Knowledge that Transforms

International audience

We assess the profitability of momentum strategies using a stochastic discount factor approach. In unconditional tests, approximately half of the strategies' profitability is explained. In conditional tests we see a further slight decline in profits. We argue that the risk of these strategies should be increasing in the market risk premium. Empirically, while their risk measures estimated relative to the stochastic discount factor behave as predicted, market betas do not; thus capital asset pricing model (CAPM)-like benchmarks may lead to incorrect inferences. Given that our nonparametric risk adjustment explains roughly half of momentum strategy profits, we cannot rule out the possibility of residual mispricing.

The effects of competitive interactions on investment decisions and on the dynamics of the price of a nonstorable commodity are studied in a model of incremental investment with time to build and operating flexibility. I find that an increase in uncertainty may encourage firms to increase their capacity. Furthermore, I show that it may be optimal to invest in additional capacity during periods in which part of the operational capacity is not being utilized. The impact of competition on the properties of the endogenous output price is dramatic. For example, I find that price volatility may be increasing in the number of competitors in the industry. Copyright 2003, Oxford University Press.

This article presents a model of information monitoring and market making in a dealership market. We model how intensively dealers monitor public information to avoid being picked off by professional day traders when monitoring is costly. Price competition among dealers is hampered by their incentives to share monitoring costs. The risk of being picked off by the day traders makes dealers more competitive. The interaction between these effects determines whether a firm quote rule improves trading costs and price discovery. Our empirical results support the prediction that professional day traders prefer stocks with small spreads, but offer less support for the prediction that their trading leads to wider spreads.

Using a new Bayesian method for the analysis of diffusion processes, this article finds that the nonlinear drift in interest rates found in a number of previous studies can be confirmed only under prior distributions that are best described as informative. The assumption of stationarity, which is common in the literature, represents a nontrivial prior belief about the shape of the drift function. This belief and the use of “flat” priors contribute strongly to the finding of nonlinear mean reversion. Implementation of an approximate Jeffreys prior results in virtually no evidence for mean reversion in interest rates unless stationarity is assumed. Finally, the article documents that nonlinear drift is primarily a feature of daily rather than monthly data, and that these data contain a transitory element that is not reflected in the volatility of longer-maturity yields.

This article introduces the concept of a statistical arbitrage opportunity (SAO). In a finite-horizon economy, a SAO is a zero-cost trading strategy for which (i) the expected payoff is positive, and (ii) the conditional expected payoff in each final state of the economy is nonnegative. Unlike a pure arbitrage opportunity, a SAO can have negative payoffs provided that the average payoff in each final state is nonnegative. If the pricing kernel in the economy is path independent, then no SAOs can exist. Furthermore, ruling out SAOs imposes a novel martingale-type restriction on the dynamics of securities prices. The important properties of the restriction are that it (1) is model-free, in the sense that it requires no parametric assumptions about the true equilibrium model, (2) can be tested in samples affected by selection biases, such as the peso problem, and (3) continues to hold when investors' beliefs are mistaken. The article argues that one can use the new restriction to empirically resolve the joint hypothesis problem present in the traditional tests of the efficient market hypothesis. Copyright 2003, Oxford University Press.

This article examines the link between several well-known asset pricing “anomalies” and the covariance structure of returns. I find size, book-to-market, and momentum strategies exhibit a strong, weak, and negligible relation to covariance risk, respectively. A size factor helps predict future volatility and covariation, improving the efficiency of investment strategies. Moreover, its premium rises following increases in both its volatility and covariation with other assets. These effects are amplified in recessions. No such relations exist for book-to-market or momentum. These findings may shed light on explanations for these premia and present a challenging set of facts for future theory.

In a sample of 2,794 initial public offerings (IPOs), we test three potential explanations for the existence of IPO lockups: lockups serve as (i) a signal of firm quality, (ii) a commitment device to alleviate moral hazard problems, or (iii) a mechanism for underwriters to extract additional compensation from the issuing firm. Our results support the commitment hypothesis. Insiders of firms that are associated with greater potential for moral hazard lockup their shares for a longer period of time. Insiders of firms that have experienced larger excess returns, are backed by venture capitalists, or go public with high-quality underwriters are more likely to be released from the lockup restrictions.

We examine the costs and benefits of the global integration of initial public offering (IPO) markets associated with the diffusion of U.S. underwriting methods in the 1990s. Bookbuilding is becoming increasingly popular outside the United States and typically costs twice as much as a fixed-price offer. However, on its own, bookbuilding only leads to lower underpricing when conducted by U.S. banks and/or targeted at U.S. investors. For most issuers, the gains associated with lower underpricing outweighed the additional costs associated with hiring U.S. banks or marketing in the United States. This suggests a quality/price trade-off contrasting with the findings of Chen and Ritter, particularly since non-U.S. issuers raising US$20 million–US$80 million also typically pay a 7% spread when U.S. banks and investors are involved.

We present a microstructure model of competition for order flow between exchanges based on liquidity provision. We find that neither a pure limit order market (PLM) nor a hybrid specialist/limit order market (HM) structure is competition-proof. A PLM can always be supported in equilibrium as the dominant market (i.e., where the hybrid limit book is empty), but an HM can also be supported, for some market parameterizations, as the dominant market. We also show the possible coexistence of competing markets. Order preferencing—that is, decisions about where orders are routed when investors are indifferent—is a key determinant of market viability. Welfare comparisons show that competition between exchanges can increase as well as reduce the cost of liquidity.