Knowledge that Transforms

Announcements of successful leveraged buyouts (LBOs) during January 1985 to April 1989 caused a significantly negative return on outstanding publicly traded nonconvertible bonds. Yet the average risk-adjusted debt holder losses are less than 7 percent of the average risk-adjusted equity holder gains. Bond losses are related to the pre-LBO rating, but only weakly to equity holder gains. We demonstrate that trader-quoted data from a major investment bank offers conclusions about the effects of LBOs on debt holders different from those drawn from commonly used matrix and exchange-based data (such as Standard & Poor’s Bond Guide data). This has important implications for event studies involving debt instruments.

In an extension of the Kyle (1985) model of continuous insider trading, it is shown that asymmetric information can make it impossible to price options by arbitrage. Even when an option would appear to be redundant, its introduction into the market can cause the volatility of the underlying asset to become stochastic. This eliminates the potential for dynamically replicating the option. The change in the price process of the asset reflects a change in the information transmitted by volume and prices when the option is traded.

Implied volatility is widely believed to be informationally superior to historical volatility, because it is the “market’s” forecast of future volatility. But for S&P 100 index options, the most actively traded contract in the United States, we find implied volatility to be a poor forecast of subsequent realized volatility. In aggregate and across subsamples separated by maturity and strike price, implied volatility has virtually no correlation with future volatility, and it does not incorporate the information contained in recent observed volatility.

I examine a two-period noisy rational expectations model of a futures market and show that the dispersion of expectations about a weighted average of future prices measures both the additional volatility and the additional expected.volume of trade associated with noisy information. The role played by dispersion helps clarify several stylized facts concerning volume and price behavior. Specifically, dispersion can be a factor contributing to the positive correlation between volume and absolute price changes, and the positive correlation between consecutive absolute price changes. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

We compare a sealed-bid uniform-price auction (the Treasury’s experimental format) with a sealed-bid discriminatory auction (the Treasury’s format heretofore), assuming the good is perfectly divisible. We show that the auction theory that prompted the experiment, which assumes single-unit demands, does not adequately describe the bidding game for Treasury securities. Collusive strategies are self-enforcing in uniform-price divisible-good auctions. In these equilibria, the seller’s expected revenue is lower than in equilibria of discriminatory auctions.

I discuss a new method for measuring the deviations between actual transaction prices and implicit efficient prices. The approach decomposes security transaction prices into random-walk and stationary components. The random-walk component may be identified with the efficient price. The stationary component, the difference between the efficient price and the actual transaction price, is termed the pricing error. Its dispersion is a natural measure of market quality. I describe practical strategies for estimating these quantities. For a sample of NYSE stocks, the average pricing error standard deviation estimate is roughly 0.33 percent of the stock price. If the pricing error is normally distributed.and if it is always a positive cost incurred by the transaction cost for these traders is 0.26 percent of the stock price. The dispersion of the pricing error is also found to be elevated at the beginning and end of the trading session. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

We examine the behavior of measured variances from the options market and the underlying stock market. Under the joint hypotheses that markets are informationally efficient and that option prices are explained by a particular asset pricing model, forecasts from time-series models of the stock return process should not have predictive content given the market forecast as embodied in option prices. Both in-sample and out-of-sample tests suggest that this hypothesis can be rejected. Using simulations, we show that biases inherent in the procedure we use to imply variances cannot explain this result. Thus, we provide evidence inconsistent with the orthogonality restrictions of option pricing models that assume that variance risk is unpriced. These results also have implications for optimum variance forecast rules.

Implied volatility is widely believed to be informationally superior to historical volatility, because it is the “market’s” forecast of future volatility. But for S&P 100 index options, the most actively traded contract in the United States, we find implied volatility to be a poor forecast of subsequent realized volatility. In aggregate and across subsamples separated by maturity and strike price, implied volatility has virtually no correlation with future volatility, and it does not incorporate the information contained in recent observed volatility.

We investigate predictability in national equity market returns, and its relation to global economic risks. We show how to consistently estimate the fraction of the predictable variation that is captured by an asset pricing model for the expected returns. We use a model in which conditional betas of the national equity markets depend on local information variables, while global risk premia depend on global variables. We examine single- and multiple-beta models, using monthly data for 1970 to 1989. The models capture much of the predictability for many countries. Most of this is related to time variation in the global risk premia.

Previous research finds that fundamental macroeconomic news has little effect on stock prices. We show that after allowing for different stages of the business cycle, a stronger relationship between stock prices and news is evident. In addition to stock prices, we examine the effect of real activity news on proxies for expected cash flows and equity discount rates. We find that when the economy is strong the stock market responds negatively to news about higher real economic activity. This negative relation is caused by the larger increase in discount rates relative to expected cash flows.