Volatility and covariation of financial assets: A high-frequency analysis

Using high frequency data for the price dynamics of equities we measure the impact that market microstructure noise has on estimates of the: (i) volatility of returns; and (ii) variance–covariance matrix of n assets. We propose a Kalman-filter-based methodology that allows us to deconstruct price series into the true efficient price and the microstructure noise. This approach allows us to employ volatility estimators that achieve very low Root Mean Squared Errors (RMSEs) compared to other estimators that have been proposed to deal with market microstructure noise at high frequencies. Furthermore, this price series decomposition allows us to estimate the variance covariance matrix of n assets in a more efficient way than the methods so far proposed in the literature. We illustrate our results by calculating how microstructure noise affects portfolio decisions and calculations of the equity beta in a CAPM setting.     

Control-ownership wedge and investment sensitivity to stock price

This study examines whether insiders’ incentives for private control benefits affect investment sensitivity to stock price. While Chen et al. (2007) link stock price informativeness to firms’ learning from the stock market, we offer an alternative agency-cost based explanation. Using a total of 2822 firms from 22 countries in East Asia and Western Europe, we document a strong negative association between control-ownership wedge and investment-q sensitivity, suggesting that insiders’ incentives for private control benefit reduce their propensity to listen to the market. Furthermore, the negative impact of wedge on investment-q sensitivity is primarily driven by sub-optimal investments. Overall, we provide evidence that agency problem is an important factor that determines the learning from the stock market in capital allocation.     

Testing weak form efficiency on the Toronto Stock Exchange

In order to test for weak form efficiency in the market a vast pool of individual stocks must be analyzed rather than a stock market index. In this paper, a model-based bootstrap is used to generate a series of simulated trials and a modified chart pattern recognition algorithm is applied to all stocks listed on the Toronto Stock Exchange (TSX). The number of patterns detected in the original price series is compared with the number of patterns found in the simulated series. By simulating the price path specific time dependencies present in real data are eliminated, making price changes purely random. Patterns, if consistently identified, carry information which adds value to the investment process, however, this informativeness does not guarantee profitability. Conclusions are drawn on the relative efficiency of some sectors of the economy. Although the null hypothesis of weak form efficiency on the TSX cannot be rejected, some sectors of the Canadian economy appear to be less efficient than others. In addition, pattern frequencies appear to be negatively dependent on the two moments of return distributions, variance and kurtosis.     

Trading frequency and asset pricing on the London Stock Exchange: Evidence from a new price impact ratio

This study proposes a new price impact ratio as an alternative to the widely used Amihud’s (2002) Return-to-Volume ratio. We demonstrate that the new price impact ratio, which is deemed Return-to-Turnover ratio, has a number of appealing features. Using daily data from all stocks listed on the London Stock Exchange over the period 1991–2008, we provide overwhelming evidence that this ratio, while being unequivocal to construct and interpret, is also free of a size bias. More importantly, it encapsulates the stocks’ cross-sectional variability in trading frequency, a relatively neglected but possibly important determinant of stock returns given the recently observed trends in financial markets. Overall, our findings argue against the conventional wisdom that there is a simple direct link between trading costs and stock returns by strongly suggesting that it is the compound effect of trading frequency and transaction costs that matters for asset pricing, not each aspect in isolation.     

A numerical method to price exotic path-dependent options on an underlying described by the Heston stochastic volatility model

We consider the problem of pricing European exotic path-dependent derivatives on an underlying described by the Heston stochastic volatility model. Lipton has found a closed form integral representation of the joint transition probability density function of underlying price and variance in the Heston model. We give a convenient numerical approximation of this formula and we use the obtained approximated transition probability density function to price discrete path-dependent options as discounted expectations. The expected value of the payoff is calculated evaluating an integral with the Monte Carlo method using a variance reduction technique based on a suitable approximation of the transition probability density function of the Heston model. As a test case, we evaluate the price of a discrete arithmetic average Asian option, when the average over n = 12 prices is considered, that is when the integral to evaluate is a 2n = 24 dimensional integral. We show that the method proposed is computationally efficient and gives accurate results.     

Stock price synchronicity,crash risk,and institutional investors

Both stock price synchronicity and crash risk are negatively related to the firm's ownership by dedicated institutional investors, which have strong incentive to monitor due to their large stake holdings and long investment horizons. In contrast, the relations become positive for transient institutional investors as they tend to trade rather than monitor. These findings suggest that institutional monitoring limits managers' extraction of the firm's cash flows, which reduces the firm-specific risk absorbed by managers, thereby leading to a lower R². Moreover, institutional monitoring mitigates managerial bad-news hoarding, which results in a stock price crash when the accumulated bad news is finally released.     

