arena for each issue. Such a system would be able to display the entire supply-demand schedule of each issue to all interested participants, regardless of geographic location and encourage competitive market making.

This would increase market transparency, improve the efficiency and fairness of markets and increase liquidity. International trading would be facilitated in a global automated trading arena. Market makers and other intermediaries would pay lower costs because of more efficient, lower-cost operations. Traders would be able to manage their risk in real time and perform more sophisticated transactions. It is important to keep in mind that “best” execution can only be achieved in a system which guarantees that best bid, first-entered, always has the opportunity to meet the best offer, first-entered.


This paper develops a continuous-time pure exchange model to theoretically study the dynamic consumption-portfolio problem of an agent who acts as a non-price-taker, and to analyze the implications of his behavior on the security prices and their dynamics. The non-price-taking behavior is modeled by allowing the non-price-taker’s consumption stream to affect Arrow-Debreu prices. This allows us to employ martingale methods in a natural way, making the analysis highly tractable. We define non-price-taking equilibrium in an economy of N price-takers and one non-price-taker, and show the existence and uniqueness of this equilibrium under common assumptions about the agents’ utility functions and dividend streams. Solving for the equilibrium consumption allocations reveals the existence of another driving factor apart from the aggregate consumption stream, the endowment stream of the non-price-taker, which leads to modified formulae for the interest rate and the consumption CAPM. We characterize the equilibrium consumption-portfolio allocations, and the Arrow-Debreu and security prices and their dynamics, i.e., the interest rate, market prices of risk, asset price volatility and risk premium. A variety of comparisons of equilibria between a price-taking and a non-price-taking economy are carried out, in some cases for general utility functions and in some cases for CARA utility of all agents. Intuition for the results is offered.


In many stock exchanges around the world there is a “call” or “batch” transaction at the opening of the trading day. Currently, an essential problem in the application of this trading mechanism is that orders in one security cannot be conditioned on prices of other securities. As a result, precise portfolio considerations cannot be based simultaneously on the prices of all securities, and there is no way to trade an asset instantly on the basis of information derived from prices of other securities. Wohl (1994) suggests and analyzes the feasibility of a trading mechanism that facilitates conditioning on an index (a weighted average of stock prices) that is determined simultaneously with the prices of all assets. In this paper we analyze the economic implications of an index-contingent trading mechanism in the framework of rational expectations equilibrium models with liquidity traders. We show that an index-contingent trading mechanism may contribute to the efficiency of prices and to the reduction of losses and risks sustained by liquidity traders. In particular, we compare two trading systems, with and without index-conditioning, and find that in the system with index-conditioning (i) price fluctuations around “true” values are lower, (ii) expected trading costs of liquidity traders are lower, (iii) the variance of the payoffs to the liquidity traders is lower, (iv) the expected utility of informed traders is lower, and (v) the expected volume of trade is higher than in a model without cross-conditioning.


This paper analyzes the effect on equity prices of large-block transactions negotiated ‘upstairs’. We develop a model of the upstairs market which yields testable hypotheses. We investigate these hypotheses with unique data for 5,625 block trades in 1985-1992. Unlike previous studies, all the trades in our data are negotiated upstairs and are identified as either buyer- or seller-initiated. This information is critical because many block trades examined in the previous literature occur downstairs. We find that price movements up to four weeks prior to the trade date are significantly related to trade size, consistent with information leakage as the block is “shopped” upstairs. This suggests that permanent price impacts measured relative to the price on the day preceding the block trade can severely underestimate the information contained in the block trade. The temporary price impact has a concave response to order size, which is consistent with our prediction of more intensive search in the upstairs market as trade size increases. Since our sample consists of mostly small market capitalization stocks, our estimated price impacts are substantially larger than found in previous studies. We also find that the price responses for buyer- and seller-initiated trades are asymmetric.


