Knowledge that Transforms

We survey the variance-bounds tests of asset-price volatility, stressing the econometric aspects of these tests. The first variance-bounds tests of the present-value relation reported apparently striking evidence of excess volatility of asset prices. The statistical significance of the results, however, was either marginal or, in the case of model-free tests, impossible to assess. Moreover, the tests were soon criticized for a number of biases. Various other tests of the present-value relations were later developed, avoiding in different degrees the econometric problems attending the first-generation tests also found excess volatility, though sometimes of borderline statistical significance. This finding of excess volatility is robust and is difficult to explain within the representative-consumer, frictionless-market model. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

We present a model in which some of the firm’s information (“news”) can be disclosed verifiably and some information (“type”) cannot, to show that some firms may voluntarily withhold good news and disclose bad news. We describe an equilibrium in which high-type firms withhold good news and disclose bad news, whereas low-type firms disclose good news and withhold bad news. Under some parameter values, this equilibrium exists when other more traditional equilibria are ruled out by standard equilibrium refinements. The model explains some otherwise anomalous empirical evidence concerning stock price reactions to disclosure, provides some new empirical predictions, and suggests that mandatory disclosure requirements may have the undesirable consequence of making it more difficult for firms to reveal information that cannot be disclosed credibly.

We show that there is an asymmetry in the predictability of the volatilities of large versus small firms. Using both univariate and multivariate ARMA–GARCH-M parameterizations, we find that volatility surprises to large market value firms are important to the future dynamics of their own returns as well as the returns of smaller firms. Conversely, however, shocks to smaller firms have no impact on the behavior of either the mean or the variance of the returns of larger capitalization companies.

In the context of an equilibrium asset-pricing model, the dynamics of the instantaneous real interest rate and the instantaneous rate of expected inflation are estimated. Unlike previous models, we allow real interest rates and inflation to be mutually dependent processes. The model is estimated as a state-space system that includes observations on various maturity Treasury bills and NBER-ASA survey forecasts of inflation. Over the period 1968-88, we find evidence that instantaneous real interest rates and expected inflation are significantly negatively correlated. Real interest rates also display greater volatility and weaker mean reversion than expected inflation. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

The Modigliani and Miller propositions on the irrelevancy of capital structure and dividends are shown to be valid in a large class of models with asymmetric information. The main assumption is that managerial compensation is chosen optimally. This differs from most of the recent articles on this topic, which impose by fiat a suboptimal contract. Even when imperfections internal to the firm preclude optimal investment, there is a separation between incentives and financing. We conclude that corporations should move toward contracts with better incentives, and that new models should be built that recognize the limitations to optimal contracting.

A simple classical Walrasian framework is proposed for the study of manipulation among asymmetrically informed risk-averse traders in financial markets, and it is used to analyze the occurrence of a market breakdown in the trading system. Such a phenomenon occurs when the outsiders refuse to trade with the insiders because the informational motive for trade of the insider outweighs her hedging motive. We demonstrate the robustness of our results by proving that the market collapse condition extends not only to the linear strategy function, but to the whole class of feasible nonlinear strategy functions. Implications for insider-trading regulation are sketched.

We examine the volatility implications of around-the-clock foreign exchange trading with transaction data on futures contracts from the Chicago Mercantile Exchange and the London International Financial Futures Exchange. We find higher U.S.–European and U.S.–Japanese exchange-rate volatilities during U.S. trading hours and higher European cross-rate volatilities during European trading hours. While the disclosure of private information through trading may partly explain these volatility patterns, we conclude that the increased volatility is more likely driven by macroeconomic news announcements. An analysis of inter- and intraday data also reveals that volatility increases at times that coincide with the release of U.S. macroeconomic news.

The extent to which the observed procedures for selling new issues are efficient is studied. We show that a posted-price mechanism, in conjunction with nonbinding preplay communication and participation restrictions, leads to an allocation of the security (and payment) that maximizes the seller’s expected revenue, given the informational constraints imposed by the optimizing incentives of the potential buyers.

In this article, we consider the possibility that some liquidity traders preannounce the size of their orders, a practice that has come to be known as “sunshine trading”. Two possible effects preannouncement might have on the equilibrium are examined. First, since it identifies certain trades as informationless, preannouncement changes the nature of any informational asymmetries in the market. Second, preannouncement can coordinate the supply and demand of liquidity in the market. We show that preannouncement typically reduces the trading costs of those who preannounce, but its effects on the trading costs and welfare of other traders are ambiguous. We also examine the implications of preannouncement for the distribution of prices and the amount of information that prices reveal.

A general approach to testing serial dependence restrictions implied from financial models is developed. In particular, we discuss joint serial dependence restrictions imposed by random walk, market microstructure, and rational expectations models recently examined in the literature. This approach incorporates more information from the data by explicitly modeling dependencies induced by the use of overlapping observations. Because the estimation problem is sufficiently simple in this framework, the test statistics have simple representations in terms of only a few unknown parameters. As a result, relatively good size properties are attained in small samples. In addition, the benefit to overlapping observations and the advantage of examining multiperiod time series are explicitly quantified.