Incomplete Information, Trading Costs and Cross‐autocorrelations in Stock Returns

This paper provides an economic rationale for the cross‐autocorrelation patterns in stock returns in the context of a microstructure model in which investors have incomplete information. The paper shows that in a market in which investors are informed about only a sub‐set of stocks, the emergence of lead‐lag, cross‐autocorrelations is a function of the cost of trading in other stocks based on information about the sub‐set of stocks. If cross‐trading costs are high, informed investors will trade only in the sub‐set of stocks they are informed about; if cross‐trading costs are moderate, informed investors will randomize between trading and not trading in other stocks; and if cross‐trading costs are low, they will trade in all stocks. When informed investors trade only in a sub‐set of stocks, prices of stocks with more informed trading will adjust to common factor information faster than the prices of stocks with less informed trading giving rise to asymmetric lead‐lag cross‐autocorrelations. When informed investors trade in all stocks, asymmetric lead‐lag cross‐autocorrelations will disappear as a result of their cross‐market arbitrage trading. These results provide a number of testable implications for lead‐lag cross‐autocorrelation patterns. The data is consistent with the empirical predictions .
(J.E.L.G12, G14).     

Viewpoint: Option prices, preferences, and state variables

Abstract.  This paper surveys recent developments in the theory of option pricing. The emphasis is on the interplay between option prices and investors' impatience and their aversion to risk. The traditional view, steeped in the risk‐neutral approach to derivative pricing, has been that these preferences play no role in the determination of option prices. However, the usual lognormality assumption required to obtain preference‐free option pricing formulas is at odds with the empirical properties of financial assets. The lognormality assumption is easily reconcilable with those properties by the introduction of a latent state variable whose values can be interpreted as the states of the economy. The presence of a covariance risk with the state variable makes option prices depend explicitly on preferences. Generalized option pricing formulas, in which preferences matter, can explain several well‐known empirical biases associated with preference‐free models such as that of Black and Scholes (1973) and the stochastic volatility extensions of Hull and White (1987) and Heston (1993) .     

The relation between the informational content of implied volatility and arbitrage costs: Evidence from the Oslo Stock Exchange

This study investigates the proposition that volatility of stock returns can be predicted from the volatility implied by options on the Oslo Stock Exchange (OSE), conditional on the ability to perform arbitrage. Insights into the relation between the informational content of implied volatility and arbitrage cost can be distilled from Oslo Stock Exchange data. For Norwegian firms, options and their underlying stock trade on the Oslo Stock Exchange and have an overlapping set of market makers thereby lowering the cost of arbitrage. Other components of arbitrage trading costs, liquidity and dispersion of stock return volatility, vary widely across Norwegian firms. Moreover, restriction on the short selling of stock in Oslo allows further insight into the role of arbitrage costs in determining the informational content of implied volatility. The results yield support for the arbitrage cost hypothesis: the lower the arbitrage cost between the stock and the option, the greater the informational content of implied volatility.     

Canadian and U.S. financial markets: testing the international integration hypothesis under time‐varying conditional volatility

Abstract.  This paper evaluates the international integration hypothesis, that is, that risk‐adjusted anticipated returns are identical, even when financial instruments are traded in different countries. Under time‐varying conditional volatility, this hypothesis is tested by verifying the equality between domestic and foreign risk prices associated with a multi‐factor analytic specification. The maximum‐likelihood and Kalman‐filter estimates are used to assess the national risk prices and interpret the factors. Empirically, the integration of Canadian and U.S. financial markets depends on the risk prices of two factors, which are related to certain non‐monetary events and to the conduct of monetary policies. JEL classification: G15, C32     

Arbitrage and equilibrium in strategic security markets

Summary. In view of the fundamental price taking hypothesis, arbitrage is never compatible with equilibrium in Walrasian markets because the existence of an arbitrage opportunity in a competitive situation always leads to unbounded arbitrage activity. In strategic markets however, the mere effort of individuals to profit alters market clearing prices and thus distorts arbitrage opportunities as well. This observation suggests a different relationship between arbitrage and equilibrium, than in the competitive model. Indeed, we show that in such markets a spread between the cost of a portfolio and its returns is compatible with equilibrium. We provide an example of an equilibrium where a resourceless individual holds a portfolio with zero cost and positive return in every state. We further demonstrate via an asymptotic result, that no arbitrage is intimately related to price taking behaviour.Received: 8 September 2001, Revised: 6 March 2003, JEL Classification Numbers: G12, D4, D5, D52. Correspondence to: Leonidas C. Koutsougeras     

Are Co-integrated Stock Prices Consistent with the Efficient Market Hypothesis?

This paper responds to the unsatisfactory argument that there is no correspondence between co-integration and the efficient market hypothesis. A law of one co-integrating vector of prices is proposed for the exchange rate and domestic and overseas stock prices. Markets must therefore be efficient in long-run equilibrium because no arbitrage opportunities exist. However, arbitrage activity via the disequilibrium error correction allows above-average (risk-adjusted) returns to be earned in the short run. The elimination of these arbitrage opportunities means that stock market inefficiency in the short run ensures stock market efficiency in the long run.     

