# Working Paper Abstracts – 1995

**01-95**

In response to the 1975 Congressional call for a national market system to provide a transparent link across individual markets that trade NYSE-listed stocks, the SEC caused the implementation of three electronic systems that provide a partial integration of these markets. This partial integration together with the trading process on the NYSE floor has created market niches in which non-NYSE markets can prosper. Empirically, the bid and asked prices of the NYSE quote are the primary determinant of the best displayed prices. Non-NYSE markets attract a significant portion of their volume for reasons other than matching or bettering the NYSE quote, such as “payment for order flow.” This fragmentation of trading is a logical outgrowth of the SEC-imposed partial integration and the trading process on the NYSE floor.

**02-95**

We develop a method of measuring ex-ante real interest rate using prices of index and nominal bonds. Employing this method and newly available data, we directly test the Fisher hypothesis that the real rate of interest is independent of inflation expectations. We find a negative correlation between ex-ante real interest rates and expected inflation. This contradicts the Fisher hypothesis but is consistent with the theories of Mundell and Tobin, Darby and Feldstein, and Stulz. We also find that nominal interest rates include an inflation risk premium that is positively related to a proxy for inflation uncertainty.

**03-95**

Microdata studies of household saving often find a significant group in the population with virtually no wealth, rising concerns about heterogeneity in motives for saving. In particular, this heterogeneity has been interpreted as evidence against the life-cycle model of saving. This paper argues that a life-cycle model can replicate observed patterns in household wealth accumulation after accounting explicitly for precautionary saving and asset-based means-tested social insurance. We demonstrate theoretically that social insurance programs with means tests are based on assets discourage saving by households with low expected lifetime income. In addition, we evaluate the model using a dynamic programming model with four state variables. Assuming common preference parameters across lifetime-income groups, we are able to replicate the empirical pattern that low-income households are more likely than high-income households to hold virtually no wealth. Low wealth accumulation can be explained as a utility-maximizing response to asset-based means-tested welfare programs.

**04-95**

This paper examines the individual’s consumption and investment problem when labor income follows a general bounded process and the dollar amounts invested in the risky assets are constrained to take values in a given nonempty, closed, convex cone. Short sale constraints, as well as incomplete markets, can be modeled as special cases of this setting. Existence of optimal policies is established using martingale and duality techniques under fairly general assumptions on the security price coefficients and the individual’s utility function. This result is obtained by reformulating the individual’s dynamic optimization problem as a dual static problem over a space of martingales. An explicit characterization of equilibrium risk premia in the presence of portfolio constraints is also provided. In the unconstrained case, this characterization reduces to Consumption-based Capital Asset Pricing Model.

**05-95**

The returns of assets that are traded on financial markets are more volatile than the returns offered by intermediaries such as banks and insurance companies. This suggests that individual investors are exposed to more risk in countries which rely heavily on financial markets. In the absence of a complete set of Arrow-Debreu securities, there may be a role for institutions that can smooth asset returns over rime. In this paper, we consider one such mechanism. We present an example of an economy in which the incompleteness of financial markets leads to underinvestment in reserves whereas the optimum, for a broad class of welfare functions, requires the holding of large reserves in order to smooth asset returns over time. We then argue that a long-lived intermediary may be able to implement the optimum. However, the position of the intermediary is fragile; competition from financial markets can cause the intertemporal smoothing mechanism to unravel, in which case the intermediary will do no better than the market.

**06-95**

In the last ten to fifteen years financial derivative securities have become an important, and controversial, product for commercial banks. The controversy concerns whether the size, complexity, and risks associated with these securities, the difficulties with accurately reporting timely information concerning the value of firms’ derivative positions, and the concentration of activity in a small number of firms, has substantially increased the risk of collapse of the world banking system. Despite the widespread attention to derivatives, there has been little systematic analysis. We estimate the market values and interest-rate sensitivity of interest rate swap positions of U.S. commercial banks to empirically address the question of whether swap contracts have increased or decreased systemic risk in the U.S. banking system. We find that the banking system as a whole faces little net interest-rate risk from swap portfolios.

**07-95**

This paper develops a continuous-time pure-exchange model to 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 equilibrium security price dynamics. The non-price-taker is modeled as a price leader in all markets; his price impact is then recast as an effect of consumption on the Arrow-Debreu prices, allowing the use of martingale methods in a tractable way. Besides the aggregate consumption, the endowment stream of the non-price-taker appears as an additional factor in driving the equilibrium allocations and prices. Comparisons of equilibria between a price-taking and a non-price-taking economy are carried out.

