Knowledge that Transforms

This article compares the bid-ask spread for New York Stock Exchange-NYSE listed securities before and after a major third market broker-dealer, Bernard L. Madoff Investment Securities, begins to selectively purchase and execute orders in those securities. Tests reveal the quoted bid-ask spread tightens when Madoff enters the market. Furthermore, trading costs as measured by the difference between the transaction price and the midpoint of the contemporaneous bid-ask spread do not increase. Together, these results suggest that the adverse selection problem associated with allowing agents to selectively execute orders in exchange-listed securities may be economically insignificant.

The authors compare execution costs (market impact plus commission) on the New York Stock Exchange (NYSE) and Nasdaq for institutional investors. The differences in cost generally conform to each market's area of specialization. Controlling for firm size, trade size, and the money management firm's identity, costs are lower on Nasdaq for trades in comparatively smaller firms, while costs for trading the larger stocks are lower on NYSE. The cost differences estimated from a regression model are, however, sensitive to the choice of time period.

Substantial progress has been made in developing more realistic option pricing models. Empirically, however, it is not known whether and by how much each generalization improves option pricing and hedging. The authors fill this gap by first deriving an option model that allows volatility, interest rates, and jumps to be stochastic. Using S&P 500 options, they examine several alternative models from three perspectives: (1) internal consistency of implied parameters/volatility with relevant time-series data, (2) out-of-sample pricing, and (3) hedging. Overall, incorporating stochastic volatility and jumps is important for pricing and internal consistency. But for hedging, modeling stochastic volatility alone yields the best performance.

Using data from the 1986 oil price decrease, the author examines the capital expenditures of nonoil subsidiaries of oil companies. He tests the joint hypothesis that (1) a decrease in cash/collateral decreases investment, holding fixed the profitability of investment, and (2) the finance costs of different parts of the same corporation are independent. The results support this joint hypothesis: oil companies significantly reduced their nonoil investment compared to the median industry investment. The 1986 decline in investment was concentrated in nonoil units that were subsidized by the rest of the company in 1985.

The Czech and Slovak Republics' mass privatization scheme used voucher points distributed to the population and a competitive bidding process to change the governance of a large number of firms. Voucher prices and following secondary market prices are shown to depend upon the resulting ownership structures. The more concentrated ownership is, the higher prices are. High absolute ownership by a single domestic investor is associated with even higher voucher prices. The author finds some evidence that initially prices are relatively lower when a bank-sponsored investment fund has a relatively large stake in a firm. This suggests conflicts of interest.

Financial economists have long debated whether monetary policy is neutral. This article addresses this question by examining how stock return data respond to monetary policy shocks. Monetary policy is measured by innovations in the federal funds rate and nonborrowed reserves, by narrative indicators, and by an event study of Federal Reserve policy changes. In every case the evidence indicates that expansionary policy increases ex post stock returns. Results from estimating a multifactor model also indicate that exposure to monetary policy increases an asset's ex ante return.

The authors test the conditional capital asset pricing model (CAPM) for the world's eight largest equity markets using a parsimonious generalized autoregressive conditional heteroskedasticity (GARCH) parameterization. Their methodology can be applied simultaneously to many assets and, at the same time, accommodate general dynamics of the conditional moments. The evidence supports most of the pricing restrictions of the model, but some of the variation in risk-adjusted excess returns remains predictable during periods of high interest rates. The authors' estimates indicate that, although severe market declines are contagious, the expected gains from international diversification for a U.S. investor average 2.11 percent per year and have not significantly declined over the last two decades.

This article examines incentives for adopting antitakeover charter amendments (ATAs) that are associated with compensational contracts. The evidence is consistent with the hypothesis that antitakeover measures such as ATAs help managers protect above-market levels of compensation. Chief executive officers (CEOs) of firms that adopt ATAs receive higher salaries and more valuable option grants than CEOs at similar firms that do not adopt them. Furthermore, the magnitude of this difference increases following ATA adoption. The evidence is inconsistent with the hypothesis that ATAs facilitate the writing of efficient compensation contracts.

Recent empirical evidence suggests that the interdaily volatility clustering for most speculative returns are best characterized by a slowly mean-reverting fractionally integrated process. Meanwhile, much shorter lived volatility dynamics are typically observed with high frequency intradaily returns. The present article demonstrates that, by interpreting the volatility as a mixture of numerous heterogeneous short-run information arrivals, the observed volatility process may exhibit long-run dependence. As such, the long-memory characteristics constitute an intrinsic feature of the return generating process, rather than the manifestation of occasional structural shifts. These ideas are confirmed by the authors' analysis of a one-year time series of five-minute Deutschemark-U.S. dollar exchange rates.

The authors examine data on analyst following for a sample of initial public offerings completed between 1975 and 1987 to see how they related to three well-documented initial public offering (IPO) anomalies. They find that higher underpricing leads to increased analyst following. Analysts are overoptimistic about the earnings potential and long-term growth prospects of recent IPOs. More firms complete IPOs when analysts are particularly optimistic about the growth prospects of recent IPOs. In the long run, IPOs have better stock performance when analysts ascribe low growth potential rather than high growth potential. These results suggest that the anomalies may be partially driven by overoptimism.