This paper employs stock market-based data to examine the systematic risk and diversification properties of publicly traded equity real estate investment trusts (REITs). A unique data sample is created by combining firm return data with information on their property type holdings and the location of their investments. A number of interesting findings arise from this work: (1) the systematic risk of equity REITs appears to vary by the type of property in which they invest, with beta being significantly higher for retail-oriented REITs than for REITs owning industrial and warehouse properties; (2) the stock market data provide no evidence that REIT diversification across property types or broad geographic regions actually results in meaningful diversification across property types or broad geographic regions actually results in meaningful diversification as reflected in a standard market-based measure — the R2 from a simple market model regression; and (3) a very simple measure of diversification, the number of properties owned by the REIT, is positively correlated with the R2 from a simple market model regression; a REIT’s stock return variance of total return also is systematically lower the greater the number of properties owned by the firm.


This paper examines the behavior of institutional traders. We use unique data on the equity transactions of 21 institutions of differing investment styles which provide a detailed account of the anatomy of the trading process. The data include information on the number of days needed to fill an order and types of order placement strategies employed. We analyze the motivations for trade, the determinants of trade duration, and the choice of order type. The analysis provides some support for the predictions made by theoretical models, but suggests that these models fail to capture important dimensions of trading behavior.


There is a wide variation in the structure of financial systems in different countries. We compare two idealized polar extremes. In one, which we refer to as the “German model,” banks and other intermediaries predominate. In the other, which we refer to as the “U.S. model,” financial markets play the major role. On the household side, we consider issues such as intergenerational and cross-sectional risk sharing, noise suppression and the provision of services. On the firm side, we consider the allocation of investment, the market for corporate control, the market for internal funds, incentives, monitoring and long term relationships and diversity of opinion.


This paper contains a survey of the literature on dividend policy. We start with a description of the Miller-Modigliani dividend irrelevance proposition and then consider the effect of relaxing the assumptions it is based on. In particular, we consider the role of taxes, asymmetric information, incomplete contracting possibilities and transaction costs.


The firm can be regarded as consisting of several groups of investors and managers whose interests are regulated by the contracts between them. This survey covers the literature that looks at the nature of optimal financial contracts in the face of various asymmetries of information, control and type. Five areas are considered: (i) costly state verification and agency; (ii) adverse selection; (iii) the allocation of control rights among investors and the design of ownership structure; (iv) the allocation of risk and (v) acquisition of information.


This paper empirically examines whether the short-swing rule (Section 16b of the Securities Exchange Act) deters managers from trading before mergers. This rule bars insiders from profiting on round-trip trades completed within a six month period. Around most corporate events, insiders can escape the short-swing rule by selling six months and a day after purchase. However, a merger forces the sale of all the outstanding common stock of the target firm, preventing insider purchases within six months before the merger from escaping this rule. We analyze the trading behavior of top managers of takeover targets before mergers. In order to disentangle the effect of this rule from the deterrent effect of Rule 10b-5, ITSA, ITSFEA and recent case law, we examine the time period from 1941 to 1961, an era when none of these regulations was enforced. We find that managers of target firms reduce their purchases before the merger announcement below their normal level of purchases and relative to a control sample of non-target firms. This evidence is consistent with a deterrent effect on Section 16b. We find that managers reduce their purchases before the merger completion only in the first half of our sample period. Surprisingly, managers do not reduce their sales before the announcement, even though 16b cannot punish deferral of planned sales. Despite a variety of tests, we are unable to resolve this puzzle.


A recent paper (Benninga-Protopapadakis 1994) considered a Lucas asset pricing model and showed that the pricing of forward and futures contracts was expressible as a simple matrix function. In this paper we derive limiting conditions for these differences and relate them to the eigenvectors of the state price matrix. We show that except for a zero-measure set of state price matrices, the differences are always small.


In the presence of transactions costs, no matter how small, arbitrage activity does not necessarily render equal all riskless rates of return. When two such rates follow stochastic processes, it is not optimal immediately to arbitrage out any discrepancy that arises between them. The reason is that immediate arbitrage would induce a definite expenditure of transactions costs whereas, without arbitrage intervention, there exists some, perhaps sufficient, probability that these two interest rates will come back together without any costs having been incurred. Hence, one can surmise that at equilibrium the financial market will permit the coexistence of two riskless rates which are not equal to each other. For analogous reasons, randomly fluctuating expected rates of return on risky assets will be allowed to differ even after correction for risk, leading to important violations of the Capital Asset Pricing Model. The combination of randomness in expected rates of return and proportional transactions costs is a serious blow to existing frictionless pricing models.


