Knowledge that Transforms

We develop an option pricing model for calls and puts written on leveraged equity in an economy with corporate taxes and bankruptcy costs. The model explains implied Black-Scholes volatility biases by relating them to the firm's structural characteristics such as leverage and debt covenants. We test the model by comparing predicted pricing biases with biases observed in a large cross-section of firms with liquid exchange traded option contracts. Our empirical study detects leverage related pricing biases. The magnitudes of these biases correspond to those predicted by our model. We also find significant pricing biases for firms financed primarily by short-term debt. This supports our model because short-term debt introduces net-worth hurdles similar to net-worth covenants.

We 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.

Price limit advocates claim that price limits decrease stock price volatility, counter overreaction, and do not interfere with trading activity. Conversely, price limit critics claim that price limits cause higher volatility levels on subsequent days (volatility spillover hypothesis), prevent prices from efficiently reaching their equilibrium level (delayed price discovery hypothesis), and interfere with trading due to limitations imposed by price limits (trading interference hypothesis). Empirical research does not provide conclusive support for either positions. We examine the Tokyo Stock Exchange price limit system to test these hypotheses. Our evidence supports all three hypotheses suggesting that price limits may be ineffective.

This article presents the first application in finance of recently developed methods for the Gaussian estimation of continuous time dynamic models. A range of one factor continuous time models of the short-term interest rate are estimated using a discrete time model and compared to a recent discrete approximation used by Chan, Karolyi, Longstaff, and Sanders (1992a, hereafter CKLS). Whereas the volatility of short-term rates is highly sensitive to the level of rates in the United States, it is not in the United Kingdom.

The development of asset pricing models that rely on instrumental variables together with the increased availability of easily-accessible economic time-series have renewed interest in predicting security returns. Evaluating the significance of these new research findings, however, is no easy task. Because these asset pricing theory tests are not independent, classical methods of assessing goodness-of-fit are inappropriate. This study investigates the distribution of the maximal R2 when k of m regressors are used to predict security returns. We provide a simple procedure that adjusts critical R2 values to account for selecting variables by searching among potential regressors.

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, we derive a variance bound that is more stringent than that of Hansen and Jagannathan (1991) . When we apply our bound to the kernel of a representative consumer with power utility, we find that the consumption risk premium increases the severity of the “equity‐premium puzzle” of Mehra and Prescott (1985) .

This article examines the auction of a portfolio of collateralized mortgage obligations (CMOs) to major broker dealers and institutional investors. The unique data set allows us to analyze a number of important empirical questions related to the valuation of CMOs by the bidders and the elasticity of demand for the securities. The results reveal that the valuations differ substantially implying a significant elasticity of demand.

The Geske–Johnson approach provides an efficient and intuitively appealing technique for the valuation and hedging of American‐style contingent claims. Here, we generalize their approach to a stochastic interest rate economy. The method is implemented using options exercisable on one of a finite number of dates. We illustrate how the value of an American‐style option increases with interest rate volatility. The magnitude of this effect depends on the extent to which the option is in the money, the volatilities of the underlying asset and the interest rates, as well as the correlation between them.

This work compares a dealer market and a limit‐order book. Dealers commonly observe order flow and collect information from multiple market orders. They may be better informed than other traders, although they do not earn rents from this information. Dealers earn rents as suppliers of liquidity, and their decisions to enter or exit the market are independent of the degree of adverse selection. Introduction of a limit‐order book lowers the execution‐price risk faced by speculators and leads them to trade more aggressively on their information. Introduction of the book also lowers dealer profits, but increases the informational efficiency of prices.

We report results from experimental asset markets with liquidity traders and an insider where we 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 we 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.