Knowledge that Transforms

This paper investigates the behavior of stock and option prices around block trades in stocks. The results indicate that for both uptick and downtick block trades the stock prices adjust within a fifteen minute period after the block trade. Moreover, for uptick blocks there is no evidence of any stock price reaction before the block trade. However, the adjustment of stock price for downtick blocks begins about fifteen minutes before the block trade. They also find that option price behavior differs considerably from stock price behavior. Specifically, the authors' results suggest that options exhibit abnormal price behavior starting thirty minutes before the block and ending one hour after the block. The pattern is more pronounced for downtick blocks and for put options. The authors interpret this abnormal price behavior of options before the block trade as consistent with intermarket frontrunning.

Whether insider trading affects stock prices is central to both the current debate over whether insider trading is harmful or pervasive, and to the broader public policy issue of how best to regulate securities markets. Using previously unexplored data on illegal insider trading from the Securities and Exchange Commission, this paper finds that the stock market detects the possibility of informed trading and impounds this information into the stock price. Specifically, the abnormal return on an insider trading day averages 3 percent, and almost half of the pre-announcement stock price run-up observed before takeovers occurs on insider trading days. Both the amount traded by the insider and additional trade-specific characteristics lead to the market's recognition of the informed trading.

This paper explores stock price behavior surrounding withdrawn buyout proposals to determine whether managers' proposal announcements reveal any information that is unrelated to the efficiency gains associated with completed buyouts. On average, firms whose managers withdraw buyout proposals do not sustain significantly positive stock price effects unless they receive subsequent acquisition bids. In addition, managers of firms with completed buyouts are no more likely to have access to inside information than managers who withdrew proposals. The author interprets this evidence as inconsistent with the notion that inside information commonly motivates management buyout proposals.

An annual loss is essentially a necessary condition for dividend reductions in firms with established earnings and dividend records: 50.9 percent of 167 NYSE firms with losses during 1980-85 reduced dividends, versus 1.0 percent of 440 firms without losses. As hypothesized by Merton H. Miller and Franco Modigliani, dividend reductions depend on whether earnings include unusual items that are likely to temporarily depress income. Dividend reductions are more likely given greater current losses, less negative unusual items, and more persistent earnings difficulties. Dividend policy has information content in that knowledge that a firm has reduced dividends improves the ability of current earnings to predict future earnings.

The authors analyze risk-sensitive, incentive-compatible deposit insurance in the presence of private information and moral hazard. Without deposit-linked subsidies, it is impossible to implement risk-sensitive, incentive-compatible deposit insurance pricing in a competitive, deregulated environment except when the deposit insurer is the least risk averse agent in the economy. The authors establish this formally in the context of an insurance scheme in which privately informed depository institutions are offered deposit insurance premia contingent on reported capital; the result holds for alternative sorting instruments as well. This suggests a contradiction between deregulation and fairly priced, risk-sensitive deposit insurance.

Members of the Institutional Investor All-American Research Team supply more accurate earnings forecasts than other analysts when forecasts are matched.by the corporation followed and by the date of brokerage house issuance. This contemporaneous advantage is complemented by a timing advantage; All-Americans supply forecasts more often than other analysts. Stocks returns immediately following large upward forecast revisions suggest that All-Americans impact prices more than other analysts. However, there is virtually no difference in returns following large downward revisions. Nevertheless, the collective results suggest a positive relation between reputation and performance, and assuming that All-Americans are better paid, pay and performance.

The authors develop a two-factor general equilibrium model of the term structure. The factors are the short-term interest rate and the volatility of the short-term interest rate. The authors derive closed-form expressions for discount bonds and study the properties of the term structure implied by the model. The dependence of yields on volatility allows the model to capture many observed properties of the term structure. The authors also derive closed-form expressions for discount bond options. The authors use Hansen's generalized method of moments framework to test the cross-sectional restrictions imposed by the model. The tests support the two-factor model.

Option replication is discussed in a discrete-time framework with transaction costs. The model represents an extension of the Cox-Ross-Rubinstein binomial option pricing model to cover the case of proportional transaction costs. The method proceeds by constructing the appropriate replicating portfolio at each trading interval. Numerical values of these prices are presented for a range of parameter values. The paper derives a simple Black-Scholes type approximation for the option prices with transaction costs and demonstrates numerically that it is quite accurate for plausible parameter values.

Using end-of-month bid-ask spreads for 540 NYSE stocks over the period 1982-87, the authors document a seasonal pattern in which both relative and absolute spreads decline from the end of December to the end of the following January. Cross-sectional regressions do not, however, provide evidence of a significant correlation between changes in spreads at the turn of the year and January stock returns. Either there is no cause and effect relation between the coincidental seasonals in bid-ask spreads and January returns for NYSE stocks or the data are too "noisy" to reveal any relation.

This paper delineates the link between the existence of information, the timing of trades, and the stochastic process of prices. The authors show that time affects prices, with the time between trades affecting spreads. Because the absence of trades is correlated with volume, the authors' model predicts a testable relation between spreads and normal and unexpected volume, and demonstrates how volume affects the speed of price adjustment. Their model also demonstrates how the transaction price series will be a biased representation of the true price process, with the variance being both overstated and heteroskedastic.