Working Papers Abstracts – 1972
The Pricing of Underwritten Offerings and the Compensation of Underwriters (Revised)
Hans R. Stoll
Past studies of new issues and secondary distributions have had two concerns. One has been with the cost of flotation and the efficiency of the underwriter in his market-making function. Another has been with the price effect of the offering and the efficiency of the marketplace in absorbing a large block of stock. Both questions are examined in this paper and an attempt is made to determine whether any relationship exists between flotation cost and prices behavior of underwritten issues.
In an efficient market, large distributions of stock should have no relative price effect other than that associated with information accompanying the offering. An efficient market contains many investors holding securities that are substitutes on the margin. By definition such a market is so large that no individual offering can effect the price merely because of its size. A finding that a large offering has a price effect not ascribable to information implies that the market is not perfectly efficient.
This paper is concerned with inefficiencies in the form of short run liquidity costs. A liquidity cost arises because of the difficulty of finding the other side of a transaction, and this will occur in a world without perfect knowledge where communication takes time and is costly. Such costs may be reflected in the commission charged by an intermediary that engages in a selling effort and is willing to inventory shares at its own risk while the other side is sought. They may also be reflected in a temporary price decline that provides an incentive (in the form of a price increase subsequent to the offering) to other investors to hold the shares, if only on a temporary basis. A lower offering price (and therefore a greater potential price recovery) makes the offering easier to sell and reduces inventory and selling costs.
Empirically the liquidity effect is distinguished from price changes due to information about the fundamental value of the issue by the existence of a price recovery. A price decline may accompany a stock offering either because of the liquidity effect or because of new information. Only under the liquidity effect would one expect a price recovery after the offering, however. Underwriter compensation in the form of a commission (spread) is preferable to compensation in the form of a temporary price deviation since in efficient markets prices should deviate as little as possible from equilibrium.
The analysis of this paper is conducted over a relatively short period of time (20 trading days around the offering date) because emphasis is on the role of the underwriter and the way in which he charges for the services he performs. All issues in the sample were registered with the SEC and therefore most information value accompanying the announcement of the issue is likely to have been reflected in the price prior to the time period examined here.
This paper considers in detail three decision variables of the underwriter — the commission (or spread), the offering price and whether or not the issue should be stabilized — and examines the interrelationships of these variables, given the characteristics of the issue and the market. First, however, the data are described and the price effects and spread are each analyzed separately.
A Model of Capital Asset Risk (revised)
Richardson R. Pettit and Randolph Westerfield
The “market model” of capital asset pricing theory posits that the one-period return on an asset is a linear function of the one-period return on a “market factor” plus the effect of factors that are unique to that asset. The coefficients of the model, estimated using realized returns, can be used for predicting asset returns conditional on market returns, and the slope or “beta” coefficient provides an estimate of the asset’s risk. Though the market model has been applied to a wide variety of capital market studies, and is now being applied by practitioners for assessing asset risk, very little research has been undertaken that attempts to discover the determinants of the beta coefficient.
This paper develops a model to derive and measure the underlying factors used by the market to assess an asset’s beta coefficient and, thus, indicates how conditional predictions from the market model might be improved. In addition, we indicate how traditional asset valuation theory can be integrated with modern capital asset pricing theory to yield an increased understanding of the process of risk assessment. The analysis shows that the market model is an important special case of a more general theory of how asset returns are generated.
Some Aspects of the Performance of Non-Convertible Preferred Stocks
Non-convertible preferred stocks have been the subject of far less discussion than bonds and common stocks. Some of these discussions suggest that preferred stocks combine some features that are inferior to those of bonds with some features that are inferior to those of common stocks. Such discussions suggest that preferred stocks may represent an inferior class of investments relative to bonds and common stocks. However, portfolio theory suggests that every security, including preferred stocks, is an integral part of the market place sine the investor is always adequately compensated for any perceived risk by the return he expects from the security. This paper employs the market model from portfolio theory and a multiple regression analysis to investigate the holding period returns to preferred stocks. In particular, we investigate and quantify some traditional thoughts about the performance of preferred stocks as well as integrate and compare the performance of preferred stock wits with the performance of common stocks of the same company and with the performance of the alternative assets in the market place. Our sample also gives us an opportunity to do some further tests of the empirical strength of the market model.
