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Volume 66: Issue 1 (February 2011)

Does Algorithmic Trading Improve Liquidity?

Pages: 1-33  |  Published: 1/2011  |  DOI: 10.1111/j.1540-6261.2010.01624.x  |  Cited by: 1108


Algorithmic trading (AT) has increased sharply over the past decade. Does it improve market quality, and should it be encouraged? We provide the first analysis of this question. The New York Stock Exchange automated quote dissemination in 2003, and we use this change in market structure that increases AT as an exogenous instrument to measure the causal effect of AT on liquidity. For large stocks in particular, AT narrows spreads, reduces adverse selection, and reduces trade‐related price discovery. The findings indicate that AT improves liquidity and enhances the informativeness of quotes.

When Is a Liability Not a Liability? Textual Analysis, Dictionaries, and 10‐Ks

Pages: 35-65  |  Published: 1/2011  |  DOI: 10.1111/j.1540-6261.2010.01625.x  |  Cited by: 3192


Previous research uses negative word counts to measure the tone of a text. We show that word lists developed for other disciplines misclassify common words in financial text. In a large sample of 10‐Ks during 1994 to 2008, almost three‐fourths of the words identified as negative by the widely used Harvard Dictionary are words typically not considered negative in financial contexts. We develop an alternative negative word list, along with five other word lists, that better reflect tone in financial text. We link the word lists to 10‐K filing returns, trading volume, return volatility, fraud, material weakness, and unexpected earnings.

The Causal Impact of Media in Financial Markets

Pages: 67-97  |  Published: 1/2011  |  DOI: 10.1111/j.1540-6261.2010.01626.x  |  Cited by: 731


Disentangling the causal impact of media reporting from the impact of the events being reported is challenging. We solve this problem by comparing the behaviors of investors with access to different media coverage of the same information event. We use zip codes to identify 19 mutually exclusive trading regions corresponding with large U.S. cities. For all earnings announcements of S&P 500 Index firms, we find that local media coverage strongly predicts local trading, after controlling for earnings, investor, and newspaper characteristics. Moreover, local trading is strongly related to the timing of local reporting, a particular challenge to nonmedia explanations.

Leverage, Moral Hazard, and Liquidity

Pages: 99-138  |  Published: 1/2011  |  DOI: 10.1111/j.1540-6261.2010.01627.x  |  Cited by: 250


Financial firms raise short‐term debt to finance asset purchases; this induces risk shifting when economic conditions worsen and limits their ability to roll over debt. Constrained firms de‐lever by selling assets to lower‐leverage firms. In turn, asset–market liquidity depends on the system‐wide distribution of leverage, which is itself endogenous to future economic prospects. Good economic prospects yield cheaper short‐term debt, inducing entry of higher‐leverage firms. Consequently, adverse asset shocks in good times lead to greater de‐leveraging and sudden drying up of market and funding liquidity.

Stock Market Liquidity and the Business Cycle

Pages: 139-176  |  Published: 1/2011  |  DOI: 10.1111/j.1540-6261.2010.01628.x  |  Cited by: 290


In the recent financial crisis we saw liquidity in the stock market drying up as a precursor to the crisis in the real economy. We show that such effects are not new; in fact, we find a strong relation between stock market liquidity and the business cycle. We also show that investors' portfolio compositions change with the business cycle and that investor participation is related to market liquidity. This suggests that systematic liquidity variation is related to a “flight to quality” during economic downturns. Overall, our results provide a new explanation for the observed commonality in liquidity.

Asset Pricing with Garbage

Pages: 177-201  |  Published: 1/2011  |  DOI: 10.1111/j.1540-6261.2010.01629.x  |  Cited by: 163


A new measure of consumption, garbage, is more volatile and more correlated with stocks than the canonical measure, National Income and Product Accounts (NIPA) consumption expenditure. A garbage‐based consumption capital asset pricing model matches the U.S. equity premium with relative risk aversion of 17 versus 81 and evades the joint equity premium‐risk‐free rate puzzle. These results carry through to European data. In a cross‐section of size, value, and industry portfolios, garbage growth is priced and drives out NIPA expenditure growth.

Derivative Pricing with Liquidity Risk: Theory and Evidence from the Credit Default Swap Market

Pages: 203-240  |  Published: 1/2011  |  DOI: 10.1111/j.1540-6261.2010.01630.x  |  Cited by: 255


We derive an equilibrium asset pricing model incorporating liquidity risk, derivatives, and short‐selling due to hedging of nontraded risk. We show that illiquid assets can have lower expected returns if the short‐sellers have more wealth, lower risk aversion, or shorter horizon. The pricing of liquidity risk is different for derivatives than for positive‐net‐supply assets, and depends on investors' net nontraded risk exposure. We estimate this model for the credit default swap market. We find strong evidence for an expected liquidity premium earned by the credit protection seller. The effect of liquidity risk is significant but economically small.

The Decision to Privatize: Finance and Politics

Pages: 241-269  |  Published: 1/2011  |  DOI: 10.1111/j.1540-6261.2010.01631.x  |  Cited by: 147


We investigate the influence of political and financial factors on the decision to privatize government‐owned firms. The results show that profitable firms and firms with a lower wage bill are likely to be privatized early. We find that the government delays privatization in regions where the governing party faces more competition from opposition parties. The results also suggest that political patronage is important as no firm located in the home state of the minister in charge is ever privatized. Using political variables as an instrument for the privatization decision, we find that privatization has a positive impact on firm performance.

Why Do Mutual Fund Advisory Contracts Change? Performance, Growth, and Spillover Effects

Pages: 271-306  |  Published: 1/2011  |  DOI: 10.1111/j.1540-6261.2010.01632.x  |  Cited by: 47


We examine changes in equity mutual funds' investment advisory contracts. We find substantial advisory compensation rate changes in both directions, with typical percentage fee shifts exceeding one‐fourth. Rate increases are associated with superior past market‐adjusted performance, whereas rate decreases reflect economies of scale associated with growth, and are not associated with extreme poor performance. There are within‐family spillover effects. Superior (e.g., star) performance for individual funds is associated with rate increases for a family's other funds. Rate reductions post‐2004 by family funds involved in market timing scandals do not have large industry spillover effects.

Style‐Related Comovement: Fundamentals or Labels?

Pages: 307-332  |  Published: 1/2011  |  DOI: 10.1111/j.1540-6261.2010.01633.x  |  Cited by: 138


I find that economically meaningless index labels cause stock returns to covary in excess of fundamentals. S&P/Barra follow a simple mechanical procedure to define their Value and Growth indices. In doing so, they reclassify some stocks from Value to Growth even after their book‐to‐market ratios have risen, and vice versa. Such stocks begin to covary more with the index they join and less with the index they leave. Backdated constituent data from Barra reveal no such label‐related shifts in comovement during the 10 years prior to the actual introduction of the indices in 1992.


Pages: 333-333  |  Published: 1/2011  |  DOI: 10.1111/j.1540-6261.2010.01634.x  |  Cited by: 0

Back Matter

Pages: 335-340  |  Published: 1/2011  |  DOI: 10.1111/j.1540-6261.2010.01648.x  |  Cited by: 0