Knowledge that Transforms

This paper examines empirically the magnitude and determinants of dealer trading by NYSE market makers (specialists) across stocks and over time. Across stocks, specialist dealer trading varies widely and is inversely related to trading volume and proxies for off-exchange competition. Over time in an individual stock, specialists participate more actively as sellers (buyers) when holding long (short) inventory positions. This results suggest that dealers control their inventory positions by selectively timing the size and direction of their trades rather than by adjusting their quotes. Further, specialists participate more in smaller trades and when the bid–ask spread is wide.

It is well documented that stock prices on ex-dividend days drop by less than the value of the dividend, on average. This has commonly been attributed to the effect of tax clienteles. We examine data from the Hong Kong stock market, where neither dividends nor capital gains are taxed. As in the U.S., the average stock price drop is less than the value of the dividend; specifically, the average dividend for the period 1980–1993 is HK 0.12 and the average price drop is HK 0.06. We are able to account for this both theoretically and empirically through market microstructure arguments.

This paper analyzes the effect of different IPO mechanisms on the structure of share ownership and explores the role of underpricing and rationing in determining investors’ shareholdings. We focus on the agency problem that results when large institutions are the only investors capable of monitoring the firm whereas small shareholders free-ride on these activities. The major conclusion is that some well-known aspects of IPOs may be explained as rational responses by the issuer to the existence of regulatory constraints in public capital markets. There is a two-stage offering mechanism in which the investment banker, acting in the interests of the issuer, optimally rations the allotment of shares to small investors in order to capture the benefits associated with better monitoring by institutions. Importantly, in our model, the existence of underpricing (and oversubscription) is an indication that the issuer has received a higher ex ante price than would have been obtained through a competitive Walrasian-type offering process.

We develop a framework for analyzing the capital allocation and capital structure decisions facing financial institutions. Our model incorporates two key features: (i) value-maximizing banks have a well-founded concern with risk management; and (ii) not all the risks they face can be frictionlessly hedged in the capital market. This approach allows us to show how bank-level risk management considerations should factor into the pricing of those risks that cannot be easily hedged. We examine several applications, including: the evaluation of proprietary trading operations, and the pricing of unhedgeable derivatives positions. We also compare our approach to the RAROC methodology that has been adopted by a number of banks.

This paper examines the degree of portfolio inefficiency subject to various constraints on portfolio weights. When portfolio weights are unconstrained, the posterior loss in expected return on the NYSE-AMEX market portfolio is over 20% (annualized). In contrast, when portfolio weights are constrained to be nonnegative, the posterior loss in expected return is only about 4% (annualized). In addition, short-sale constraints greatly reduce uncertainty in inferences about portfolio efficiency.

Eastern Airlines' bankruptcy illustrates the devastating effect on firm value of court-sponsored asset stripping, i.e., the use of creditors' collateral to invest in high-variance negative net present value projects. During its bankruptcy, Eastern's value dropped over 50%. A substantial portion of this value decline occurred because an overprotective court insulated Eastern from market forces and allowed value-destroying operations to continue long after it was clear that Eastern should have been shut down. The failure of Eastern's Chapter 11 demonstrates the importance of having a bankruptcy process that protects a distressed firm's assets, not simply from a run by creditors, but also from overly optimistic managers and misguided judges.

Studies by Vermaelen (1981) and others indicate that the positive excess stock returns around self-tender offer announcements are the result of a signal of future earnings improvements. Comment and Jarrell (1991), Lee, Mikkelson and Partch (1992) and Persons (1994) argue that the signal in fixed-price self-tender offers should be stronger than the signal in Dutch auction self-tender offers. This study tests whether the earnings improvement following fixed-price self-tender offers is greater than that following Dutch auction self-tender offers. We find some evidence that earnings improve following both types of self-tender offers. However, we find no difference in earnings improvement between the two types of offers.

We estimate and test the conditional version of an International Capital Asset Pricing Model using a parsimonious multivariate GARCH process. Since our approach is fully parametric, we can recover any quantity that is a function of the first two conditional moments. Our findings strongly support a model which includes both market and foreign exchange risk. However, both sources of risk are only detected when their prices are allowed to change over time. The evidence also indicates that, with the exception of the U.S. equity market, the premium for bearing currency risk often represents a significant fraction of the total premium.

SOES bandits are individual investors who use Nasdaq's Small Order Execution System (SOES) for day trading. Their average profit per trade is small, but they trade dozens or hundreds of times per week. Bandits usually establish a position before most market-makers have updated their quotes, and lay off the position at favorable prices through Instinet or SelectNet. It is noteworthy that they trade profitably with market-makers despite having less information. Bandits keep the profits and bear the losses from their trades. Thus they have greater incentives to trade well than the employees of market-making firms.