Should the Two Parameter Capital Market Theories be Extended to Higher Order Moments? (Revised)
Jack Clark Francis
The Simultaneity of Systematic Stock Price Movements (Revised)
Jack Clark Francis
The Value of Information for Investment Decisions
Investment decisions can often be improved when the investor has access to better information. Yet, it may not always be worthwhile to acquire that information when it is costly. The desideratum is a framework for analyzing the trade-off between the benefits and the costs of information relevant to investment decisions. This paper develops a simple Bayesian model of the decision of whether or not to acquire information.
In a world characterized by uncertainty a decision maker does not know with certainty the consequences of his decisions. At best, he can only make decisions which are optimal given the knowledge available at the time of the decision. While this decision can be considered optimal on an ex ante basis, in the sense that it is the expected utility maximizing decision given the knowledge, it may, in fact, not be optimal evaluated ex post, that is, after the fact with the benefit of hindsight.
If the decision maker’s knowledge is characterized by his probability beliefs regarding the consequences of each decision, then we can regard information as the flow of “material” to the decision maker with which her revises his probability beliefs and thereby modifies his stock of knowledge. As more information is made available to the decision maker, his probability beliefs will be more refined and the closer his ex ante decisions will approach the optimal ex post decisions. It is in this sense that information decreases the risks associated with the decision.
Obviously, the investor would like to acquire as much information as possible, yet it is equally obvious that information is costly. There must be a trade off between the costs of information acquisition and the reduction of risks associated with information acquisition. There is a need for framework for the analysis of costly information which allows us to explore the balancing of the benefits information against the costs. This paper will present such a framework and then analyze some of the implications for the investor of the costliness of information.
Some Contributions of the Institutional Investor Study (with “Discussion” by Marshall E. Blume)
Lawrence D. Jones
This paper traces some of the critical standards of analyses and findings produced by the Securities and Exchange Commission’s Institutional Investor Study in its examination of institutional trading of common stocks. First a background description of the nature of the Study and the issues which focused attention upon institutional trading behavior is provided. In reviewing the trading impacts of institutions the paper examines the Study’s analysis of the extent and nature of trading imbalances generated by institutions and the evidence produced from the Study’s several analyses of price effects of institutional trading. From there the paper evaluates the role of institutional trading and of the regulatory structure in affecting the efficiency with which the market making function is performed. Finally, some impacts of the market system upon institutional trading behavior are considered.
Deposit Mix at Commercial Banks and Monetary Policy
Paul F. Smith and Robert C. Jones
Price, Beta and Exchange Listing
Marshall E. Blume and Frank Husic
The Investment Performance of all Institutional Investors: An Initial Appraisal
Marshall E. Blume and Irwin Friend
The Theory of Insurance Reconsidered for Urban Analysis: An Expected Utility Approach (Revised)
Robert H. Edelstein
This essay attempts to explore the demand for and supply of insurance through the use of simplified mathematical models. The theoretical analysis uses an expected utility-portfolio approach in order to derive implications for static equilibrium in the insurance market. In addition to the theoretical models, there are suggested applications of the theory for urban core insurance problems. Some of the major conclusions of the essay are (1) given the apparent risks involved in urban core areas, the government will probably be called upon to be the insurer or re-insurer for significant quantities of property insurance, (2) governmental price regulation in the insurance market is likely to be a partial cause for inadequate urban core coverage, and (3) Fair Access to Insurance Requirements plans (FAIR) and Excess Rates planes either currently in effect or proposed will be non-optimal and inadequate solutions to urban property insurance problems.
Portfolio and Capital Market Theory with Arbitrary Preferences and Distributions: The General Validity of the Mean-Variance Approach in Large Markets
Stephen A. Ross
Using the Capital Asset Pricing Model and the Market Model to Predict Security Returns (Revised)
Richardson R. Pettit and Randolph Westerfield
This paper examines the validity of two widely used methods for forming conditional predicted portfolio returns. The first method relies on a one-period, mean-variance theory of equilibrium expected return, sometimes referred to as the “Capital Asset Pricing Model” (CAPM). The second method is based upon a proposal by Markowitz and is called the “Market Model” (MM).
The market model bears a close resemblance to the ex post version of the capital asset pricing model and both posit a linear relationship between the returns on individual securities and the returns on a portfolio of all assets.
Promoting conditional predictions using one of these two models is advocated in almost every recent treatment of investment performance where conditional predictions of portfolio returns have been needed. These models are apparently gaining acceptance and their ability to formulate expected returns is often assumed. For example, a common use has been to adjusted for market wide effects in the assessment of unusual security returns arising out of an information producing event — such as dividend or earnings announcements. In addition, well known financial institutions have been recommending common stocks with the highest (lowest) slope coefficients estimates or “beta coefficients” dependent on whether above (below) average over-all market returns are anticipated.
