The Journal of Finance

Around and Around: The Expectations Hypothesis

Published: 12/17/2002   |   DOI: 10.1111/0022-1082.145490

Mark Fisher, Christian Gilles

We show how to construct models of the term structure of interest rates in which the expectations hypothesis holds. McCulloch (1993) presents such a model, thereby contradicting an assertion by Cox, Ingersoll, and Ross (1981), but his example is Gaussian and falls outside the class of finite‐dimensional Markovian models. We generalize McCulloch's model in three ways: (i) We provide an arbitrage‐free characterization of the unbiased expectations hypothesis in terms of forward rates; (ii) we extend this characterization to a whole class of expectations hypotheses; and (iii) we show how to construct finite‐dimensional Markovian and non‐Gaussian examples.

Approximate Factor Structures: Interpretations and Implications for Empirical Tests

Published: 12/01/1985   |   DOI: 10.1111/j.1540-6261.1985.tb02388.x

MARK GRINBLATT, SHERIDAN TITMAN

This paper provides some new insights about approximate factor structures, as defined by Chamberlain and Rothschild [2], and their implications for empirical tests. First, we show that any economy that satisfies an approximate factor structure can be transformed, in a manner that does not alter the characteristics of investor portfolios, into an economy that satisfies an exact factor structure, as defined by Ross [9]. Second, we show that principal components analysis represents just one of many methods of forming groups of well‐diversified portfolios with no idiosyncratic risk in large samples. Correct factor loadings will be obtained by regressing security returns on any group of these portfolios. Our interpretations of the Chamberlain and Rothschild results also provide additional insights into the testability of the Arbitrage Pricing Theory. We show that securities cannot be repackaged to hide factors in the manner suggested by Shanken [10] without the variance of some of the repackaged securities approaching infinity in large economies.

Is the Corporate Loan Market Globally Integrated? A Pricing Puzzle

Published: 11/28/2007   |   DOI: 10.1111/j.1540-6261.2007.01298.x

MARK CAREY, GREG NINI

We offer evidence that interest rate spreads on syndicated loans to corporate borrowers are economically significantly smaller in Europe than in the United States, other things equal. Differences in borrower, loan, and lender characteristics do not appear to explain this phenomenon. Borrowers overwhelmingly issue in their natural home market and bank portfolios display home bias. This may explain why pricing discrepancies are not competed away, though their causes remain a puzzle. Thus, important determinants of loan origination market outcomes remain to be identified, home bias appears to be material for pricing, and corporate financing costs differ across Europe and the United States.

Characteristics of Risk and Return in Risk Arbitrage

Published: 12/17/2002   |   DOI: 10.1111/0022-1082.00401

Mark Mitchell, Todd Pulvino

This paper analyzes 4,750 mergers from 1963 to 1998 to characterize the risk and return in risk arbitrage. Results indicate that risk arbitrage returns are positively correlated with market returns in severely depreciating markets but uncorrelated with market returns in flat and appreciating markets. This suggests that returns to risk arbitrage are similar to those obtained from selling uncovered index put options. Using a contingent claims analysis that controls for the nonlinear relationship with market returns, and after controlling for transaction costs, we find that risk arbitrage generates excess returns of four percent per year.

What Makes Investors Trade?

Published: 12/17/2002   |   DOI: 10.1111/0022-1082.00338

Mark Grinblatt, Matti Keloharju

A unique data set allows us to monitor the buys, sells, and holds of individuals and institutions in the Finnish stock market on a daily basis. With this data set, we employ Logit regressions to identify the determinants of buying and selling activity over a two‐year period. We find evidence that investors are reluctant to realize losses, that they engage in tax‐loss selling activity, and that past returns and historical price patterns, such as being at a monthly high or low, affect trading. There also is modest evidence that life‐cycle trading plays a role in the pattern of buys and sells.

High‐Water Marks: High Risk Appetites? Convex Compensation, Long Horizons, and Portfolio Choice

Published: 01/23/2009   |   DOI: 10.1111/j.1540-6261.2008.01427.x

STAVROS PANAGEAS, MARK M. WESTERFIELD

We study the portfolio choice of hedge fund managers who are compensated by high‐water mark contracts. We find that even risk‐neutral managers do not place unbounded weights on risky assets, despite option‐like contracts. Instead, they place a constant fraction of funds in a mean‐variance efficient portfolio and the rest in the riskless asset, acting as would constant relative risk aversion (CRRA) investors. This result is a direct consequence of the in(de)finite horizon of the contract. We show that the risk‐seeking incentives of option‐like contracts rely on combining finite horizons and convex compensation schemes rather than on convexity alone.