We consider a model of the stock market with delegated portfolio management. All agents are rational: some trade for hedging reasons, some investors optimally contract with portfolio managers who may have stock-picking abilities, and portfolio managers trade optimally given the incentives provided by this contract. Managers try, but sometimes fail, to discover profitable trading opportunities. Although it is best not to trade in this case, their clients cannot distinguish “actively doing nothing,” in this sense, from “simply doing nothing.” Because of this problem: (i) some portfolio managers trade even though they have no reason to prefer one asset to another (noise trade). We also show that, (ii), the amount of such noise trade can be large compared to the amount of hedging volume. Perhaps surprisingly, (iii), noise trade may be Pareto-improving. Noise trade may be viewed as a public good. Results (i) and (ii) are compatible with observed high levels of turnover in securities markets. Result (iii) illustrates some of the possible subtleties of the welfare economics of financial markets.


This paper develops a structural model of intraday price formation that embodies both public information shocks and microstructure effects. Due to its structural nature, the model’s underlying parameters provide summary measures to asset trading costs, the sources of short-run price volatility, and the speed of price discovery in an internally consistent, unified setting. We estimate the model using transaction level data for a cross-section of NYSE stocks. We find, for example, that the parameter estimates jointly explain the observed U-shaped pattern in quoted bid-ask spreads and in price volatility, the magnitude of transaction price volatility due to market frictions, and the autocorrelation patterns of transaction returns and quote revisions. Further, in contrast to bid-ask spread patterns, we find that execution costs of a trade are much smaller than the spread and increase monotonically over the course of the day. This may provide an explanation for why there is concentration in trade at the open.


A number of studies have presented evidence rejecting the validity of the Capital Asset Pricing Model (CAPM). This evidence has spawned research into possible explanations. These explanations can be divided into two main categories — the risk-based alternatives and the nonrisk-based alternatives. The risk-based category includes multifactor asset pricing models developed under the assumptions of investor rationality and perfect capital markets. The nonrisk-based category includes biases introduced in the empirical methodology, the existence of market frictions, or explanations arising from the presence of irrational investors. The distinction between the two categories is important for asset pricing applications such as estimation of the cost of capital. This paper proposes to distinguish between the two categories using ex ante analysis. A framework is developed showing that ex ante one should expect that CAPM deviations due to missing risk factors will be very difficult to empirically detect. In contrast, deviations resulting from nonrisk-based sources will be easy to detect. Examination of empirical results leads to the conclusion that the risk-based alternatives is not the whole story for the CAPM deviations. The implication of this conclusion is that the adoption of empirically developed multifactor asset pricing models may be premature.


Recent empirical findings suggest that equity returns are predictable. These findings document persistent cross-sectional and time series patterns in returns that are not predicted by extant theory, and are, therefore, often classified as anomalies. In this paper we synthesize the evidence on predictable returns, focusing on the subset of the findings whose existence has proved most robust with respect to both time and the number of stock markets in which they have been observed.


This paper develops and tests the notion that it is possible to use the post-announcement prices from the stock and option markets to infer both the probability of success and timing of an attempted takeover. Using a sample of 65 cash tender offers from the period January 1980 to July 1989, we demonstrate that the sequence of implied stock volatilities generated from the options of the target firm expiring both before and after the resolution date of the proposed deal exhibit a pattern strongly consistent with the hypothesis that prices are set in anticipation of the eventual outcome. We conclude that traders in the market for takeover candidates behave in a rational manner, although with less-than-perfect foresight.


Assets and liabilities management practices currently in use are reviewed. Some of the improvements currently under development are presented. Potential problems in the application of current ALM techniques to universal banks are considered.


