Knowledge that Transforms

We report results from experimental asset markets with liquidity traders and an insider where we allow bilateral trade to take place, in addition to public trade with dealers. In the absence of the search alternative, dealer profits are large—unlike in models with risk-neutral, competitive dealers. However, when we allow traders to participate in the search market, dealer profits are close to zero. Dealers compete more aggressively with the alternative trading avenue than with each other. There is no evidence that price discovery is less efficient when the specialists are not the only game in town.

The goal of this article is to examine the impact of 1975 Congressional mandate to integrate the trading of NYSE-listed stocks. The conclusions are: most of the time, the New York Stock Exchange (NYSE) quote matches or determines the best displayed quote, and the NYSE is the most frequent initiator of quote changes. Non-NYSE markets attract a significant portion of their volume when they are posting inferior bids or offers, indicating they obtain order flow for other reasons, such as “payment for order flow.” Yet, when a non-NYSE market does post a better bid or offer, it does attract additional order flow.

The Geske–Johnson approach provides an efficient and intuitively appealing technique for the valuation and hedging of American-style contingent claims. Here, we generalize their approach to a stochastic interest rate economy. The method is implemented using options exercisable on one of a finite number of dates. We illustrate how the value of an American-style option increases with interest rate volatility. The magnitude of this effect depends on the extent to which the option is in the money, the volatilities of the underlying asset and the interest rates, as well as the correlation between them.

Recent empirical evidence suggests that the long-run dependence in financial market volatility is best characterized by a slowly mean-reverting fractionally integrated process. At the same time, much shorter-lived volatility dependencies are typically observed with high-frequency intradaily returns.

We compare initial offer prices in privatizations to initial prices in public offerings of private companies. The evidence indicates that government officials in the United Kingdom underprice IPOs significantly more than their private company counterparts. In Canada and Malaysia, however, the opposite is true. There does not appear to be a general tendency for privatizations to be underpriced to a greater degree than private company IPOs. We provide additional evidence on the determinants of privatization initial returns. Our findings indicate that initial returns are significantly higher in relatively primitive capital markets and for privatized companies in regulated industries.

This article examines whether shifts in the stance of monetary policy can account for the observed predictability in excess stock returns. Using long-horizon regressions and short-horizon vector autoregressions, the article concludes that monetary policy variables are significant predictors of future returns, although they cannot fully account for observed stock return predictability. I undertake variance decompositions to investigate how monetary policy affects the individual components of excess returns (risk-free discount rates, risk premia, or cash flows).

ABSTRACT This article develops a game‐theoretic model to analyze market makers' intertemporal pricing strategies. We show that dealers who adopt noncooperative pricing strategies may set bid‐ask spreads above competitive levels. This form of “implicit collusion” differs from explicit collusion, where dealers cooperate to fix prices. Price discreteness or asymmetric information are not required for collusion to occur. Rather, institutional arrangements that restrict access to the order flow are important determinants of the ability to collude because they reduce dealers' incentives to compete on price. Public policy efforts to increase interdealer competition should focus on such restrictions.

ABSTRACT We develop an option pricing model for calls and puts written on leveraged equity in an economy with corporate taxes and bankruptcy costs. The model explains implied Black‐Scholes volatility biases by relating them to the firm's structural characteristics such as leverage and debt covenants. We test the model by comparing predicted pricing biases with biases observed in a large cross‐section of firms with liquid exchange traded option contracts. Our empirical study detects leverage related pricing biases. The magnitudes of these biases correspond to those predicted by our model. We also find significant pricing biases for firms financed primarily by short‐term debt. This supports our model because short‐term debt introduces net‐worth hurdles similar to net‐worth covenants.

ABSTRACT This article examines the efficiency of the National Football League (NFL) betting market. The standard ordinary least squares (OLS) regression methodology is replaced by a probit model. This circumvents potential econometric problems, and allows us to implement more sophisticated betting strategies where bets are placed only when there is a relatively high probability of success. In‐sample tests indicate that probit‐based betting strategies generate statistically significant profits. Whereas the profitability of a number of these betting strategies is confirmed by out‐of‐sample testing, there is some inconsistency among the remaining out‐of‐sample predictions. Our results also suggest that widely documented inefficiencies in this market tend to dissipate over time.

This paper analyzes the timing of CEO stock option awards, as a method of investigating corporate managers’ influence over the terms of their own compensation. In a sample of 620 stock option awards to CEOs of Fortune 500 companies between 1992 and 1994, I find that the timing of awards coincides with favorable movements in company stock prices. Patterns of companies’ quarterly earnings announcements are consistent with an interpretation that CEOs received stock option awards shortly before favorable corporate news. I evaluate and reject several alternative explanations of the results, including insider trading and the manipulation of news announcement dates.