Knowledge that Transforms

Journal Article Title Index Get access The Review of Financial Studies, Volume 15, Issue 5, October 2002, Pages 1591–1594, https://doi.org/10.1093/rfs/15.5.1591 Published: 16 June 2015

This dissertation analyzes equilibrium in a dynamic pure-exchange economy under a generalization of Merton's (1987) investor recognition hypothesis (IRH). Because of information costs, a class of investors is assumed to possess incomplete information, which suffices to implement only a particular trading strategy. The IRH is mapped into corresponding portfolio restrictions that bind a subset of agents. The model is formulated in continuous time, and characterization of risk premia, interest rates, and consumption policies of the heterogeneous agents is provided. The model implies that a risk premium on a less visible stock need not be higher than that on a more visible stock with a lower volatility, all else being equal. This contrasts with results previously derived in a static mean-variance setting. An empirical analysis evaluates the IRH based on the premise that the trading strategy of informationally constrained agents is well captured by a combination of two portfolios. The first portfolio represents their (direct) investment in stocks with high visibility. The second portfolio proxies for their exposure (via delegated investment) to stocks with good past-return performance (consistent with documented evidence regarding portfolios of money managers). The findings suggest that a consumption-based capital asset pricing model (CCAPM) augmented by the IRH is a more realistic model than the traditional CCAPM for explaining the cross-sectional variation in unconditional expected equity returns.

A significant amount of research by financial economists over the last few decades has attempted to understand various anomalous or puzzling empirical observations taken from financial markets.1 These range from the equity premium puzzle at the aggregate level [see, e.g., Grossman and Shiller (1982) and Mehra and Prescott (1985)], to the small-firm effect [see, e.g., Banz (1981) and Fama and French (1992)], to momentum in returns [see, e.g., De Bondt and Thaler (1985) and Jegadeesh and Titman (1993)], to postevent abnormal returns [see, e.g., Latane and Jones (1977) and Ritter (1991)] at the level of individual stock and portfolio returns. In each case these empirical puzzles are identified by finding portfolios with average returns that are high relative to their risk as measured by the covariance of the returns with the market portfolio, as in the capital asset pricing model (CAPM), or with aggregate consumption, as in the consumption-based CAPM. If the assumptions about market structure and the behavior of agents justifying the models are correct, then return observations imply that agents should trade to take advantage of the observed patterns in returns. There have been three types of explanations put forward for why agents don’t take advantage of the anomalies.

This article studies access regulation to international large-value payment systems when banking supervision is national. We focus on the choice between net and real-time gross settlement. As a novel feature, the communication between the public authorities is endogenized. It is shown that the national authorities’ incentives are not perfectly aligned concerning the settlement method. Therefore public regulation fails to implement the first-best access criteria. Banks prefer net settlement too often due to limited liability. Still, if banks have superior information about their counterparties, private involvement in access regulation is desirable as it reveals information to the public authorities.

We model rational herd behavior when the underlying value changes over time, with payoffs that are either dependent or independent of the underlying value. We show that herding does not last forever and is not monotone in signal quality. High correlation among agents' actions does not necessarily imply herding. This suggests alternative empirical methods are needed to detect herding. The model has many applications, including the IPO decision in which payoffs are state dependent. The model implies that the decision to go public is more likely associated with herding than the decision to delay an IPO. Copyright 2002, Oxford University Press.

We examine the effect of bargaining power and informational asymmetry on the design of international cooperative ventures in the presence of restrictions on equity participation and investment. When the bargaining advantage rests with the multinational, equity participation restrictions can increase the profits to domestic firms and encourage suboptimal investment policies. Overinvestment occurs when the multinational's bargaining advantage is reinforced by an informational advantage, while underinvestment occurs when the domestic firm possesses the informational advantage. In contrast, when the bargaining advantage rests with the domestic firm, equity participation restrictions do not affect investment levels. Copyright 2002, Oxford University Press.

We study the effects of financial innovation in a model of endogenous information acquisition. We determine the conditions under which the introduction of a derivative written on an existing stock increases or decreases the incentive to purchase information. We show that financial innovation produces some effects which hold across informational structures and others which differ. The former coincide with the few empirical results that are robust in the literature (effects on prices, risk premia, and volatility), while the latter coincide with the ones that differ experiment by experiment (effects on volume, correlation between volume and volatility, and market informational efficiency).

This paper investigates how firms’ bidding behavior in various auctions is affected by capital structure. A theoretical model is developed where the first price sealed bid and the English auction are examined. We find as debt levels increase, firms tend to decrease their bids. The lower bids give the competition incentives to decrease their bid as well. These results are then investigated empirically using the recent FCC spectrum auctions. Consistent with the theoretical model, larger debt levels of the bidding firm and the competition tend to lead to lower bids. Additional determinants of bidding behavior in these auctions are also analyzed.

We examine the impact deciding to route limit orders away from the New York Stock Exchange (NYSE) has on three dimensions of execution quality with methodologies controlling for market conditions and order submission strategies. Overall differences in limit order execution quality between regional stock exchanges and the NYSE are small, suggesting that the order routing decision may not affect retail limit order traders substantively. Conditioning on the distance between the limit order’s price and prevailing quotes, however, reveals systematic differences in execution quality. This implies that brokers can strategically route limit orders to improve retail limit order execution quality.

In most models of market microstructure tractability requires that all market participants know the number (and presence) of competing insiders. I drop this assumption in experimental asset markets. Outcomes are qualitatively consistent with theoretical models when the number of insiders is disclosed prior to trade. When it is not, insiders use the timing and size of trades interactively to hide from the dealers and each other, dealers have difficulty identifying insider trades, and liquidity patterns do not differ as a function of the number of insiders. In general, insider behavior has strategic dimensions not admitted in Kyle (1985) and extensions. Copyright 2002, Oxford University Press.