Financial Innovation and the Role of Derivative Securities: An Empirical Analysis of the Treasury STRIPS Program

Published: 12/17/2002   |   DOI: 10.1111/0022-1082.00252

Mark Grinblatt, Francis A. Longstaff

The role that financial innovation plays in financial markets is very controversial. To provide insight into this role, we examine how market participants use the highly successful Treasury STRIPS program. We find that investors use the option to create Treasury‐derivative STRIPS primarily to make markets more complete and take advantage of tax and accounting asymmetries. Although liquidity‐related factors help explain differences in the prices of Treasury bonds and STRIPS, we find little evidence that the option to strip and reconstitute securities is used for speculative or arbitrage‐related purposes.

Individual Investors and Local Bias

Published: 09/21/2010   |   DOI: 10.1111/j.1540-6261.2010.01600.x

MARK S. SEASHOLES, NING ZHU

The paper tests whether individuals have value‐relevant information about local stocks (where “local” is defined as being headquartered near where an investor lives). Our methodology uses two types of calendar‐time portfolios—one based on holdings and one based on transactions. Portfolios of local holdings do not generate abnormal performance (alphas are zero). When studying transactions, purchases of local stocks significantly underperform sales of local stocks. The underperformance remains when focusing on stocks with potentially high levels of information asymmetries. We conclude that individuals do not help incorporate information into stock prices. Our conclusions directly contradict existing studies.

Correlated Trading and Location

Published: 11/27/2005   |   DOI: 10.1111/j.1540-6261.2004.00694.x

LEI FENG, MARK S. SEASHOLES

This paper analyzes the trading behavior of stock market investors. Purchases and sales are highly correlated when we divide investors geographically. Investors who live near a firm's headquarters react in a similar manner to releases of public information. We are able to make this identification by exploiting a unique feature of individual brokerage accounts in the People's Republic of China. The data allow us to pinpoint an investor's location at the time he or she places a trade. Our results are consistent with a simple, rational expectations model of heterogeneously informed investors.

The Limits of Investor Behavior

Published: 01/20/2006   |   DOI: 10.1111/j.1540-6261.2006.00835.x

MARK LOEWENSTEIN, GREGORY A. WILLARD

Many models use noise trader risk and corresponding violations of the Law of One Price to explain pricing anomalies, but include a storage technology in perfectly elastic supply or unlimited asset liability. Storage allows aggregate consumption risk to differ from exogenous fundamental risk, but using aggregate consumption as a factor for asset returns can make noise trader risk superfluous. Using (i) limited asset liability and limited storage withdrawals, or (ii) an endogenous locally riskless interest rate eliminates violations of the Law of One Price. Our main results use only budget equations and market clearing, and require virtually no assumptions about behavior.

Consumer Default, Credit Reporting, and Borrowing Constraints

Published: 05/15/2017   |   DOI: 10.1111/jofi.12522

MARK J. GARMAISE, GABRIEL NATIVIDAD

Why do negative credit events lead to long‐term borrowing constraints? Exploiting banking regulations in Peru and utilizing currency movements, we show that consumers who face a credit rating downgrade due to bad luck experience a three‐year reduction in financing. Consumers respond to the shock by paying down their most troubled loans, but nonetheless end up more likely to exit the credit market. For a set of borrowers who experience severe delinquency, we find that the associated credit reporting downgrade itself accounts for 25% to 65% of their observed decline in borrowing at various horizons over the following several years.

Does the Medium Matter? The Relations among Bankruptcy Petition Filings, Broadtape Disclosure, and the Timing of Price Reactions

Published: 12/17/2002   |   DOI: 10.1111/0022-1082.00047

Mark C. Dawkins, Linda Smith Bamber

Drawing on a comprehensive sample of 330 bankruptcy petition filings from 1980 to 1993, we find that most of the market reaction does not occur on the bankruptcy petition filing date when the information becomes publicly available. Rather, most of the reaction occurs when news of the bankruptcy filing is more widely disseminated via the Broadtape. This “Broadtape announcement effect” persists after controlling for firm size, exchange listing, and predisclosure information. These are primarily timing differences since abnormal returns cumulated over an 11–day window centered on the filing date do not differ significantly across Broadtape disclosure date classifications.

What Makes a Good Trader? On the Role of Intuition and Reflection on Trader Performance

Published: 02/16/2018   |   DOI: 10.1111/jofi.12619

BRICE CORGNET, MARK DESANTIS, DAVID PORTER

Using laboratory experiments, we provide evidence on three factors influencing trader performance: fluid intelligence, cognitive reflection, and theory of mind (ToM). Fluid intelligence provides traders with computational skills necessary to draw a statistical inference. Cognitive reflection helps traders avoid behavioral biases and thereby extract signals from market orders and update their prior beliefs accordingly. ToM describes the degree to which traders correctly assess the informational content of orders. We show that cognitive reflection and ToM are complementary because traders benefit from understanding signals’ quality only if they are capable of processing these signals.

Do Industries Explain Momentum?

