Knowledge that Transforms

The authors report results from experimental asset markets with liquidity traders and an insider where they allow bilateral trade to take place, in addition to public trade with dealers. In the absence of the search alternative, dealer profits are large–unlike in models with risk-neutral, competitive dealers. However, when the authors allow traders to participate in the search market, dealer profits are close to zero. Dealers compete more aggressively with the alternative trading avenue than with each other. There is no evidence that price discovery is less efficient when the specialists are not the only game in town.

Using a sample of forty-nine countries, the authors show that countries with poorer investor protections, measured by both the character of legal rules and the quality of law enforcement, have smaller and narrower capital markets. These findings apply to both equity and debt markets. In particular, French civil law countries have both the weakest investor protections and the least developed capital markets, especially as compared to common law countries. Coauthors are Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert W. Vishny.

The relation between default-free interest rates and expected economic growth is substantially stronger than suggested by extant literature. Futures-implied Treasury bill yield spreads are more highly correlated with future real consumption, investment, and GNP growth than spot spreads. This stronger relation arises because using futures removes a component of the spot term structure that covaries negatively with real economic growth. Treasury forward rates from spot bills contain a premium for the risk that short-sellers will default. This risk premium is negatively related to expected economic growth.

The author documents a delisting bias in the stock return data base maintained by the Center for Research in Security Prices. He finds that delists for bankruptcy and other negative reasons are generally surprises and that correct delisting returns are not available for most of the stocks that have been delisted for negative reasons since 1962. Using over-the-counter price data, the author shows that the omitted delisting returns are large. Implications of the bias are discussed.

The introduction of exchange-traded options in 1973 led to explosive growth in the stock options market, but put and call options on equity securities have existed for more than a century. Prior to the listing of option contracts, trading was conducted in an order-driven over-the-counter market. From 1873 to 1875, quotes for options contracts were published weekly in The Commercial and Financial Chronicle during a period that saw extensive marketing efforts by a number of brokerage firms. In this article, the authors examine these quotes to determine why this seemingly sophisticated market existed for only a brief period in financial history.

Minimum price variation rules help explain why stock prices vary substantially across countries and other curiosities of share prices. Companies tend to split their stock so that the institutionally mandated minimum tick size is optimal relative to the stock price. A large relative tick size provides an incentive for dealers to make markets and for investors to provide liquidity by placing limit orders, despite its placing a high floor on the quoted bid-ask spread. A simple model suggests that idiosyncratic risk, firm size, and visibility of the firm affect the optimal relative tick size and thus the share price.

This article examines the hypothesis that the superior return to so-called value stocks is the result of expectational errors made by investors. The authors study stock price reactions around earnings announcements for value and glamour stocks over a five-year period after portfolio formation. The announcement returns suggest that a significant portion of the return difference between value and glamour stocks is attributable to earnings surprises that are systematically more positive for value stocks. The evidence is inconsistent with a risk-based explanation for the return differential. Coauthors are Josef Lakonishok, Andrei Shleifer, and Robert Vishny.

This article develops a multi-factor econometric model of the term structure of interest-rate swap yields. The model accommodates the possibility of counterparty default, and any differences in the liquidities of the Treasury and Swap markets. By parameterizing a model of swap rates directly, the authors are able to compute model-based estimates of the defaultable zero-coupon bond rates implicit in the swap market without having to specify a priori the dependence of these rates on default hazard or recovery rates. The time series analysis of spreads between zero-coupon swap and treasury yields reveals that both credit and liquidity factors were important sources of variation in swap spreads over the past decade.

This article examines the role of corporate headquarters in allocating scare resources to competing projects in an internal capital market. Unlike a bank, headquarters has control rights that enable it to engage in 'winner-picking'–the practice of actively shifting funds from one project to another. By doing a good job in the winner-picking dimension, headquarters can create value even when it cannot help at all to relax overall firmwide credit constraints. The model implies that internal capital markets may sometimes function more efficiently when headquarters oversees a small and focused set of projects.