Knowledge that Transforms

Under fairly general conditions, this article derives the equilibrium price schedule determined by the bids and offers in an open limit order book. The analysis shows that the order book has a small-trade positive bid-ask spread, and limit orders profit from small trades; the electronic exchange provides as much liquidity as possible in extreme situations; the limit order book does not invite competition from third market dealers, while other trading institutions do; and, if an entering exchange earns nonnegative trading profits, the consolidated price schedule matches the limit order book price schedule.

The daily and intraday behavior of returns on Chicago Board Options Exchange options is examined. Option returns contain systematic patterns even after adjusting for patterns in the means and variances of the underlying assets. This is consistent with the hypothesis that informed trading in options can make the order flow in the options market informative about the value of the underlying asset, making options nonredundant. The intraday patterns in adjusted option return variances are further consistent with a model of strategic trading by informed and discretionary liquidity traders.

Richard T. Baillie and Tim Bollerslev (1989) have recently argued that nominal dollar spot exchange rates are cointegrated. Here the authors examine an immediate implication of their finding, namely, that cointegration implies an error-correction representation yielding forecasts superior to those from a martingale benchmark in light of a large earlier literature highlighting the predictive superiority of the martingale. In an out-of-sample forecasting exercise, the authors find the martingale model to be superior. They then perform a battery of improved cointegration tests and find that the evidence for cointegration is much less strong than previously thought, a result consistent with the outcome of the forecasting exercise.

This paper empirically examines how ties between a firm and its creditors affect the availability and cost of funds to the firm. The authors analyze data collected in a survey of small firms by the Small Business Administration. The primary benefit of building close ties with an institutional creditor is that the availability of financing increases. The authors find smaller effects on the price of credit. Attempts to widen the circle of relationships by borrowing from multiple leaders increases the price and reduces the availability of credit. In sum, relationships are valuable and appear to operate more through quantities rather than prices.

The authors compare the relative magnitudes of the components of the bid-ask spread for New York Stock Exchange (NYSE)/American Stock Exchange (AMEX) stocks to those of National Association of Securities Dealers Automated Quotations (NASDAQ)/National Market System (NMS) stocks. They find that the order-processing cost component is smaller, and the adverse selection component is greater, on the NYSE/AMEX trading systems than on the NASDAQ/NMS system. The inventory holding component is also greater for exchange-traded stocks than for NASDAQ/NMS stocks, but this may be attributable to differences in the characteristics of the firms whose stocks trade on the respective systems.

This article examines the effect of issuing debt with and without 'poison put' covenants on outstanding debt and equity claims for the period 1988 to 1989. The analysis shows that poison put covenants affect stockholders negatively and outstanding bondholders positively, while debt issued without such covenants has no effect. The study also finds a negative relationship between stock and bond returns for firms issuing poison put debt. These results are consistent with a 'mutual interest hypothesis,' which suggests that the issuance of poison put debt protects managers and, coincidentally, bondholders at the expense of stockholders.

Linear and nonlinear Granger causality tests are used to examine the dynamic relation between daily Dow Jones stock returns and percentage changes in New York Stock Exchange trading volume. The authors find evidence of significant bidirectional nonlinear causality between returns and volume. They also examine whether the nonlinear causality from volume to returns can be explained by volume serving as a proxy for information flow in the stochastic process generating stock return variance as suggested by P. Clark's (1973) latent common-factor model. After controlling for volatility persistence in returns, the authors continue to find evidence of nonlinear causality from volume to returns.

The Euler equations derived from intertemporal asset pricing models, together with the unconditional moments of asset returns, imply a lower bound on the volatility of the intertemporal marginal rate of substitution. This paper develops and implements statistical tests of these lower bound restrictions. While the availability of short time series of consumption data often undermines the ability of these tests to discriminate among different utility functions, the authors find that the restrictions implied by a number of widely studied financial data sets continue to pose quite a challenge to the current generation of intertemporal asset pricing theories.

This article uses the articles and citations from a set of eight finance journals to explore interjournal citation patterns, the research interests of individual journals, each journal's influence in particular areas, areas of recent interest to finance, and the extent of interdisciplinary borrowing by finance. The authors find the following: two journals comprise the research core of finance research, most journals publish in a variety of research areas but are influential in a smaller number, a higher level of interest in financial markets than in corporate finance or financial institutions, and an overall low level of borrowing from outside disciplines.