Published: 12/17/2002   |   DOI: 10.1111/0022-1082.00146

Tobias J. Moskowitz, Mark Grinblatt

This paper documents a strong and prevalent momentum effect in industry components of stock returns which accounts for much of the individual stock momentum anomaly. Specifically, momentum investment strategies, which buy past winning stocks and sell past losing stocks, are significantly less profitable once we control for industry momentum. By contrast, industry momentum investment strategies, which buy stocks from past winning industries and sell stocks from past losing industries, appear highly profitable, even after controlling for size, book‐to‐market equity, individual stock momentum, the cross‐sectional dispersion in mean returns, and potential microstructure influences.

Recovering Probability Distributions from Option Prices

Published: 12/01/1996   |   DOI: 10.1111/j.1540-6261.1996.tb05219.x

JENS CARSTEN JACKWERTH, MARK RUBINSTEIN

This article derives underlying asset risk‐neutral probability distributions of European options on the S&P 500 index. Nonparametric methods are used to choose probabilities that minimize an objective function subject to requiring that the probabilities are consistent with observed option and underlying asset prices. Alternative optimization specifications produce approximately the same implied distributions. A new and fast optimization technique for estimating probability distributions based on maximizing the smoothness of the resulting distribution is proposed. Since the crash, the risk‐neutral probability of a three (four) standard deviation decline in the index (about −36 percent (−46 percent) over a year) is about 10 (100) times more likely than under the assumption of lognormality.

Cheap Credit, Lending Operations, and International Politics: The Case of Global Microfinance

Published: 03/19/2013   |   DOI: 10.1111/jofi.12045

MARK J. GARMAISE, GABRIEL NATIVIDAD

The provision of subsidized credit to financial institutions is an important and frequently used policy tool of governments and central banks. To assess its effectiveness, we exploit changes in international bilateral political relationships that generate shocks to the cost of financing for microfinance institutions (MFIs). MFIs that experience politically driven reductions in total borrowing costs hire more staff and increase administrative expenses. Cheap credit leads to greater profitability for MFIs and promotes a shift toward noncommercial loans but has no effect on total overall lending. Instead, the additional resources are either directed to promoting future growth or dissipated.

Insider Trading, Ownership Structure, and the Market Assessment of Corporate Sell‐Offs

Published: 09/01/1989   |   DOI: 10.1111/j.1540-6261.1989.tb02633.x

MARK HIRSCHEY, JANIS K. ZAIMA

This paper finds that the generally favorable assessment of corporate sell‐off decisions is most apparent for closely held firms where insider net‐buy activity is prevalent during the prior six‐month period. This suggests that insider trader activity and ownership structure information are used by the market in the characterization of sell‐off decisions as favorable or unfavorable for investors.

Limited Arbitrage in Equity Markets

Published: 12/17/2002   |   DOI: 10.1111/1540-6261.00434

Mark Mitchell, Todd Pulvino, Erik Stafford

We examine 82 situations where the market value of a company is less than its subsidiary. These situations imply arbitrage opportunities, providing an ideal setting to study the risks and market frictions that prevent arbitrageurs from immediately forcing prices to fundamental values. For 30 percent of the sample, the link between the parent and its subsidiary is severed before the relative value discrepancy is corrected. Furthermore, returns to a specialized arbitrageur would be 50 percent larger if the path to convergence was smooth rather than as observed. Uncertainty about the distribution of returns and characteristics of the risks limits arbitrage.

Tax‐Induced Trading and the Turn‐of‐the‐Year Anomaly: An Intraday Study

Published: 06/01/1993   |   DOI: 10.1111/j.1540-6261.1993.tb04728.x

MARK D. GRIFFITHS, ROBERT W. WHITE

This study tests the tax‐induced trading hypothesis as an explanation of the turn‐of‐the‐year anomaly using Canadian and U.S. intraday data. Since the Canadian tax year‐end precedes the calendar year‐end by five business days, tax effects may be isolated. We find the anomaly is related to the degree of seller‐and buyer‐initiated trading and depends upon the incidence of the taxation year‐end. Seller‐initiated transactions (at bid prices) dominate until the tax year‐end after which buyer‐initiated trades (at ask prices) dominate. The anomaly is a function of bid‐ask prices.

Option Prices, Implied Price Processes, and Stochastic Volatility

Published: 12/17/2002   |   DOI: 10.1111/0022-1082.00228

Mark Britten‐Jones, Anthony Neuberger

This paper characterizes all continuous price processes that are consistent with current option prices. This extends Derman and Kani (1994), Dupire (1994, 1997), and Rubinstein (1994), who only consider processes with deterministic volatility. Our characterization implies a volatility forecast that does not require a specific model, only current option prices. We show how arbitrary volatility processes can be adjusted to fit current option prices exactly, just as interest rate processes can be adjusted to fit bond prices exactly. The procedure works with many volatility models, is fast to calibrate, and can price exotic options efficiently using familiar lattice techniques.