Pricing and Hedging Credit Derivatives with Copulas

In this paper, we apply a copula function pricing technique to the evaluation of credit derivatives, namely a vulnerable default put option and a credit switch. Also in this case, copulas enable one to separate the specification of marginal default probabilities from their dependence structure. Their use is based here on no–arbitrage arguments, which provide pricing bounds and easy–to–implement super–replication strategies.
At a second stage, we specify the copula function to be a mixture one. In this case, we obtain closed form prices and hedges, which we calibrate on real market data. For the sake of comparison, we add a Clayton calibration.
(J.E.L: G11, G12).     

Price bounds on bond options,swaptions, caps,and floors assuming only nonnegative interest rates

This paper derives bounds on the prices of European and American bond options, caps, floors, and European swaptions assuming only absence of arbitrage and nonnegative interest rates. The bounds are considerably tighter than Merton's bounds on stock option prices, especially for options on short-term bonds or swaps and short-term caps and floors. For American bond options, it is important to distinguish between options on the quoted (“clean”) bond price and options on the actual (“dirty”) bond price. For example, it is shown that it may be optimal to exercise an American call on the quoted bond price early even if the underlying bond makes no payments in the remaining life of the option.     

Trading Behavior and Asset Returns: Evidence from the Interday Serial Correlations of Intraday‐to‐Intraday Daily Returns of Taiwan

This paper sheds light on the importance of trading behavior in the determination of asset prices by examining the interday serial correlations of intraday‐to‐intraday daily returns of the Taiwan Stock Exchange (TSEC). The TSEC exhibits positive serial correlation in the beginning and the end of the week and negative serial correlation in the middle of the week. The interday serial correlation is not a result of non‐synchronous trading, bid‐ask bounce in transaction price, or price limits. The serial correlation is positively related to trading volume and similar to the pattern in the US. We suggest that trading behavior seems to be an important determinant of asset prices.     

Arbitrage costs and nonlinear adjustment in the G7 stock markets

This article aims to study stock price adjustments towards fundamentals due to the existence of arbitrage costs defined as the sum of transaction costs and a risky arbitrage premium associated with the uncertainty characterizing the fundamentals. Accordingly, it is shown that a two regime Smooth Transition Error Correction Model (STECM) is appropriate to reproduce the dynamics of stock price deviations from fundamentals in the G7 countries during the period 1969 to 2005. This model takes into account the interdependences or contagion effects between stock markets. Deviations appear to follow a quasi random walk in the central regime when prices are near fundamentals (i.e. when arbitrage costs are greater than expected arbitrage profits, the mean reversion mechanism is inactive), while they approach a white noise in the outer regimes (i.e. when arbitrage costs are lower than expected arbitrage profits, the mean reversion is active). Interestingly, as expected when arbitrage costs are heterogeneous, the estimated STECM shows that stock price adjustments are smooth and that the convergence speed depends on the size of the deviation. Finally, using two appropriate indicators proposed by Peel and Taylor (2000), both the magnitudes of under and overvaluation of stock price and the adjustment speed are calculated per date in the G7 countries. These indicators show that the dynamics of stock price adjustment are strongly dependent on both the date and the country under consideration.     

Local martingales, arbitrage, and viability Free snacks and cheap thrills

Summary. We revisit a standard model of security prices as Ito processes, and provide some new economic insights about the role of arbitrage and credit limits within such a model. We show that the standard assumptions of a positive state prices and existence of an equivalent martingale measure exclude prices that are viable models of competitive equilibrium and that are potentially useful for modeling actual financial markets. These models have been dismissed in the past as allowing arbitrage, but in fact an agent who prefers more to less and who has limited access to credit may have an optimum. Received: June 9, 1999; revised version: October 4, 1999     

Product differentiation, cost‐reducing mergers, and consumer welfare

Abstract.  Cost synergies are an explicitly recognized justification for a two‐firm merger, and empirical techniques are now widely used to assess the impact of cost‐reducing mergers on prices and welfare in the post‐merger market. We show that if the merger occurs in a vertically product differentiated market, then the merger will lead to a reduction in product offerings that limits the usefulness of pre‐merger empirical estimates. Indeed, we further show that in such markets, two‐firm mergers will typically lead to higher prices regardless of the merger's cost savings. JEL classification: L10, L41     

Rational expectations equilibrium with conditioning on past prices: A mean-variance example

The paper uses an intertemporal mean-variance model of the market for a dividend-paying risky asset to analyse rational expectations equilibria when all agents condition their expectations on past rather than current prices. The main result shows that if the time span between successive market periods is short, the market will approximate full informational efficiency arbitrarily closely, yet the returns to being informed are bounded away from zero. This contrasts with the Grossman-Stiglitz proposition that markets cannot come close to informational efficiency if the acquisition of information is costly.     