**08-95**

This paper develops an intertemporal model of international capital market segmentation. Within the model, under various forms of segmentation/integration, the equilibrium asset prices and allocations, the risk-free interest rate, and the intertemporal consumption behavior and welfares of two countries are derived and compared. It is shown that the equilibrium interest rate is increased on integration, and that integrating markets may be significantly welfare decreasing for one of the countries. Conditions that may lead to a decrease in welfare are investigated. The conclusions as to the effects of segmentation on asset prices in the mean-variance model of the existing finance segmentation literature are also shown to break down in an intertemporal model.

**09-95**

This paper examines the execution costs and investment performance of $83 billion of recent equity transactions by 21 institutional traders. These traders are of particular interest because we have detailed information on the order submission strategy adopted by traders with different investment styles. We analyze the major components of execution costs, including explicit and implicit costs. Execution costs are substantial relative to investment performance and are positively related to measures of trade difficulty. Trading systems differ in their ability to accommodate large trades; orders in exchange-listed stocks generally have a lower price impact than in comparable NASDAQ stocks. There is substantial 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.

**10-95**

There is a substantial empirical literature, beginning with Fama [1975], that utilizes regressions of the inflation rate in a given period on initial interest rates (or inflation differentials on the slope of the initial yield curve) to test the Fisher hypothesis and/or to provide forecasts of inflation. Both uses depend critically on the maintained hypothesis that asset market prices fully incorporate all relevant current information about future yields. This paper will investigate the plausibility of the rational expectations hypothesis for real returns in markets for one-period default-free bonds, will show that under normal macroeconomic assumptions it cannot be expected to hold, and will consider the consequences of its failure for the interpretation of empirical results.

**11-95**

This paper investigates the properties of contingent claim prices in a one dimensional diffusion world and establishes that (i) the delta of any claim is bounded above (below) by the sup (inf) of its delta at maturity, and (ii), if its payoff is convex (concave) then its current value is convex (concave) in the current value of the underlying. These properties are used as the foundation for a detailed study of the properties of option prices. Interestingly, although an upward shift in the term structure of interest rates will always increase a call’s value, a decline in the present value of the exercise price can be associated with a decline in the call price. We provide a new bound on the values of calls on dividend-paying assets. We establish that when the underlying’s instantaneous volatility is bounded above (below), the call price is bounded above (below) by its Black-Scholes value evaluated at the bounding volatility level. This leads to a new bound on a call’s delta. We also show that if changes in the value of the underlying follow a multidimensional diffusion (i.e., a stochastic volatility world), or are discontinuous or non-Markovian, then call option prices can exhibit properties very different from those of a Black-Scholes world: they can be decreasing, concave functions of the value of the underlying.

**12-95**

This paper presents a characterization of callable bond pricing and call decision when there are transactions costs. When a capital structure is kept constant a firm that has outstanding callable bonds refinances them with similarly structured callable bonds. Since refinancing is costly, firms will delay the call decision. Given that the firm’s cash flows differ from investors’ cash flows, the valuation of the callable bond will be different for the firm and for the investors. We find that the investors’ valuation function exhibits three important empirical regularities for low interest rates: Inverse convexity, negative duration and market prices higher than call prices. In the region between the next optimal refinancing rate and the first time that the price of the bonds equals the call price, the market valuation of the bonds has a hump.

To simplify the problem we have assumed that the firm will replace the outstanding bond with an identically structured bond. Because the firm will be replacing a seasoned bond with a new one, it will be pasting a function with itself at two different maturities. A head for the new issue and a tail for the seasoned bond. By following this procedure we collapse into a single step the problem of figuring out when to replace a callable bond with another callable bond that needs to be priced before pricing the former. This exchange of bond will occur at a lower rate than the normal call rate when cash in hand is used. Small transaction costs may justify waiting past the call price if the firm wants to keep a callable bond in its capital structure.

We conclude that transaction costs alone may be enough to explain the overvaluation of callable bonds with respect to the call price. We use a general one-factor interest rate process in continuous time that nests most of the popular one-factor interest rate models used by researchers and practitioners.