R-Squared and Dividend Payout: Evidence from the Korean Market

The authors investigate R ² and its relationship with dividend payouts in the Korean stock market. R ² is derived from the market model regression. Their results are consistent with the previous literature on corporate governance and dividend payouts: they find that R ² is higher for business group (chaebol) firms and that there is a negative relationship between R ² and dividend payout. However, the relationship is not stronger for the business group firms than for the non-business group firms. The findings elucidate the relationship between R ² and dividend payout policy in the United States.     

Rumors in the sky: Corporate rumors and stock price synchronicity

Using hand-collected rumor clarification announcements from Chinese listed firms to identify corporate rumors, we find that rumored firms have lower stock price synchronicity (R²) than do firms without rumors. Channel analyses reveal that rumors reduce stock price synchronicity through elevating investor sentiment rather than stimulating informed trading. Additionally, the negative association between corporate rumors and stock price synchronicity is more evident among firms with more individual investors and higher information opacity. Moreover, corporate rumors are associated with higher analyst forecast errors and forecast dispersion. Overall, our evidence suggests that corporate rumors reduce stock price synchronicity by increasing investor irrationality.     

Stock price synchronicity and analyst coverage in emerging markets

This paper examines the relation between the stock price synchronicity and analyst activity in emerging markets. Contrary to the conventional wisdom that security analysts specialize in the production of firm-specific information, we find that securities which are covered by more analysts incorporate greater (lesser) market-wide (firm-specific) information. Using the R² statistics of the market model as a measure of synchronicity of stock price movement, we find that greater analyst coverage increases stock price synchronicity. Furthermore, after controlling for the influence of firm size on the lead–lag relation, we find that the returns of high analyst-following portfolio lead returns of low analyst-following portfolio more than vice versa. We also find that the aggregate change in the earnings forecasts in a high analyst-following portfolio affects the aggregate returns of the portfolio itself as well as those of the low analyst-following portfolio, whereas the aggregate change in the earnings forecasts of the low analyst-following portfolio have no predictive ability. Finally, when the forecast dispersion is high, the effect of analyst coverage on stock price synchronicity is reduced.     

Oil price dynamics,macro-finance interactions and the role of financial speculation

What is the role of financial speculation in determining the real oil price? We find that while macroeconomic shocks have been the main real oil price upward driver since mid-1980s, financial shocks have sizably contributed since early 2000s as well, and at a much larger extent since mid-2000s. Even though financial shocks contribute 44% out of the 65% real oil price increase over the period 2004–2010, the third oil price shock is a macro-finance episode: macroeconomic shocks actually largely account for the 2007–2008 oil price swing. While we then find support to the demand side view of real oil price determination, we however also find a much larger role for financial shocks than previously noted in the literature.     

Timing of Sale,Pricing, and Cost Information: Evidence from the Airline Industry*

This study examines the association between when an airline sells its passenger seats and the pricing method (marginal cost or full cost) it employs. Prior literature suggests that when firms are able to change prices during the selling period, the optimality of full cost pricing or marginal cost pricing depends on when demand information is revealed during the period between capacity commitment decisions and time of sale. Full cost‐based pricing is appropriate in determining capacity commitment and prices simultaneously, while marginal cost provides more relevant information for pricing when capacity has been committed. Using the price and cost data from a sample of four U.S. domestic airlines, we find that full cost explains price variations of first‐day sales robustly. The adjusted R² of the marginal cost pricing model is larger in the sample of sales two days prior to departure than in the sample of first‐day sales. In the analysis of the sample of sales two days prior to departure, we find that, based on the adjusted R² of the full cost pricing and marginal cost pricing models, the explanatory power of marginal cost pricing is relatively weaker than full cost pricing. Our results document the use of different cost information along the dynamic change of price and provide implications in understanding the role of cost information in setting prices.     

The Costs, Wealth Effects, and Determinants of International Capital Raising: Evidence from Public Yankee Bonds

This paper examines the costs, wealth effects, and determinants of international capital raising for a sample of 260 public debt issues made by non-U.S. firms in the Yankee bond market. We find that investors demand economically significant premiums on bonds issued by firms that are located in countries that do not protect investors' rights and do not have a prior history of ongoing disclosure. The results provide support for the literature that suggests better legal protections and more detailed information disclosure increases the price investors will pay for financial assets. Journal of Economic Literature Classification Numbers: F3, G1.     

