Knowledge that Transforms

This study analyzes the effects of changes in S&P 500 index composition from January 1986 through June 1994, a period during which Standard and Poor's began its practice of preannouncing changes five days beforehand. The new announcement practice has given rise to the “S&P game” and has altered the way stock prices react. We find that prices increase abnormally from the close on the announcement day to the close on the effective day. The overall increase is greater than under the old announcement policy although part of the increase reverses after the stock is included in the index.

This paper examines a new database that details corporate risk management activity in the North American gold mining industry. I find little empirical support for the predictive power of theories that view risk management as a means to maximize shareholder value. However, firms whose managers hold more options manage less gold price risk and firms whose managers hold more stock manage more gold price risk, suggesting that managerial risk aversion may affect corporate risk management policy. Further, risk management is negatively associated with the tenure of firms' CFOs, perhaps reflecting managerial interests, skills, or preferences.

We study a new class of unconditional and conditional mean‐variance spanning tests that exploits the duality between Hansen‐Jagannathan bounds (1991) and mean‐standard deviation frontiers. The tests are shown to be equivalent to standard spanning tests in population, but we document substantial differences in the small sample performance of alternative tests. Our empirical application examines the diversification benefits from emerging equity markets using an extensive new data set on U.S. and U.K.‐traded closed‐end funds. We find significant diversification benefits for the U.K. country funds, but not for the U.S. funds. The difference appears to relate to differences in portfolio holdings rather than to the behavior of premiums in the United States versus the United Kingdom.

This study investigates the behavior of the components of the bid‐ask spread around earnings announcements. We find that the adverse selection cost component significantly increases surrounding the announcements, while the inventory holding and order processing components significantly decline during the same periods. Our results suggest that the directional change in the total bid‐ask spread depends on the relative magnitudes of the changes in these three components. Specifically, the decreases in inventory holding costs and order processing costs imply that earnings announcements may have an insignificant impact on the total bid‐ask spread, even when they result in increased information asymmetry.

Canonical valuation uses historical time series to predict the probability distribution of the discounted value of primary assets' discounted prices plus accumulated dividends at any future date. Then the axiomatically‐rationalized maximum entropy principle is used to estimate risk‐neutral (equivalent martingale) probabilities that correctly price the primary assets, as well as any predesignated subset of derivative securities whose payoffs occur at this date. Valuation of other derivative securities proceeds by calculation of its discounted, risk‐neutral expected value. Both simulation and empirical evidence suggest that canonical valuation has merit.

We analyze the rationale for limit order trading. Use of limit orders involves two risks: 1) an adverse information event can trigger an undesirable execution, and 2) favorable news can result in a desirable execution not being obtained. On the other hand, a paucity of limit orders can result in accentuated short‐term price fluctuations that compensate a limit order trader. Our empirical tests suggest that trading via limit orders dominates trading via market orders for market participants with relatively well balanced portfolios, and that placing a network of buy and sell limit orders as a pure trading strategy is profitable.

We study the capital allocation process within firms. Observed budgeting processes are explained as a response to decentralized information and incentive problems. It is shown that these imperfections can result in underinvestment when capital productivity is high and overinvestment when it is low. We also investigate how the budgeting process may be expected to vary with firm or division characteristics such as investment opportunities and the technology for information transfer.

This article investigates whether differences in information-based trading can explain observed differences in spreads for active and infrequently traded stocks. Using a new empirical technique, we estimate the risk of information-based trading for a sample of New York Stock Exchange (NYSE) listed stocks. We use the information in trade data to determine how frequently new information occurs, the composition of trading when it does, and the depth of the market for different volume-decile stocks. Our most important empirical result is that the probability of information-based trading is lower for high volume stocks. Using regressions, we provide evidence of the economic importance of information-based trading on spreads.

Kothari, Shanken, and Sloan (1995) claim that β s from annual returns produce a stronger positive relation between β and average return than β s from monthly returns. They also contend that the relation between average return and book‐to‐market equity (BE/ME) is seriously exaggerated by survivor bias. We argue that survivor bias does not explain the relation between BE/ME and average return. We also show that annual and monthly β s produce the same inferences about the β premium. Our main point on the β premium is, however, more basic. It cannot save the Capital asset pricing model (CAPM), given the evidence that β alone cannot explain expected return.