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Volume 44: Issue 1 (March 1989)

Information and Volatility: The No‐Arbitrage Martingale Approach to Timing and Resolution Irrelevancy

Pages: 1-17  |  Published: 3/1989  |  DOI: 10.1111/j.1540-6261.1989.tb02401.x  |  Cited by: 525


The no‐arbitrage martingale analysis is used to study the effect on asset prices of changes in the rate of information flow. The analysis is first used to develop some simple tools for asset pricing in a continuous‐time setting. These tools are then applied to determine the effect of information on prices and price volatility, to extend Samuelson's theorem on prices fluctuating randomly, and to study the impact on prices of the resolution of uncertainty. The conditions under which uncertainty resolution is irrelevant for asset pricing are shown to be similar to those which support the MM irrelevance theorems.

Dynamic Capital Structure Choice: Theory and Tests

Pages: 19-40  |  Published: 3/1989  |  DOI: 10.1111/j.1540-6261.1989.tb02402.x  |  Cited by: 840


This paper develops a model of dynamic capital structure choice in the presence of recapitalization costs. The theory provides the optimal dynamic recapitalization policy as a function of firm‐specific characteristics. We find that even small recapitalization costs lead to wide swings in a firm's debt ratio over time. Rather than static leverage measures, we use the observed debt ratio range of a firm as an empirical measure of capital structure relevance. The results of empirical tests relating firms' debt ratio ranges to firm‐specific features strongly support the theoretical model of relevant capital structure choice in a dynamic setting.

Preemptive Bidding and the Role of the Medium of Exchange in Acquisitions

Pages: 41-57  |  Published: 3/1989  |  DOI: 10.1111/j.1540-6261.1989.tb02403.x  |  Cited by: 315


The medium of exchange in acquisitions is studied in a model where (i) bidders' offers bring forth potential competition and (ii) targets and bidders are asymmetrically informed. In equilibrium, both securities and cash offers are observed. Securities have the advantage of inducing target management to make an efficient accept/reject decision. Cash has the advantage of serving, in equilibrium, to “preempt” competition by signaling a high valuation for the target. Implications concerning the medium of exchange of an offer, the probability of acceptance, the probability of competing bids, expected profits, and the costs of bidders are derived.

The Winner's Curse and Bidder Competition in Acquisitions: Evidence from Failed Bank Auctions

Pages: 59-75  |  Published: 3/1989  |  DOI: 10.1111/j.1540-6261.1989.tb02404.x  |  Cited by: 100


This study examines the effect of bidder competition in acquisitions. We use predictions from auction theory to test whether acquirers of failed banks overpay (the “winner's curse”) when bidding in FDIC sealed‐bid purchase and assumption (P&A) transactions (auctions). The empirical results indicate that winning bids tend to increase as the number of competitors increases, as predicted by theory. We also find that bid levels of all bidders increase with increased competition, which is consistent with bidders' failing to adjust for the winner's curse in a common value auction setting. However, additional tests using winning bids only are consistent with both a common value and a private values model, so this result should be interpreted with caution.

The October 1987 S&P 500 Stock‐Futures Basis

Pages: 77-99  |  Published: 3/1989  |  DOI: 10.1111/j.1540-6261.1989.tb02405.x  |  Cited by: 99


Five‐minute changes in the S&P 500 index and futures contract are examined over a ten‐day period surrounding the October 1987 stock market crash. Since nonsynchronous trading problems are severe in these data, new index estimators are derived and used. The estimators use the complete transaction history of all 500 stocks. Nonsynchronous trading explains part of the large absolute futures‐cash basis observed during the crash. The remainder may be due to disintegration of the two markets. Even after adjustment for nonsynchronous trading, the index displays more autocorrelation than does the futures and the futures leads the index.

The Quality Option and Timing Option in Futures Contracts

Pages: 101-113  |  Published: 3/1989  |  DOI: 10.1111/j.1540-6261.1989.tb02406.x  |  Cited by: 43


Often futures contracts contain quality options whereby the short position has the choice of delivering one of an acceptable set of assets. We explore the implications of the quality option on the futures price. We develop a method for pricing the quality option for the general case of n deliverable assets and provide numerical illustrations of its significance. Even when the asset prices are very highly correlated, this option can have nontrivial value, especially when there is a large number of deliverable assets. We analyze the impact of the timing option and its interaction with the quality option. A procedure is developed for valuing the timing option in the presence of the quality option, and some numerical estimates are obtained.

Inferring the Components of the Bid‐Ask Spread: Theory and Empirical Tests

Pages: 115-134  |  Published: 3/1989  |  DOI: 10.1111/j.1540-6261.1989.tb02407.x  |  Cited by: 460


The relation between the square of the quoted bid‐ask spread and two serial covariances—the serial covariance of transaction returns and the serial covariance of quoted returns—is modeled as a function of the probability of a price reversal, π, and the magnitude of a price change, ∂, where ∂ is stated as a fraction of the quoted spread. Different models of the spread are contrasted in terms of the parameters, π and ∂. Using data on the transaction prices and price quotations for NASDAQ/NMS stocks, π and ∂ are estimated and the relative importance of the components of the quoted spread—adverse information costs, order processing costs, and inventory holding costs—is determined.

