Knowledge that Transforms

[Program trading and intraday changes in the S&P 500 Index are correlated. Futures prices and, to a lesser extent, cash prices lead program trades. Index arbitrage trades are followed by an immediate change in the cash index, which ultimately reverses slightly. No reversal follows nonarbitrage trades. The cumulative index changes associated with buy-and-sell trades and with arbitrage and nonarbitrage trades all are similar. Price decompositions suggest that the results are not due to microstructure effects. Program trades in this 1989--1990 sample do not seem to have created major short-term liquidity problems. The results are stable within the sample.]

[We examine the effect of changes in output uncertainty on the price of aggregate capital and on the prices of levered claims on capital. The relation between the volatility of the marginal product of capital and the price of capital depends on the level of capital adjustment costs and the elasticity of intertemporal substitution. For available estimates of this elasticity, the value of capital and risk are directly related while the value of levered equity claims on capital may be decreasing in risk. We use these results to analyze the argument that increase risk was responsible for the U.S. stock market decline of the 1970s.]

[To what extent are the empirical regularities implied by market microstructure theories useful in predicting the short-run behavior of stock returns? A two-equation econometric model of quote revisions and transaction returns is developed and used to identify the relative importance of different microstructure theories and to make predictions. Microstructure variables and lagged stock index futures returns have in-sample and out-of-sample predictive power based on data observed at five-minute intervals. The most striking microstructure implication of the model, confirmed by the empirical results, specifies that the expected quote return is positively related to the deviation between the transaction price and the quote midpoint while the expected transaction return is negatively related to the same variable.]