Price taking behavior and trading in options

Equilibrium prices of options are arbitrage prices in economies in which prices are determined endogenously and all agents are price takers. This paper shows that the price taking assumption in options' markets is unreasonable because a small agent can make huge gains by not being a price taker.     

A proposition on short-run departures from the law-of-one-price: Unanticipated inflation,relative-price dispersion,and commodity arbitrage

This paper proposes an explanation of short-run departures from the law-of-one-price based on the characteristics of the inflationary process and changes in the distribution of relative prices. Unexpected inflation gives rise to volatility of relative prices. The more unexpected (and hence uneven) the rate of inflation, the greater the difficulty in discerning from a given structure of relative prices commodity-arbitrage opportunities which may be expected to persist and those transient opportunities which do not warrant a firm's incurring fixed costs of arbitrage. An illustration portrays a risk-averse firm confronting an international arbitrage opportunity.     

Estimating Quality‐adjusted Price Changes: Method and Application to VCRs

This paper uses scanner data to generate estimates of quality‐adjusted price changes for video‐recorders. We use hedonic regressions to derive estimates of the changing worth of each quality component. These are then applied to weighted changes in the mix of quality attributes of products to derive estimates of quality‐adjusted price (QAP) changes. The data source used is electronic‐point‐of‐sale (EPOS) scanner data that are available for a wide range of goods. This study provides an example of how such methods can be more widely applied. The estimates of QAP changes correspond to constant‐utility, (hedonic) cost‐of‐living indexes defined in economic theory as the ratio of expenditure functions at constant utility allowing for changing prices and characteristics of goods. This method is proposed as an improvement on the existing direct method , which takes its estimates directly from the coefficients associated with 'time dummies' in a hedonic regression. We finally undertake a matching process, akin to that used by statistical offices, and compare the results. Direct comparisons with RPI estimates and these hedonic approaches are not easy since the approaches use quite different data sets. Our replication of a procedure akin to that used for the RPI on the scanner data set provides insights into sources of potential bias.     

Imperfect financial integration and asymmetric information: competing explanations of the home bias puzzle?

Abstract This paper shows that imperfect financial integration and informational asymmetries are not competing theories but rather complementary ideas to a single explanation of the home bias puzzle. We develop a rational expectations model of asset prices with investors that face informational constraints and find that informational advantages arise endogenously as a response to small financial frictions. We also present empirical evidence that (i) international financial frictions are correlated to observed patterns of US investors’ attention and that (ii) the attention US investors allocate to foreign stocks helps explain home bias towards those countries, even after controlling for financial integration levels.     

Monopoly extraction of an exhaustible resource with two markets

Abstract.  Although much has been written about monopoly extraction of natural resources, the case of a resource being sold in two separate markets has escaped notice. We find that a monopolist facing two different iso‐elastic demand schedules extracts more rapidly than the social planner, whether or not arbitrage prevents price discrimination between markets. JEL classification: D42, Q3     

Measuring efficiency when competitive prices aggregate differences in product quality and risk

In perfectly competitive markets with homogenous goods, prices aggregate inputs and outputs into a money metric that allows production plans and, hence, firms to be ranked by their profitability. Standard techniques of efficiency measurement use this metric to estimate cost and profit frontiers that identify “best-practice” production, conditioned on these exogenous prices. However, when prices vary due to differences among firms in the quality of outputs and inputs and in how asymmetric informational problems are resolved, both quality and the production of information can be decision variables of the firm, and prices will have endogenous components linked to production decisions. For example, in banking, prices of financial inputs and outputs are linked to credit quality and, hence, to risk and, thus, aggregate both inputs and outputs and their risk characteristics as well as reflect how informational asymmetries in credit markets are ameliorated. This paper argues that these cases pose two serious problems for the standard techniques of efficiency measurement: (1) they underestimate inefficiency because, in conditioning on prices, they fail to account for the effects of suboptimal pricing strategies on profitability; and (2) in ignoring how production plans and pricing strategies affect market-priced risk, the standard techniques neglect the effects of different pricing strategies on the discount rate, on expected profit and, hence, on market value. Two alternative techniques that do not condition their frontiers on prices and that account for risk are described to show how they measure the efficiency of different pricing strategies as well as production plans. These two alternative models for measuring efficiency are employed to study how differences in pricing strategies affect the efficiency and market value of highest-level bank holding companies in the United States in 1994.     

Multidivisional firms, internal competition, and the merger paradox

Abstract.  Traditional modelling of mergers has the merged firms (insiders) cooperate and maximize joint profits. This approach has several unappealing results in quantity‐setting games, for example, mergers typically are not profitable for insiders, but are profitable for non‐merging firms (outsiders). We take a different approach and allow for a parent company that can play each insider off one another. In quantity‐setting games, with our approach mergers are profitable for insiders, unprofitable for outsiders, socially beneficial, and involve (in a non‐monopolizing merger) a small number of firms. Finally, we find that the optimal strategy depends on whether firms compete in quantity or prices. JEL classification: L000