Textbook arbitrage in financial markets requires no capital and entails no risk. In reality, almost all arbitrage requires capital and is typically risky. Moreover, professional arbitrage is conducted by a relatively small number of highly specialized investors using other people's capital. Such professional arbitrage has a number of interesting implications for security pricing, including the possibility that arbitrage becomes ineffective in extreme circumstances when prices diverge far from fundamental values. The model also suggests where anomalies in financial markets are likely to appear, and why arbitrage fails to eliminate them.
In this article, the authors develop alternative ways to compare asset pricing models when it is understood that their implied stochastic discount factors do not price all portfolios correctly. Unlike comparisons based on chi square statistics associated with null hypotheses that models are correct, the authors' measures of model performance do not reward variability of discount factor proxies. One of their measures is designed to exploit fully the implications of arbitrage-free pricing of derivative claims. The authors demonstrate empirically the usefulness of their methods in assessing some alternative stochastic factor models that have been proposed in asset pricing literature.
This article examines whether shifts in the stance of monetary policy can account for the observed predictability in excess stock returns. Using long-horizon regressions and short-horizon vector autoregressions, the article concludes that monetary policy variables are significant predictors of future returns, although they cannot fully account for observed stock return predictability. The author undertakes variance decompositions to investigate how monetary policy affects the individual components of excess returns (risk-free discount rates, risk premia, or cash flows).
The authors use a robust regression estimator to analyze the risk premia on size and book-to-market. They find that the risk premium on size that was estimated by Eugene F. Fama and Kenneth R. French (1992) completely disappears when the 1 percent most extreme observations are trimmed each month. The authors also show that the negative average of the monthly size coefficients reported by Fama and French can be entirely explained by the sixteen months with the most extreme coefficients. They argue that further investigation of these results could lead to an understanding of the economic forces underlying the size effect, and may also yield important insights into how firms grow.
This study examines the initial-day and aftermarket price performance of corporate straight debt IPOs. The authors find that initial public offereings (IPOs) of speculative grade debt are underpriced like equity IPOs, while those rated investment grade are overpriced. IPOs of investment grade debt are typically issued by firms listed on the major exchanges and underwritten by prestigious underwriters. In contrast, junk bond IPOs are more likely to be handled by less prestigious underwriters and are typically issued by over-the-counter firms. The authors' analysis also reveals that bond rating, market listing of the firm, and investment banker quality are significant determinants of bond IPO returns.
This article empirically examines the liquidity premium predicted by the Amihud and Mendelson (1986) model using NASDAQ data over the 1973-90 period. The results support the model and are much stronger than for the New York Stock Exchange (NYSE), as reported by Nai-Fu Chen and Raymond Kan (1989) and Venkat R. Eleswarapu and Marc R. Reinganum (1993). The author conjectures that the stronger evidence on the NASDAQ is due to the dealers' inside spreads on the NASDAQ being a better proxy for the actual cost of transacting than the quoted spreads on the NYSE, since the NASDAQ dealers do not face competition from limit orders or floor traders.
This article identifies price leadership patterns in foreign exchange trading, with a focus on central bank intervention as an informational trigger for leadership positioning. Granger causality tests applied to DM/US$ spot rate quotes reveal Deutsche Bank as a price leader up to sixty minutes prior to Bundesbank interventionary reports. By the minus twenty-five-minute mark, interbank quote adjustments become two-way Granger-causal. These results suggest that central bank activity is revealed in stages: first to the price leader, then to competitors, and lastly to the general public.
If a pricing kernel assigns a premium to a risk variable that differs from the one assigned by the minimum-variance admissible kernel, then the pricing kernel must exhibit more variability than the minimum-variance kernel. Based on this intuition, the authors derive a variance bound that is more stringent than that of Lars Peter Hansen and Ravi Jagannathan (1991). When the authors apply their bound to the kernel of a representative consumer with power utility, they find that the consumption risk premium increases the severity of the 'equity-premium puzzle' of Rajnish Mehra and Edward C. Prescott (1985).
This article examines possible explanations for 'winner-loser reversals' in the national stock market indices of sixteen countries. There is no evidence that loser countries are riskier than winner countries either in terms of standard deviations, covariance with the world market or other risk factors, or performance in adverse economic states of the world. While there is evidence that small markets are subject to larger reversals than large markets, perhaps due to some form of market imperfection, the reversals are not only a small market phenomenon. The apparent anomaly of winner-loser reversals in national market indices therefore remains unresolved.