**13-95**

This paper examines empirically whether the short-swing rule (Section 16b of the Securities Exchange Act) deters managers from trading before mergers. Since a merger forces the sale of the target’s outstanding equity, insider purchases within six months before the merger cannot escape this rule. We examine the 1941-61 period when no other insider trading laws were enforced. Consistent with 16b’s deterrent effect, managers’ purchases drop significantly before the announcement. Before completion, the decrease occurs only in the 1941-55 period. Surprisingly, pre-announcement sales do not decline, even though 16b cannot punish deferral of planned sales.

**14-95**

This paper discusses the commonly used methods for testing option pricing models, including the Black-Scholes, constant elasticity of variance, stochastic volatility, and jump-diffusion models. Since options are derivative assets, the central empirical issue is whether the distributions implicit in option prices are consistent with the time series properties of the underlying asset prices. Three relevant aspects of consistency are discussed, corresponding to whether time series-based inferences and option prices agree with respect to volatility, changes in volatility, and higher moments. The paper surveys the extensive empirical literature on stock options, options on stock index futures, and options on currencies and currency futures.

**15-95**

Capital investment decisions must recognize the limitations on the firm’s ability to later sell off or expand capacity. This paper shows how opportunities for future expansion or contraction can be valued as options, how this valuation relates to the q-theory of investment, and how these options affect the incentive to invest. Generally, the option to expand reduces the incentive to invest, while the option to disinvest raises it. We show how these options interact to determine the effect of uncertainty on investment, how these option values change in response to shifts of the distribution of future profitability, and how the q-theory and option pricing approaches to investment are related.

**16-95**

In a capitalist economy prices serve to equilibrate supply and demand for goods and services, continually changing to reallocate resources to their most efficient uses. However, secondary stock market prices, often viewed as the most “informationally efficient” prices in the economy, have no direct role in the allocation of equity capital since mangers have discretion in determining the level of investment. What is the link between stock price informational efficiency and economic efficiency?

We present a model of the stock market in which: (i) managers have discretion in making investments and must be given the right incentives; and (ii) stock market traders may have important information that managers do not have about the value of prospective investment opportunities. In equilibrium, information in stock prices will guide investment decisions because managers will be compensated based on informative stock prices in the future.

The stock market indirectly guides investment by transferring two kinds of information: information about investment opportunities and information about managers’ past decisions. The fact that stock prices only have an indirect role suggests that the stock market may not be a necessary institution for the efficient allocation of equity. We emphasize this by providing an example of a banking system that performs as well.

**17-95**

We study whether the socially optimal level of stability of the banking system can be implemented with regulatory capital requirements in a multi-period general equilibrium model of banking. We show that: (i) bank capital is costly because of the unique liquidity services provided by demand deposits, so a bank regulator may optimally choose to have a risky banking system; (ii) even if the regulator prefers more capital in the system, the regulator is constrained by the private cost of bank capital, which determines whether bank shareholders will agree to meet capital requirements rather than exit the industry.

**18-95**

In its attempt to integrate the trading of NYSE-listed stocks across market places, the SEC has caused the implementation of three electronic systems which provide a partial integration of these markets. The paper analyzes the implications of this partial integration and shows how it has created market niches in which non-NYSE markets can prosper. The empirical analysis shows: The bid and asked prices of the NYSE quote equal the best prices displayed across all markets most of the time. Non-NYSE markets attract a significant portion of their volume for reasons other than matching or bettering the NYSE quote, such as “payment for order flow.” When non-NYSE markets post better bids or offers, they do attract additional order flow, but substantial order flow still flows to other markets. In posting better bids or offers, non-NYSE markets do contribute to “price discovery.”

**19-95**

Discrete time stochastic volatility models (hereafter SVOL) are noticeably harder to estimate than the successful ARCH family of models. Recent advances in the literature now make it possible to produce efficient estimation and prediction for a basic univariate SVOL model. However, the basic model may be insufficient for numerous economics and finance applications. In this paper, we develop methods for finite sample inference, smoothing, and prediction for a number of univariate and multivariate SVOL models. Specifically, we model fat-tailed and skewed conditional distributions, correlated errors distributions (leverage effect), and two multivariate models, a stochastic factor structure model and a stochastic discount dynamic model. We apply some of these extensions to financial series. We find (1) strong evidence of non-normal conditional distributions for stock returns and exchange rates, and (2) evidence of correlated errors for stock returns. These departures from the basic model affect the measured persistence and hence the prediction of volatility. This result as a policy implication on decisions and models such as asset allocation and option pricing which inputs are prediction of volatility.

