Knowledge that Transforms

A model of a noncompetitive speculative market is analyzed in which privately informed traders and market makers are risk averse. Market liquidity is found to be nonmonotonic in the number of informed traders, their degree of risk aversion, and the precision of their information. It is also shown that increased liquidity trading leads to reduced priced efficiency, and that, under endogenous information acquisition, market liquidity may also be nonmonotonic in the variance of liquidity trades.

We examine the intraday relationship between returns and returns volatility in the stock index and stock index futures markets. Our results indicate a strong intermarket dependence in the volatility of the cash and futures returns. Price innovations that originate in either the stock or futures markets can predict the future volatility in the other market. We show that this relationship persists even during periods in which the dependence in the returns themselves appears to weaken. The findings are robust to controlling for potential market frictions such as asynchronous trading in the stock index. Our results have implications for understanding the pattern of information flows between the two markets.

The effect of financial policy on a firm’s incentives to maintain its reputation for producing a high-quality product is analyzed. It is demonstrated that in certain situations debt will reduce a firm’s ability to credibly offer high-quality products and, as a consequence, will reduce its value. However, for firms with assets that have high salvage values in liquidation, debt may increase their ability to credibly offer high-quality products and, therefore, increase their values.

In a security market with asymmetrically informed participants, trades are signals of private information. In this article, new measures of trade informativeness are proposed based on a decomposition of the variance of changes in the efficient price into trade-correlated and -uncorrelated components. The trade-correlated component has a natural interpretation as an absolute measure of trade informativeness. The ratio of this component to the total variance is a relative measure (i.e., a proportion normalized with respect to the total public information). For a sample NYSE-listed companies, trade are found to be more informative for small firms in both absolute and relative senses. From an analysis of intraday patterns, it appears that trades are in absolute terms more informative at the beginning of trading, but slightly less informative in relative terms. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

It is demonstrated that markets in stock index futures or, more generally, in baskets of securities, provide a preferred trading medium for uninformed liquidity traders who wish to trade portfolios, because adverse selection costs are typically lower in these markets than in markets for individual securities. Thus, an explanation is provided for the immense liquidity and popularity of markets in stock index futures. Implications are also developed for the effect of the introduction of a basket on market liquidity and the informativeness and variability of component security prices, and for the price relationship between the basket and its underlying portfolio. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

Stock prices cluster on round fractions. Clustering increases with price level and volatility, and decreases with capitalization and transaction frequency. Clustering is pervasive. Price clustering will occur if traders use discrete price sets to simplify their negotiations. Exchange regulations require that most stocks be traded on eighths. Clustering on larger fractions will occur if traders choose to use discrete price sets based on quarters, halves, or whole numbers. An econometric model of clustering is derived and estimated. Projections from the results suggest that traders would frequently use odd sixteenths when trading low-price stocks, if exchange regulations permitted trading on sixteenths. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

Abstract We show that time variation in expected returns and/or partial price adjustments lead to a downward bias in previous estimators of both the spread and its components. We introduce a new approach that provides unbiased and efficient estimators of the components of the spread. We find that between 77 and 97 percent of the downward bias in previous spread estimates is caused by time variation in expected returns. More importantly, the adverse-selection component, though significant, accounts for a much smaller proportion (8 to 13 percent) of the quoted spread, at least for small trades, than the proportion (over 40 percent) previously reported in the literature. Order processing costs are the predominant component of quoted spreads.

When a security trades at multiple locations simultaneously, an informed trader has several avenues in which to exploit his private information. The greater the proportion of liquidity trading by “large” traders who can split their trades across markets, the larger is the correlation between volume in different markets and the smaller is the informativeness of prices. We show that one of the markets emerges as the dominant location for trading in that security. When informed traders can use their information for more than one trading period, the timely release of price information by market makers at one location adversely affects the profits informed traders expect to make subsequently at other locations. Market makers, competing to offer the lowest cost of trading at their location, consequently deter informed trading by voluntarily making the price information public and by “cracking down” on insider trading.

This paper investigates the sensitivity of mean-variance(MV)-efficient portfolios to changes in the means of individual assets. When only a budget constraint is imposed on the investment problem, the analytical results indicate that an MV-efficient portfolio’s weights, mean, and variance can be extremely sensitive to changes in asset means. When nonnegativity constraints are also imposed on the problem, the computational results confirm that a positively weighted MV-efficient portfolio’s weights are extremely sensitive to changes in asset means, but the portfolio’s returns are not. A surprisingly small increase in the mean of just one asset drives half the securities from the portfolio. Yet the portfolio’s expected return and standard deviation are virtually unchanged.

We study the stock price distributions that arise when prices follow a diffusion process with a stochastically varying volatility parameter. We use analytic techniques to derive an explicit closed-form solution for the case where volatility is driven by an arithmetic Ornstein–Uhlenbeck (or AR1) process. We then apply our results to two related problems in the finance literature: (i) options pricing in a world of stochastic volatility, and (ii) the relationship between stochastic volatility and the nature of “fat tails” in stock price distributions.