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Volume 59: Issue 1 (February 2004)

Endogenous Liquidity in Asset Markets

Pages: 1-30  |  Published: 2/2004  |  DOI: 10.1111/j.1540-6261.2004.00625.x  |  Cited by: 212

Andrea L. Eisfeldt

This paper analyzes a model in which long‐term risky assets are illiquid due to adverse selection. The degree of adverse selection and hence the liquidity of these assets is determined endogenously by the amount of trade for reasons other than private information. I find that higher productivity leads to increased liquidity. Moreover, liquidity magnifies the effects of changes in productivity on investment and volume. High productivity implies that investors initiate larger scale risky projects which increases the riskiness of their incomes. Riskier incomes induce more sales of claims to high‐quality projects, causing liquidity to increase.

Price Pressure around Mergers

Pages: 31-63  |  Published: 2/2004  |  DOI: 10.1111/j.1540-6261.2004.00626.x  |  Cited by: 248

Mark Mitchell, Todd Pulvino, Erik Stafford

This paper examines the trading behavior of professional investors around 2,130 mergers announced between 1994 and 2000. We find considerable support for the existence of price pressure around mergers caused by uninformed shifts in excess demand, but that these effects are short‐lived, consistent with the notion that short‐run demand curves for stocks are not perfectly elastic. We estimate that nearly half of the negative announcement period stock price reaction for acquirers in stock‐financed mergers reflects downward price pressure caused by merger arbitrage short selling, suggesting that previous estimates of merger wealth effects are biased downward.

Value‐Enhancing Capital Budgeting and Firm‐specific Stock Return Variation

Pages: 65-105  |  Published: 2/2004  |  DOI: 10.1111/j.1540-6261.2004.00627.x  |  Cited by: 598

Art Durnev, Randall Morck, Bernard Yeung

We document a robust cross‐sectional positive association across industries between a measure of the economic efficiency of corporate investment and the magnitude of firm‐specific variation in stock returns. This finding is interesting for two reasons, neither of which is a priori obvious. First, it adds further support to the view that firm‐specific return variation gauges the extent to which information about the firm is quickly and accurately reflected in share prices. Second, it can be interpreted as evidence that more informative stock prices facilitate more efficient corporate investment.

Bondholder Wealth Effects in Mergers and Acquisitions: New Evidence from the 1980s and 1990s

Pages: 107-135  |  Published: 2/2004  |  DOI: 10.1111/j.1540-6261.2004.00628.x  |  Cited by: 243

Matthew T. Billett, Tao‐Hsien Dolly King, David C. Mauer

We examine the wealth effects of mergers and acquisitions on target and acquiring firm bondholders in the 1980s and 1990s. Consistent with a coinsurance effect, below investment grade target bonds earn significantly positive announcement period returns. By contrast, acquiring firm bonds earn negative announcement period returns. Additionally, target bonds have significantly larger returns when the target's rating is below the acquirer's, when the combination is anticipated to decrease target risk or leverage, and when the target's maturity is shorter than the acquirer's. Finally, we find that target and acquirer announcement period bond returns are significantly larger in the 1990s.

Social Interaction and Stock‐Market Participation

Pages: 137-163  |  Published: 2/2004  |  DOI: 10.1111/j.1540-6261.2004.00629.x  |  Cited by: 1144

Harrison Hong, Jeffrey D. Kubik, Jeremy C. Stein

We propose that stock‐market participation is influenced by social interaction. In our model, any given “social” investor finds the market more attractive when more of his peers participate. We test this theory using data from the Health and Retirement Study, and find that social households—those who interact with their neighbors, or attend church—are substantially more likely to invest in the market than non‐social households, controlling for wealth, race, education, and risk tolerance. Moreover, consistent with a peer‐effects story, the impact of sociability is stronger in states where stock‐market participation rates are higher.

Market Imperfections, Investment Flexibility, and Default Spreads

Pages: 165-205  |  Published: 2/2004  |  DOI: 10.1111/j.1540-6261.2004.00630.x  |  Cited by: 45

Sheridan Titman, Stathis Tompaidis, Sergey Tsyplakov

This paper develops a structural model that determines default spreads in a setting where the debt's collateral is endogenously determined by the borrower's investment choice, and a demand variable with permanent and temporary components. We also consider the possibility that the borrower cannot commit to taking the value‐maximizing investment choice, and may, in addition, be constrained in its ability to raise external capital. Based on a model calibrated to data on office buildings and commercial mortgages, we present numerical simulations that quantify the extent to which investment flexibility, incentive problems, and credit constraints affect default spreads.

Compensation, Incentives, and the Duality of Risk Aversion and Riskiness

Pages: 207-225  |  Published: 2/2004  |  DOI: 10.1111/j.1540-6261.2004.00631.x  |  Cited by: 459

Stephen A. Ross

The common folklore that giving options to agents will make them more willing to take risks is false. In fact, no incentive schedule will make all expected utility maximizers more or less risk averse. This paper finds simple, intuitive, necessary and sufficient conditions under which incentive schedules make agents more or less risk averse. The paper uses these to examine the incentive effects of some common structures such as puts and calls, and it briefly explores the duality between a fee schedule that makes an agent more or less risk averse, and gambles that increase or decrease risk.