We specify the models as a hierarchy of conditional distributions: p(data | volatilities), p(volatilities | parameters) and p(parameters). Given a model and the data, inference and prediction are based on the joint posterior distribution of the volatilities and the parameters which we simulate via Markov chain Monte Carlo (hereafter MCMC) methods. This approach also provides a sensitivity analysis for parameter inference and an outlier diagnostic. The hierarchical framework is a natural environment for the construction of SVOL models departing from the standard distributional assumptions.

**20-95**

A genetic algorithm is used to learn technical trading rules for Standard and Poor’s composite stock index using data from 1963-69. In the out-of-sample test period 1970-1989 the rules are able to identify periods to be in the index when returns are positive and volatility is low and out when the reverse is true. Compared to a simple buy-and-hold strategy, they lead to positive excess returns after transaction costs in the period of 1970-89. Using data for other periods since 1929, the rules can identify high returns and low volatility but do not lead to excess returns after transaction costs. The results are compared to benchmark models of a random walk, an autoregressive model, and a GARCH-AR model. Bootstrapping simulations indicate that none of these models of stock returns can explain the findings.

**21-95**

When investment decisions cannot be reversed and returns to capital are uncertain, the firm faces a higher user cost of capital than if it could reverse its decisions. This higher user cost tends to reduce the firm’s capital stock. Opposing this effect is the irreversibility constraint itself: when the constraint binds, the firm would like to sell capital but cannot. This effect tends to increase the firm’s capital stock. We show that a firm with irreversible investment may have a higher or a lower expected capital stock, even in the long run, compared to an otherwise identical firm with reversible investment. Furthermore, an increase in uncertainty can either increase or decrease the expected long-run capital stock under irreversibility relative to that under reversibility. However, changes in the expected growth rate of demand, the interest rate, the capital share in output, and the price elasticity of demand all have unambiguous effects.

**22-95**

This paper presents a characterization of callable bond pricing and call decision when there are transactions costs. To keep capital structure constant a firm that has outstanding callable bonds refinances them with similarly structured callable bonds. Since refinancing is costly, firms will delay the call decision. Given that the firm’s cash flows differ from investors’ cash flows by transaction costs, the valuation of the callable bond will be different for the firm and for investors. We find that investors’ valuation function exhibits three important empirical regularities for low interest rates: Inverse convexity, negative duration and market (investors’) prices higher than call prices. In addition, for low interest rates, the market valuation of the bonds has a hump.

We have assumed that the firm will replace the outstanding bond with an identically structured bond in order to simplify the problem of analyzing multiple refundings. The firm will be replacing a seasoned bond with a new one. It will therefore be pasting a pricing function with itself at two different times to expiration. We can say that the new issue is the head and the seasoned bond the tail because it is at the end of its life. Following this procedure we collapse into a single step the problem of figuring out when to replace a callable bond with another callable bond that needs to be priced before pricing the former. This exchange of bond will occur at a lower rate than the normal call rate when cash in hand is used. Small transaction costs will justify waiting past the call price if the firm wants to keep a callable bond in its capital structure. Replacing a callable bond with another callable bond also allows the analysis of multiple future refundings.

We conclude that transaction costs alone may be enough to explain the overvaluation of callable bonds with respect to the call price. We use a general one-factor interest rate process in continuous time that nests most of the popular one-factor interest rate models used by researchers and practitioners.

By comparing the refunding characteristics for two different alternatives we shed light into the problem of optimal capital structure. When refunding is costly, the indifference among funding sources disappears. Once an alternative source has been chosen, the firm is in a sense locked to that source because it is costly to change. The firm will therefore choose a capital structure that will minimize refunding costs. Transaction costs make capital structure irreversible, implying that capital structure matters.

**23-95**

It is often stated that bidders acquire poorly-run targets in order to improve firm performance. This inefficient management hypothesis is frequently tested by examining target stock returns in the years prior to an acquisition. While the hypothesis is commonly assumed in the literature to be true, previous papers generally do not show significantly negative returns for targets in the years prior to acquisition. Our paper re-examines this issue thoroughly with a number of methodological improvements and a large sample of acquisitions over the period from 1930 to 1987. Although we find insignificant abnormal returns over the four years prior to the acquisition announcement, a result consistent with the previous literature, the abnormal returns are significantly negative when a longer time period prior to acquisition is used. Our results suggest that takeovers discipline managers, but with a delay that may protect them through much of their normal tenures.