Knowledge that Transforms

Stambaugh, and especially to Robert Merton for comments on a previous draft. This paper is part of NBER's research program in Financial Markets and Monetary Economics. Any opinions expressed are those of the author not those

This article analyzes the behavior of stock return volatility using daily data from 1885 through 1988. The October 1987 stock market crash was unusual in many ways. October 19 was the largest percentage change in market value in over 29,000 days. Stock volatility jumped dramatically during and after the crash. Nevertheless, it returned to lower, more normal levels more quickly than past experience predicted. I use data on implied volatilities from call option prices and estimates of volatility from futures contracts on stock indexes to confirm this result.

We investigate product-market competition when managers maximize shareholder value rather than their expected discounted value of profits. If shareholders are imperfectly informed about future profitability, shareholder-value maximization can lead to either more or less aggressive product-market strategies. Lower rivals’ profits lead investors to believe that the firm’s costs are low relative to those of its rivals and that the industry’s prospects are poor. If the former (latter) inference dominates, each firm tries to lower (raise) its rivals’ profits to increase its own stock price. We also consider implications for corporate financial structure.

This article generalizes the Cox, Ross, and Rubinstein (1979) binomial option-pricing model, and establishes a convergence from discrete-time multivariate multinomial models to continuous-time multidimensional diffusion models for contingent claims prices. The key to the approach is to approximate the N-dimensional diffusion price process by a sequence of N-variate, (N+1)-nomial processes. It is shown that contingent claims prices and dynamic replicating portfolio strategies derived from the discrete time models converge to their corresponding continuous-time limits.

We find that conditional means and variances of consumption growth vary through time, and this variation appears to be associated with the business cycle. A pricing model with fluctuating means and variances of consumption growth provides implications about conditional moments of returns for both short and long investment horizons, and these implications are explored empirically. The U-shaped pattern of first-order autocorrelations of returns, as well as business cycle patterns in the price of risk, appears to be consistent with the model, but our exploration suggests that other implications about conditional return moments are at odds with the data.

We investigate several asset pricing models in an international setting. We use data on a large number of assets traded in the United States, Japan, the United Kingdom, and France. The model together with the hypothesis of capital market integration imply testable restrictions on multivariate regressions relating asset returns to various benchmark portfolios. We find that multifactor models tend to outperform single-index models in both domestic and international forms especially in their ability to explain seasonality in asset returns. We also find that the behavior of the models is affected by change in the regulatory environment in international markets.

We derive and test a dynamic discrete-time model of asset returns. Both the risks of individual securities and equilibrium risk premia change predictably in the model, but these changes can be attributed to movements in the returns and prices of only two well-diversified portfolios. Any other components of returns should be unpredictable. Using the generalized method of moments, the model is estimated and tested on portfolios of equities. We find the data supportive of the model’s restrictions, even when instruments designed to capture the January effect are employed.

This article develops a model of competitive bidding with a resale market. The primary market is modeled as a common-value auction, in which bidders participate for the purpose of resale. After the auction the winning bidders sell the objects in a secondary market, and the buyers in the secondary market receive information about the bids submitted in the auction. The effect of this information linkage between the primary auction and the secondary market on bidding behavior in the primary auction is examined. The auctioneer’s expected revenues from organizing the primary market as a discriminatory auction versus a uniform-price auction are compared, and sufficient conditions under which the uniform-price auction will yield higher expected revenues are obtained. An example of our model, with the primary market organized as a discriminatory auction, is the U.S. Treasury bill market.

This article suggests that the lack of use of rights offerings in the United States, a phenomenon referred to as the equity underwriting paradox, can be explained by transaction costs. A sample of underwritten rights offerings provides support for the explanation. Firms making underwritten rights offerings paid lower underwriter fees but incurred significantly larger price drops just prior to the offering than did firms making underwritten offerings. Further analysis reveals that the underwritten-rights-offering price concessions are a form of transaction cost that is not found in underwritten public offerings.

A linearization of a rational expectations present value model for corporate stock prices produces a simple relation between the log dividend-price ratio and mathematical expectations of future log real dividend changes and future real discount rates. This relation can be tested using vector autoregressive methods. Three versions of the linearized model, differing in the measure of discount rates, are tested for U. S. time series 1871-1986: versions using real interest rate data, aggregate real consumption data, and return variance data. The results yield a metric to judge the relative importance of real dividend growth, measured real discount rates and unexplained factors in determining the dividend-price ratio.