Knowledge that Transforms

This study of 862 press recommendations demonstrates that the size effect can distort longer-term performance measures, and hence event studies. Relative to similar sized companies, post-publication performance is neutral. However, market adjustments, the CAPM and Market Model, with equally or capitalization weighted indexes, all produce biased results. Event studies are most exposed to such bias when the measurement interval is long, event securities differ systematically in size or weighting from the index constituents, the size effect is large and/or volatile, and when CAPM-type methodologies are used. These distortions are avoided by explicitly controlling for size.

The term structure relations implied by a model in which preferences are non-separable functions of the service flows from two goods are investigated. The parameters characterizing preferences are estimated and restrictions on the co-movements of consumptions and Treasury bill returns are examined. Both the durability of goods and the non-separability of preferences are important factors in explaining the time paths of individual returns, but there is substantial evidence against the cross-sectional restrictions implied by our model. Differences between sample mean returns are too large relative to the sample covariances of the return differences and the marginal utility of consumption.

A new methodology for statistically testing contingent-claims asset-pricing models based on asymptotic statistical theory is proposed. It is introduced in the context of the Black-Scholes option-pricing model, for which some illustrative estimation, inference, and simulation results are also presented. The proposed methodology is then extended to arbitrary contingent claims by first considering the estimation problem for general Itô processes and then deriving the asymptotic distribution of a general contingent claim which depends upon such Itô processes.

A framework for valuing floating-rate notes is developed to examine the effects of (1) lags in the coupon formula, (2) special contractual features and (3) default risk. Evidence from a sample of floaters indicates they sold at significant discounts. While lags in the coupon formulas and other contractual features make these notes more variable, they do not account for the magnitude of the discounts. We conclude that the fixed default premium in the coupon formula of a typical note is inadequate to compensate for time-varying default premiums demanded by investors, who treat other corporate short-term paper as close substitutes.

This paper presents the results of an empirical investigation of whether there is any difference in the cost incurred by public utilities if they issue new equity through a negotiated or competitive underwriting. We conclude that the expected cost of a competitive offer is less than the expected cost of a negotiated offer, but that the variance of the cost is substantially greater with a competitive offer. These results are interesting because most public utilities use negotiated underwriting unless forced by regulation to use competitive offers. This paper is also an addition to the growing agency theory literature.

We document a January seasonal in the U.S. market for long-term corporate bonds that becomes more evident as the bond rating declines. Moreover, a similar, but weaker, relation is observed for the stocks of firms with low-quality bonds. These patterns may relate to firm size since bond ratings and firm size in our sample are positively related. However, even our smallest firms are relatively large. Much of the January effect we document appears to be consistent with the tax-loss selling hypothesis.

We examine the effects of market making and intermittent trading on estimates of stock price volatility. When observed price changes are correctly tied to a stock's true price dynamics, it is found that non-trading per se causes a loss of efficiency but no bias in traditional volatility estimates. Non-trading induces substancial inefficiency in the extreme value estimator of volatility which it biases downward. Market making's effects add to the non-trading induced inefficiency in the traditional estimator, while information trading causes a downward bias, and liquidity trading a potentially removable upward bias, in that estimator.

This paper develops a theory of the role of the underwriter in certifying that risky issue prices reflect potentially adverse inside information. The theory derives from the literature on the use of reputational capital to guarantee product quality. An underwriting cost/benefit paradigm is employed to generate testable implications related to announcement effects, issue underpricing, the choice of competitive versus negotiated underwriting, and the level of underwriter compensation as a function of firm-specific information. Existing empirical literature is reviewed in the context of the certification hypothesis and several new tests are conducted. All of the findings are supportive of the hypothesis.

The existence of price limits in certain futures markets is explained by demonstrating that price limits may act as a partial substitute for margin requirements in ensuring contract performance. Their effectiveness is a decreasing function of the amount of information available to traders about the equilibrium futures price which is unobservable in the event of a limit move, and the theory predicts that no limits will exist in the markets for financial futures. Actual limits are broadly consistent with the theory. “His interpretation…, plausible as it was, was totally misleading, with the dangerous verisimilitude of a theory which will fit all, or nearly all, the facts, and yet more entirely miss the truth, by a mere accident, then would a frank perplexity.” Heritage, V. Sackville-West

This paper examines an economy in which aggregate shocks are not dispersed equally throughout the population. Instead, while these shocks affect all individuals ex ante, they are concentrated among a few ex post. The equity premium in general depends on the concentration of these aggregate shocks; it follows that one cannot estimate the degree of risk aversion from aggregate data alone. These findings suggest that the empirical usefulness of aggregation theorems for capital asset pricing models is limited.