An approximate solution to the American put value is proposed and implemented numerically. Relaxation techniques enable the critical price to be determined with high accuracy. The method uses a modification of the quadratic approximation of MacMillan and Barone-Adesi and Whaley which gives an expression for the critical price. Numerical experimentation and iterative methods quickly provide highly accurate solutions.


We examine the magnitude and determinants of execution costs are associated with institutional equity trades and their effect on investment performance. Using detailed information on over $83 billion of recent equity transactions by 21 institutions, we analyze the major components of execution costs, including explicit and implicit costs. We find that execution costs are significantly related to trade size, exchange listing, and the traded stock’s market capitalization. We also find that buyer-initiated trades are more costly than equivalent seller-initiated trades. Our results indicate that execution costs have a significant effect on performance over short horizons, and there is significant variation in trading costs and performance across institutions, reflecting differences in trading ability and style. The results provide a way to assess various trading strategies and to form benchmarks to evaluate portfolio managers.


Sample evidence about the predictability of monthly stock returns is considered from the perspective of an investor allocating funds between stocks and cash. A regression of stock returns on a set of predictive variables might seem weak when described by usual statistical measures, but such measures can fail to convey the economic significance of the sample evidence when it is used by a risk-averse Bayesian investor to update prior beliefs about the regression relation and to compute an optimal asset allocation. Even when those prior beliefs are weighted substantially against predictability, the current values of the predictive variables can exert a strong influence on the portfolio decision.


The threat of takeover acts to discipline managers and so reduces the agency problems between managers and shareholders. But it also makes shareholder assurances to managers less reliable and so interfered with contracting between them. These two effects have opposing implications about the level of executive compensation: the disciplinary effect implies a reduction in compensation; the contracting effect implies an increase. Which of the two effects dominates is an empirical issue. We examine the relation between managerial compensation and the (industry-wide) threat of takeover to address this issue. Using compensation data for the CEOs of over 500 firms and after controlling for other determinants of executive compensation found in prior studies, we find a consistently positive effect of the threat of takeover, indicating that the contracting effect dominates. The magnitude of this net contracting effect is economically significant. A 10% increase in the annual probability of takeover from 4.6% to 5.06% results in an increase of $7,300 in the typical CEO’s annual salary plus bonus and an increase of $10,100 in his annual total compensation. Among CEOs without golden parachutes, this increase is even larger at $11,200 in salary plus bonus and $15,000 in total compensation. We also find a direct positive direct effect of the presence of a golden parachute on CEO compensation. These results do not seem to be driven by industry effects and are robust to alternative specifications. Together, they provide evidence on an important way in which the market for corporate control affects internal contracting and add to the growing literature on the determinants of the level of executive compensation.


This paper examines firms’ choice of the mix of mechanisms used to reduce agency problems between managers and shareholders. We empirically address two questions. First, is there interdependence between the use of the various “control mechanisms”? Second, does cross-sectional evidence suggest that firms fail to adjust their use of these control mechanisms optimally? We consider the use of seven control mechanisms in a sample of nearly 400 large U.S. firms. These mechanisms are: shareholdings of insiders, institutions, and large blockholders; use of outside directors; debt policy; the labor market for managers; and the market for corporate control. We present two main empirical findings. First, there is evidence of interdependence among the use of these mechanisms. Second, given this interdependence, cross-sectional OLS regressions of single mechanisms on firm performance can be misleading. Like prior studies, we find a positive effect of insider shareholding on firm performance when insider shareholding is examined alone. However, this effect disappears when all of the mechanisms are included in an OLS estimation and when the relation is estimated within a systems framework. We also find a negative effect of a larger fraction outside directors, greater debt, and more activity in the market for corporate control on firm performance in OLS estimations, but only the negative effect of board composition persists in the systems framework. The lack of a relation between insider shareholding and firm performance in the more inclusive estimations is consistent with the argument in Demsetz and Lehn (1985) that firms choose ownership structures optimally. In contrast, the persistent negative relation between board composition and firm performance suggests that boards contain too many outsiders.