Knowledge that Transforms

The authors develop a method of measuring ex ante real interest rates using prices of index and nominal bonds. Employing this method and newly available data, they directly test the Fisher hypothesis that the real rate of interest is independent of inflation expectations. The authors 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 Robert A. Mundell and James Tobin, Michael R. Darby and Martin Feldstein, and Rene Stulz. The authors also find that nominal interest rates include an inflation risk premium that is positively related to a proxy for inflation uncertainty.

The authors 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. The authors 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 study examines the behavior of laboratory markets in which two uninformed marketmakers compete to trade with heterogeneously informed investors. The data provide three main results. First, marketmakers set quotes to protect against adverse selection and to control inventory. Second, when investors are 1ess well-informed, their trades are less reliable measures of their information, and marketmakers respond to those trades with greater skepticism. Third, errors in marketmakers' reactions to trades cause the time-series behavior of quotes and prices to depend on the information environment in ways beyond those captured in extant theory.

This article derives underlying asset risk-neutral probability distributions of European options on the S&P 500 index. Nonparametric methods are used to choose probabilities that minimize an objective function subject to requiring that the probabilities are consistent with observed option and underlying asset prices. Alternative optimization specifications produce approximately the same implied distributions. A new and fast optimization technique for estimating probability distributions based on maximizing the smoothness of the resulting distribution is proposed. Since the crash, the risk-neutral probability of a three (four) standard deviation decline in the index (about -36 percent (-46 percent) over a year) is about 10 (100) times more likely than under the assumption of lognormality.

An analysis of new buy and sell recommendations of stocks by security analysts at major U.S. brokerage firms shows significant, systematic discrepancies between prerecommendation prices and eventual values. The initial return at the time of the recommendations is large, even though few recommendations coincide with new public news or provide previously unavailable facts. However, these initial price reactions are incomplete. For buy recommendations, the mean postevent drift is modest (+2.4 percent) and short-lived, but for sell recommendations, the drift is larger (-9.1 percent) and extends for six months. Analysts appear to have market timing and stock picking abilities.

This article presents a model for valuing claims subject to default by both contracting parties, such as swaps and forwards. With counterparties of different default risk, the promised cash flows of a swap are discounted by a switching discount rate that, at any given state and time, is equal to the discount rate of the counterparty for whom the swap is currently out of the money (that is, a liability). The impact of credit-risk asymmetry and of netting is presented through both theory and numerical examples, which include interest rate and currency swaps.

Plotting daily stock returns against themselves with one day's lag reveals a striking pattern. Evenly spaced lines radiate from the origin; the thickest lines point in the major directions of the compass. This 'compass rose' pattern appears in every stock. It is caused by discreteness. However, counterexamples demonstrate that the existence of exchange-imposed tick sizes (e.g., eighths) is neither necessary nor sufficient for the compass rose. The compass rose cannot be used to make abnormal profits: it is structure without predictability. Among other consequences, the compass rose may bias estimation of ARCH models and tests for chaos.

Trading systems differ in their degree of transparency, here defined as the extent to which marketmakers can observe the size and direction of the current order flow. The authors investigate whether greater transparency enhances market liquidity by reducing the opportunities for taking advantage of uninformed participants. They compare the price formation process in several stylized trading systems with different degrees of transparency: various types of auction markets and a stylized dealer market. The authors find that greater transparency generates lower trading costs for uninformed traders on average, although not necessarily for every size of trade.

In this article, the authors generalize C. Harvey's (1989) empirical specification of conditional asset pricing models to allow for both time-varying covariances between stock returns and marketwide factors and time-varying reward-to-covariabilities. The model is then applied to examine the effects of firm size and book-to-market equity ratios. The authors find that the traditional asset pricing model with commonly used factors can only explain a small portion of the stock returns predicted by firm size and book-to-market equity ratios. The results indicate that allowing time-varying covariances and time-varying reward-to-covariabilities does little to salvage the traditional asset pricing models. Coauthors are Raymond Kan, Lilian Ng, and Chu Zhang.