The Statistical and Economic Role of Jumps in Continuous‐Time Interest Rate Models

Pages: 227-260  |  Published: 2/2004  |  DOI: 10.1111/j.1540-6321.2004.00632.x  |  Cited by: 354

Michael Johannes

This paper analyzes the role of jumps in continuous‐time short rate models. I first develop a test to detect jump‐induced misspecification and, using Treasury bill rates, find evidence for the presence of jumps. Second, I specify and estimate a nonparametric jump‐diffusion model. Results indicate that jumps play an important statistical role. Estimates of jump times and sizes indicate that unexpected news about the macroeconomy generates the jumps. Finally, I investigate the pricing implications of jumps. Jumps generally have a minor impact on yields, but they are important for pricing interest rate options.

Are Investors Rational? Choices among Index Funds

Pages: 261-288  |  Published: 2/2004  |  DOI: 10.1111/j.1540-6261.2004.00633.x  |  Cited by: 222

Edwin J. Elton, Martin J. Gruber, Jeffrey A. Busse

S&P 500 index funds represent one of the simplest vehicles for examining rational behavior. They hold virtually the same securities, yet their returns differ by more than 2 percent per year. Although the relative returns of alternative S&P 500 funds are easily predictable, the relationship between cash flows and performance is weaker than rational behavior would lead us to expect. We show that selecting funds based on low expenses or high past returns outperforms the portfolio of index funds selected by investors. Our results exemplify the fact that, in a market where arbitrage is not possible, dominated products can prosper.

Optimal Consumption and Investment with Transaction Costs and Multiple Risky Assets

Pages: 289-338  |  Published: 2/2004  |  DOI: 10.1111/j.1540-6261.2004.00634.x  |  Cited by: 220

Hong Liu

We consider the optimal intertemporal consumption and investment policy of a constant absolute risk aversion (CARA) investor who faces fixed and proportional transaction costs when trading multiple risky assets. We show that when asset returns are uncorrelated, the optimal investment policy is to keep the dollar amount invested in each risky asset between two constant levels and upon reaching either of these thresholds, to trade to the corresponding optimal targets. An extensive analysis suggests that transaction cost is an important factor in affecting trading volume and that it can significantly diminish the importance of stock return predictability as reported in the literature.

Informed Trading When Information Becomes Stale

Pages: 339-390  |  Published: 2/2004  |  DOI: 10.1111/j.1540-6261.2004.00635.x  |  Cited by: 52

Dan Bernhardt, Jianjun Miao

This paper characterizes informed trade when speculators can acquire distinct signals of varying quality about an asset's value at different dates. The most reasonable characterization of private information about stocks is that while information is long‐lived, new information will arrive over time, information that may be acquired by others. Hence, while a speculator may know more than others at a moment, in the future, his information will become stale, but not valueless. In an environment that allows for arbitrary correlations among signals, we characterize equilibrium outcomes including trading, prices, and profits. We provide explicit numerical characterizations for different informational environments.

Convertible Bond Design and Capital Investment: The Role of Call Provisions

Pages: 391-405  |  Published: 2/2004  |  DOI: 10.1111/j.1540-6261.2004.00636.x  |  Cited by: 55

Timo P. Korkeamaki, William T. Moore

If firms issue convertible securities to facilitate sequential investment, the securities should be engineered to give sufficient flexibility to accommodate timing of follow‐on investment. We examine call provisions in convertible bonds and argue that firms with investment options expected to expire sooner (later) will offer weaker (stronger) call protection. We find that issues with weak or no call protection are offered by firms that invest greater amounts soon after issuance than those issuing convertibles with strong protection. Moreover, capital expenditure levels during the 5‐year period following issuance are inversely related to the length of call‐protection periods.

Option‐Implied Risk Aversion Estimates

Pages: 407-446  |  Published: 2/2004  |  DOI: 10.1111/j.1540-6261.2004.00637.x  |  Cited by: 465

Robert R. Bliss, Nikolaos Panigirtzoglou

Using a utility function to adjust the risk‐neutral PDF embedded in cross sections of options, we obtain measures of the risk aversion implied in option prices. Using FTSE 100 and S&P 500 options, and both power and exponential‐utility functions, we estimate the representative agent's relative risk aversion (RRA) at different horizons. The estimated coefficients of RRA are all reasonable. The RRA estimates are remarkably consistent across utility functions and across markets for given horizons. The degree of RRA declines broadly with the forecast horizon and is lower during periods of high market volatility.

How Do Exchanges Select Stocks for Option Listing?

Pages: 447-471  |  Published: 2/2004  |  DOI: 10.1111/j.1540-6261.2004.00638.x  |  Cited by: 131

Stewart Mayhew, Vassil Mihov

We investigate the factors influencing the selection of stocks for option listing. Exchanges tend to list options on stocks with high trading volume, volatility, and market capitalization, but the relative effect of these factors has changed over time as markets have evolved. We observe a shift from volume toward volatility after the moratorium on new listings ended in 1980. Using control sample methodology designed to correct for the endogeneity of option listing, we find no evidence that volatility declines with option introduction, in contrast to previous studies that do not use control samples.


Pages: 473-474  |  Published: 2/2004  |  DOI: 10.1111/j.1540-6261.2004.00639.x  |  Cited by: 0