Knowledge that Transforms

The incorporation of diverse information into asset prices is empirically examined in an actual securities market with multiple rounds of trade. Using prices of Israeli index and nominal bonds of equal maturity, we calculate implied expectations of inflation that has already occurred but for which the official statistic has not yet been announced. Learning is defined as the convergence of these expectations to the actual level of inflation in the period after the end of the month but before the announcement of the official statistic. We find that the variance of the inflation expectation errors decreases with trading days in this period. The decline in the variance suggests that investors learn, by repeatedly observing prices, about the distribution of other investors' information. We also find a positive relation between the dispersion of relative price changes and the size of the inflation‐expectation errors on the first round of trade. The correlation diminishes as investors learn about the distribution of inflation information in the economy.

I characterize the optimal design of a new futures market (an innovation) by an exchange in the presence of market frictions. Futures markets are characterized by both the contract and the level of trader participation; both can be determined by an exchange. A game in which exchanges simultaneously design markets is considered, and a particular equilibrium (not necessarily unique) is constructed. A game in which exchanges sequentially design markets (and incur design costs) is also considered and the (generically unique) equilibrium is constructed. The nature of equilibrium with multiple exchanges is discussed in these simultaneous and sequential settings, illustrating the role played by liquidity considerations both in market design and in the nature of competition between exchanges.

In this article we derive necessary and sufficient conditions that must be satisfied by equilibrium asset price processes in a pure exchange economy. We examine a world in which asset prices follow a diffusion process, asset markets are dynamically complete, all investors maximize their (state-independent) expected utility of consumption at some future date, and investors have nonrandom exogenous income. We show that it is necessary and sufficient that the coefficients of an equilibrium diffusion price process satisfy a partial differential equation and a boundary condition. We also examine how the dynamics of asset prices are related to the shape of the representative investor's utility function through the boundary condition. For example, in a constant-volatility economy, the expected instantaneous return of the market portfolio is mean reverting if and only if the relative risk aversion of the representative investor is decreasing in terminal wealth.

The incorporation of diverse information into asset prices is empirically examined in an actual securities market with multiple rounds of trade. Using prices of Israeli index and nominal bonds of equal maturity, we calculate implied expectations of inflation that has already occurred but for which the official statistic has not yet been announced. Learning is defined as the convergence of these expectations to the actual level of inflation in the period after the end of the month but before the announcement of the official statistic. We find that the variance of the inflation expectation errors decreases with trading days in this period. The decline in the variance suggests that investors learn, by repeatedly observing prices, about the distribution of other investors' information. We also find a positive relation between the dispersion of relative price changes and the size of the inflation‐expectation errors on the first round of trade. The correlation diminishes as investors learn about the distribution of inflation information in the economy.

We study a dynamic model where uncertainty about interim output adjustments causes producers to face price, cost and output uncertainty. Stochastically separable production decisions are independent of the producer’s risk preferences and expectations and are based on the prevailing futures price as a certain output price. Conditions under which futures contracts achieve stochastic separation are established. Optimal hedging and maturity structure of futures contracts, equilibrium futures prices, and the effects of futures trading on output are studied. The systematic risk premium depends on the product of the futures beta and the covariance of the market return with production revenues.

We explore the dynamics of a takeover bid. In contrast to preceding models, if the initial takeover bid is unsuccessful a raider is allowed to make a new tender offer in order to try and secure the remaining shares. Numerical analysis shows that the raider’s tender offer rises over time as he accumulates more shares. The anticipation of a higher tender offer in the future makes shareholders more inclined to hold their shares and forces the raider to offer a higher premium than is predicted by static theories. As the time between tender offers goes to zero, we show analytically that the expected profit from engaging in a takeover goes to zero.

We test the theory of the term structure of indexed-bond prices due to Cox, Ingersoll, and Ross (CIR). The econometric method uses Hansen’s generalized method of moments and exploits the probability distribution of the single-state variable in CIR’s model, thus avoiding the use of aggregate consumption data. It enables us to estimate a continuous-time model based on discretely sampled data. The tests indicate that CIR’s model for index bonds performs reasonably well when confronted with short-term Treasury-bill returns. The estimates indicate that term premiums are positive and that yield curves can take several shapes. However, the fitted model does poorly in explaining the serial correlation in real Treasury-bill returns.

Corporate debt sales have been regarded as “no news” events because there is no significant price reaction on average to their announcement. We explore the hypothesis that this lack of average price reaction to debt sale announcements is explained by the partial anticipation of debt offers. Theory suggests that the demand for debt capital is fundamentally related to changes in the sources and uses of funds, and we find evidence that earnings are significantly lower, investment growth is significantly higher, and, for some issuers, debt refunding requirements are significantly greater in the period immediately prior to issue than in periods well before and after the issue. We find that this preissue information conditions investors’ expectations of issue, thereby affecting the cross-sectional announcement date price reaction to debt sales in two ways. First, announcement date price reactions are negative, on average, for unanticipated offers or for those offers where prior information suggests that an issue is unlikely. Second, holding the probability of issue constant, announcement date price reactions are significantly more negative for offers that raise more capital than investors expected. These results are consistent with cash flow signaling and asymmetric information models of corporate financings.

We study firms signaling with cash disbursements and show that the choice of a deterministic or a stochastic disbursement depends on a property of the firm’s production function that is analogous to absolute risk aversion for a utility function. With decreasing (increasing) absolute risk aversion, the high-quality firm prefers to distinguish itself from the low-quality firm with a stochastic (deterministic) outlay. We then study in detail two common forms of corporate cash distributions: dividends, a deterministic disbursement, and share repurchases, a stochastic disbursement.

Corporate debt sales have been regarded as “no news” events because there is no significant price reaction on average to their announcement. We explore the hypothesis that this lack of average price reaction to debt sale announcements is explained by the partial anticipation of debt offers. Theory suggests that the demand for debt capital is fundamentally related to changes in the sources and uses of funds, and we find evidence that earnings are significantly lower, investment growth is significantly higher, and, for some issuers, debt refunding requirements are significantly greater in the period immediately prior to issue than in periods well before and after the issue. We find that this preissue information conditions investors’ expectations of issue, thereby affecting the cross-sectional announcement date price reaction to debt sales in two ways. First, announcement date price reactions are negative, on average, for unanticipated offers or for those offers where prior information suggests that an issue is unlikely. Second, holding the probability of issue constant, announcement date price reactions are significantly more negative for offers that raise more capital than investors expected. These results are consistent with cash flow signaling and asymmetric information models of corporate financings.