Earnings Yields, Market Values, and Stock Returns

Pages: 135-148  |  Published: 3/1989  |  DOI: 10.1111/j.1540-6261.1989.tb02408.x  |  Cited by: 222


Earlier evidence concerning the relation between stock returns and the effects of size and earnings to price ratio (E/P) is not clear‐cut. This paper re‐examines these two effects with (a) a substantially longer sample period, 1951–1986, (b) data that are reasonably free of survivor biases, (c) both portfolio and seemingly unrelated regression tests, and (d) an emphasis on the important differences between January and other months. Over the entire period, the earnings yield effect is significant in both January and the other eleven months. Conversely, the size effect is significantly negative only in January. We also find evidence of consistently high returns for firms of all sizes with negative earnings.

Portfolio Rebalancing and the Turn‐of‐the‐Year Effect

Pages: 149-166  |  Published: 3/1989  |  DOI: 10.1111/j.1540-6261.1989.tb02409.x  |  Cited by: 82


This paper finds that, for the 1935–1986 period, the market's risk‐return relation does not have a January seasonal. The findings differ from those of other studies due to the use of value‐weighted, rather than equally weighted, portfolios. Inferences are sensitive to the weighting procedure because of the small‐firm return patterns in January. In particular, even in those Januaries for which the market return is negative, small‐firm returns are positive, and they are more positive the higher is beta. This is consistent with the portfolio rebalancing explanation of the turn‐of‐the‐year effect.

Common Stochastic Trends in a System of Exchange Rates

Pages: 167-181  |  Published: 3/1989  |  DOI: 10.1111/j.1540-6261.1989.tb02410.x  |  Cited by: 241


Univariate tests reveal strong evidence for the presence of a unit root in the univariate time‐series representation for seven daily spot and forward exchange rate series. Furthermore, all seven spot and forward rates appear to be cointegrated; that is, the forward premiums are stationary, and one common unit root, or stochastic trend, is detectable in the multivariate time‐series models for the seven spot and forward rates, respectively. This is consistent with the hypothesis that the seven exchange rates possess one long‐run relationship and that the disequilibrium error around that relationship partly accounts for subsequent movements in the exchange rates.

An Analysis of Intertemporal Pricing for Forward Foreign Exchange Contracts

Pages: 183-194  |  Published: 3/1989  |  DOI: 10.1111/j.1540-6261.1989.tb02411.x  |  Cited by: 7


An asset‐pricing model with an unobservable time‐varying risk premium is used to price forward foreign exchange contracts. Specifically, the term spectrum of forward foreign exchange contracts is examined in order to focus on country‐specific and maturity‐specific information. The testable restrictions imposed by the model are consistent with both cross‐country and cross‐maturity forward contracts except at the short end of the maturity spectrum for cross‐country forward exchange rates. This indicates that the intertemporal model is relatively robust in valuing forward contracts of different maturities and for different exchange rates but that it may fail when there are significant short‐term country‐specific shocks.

Syndicate Size, Spreads, and Market Power during the Introduction of Shelf Registration

Pages: 195-204  |  Published: 3/1989  |  DOI: 10.1111/j.1540-6261.1989.tb02412.x  |  Cited by: 6


The introduction of shelf registration in 1982 is used to examine the extent of price‐taking behavior among investment banks. Changes in underwriting syndicates are compared with the concomitant adjustment in underwriting spreads and management fees. The evidence is consistent with higher organizing costs and/or market power in the underwriting syndicate. Evidence on the components of the spreads and syndicate composition during the introduction of shelf registration is also presented.

An Exact Bond Option Formula

Pages: 205-209  |  Published: 3/1989  |  DOI: 10.1111/j.1540-6261.1989.tb02413.x  |  Cited by: 344


This paper derives a closed‐form solution for European options on pure discount bonds, assuming a mean‐reverting Gaussian interest rate model as in Vasicek [8]. The formula is extended to European options on discount bond portfolios.

Computing the Constant Elasticity of Variance Option Pricing Formula

Pages: 211-219  |  Published: 3/1989  |  DOI: 10.1111/j.1540-6261.1989.tb02414.x  |  Cited by: 193


This paper expresses the constant elasticity of variance option pricing formula in terms of the noncentral chi‐square distribution. This allows the application of well‐known approximation formulas and the derivation of a whole class of closed‐form solutions. In addition, a simple and efficient algorithm for computing this distribution is presented.

Book Reviews

Pages: 221-226  |  Published: 3/1989  |  DOI: 10.1111/j.1540-6261.1989.tb02415.x  |  Cited by: 0

Security Markets: Stochastic Models. By DARRELL DUFFIE. San Diego: Academic Press, 1988. Pp. xx + 358.


Pages: 227-228  |  Published: 3/1989  |  DOI: 10.1111/j.1540-6261.1989.tb02416.x  |  Cited by: 0