Knowledge that Transforms

This paper provides a global asset pricing perspective on the debate over the relation between predetermined attributes of common stocks, such as ratios of price-to-book-value, cash-flow, earnings, and other variables to the future returns. Some argue that such variables may be used to find securities that are systematically undervalued by the market, while others argue that the measures are proxies for exposure to underlying economic risk factors. It is not possible to distinguish between these views without explicitly modelling the relation between such attributes and risk factors. We present an empirical framework for attacking the problem at a global level, assuming integrated markets. Our perspective pulls together the traditional academic and practitioner viewpoints on lagged attributes. We present new evidence on the relative importance of risk and mispricing effects, using monthly data for 21 national equity markets. We find that the cross-sectional explanatory power of the lagged attributes is related to both risk and mispricing in the two-factor model, but the risk effects explain more of the variance than mispricing.

This paper expands the empirical research on the auctions of failed financial institutions by examining the thrift industry Accelerated Resolution Program as an alternative to the standard auction procedures. Jointly managed by the Office of Thrift Supervision and the Resolution Trust Corporation, the objective of this program was to intervene before insolvency and, thereby, to reduce the regulatory expenditures. Previous research has often found the existence of a wealth transfer to the winning bidders in both commercial bank and thrift auctions. In contrast to this previous research, no evidence is found in this study to conclude that a wealth transfer occurred in standard Resolution Trust Corporation auctions. Furthermore, while the Accelerated Resolution Program yielded positive abnormal returns, there is also no evidence of a wealth transfer.

This paper presents a reputation model of divestiture activity that yields a sharp cross-sectional implication for event studies of sell-off announcements: A decision to divest a division that is known to be successful conveys good news about the division; in contrast, a decision to divest a division that is known for underperformance conveys no news about the division. We test these hypotheses on a sample of sell-off announcements for which we find stories in the Wall Street Journal unambiguously characterizing the division being sold as either a “winner” or a “loser”. The stock price reaction to the sell-off of losers is indistinguishable from zero while the stock price reaction to the sell-off of winners is a statistically significant 2.5%. These results are strengthened when we expand the sample to include divisions whose profitability was announced in the company's annual report. For this expanded sample, the average stock price reaction to the announcements of sell-offs of losers remains indistinguishable from zero, while returns from the sell-offs of winners average a highly significant 3.4%.

This study tests the hypothesis that common stock call options are exercised rationally and in accordance with the commonly used frictionless markets boundary conditions. Using two years of historical early exercise data for common stock call options, the results show that contrary to the frictionless markets boundary conditions, approximately 20 percent of the early call exercise occurs at times other than ex-dividend dates. While most of the non-dividend related early exercise may be explained by transactions costs, a significant number of contracts appear to be exercised irrationally. These results suggest that failure to incorporate market frictions in option pricing models is likely to lead to specification error.

Some of the most recent empirical studies on interest rate derivatives have found humped shapes in the volatility structure of interest rates. In this paper, we propose a simple model that allows for humped volatility structures, and that can be described by one state variable. With the model, American style claims can be priced very efficiently which is very important if the model has to be calibrated daily to market prices of standard American options. Furthermore, the model allows for explicit formulas for European style options. Finally, the computational efficiency of our model in the Li et al. (1995) framework is compared with the efficiency in a typical Hull and White (1993a, 1994, 1996) framework. In fact, we can use both procedures for our model, since we prove that if a deterministic volatility model can be embedded in either of these algorithms, then so it does in the other one. Empirical evidence from option data supporting our model is provided as well.

This paper investigates the role of interest rate risk in explaining security price changes. We develop and test a two-factor linear beta pricing model of security returns in which the factors are the excess returns on the long-term, riskless bond and the equal-weighted equity market index. We find that time-variation in the interest rate and market risk premia influence expected security returns. Furthermore, conditional interest rate volatility affects security returns, particularly during periods of substantial interest rate movements.

It is well known that long-term interest rates display a lower volatility than short-term interest rates. The imperfect correlation between changes in long-term and short-term interest rates is also well documented. Simple immunization techniques based on duration and convexity do not take such factors into account. This paper suggests an approach which considers unequal volatility and imperfect correlation when building immunizing portfolios. Our results suggest that this approach may lead to significant improvements over both duration-based and convexity-based immunization strategies. Volatility-adjusted and correlation-adjusted immunization also outperform strategies based on factor analysis of interest rates changes.

This paper estimates multi-product cost functions for nearly 900 thrifts from 1990 to 1995. The results show the thrift industry benefited in the 1990s from a combination of reduced scale diseconomies, technical progress, and industry consolidation. The 1990 sample is characterized by substantial diseconomies of scale, which increased with thrift size, while the 1995 sample shows thrifts of all sizes operating with constant returns to scale. Sample selection is an important issue since there are fundamental differences between the thrifts that exited the industry during the 1990s and those that survived through the 1990s. If one examines all operating thrifts each year, for example, estimates of technical progress are biased upward, since large, inefficient thrifts regularly exited the industry in the 1990s.

This paper attempts to estimate both the direct and indirect costs of regulation for major sectors of the UK financial services industry. We also compare UK direct costs with those for the US and France and this provides a benchmark for assessing the effect of regulation on the competitive position of the UK financial services industry. We believe that this is the first attempt to compare regulatory costs in the UK with those of its major competitors. For indirect costs, in the absence of an international benchmark we compare our results with the predictions made at the time of the introduction of the Financial Services Act, by Lomax (Lomax, D., 1987. London Markets After the Financial Services Act, Butterworths, London) and Goodhart (Goodhart, C., 1988. The costs of regulation. In: Seldon, A. (Ed.), Financial Regulation or Over-regulation. Institute of Economic Affairs, London, p. 31). They estimated that indirect costs would be £4 for every £1 of direct costs and that annual aggregate costs would be £100 million. Our results suggest that, so far as direct costs are concerned, the costs of regulation for the securities and derivatives trading and broking sector are substantially lower for the UK than for the US and France. In contrast, for the investment management and unit trust industry UK costs are significantly higher than those for the other two countries. For the life insurance industry, UK costs are similar to those in France but markedly lower than those for the US. We also find for the securities industry around £4.1 of indirect costs per £1 of direct costs. For the investment management industry the corresponding figure is £3.2. However there is substantial variation across firms and, although our sample is too small to be definitive, the ratio appears to be related to firm size. Although these results are broadly in line with the predictions of Lomax and Goodhart it should be borne in mind that both numerator and denominator are substantially higher in real terms than those used by Lomax and Goodhart.