Single Parameter Risk Measures and Multiple Sources of Risk: A Re-Examination of the Data Based on Changes in Determinants of Price and Beta Over Time (Revised)
15-72 no symbols
The Valuation of Convertible Bonds: A Further Analysis
James Walter and Augustin Que
The intent of this paper is to supplement previous studies of convertible debentures in at least two respects. One, the specific influence of the so-called bond floor upon the risk premiums associated with convertible debentures is analyzed by reference to the market model developed by Sharpe and Lintner. Two, the effect of involuntary terminations upon the range of possible returns from holding convertible debentures is examined by means of a simulation model.
Under the market model, convertible debentures — like their underlying common shares — are regarded as components of a risky market portfolio. Such assets differ from their underlying stocks in that they may be less responsive to the vicissitudes of the market and may therefore feature smaller risk premiums. The essence of the bond floor in the context of the market model is that it conditions covariability with the market.
Despite the highly useful insights that it affords, the market model cannot cope effectively with the changing responsiveness of convertible debentures to the market (occasioned by varying ratios of stock conversion value to straight bond value) and with the stochastic process by which convertible debentures disappear from the scene. An alternative approach of Monte Carlo simulation is thus introduced to obtain comprehensive forecasts of rates of return on convertible debentures conditional upon the simulated behavior of the underlying stock.
In the treatment that follows, the conventional model is first described for purposes of contrast. The market model and its limitations are then treated. The remaining sections deal with the simulation model, its behavioral inputs, and simulation results.
Dividend Policy Under Imperfect Capital Markets: Revised and Extended Results
Improving the Selection of Credit Risks: An Analysis of a Commercial Bank Minority Lending Program
Robert H. Edelstein
This paper examines the performance of Philadelphia’s eight-bank minority loan program, The Job Loan and Urban Venture Corporation of Philadelphia (JLC), and assesses its ability to select good credit risks from its total minority loan applicant pool. JLC is a non-profit corporation that was created in April, 1968 by eight Philadelphia commercial banks for the purpose of issuing and guaranteeing loans to minority entrepreneurs. Through January 1970 (the time through which the data used in this study were gathered), JLC processed 848 loan applicants, of whom 290 were approved, and received approximately three million dollars in loans.
The key issue explored by this paper – how does a bank differentiate between potentially good and potentially bad credit risks – goes beyond the questions raised by the examination of a single program’s performance. To properly evaluate the JLC program’s ability to select good credit risks, a generalized method for selecting potentially superior loan customers had to be developed. This methodology, as developed here and applied to JLC, has potential applications in other minority-oriented loan programs as well as other non-minority credit operations. Finally, the findings about JLC bear upon a turbulent and extremely important contemporary debate – the viability of black capitalism and the possible role of utilizing private sector capital to finance it.
Risk, Investment Strategy and the Long-Run Rates of Return
Marshall E. Blume and Irwin Friend
Unbiased Estimators of Long-Run Expected Rates of Return
Marshall E. Blume
This paper documents the biases in using sample arithmetic or geometric means of one-period returns to assess long run expected rates of return. The formulae developed are applicable to other compound growth processes. For types of distributions of one period returns likely to be encountered for bonds and stocks, numerical values for these biases are given. Then four unbiased estimators of long run expected rates of return are developed and their relative efficiency examined.
Investment for the Long Run
Harry M. Markowitz
Competitive Commissions on the New York Stock Exchange
Marshall E. Blume and Irwin Friend
In a recent study, we examined in depth the effects of moving from fixed to competitive commissions upon NYSE member firms, investors, market efficiency, and the economy. That study found no persuasive reason to maintain the current fixed rates.
The purpose of this paper is to present some of the more important empirical analyses of our study with particular reference to those results which are based upon the income and expense statements of individual NYSE firms for each of the years 1965-1970. The Securities and Exchange Commission allowed us to use their computer to perform various statistical analyses of these statements. This is the first time that any outside researchers have been given access to these files. The empirical results summarized in this current paper therefore should prove most interesting to students of financial markets.
To provide an initial perspective, the paper begins with an overview of the brokerage industry and a discussion of the more important economic arguments for and against competitive commissions. Following this, cost and profit functions for individual brokerage firms are developed using two different approaches. An analysis of the major ways in which competitive commissions might affect market efficiency is then presented, again with some new statistical results. A brief conclusion ends the paper.