External Conditions,the Evolution of Financial Risks,and the Informational Content of Stock Prices: The Case of Chile

ABSTRACT

In this article, we find that the dynamics of local financial risks in the Chilean stock market are associated with the evolution of external economic conditions, with a strong reduction in both idiosyncratic and systematic risks during periods of stable conditions. Despite this, we fail to find any significant change in the traditional measures of stock price synchronicity developed in the R² literature in our sample. We argue that these measures neglect the relationship between stock prices and fundamentals and find that the strength of the association between prices and fundamentals changes during our sample period, being much stronger during times of stable external conditions and diminished stock price volatility.     

Price setting, price dispersion, and the value of money: or, the law of two prices

We study models combining search, money, price posting, and preference shocks. We show how these features interact to influence the price level and price dispersion. First, price-posting equilibria exist with valued fiat currency. Second, although both are possible, price dispersion is more common than a single price. Third, we prove that generically there cannot be more than two prices. We provide intuition for this law of two prices, show it also holds in some nonmonetary search models, and discuss variations of the assumptions under which it may not hold.     

Detecting the presence of insider trading via structural break tests

The occurrence of abnormal returns before the unscheduled announcement of price sensitive information is a potential indicator of insider trading. We identify insider trading with a structural change in the intercept of an extended capital asset pricing model. To detect such a change we introduce a consistent timing structural break test (CTSB) based upon a U-statistic type process. Unlike the traditional CUSUM test, the CTSB test provides a consistent estimator of the timing of a break in the intercept that occurs across the whole evaluation period. We apply our test to a rich data set covering 370 price sensitive announcements relating to FTSE 350 companies. Our test is able to detect potential insider trading far more reliably than the standard CUSUM test. We also show that the majority of suspected insider trading takes place in the 25 days prior to the release of market sensitive information.     

The modified dividend–price ratio

We show that log-dividends (d) and log-prices (p) are cointegrated, but, instead of de facto assuming the stationarity of the classical log dividend–price ratio, we allow the data to reveal the cointegration vector between d and p. We define the modified dividend–price ratio (mdp), as the long run trend deviation between d and p. Using S&P 500 data for the period 1926 to 2012, we show that mdp provides substantially improved forecasting results over the classical dp ratio. Out of sample, while the dp ratio cannot outperform the “simplistic forecast” benchmark for any useful horizon, an investor who employs the mdp ratio will do significantly better in forecasting 3-, 5- and 7-year returns with an R_OS² of 7%, 26% and 31% respectively. In some sense mdp can be considered as a de-noising of the classical ratio as it addresses the major weakness in dp, its presumed inability in revealing business cycle variation in expected returns. Unlike dp, mdp exhibits positive correlation with the risk free return component, and can discern if a low dividend state coincides with a low yield state.     

Asymmetric Information and News Disclosure Rules

When the imminence of news announcements is not public knowledge, many traders will lack information on both the mean and variance of private information. Our analysis of such a setting in both single and multisecurity contexts implies that disclosure of impending information events by firms can bound variance uncertainty and thereby improve investor welfare by mitigating the market breakdown problem. We also find that the equilibrium pricing functions are nonlinear; specifically, convex for small trades and concave for larger ones. In addition, we predict that large transactions will be followed by large levels of volatility. Journal of Economic Literature Classification Numbers: 022, 026, 522.     

Opaque financial reports and R2: Revisited

In this study, we revisit the link between R² (synchronicity) and earnings management (opacity) because of the importance of the ongoing debate on the relation between idiosyncratic risk and earnings management in the finance and accounting literatures. Hutton et al. (J. Financial Economics, 2009) provide evidence of a positive link between opacity and R². They interpret their finding to imply that firms with high R² (high synchronicity) have less firm-specific information impounded in their stock price. Our results for this relationship fail to unequivocally support the results reported in Hutton et al. (2009). We show that their results are not only time variant but also not robust to the alternative empirical technique recommended for panel data by Petersen (2009) and alternative estimation of discretionary accruals adjusted for firm performance prescribed by Kothari et al. (2005). We also find no support for a convex relation between idiosyncratic risk and opacity. The findings documented in this study substantially revise some of Hutton et al.'s findings in this important and growing area of research.     

Passive Institutional Ownership,R2 Trends,and Price Informativeness

A distinctive trend in the capital markets over the past two decades is the rise in equity ownership of passive financial institutions. We propose that this rise has a negative effect on price informativeness. By not trading around firm‐specific news, passive investors reduce the firm‐specific component of total volatility and increase stock correlations. Consistent with this hypothesis, we find that the growth in passive institutional ownership is robustly associated with the growth in market model R²s of individual stocks since the early 1990s. Additionally, we find a negative relation between passive ownership and earnings predictability, an informativeness proxy.