Knowledge that Transforms

This study investigates market price integration by testing per-share trade execution price or cost (TEP/C) differentials for matched intraday trades for a sample of Canadian shares cross-listed in the U.S. The TSE trade price advantage over the entire time period changed significantly after both the TSE's own minimum quotation increment reduction and that of its U.S. competitors. We show that the differential TEP/C is equivalent to the international effective spread differential and that market quality comparisons, which benchmark using the National instead of the International BBO, need to compare both national effective half-spread and midspread differences. Our cross-sectional regression results support our predictions that TEP/C differentials can be explained by differences in national midspreads and by ex ante proxies of national effective half-spreads. The TEP/C differentials vary inversely with increasing levels of our measure of signed market nonfragmentation.

This paper values American options on foreign assets in a stochastic interest rate economy using a two-point Geske and Johnson (1984) technique. The method requires the valuation of just two options: a European option and a twice-exercisable option. I first derive the risk-neutral distributions of asset prices under two forward risk-adjusted measures. Closed form solutions for European options on foreign assets are then obtained by applying these risk-neutral distributions. This article also provides analytic solutions for pricing twice exercisable options that are at most two-dimensional even though the valuation problem involves four risk factors at two exercise dates. I report the results of numerical evaluations of American option values using my method and show how they vary with the interest rate parameters. I also verify the accuracy of the proposed method by comparing with the benchmark values obtained from the least-square method of Longstaff and Schwartz (2001).

American options require numerical methods, namely lattice models, to provide accurate price estimates. The computations can become expensive when more than one state variable is involved. Analytical upper bounds can therefore provide a useful guideline for how high American values can reach. In this paper, we derive analytical (closed-form) upper bounds for American option prices under stochastic interest rates, stochastic volatility, and jumps where American option prices are difficult to compute with accuracy. In a stochastic volatility model (Heston (1993) and Scott (1997)) that has two random factors, we demonstrate that the upper bound only takes a very small fraction of the time that the American option needs to compute.

Hans G. Heidle, Roger D. Huang, Information-Based Trading in Dealer and Auction Markets: An Analysis of Exchange Listings, The Journal of Financial and Quantitative Analysis, Vol. 37, No. 3 (Sep., 2002), pp. 391-424

Diane Del Guercio, Paula A. Tkac, The Determinants of the Flow of Funds of Managed Portfolios: Mutual Funds vs. Pension Funds, The Journal of Financial and Quantitative Analysis, Vol. 37, No. 4 (Dec., 2002), pp. 523-557

This paper extends the seminal Cox-Ross-Rubinstein ((1979), CRR hereafter) binomial model to multiple assets. It differs from previous models in that it is derived under the complete market environment specified by Duffie and Huang (1985) and He (1990). The complete market assumption requires the number of states to grow linearly with the number of assets. However, the number of correlations grows at a faster rate, causing the CRR model to be indirectly extendable. We solve such a problem by recognizing that the fast growing correlation number is matched by the number of the angles of the edges of a hypercube spanned by the risky assets. As a result, we derive a solution that allows the number of equations to equal the number of risky assets and the riskless bond. The resulting tree structure hence provides the same intuition of pricing and hedging contingent claims as that provided by the CRR model. Finally, the proposed model is not only as easy to implement as the one-dimensional CRR model but also it is more memory efficient than the existing multi-factor lattice models.

I develop an agency model where returns-chasing behavior by mutual fund investors causes beta not to be priced to the degree predicted by the standard CAPM. Mutual fund investors chase returns through time, precipitating unusually large aggregate cash inflows into mutual funds just after dramatic market runups. Mutual fund investors also chase returns cross-sectionally across funds so that the highest-performing funds capture the largest fraction of the aggregate inflows into the mutu al fund sector. The interaction of these two flow-performance relationships induces an asymmetry in payoffs to mutual funds where fund managers care most about outperforming peers during bull markets. Since high-beta stocks tend to outperform in up markets, active fund managers tilt their portfolios toward high-beta stocks, reducing the beta risk premium in equilibrium. To support the model's time-series flow-performance assumption, I show empirically that market returns have a large economic impact on subsequent aggregate mutual fund flows. In addition, data on mutual fund holdings suggest that the aggregate stock portfolio held by equity funds is overweighted in high-beta stocks relative to the overall market, though this does not include the cash held by mutual funds. Fama-MacBeth tests indicate that the equity premium falls only slightly as the relative size of mutual funds increases, and the relation is not statistically significant.

The options-based approach to studying irreversible investment under uncertainty emphasizes that the opportunity cost of investment includes the value of the option to wait that is extinguished when an investment is undertaken. Thus, the investment decision is affected by the determinants of the value of this option. We extend and generalize a standard model of irreversible investment by introducing a second fully reversible technology, and also incorporate partial reversibility by allowing capital to be abandoned at a cost. As in the existing literature, we find that the threshold value of the “underlying asset” (in our case, demand) at which investment takes place is increasing in the uncertainty of demand. We also find that the value of the option and thus the threshold value of the option value multiple at which investment takes place may be either increasing or decreasing in the uncertainty of demand. In addition, we find that for the case in which capital is used to replace the reversible technology, the threshold value of the option value multiple is insensitive to the degree of reversibility of capital.

We use a two-year panel of individual accounts in an S&P 500 index mutual fund to examine the trading and investment behavior of more than 91 thousand investors who have chosen a low-cost, passively managed vehicle for savings.This allows us to characterize investors' heterogeneity in terms of their investment patterns.In particular, we identify positive feedback traders as well as contrarians whose activities are conditional upon preceding day stock market moves.We test the consistency and profitability of these conditional strategies over time.We find that more frequent traders are typically contrarians, while infrequent traders are more typically momentum investors.The dynamics of these investor classes help us to partially examine the question of the marginal investor over the period of our study.We find that the behavior of momentum investors is typically more correlated to changes in the S&P 500 and we trace its dynamics over time.We build up "behavioral factors" based on contrarian and momentum flows and show that they perform well against a benchmark of loadings on latent factors extracted from returns.We also use the behavior of momentum and contrarian investors to build a measure of "market polarization".This captures the dispersion of beliefs among the investors and helps to account for asset pricing better than standard measures of dispersion of beliefs.

This study shows that international firms listing their shares on the New York Stock Exchange (NYSE) or the London Stock Exchange (LSE) experience a significant increase in visibility, as proxied by analyst coverage and print media attention (The Wall Street Journal or Financial Times). The increase in analyst following is also associated with a decrease in the cost of equity capital after the listing event in a way consistent with Merton's (1987) investor recognition hypothesis. Our results are stronger for NYSE listing firms than for LSE listing firms. This may partially compensate firms for the higher costs associated with NYSE listing (compared to LSE listing).