Background risk and the demand for state-contingent claims

Summary. We consider the demand for state-contingent claims, in the presence of an independent zero-mean, non-hedgeable background risk. An agent is defined to be generalized risk averse if he/she chooses a demand function for contingent claims with a smaller slope everywhere, given a simple increase in background risk. We show that the conditions for standard risk aversion, that is positive, declining absolute risk aversion and prudence, are necessary and sufficient for generalized risk aversion.Received: 13 February 2002, Revised: 10 February 2003, JEL Classification Numbers: D52, D81, G11. Correspondence to: Guenter FrankeWe are grateful to Louis Eeckhoudt, Christian Gollier, Harris Schlesinger and an unknown referee for valuable comments.     

Divergence of US and Local Returns in the After‐market for Equity Issuing ADRs

We study one‐year post‐listing prices and returns to equity issuing ADRs that listed in the US between January 1991 and October 2000. ADRs from countries that impose restrictions on capital flows are priced at a premium to their home market ordinaries. While the mean premium for the full sample is statistically indistinguishable from zero, after an adjustment for asynchronous trading, the magnitude of the premium to ADRs from restricted markets is 11.33% at the 300‐day post listing interval, which is statistically significant. In the short run (30 days) following listing, the magnitude of the premium is larger for ADRs with larger excess demand from US investors. At the longer 300‐day horizon, Nasdaq listed ADRs earn a larger premium than their NYSE/AMEX listed counterparts. Time‐series regressions and two‐stage cross‐sectional regressions establish that the premium to foreign equity issuers is greater if the US listing attracts liquidity and if US returns have a lower correlation with the local country index.     

Stock salience and the asymmetric market effect of consumer sentiment news

We document asymmetric announcement effects of consumer sentiment news on United States stock and stock futures markets. While a negative market effect occurs upon the release of bad sentiment news, there is no market reaction for the counterpart good news. This supports the “negativity effect” hypothesis. Notably, this effect seems most likely to occur in salient stocks, which is consistent with the availability heuristic.     

Recent trends in trading activity and market quality

We explore the sharp uptrend in recent trading activity and accompanying changes in market efficiency. Higher turnover has been associated with more frequent smaller trades, which have progressively formed a larger fraction of trading volume over time. Evidence indicates that secular decreases in trading costs have influenced the turnover trend. Turnover has increased the most for stocks with the greatest level of institutional holdings, suggesting professional investing as a key contributor to the turnover trend. Variance ratio tests suggest that more institutional trading has increased information-based trading. Intraday volatility has decreased and prices conform more closely to random walk in recent years. The sensitivity of turnover to past returns has increased and cross-sectional predictability of returns has decreased significantly, revealing a more widespread use of quantitative trading strategies that allow for more efficient securities prices.     

Price dispersion in OTC markets: A new measure of liquidity

In this paper, we model price dispersion effects in over-the-counter (OTC) markets to show that, in the presence of inventory risk for dealers and search costs for investors, traded prices may deviate from the expected market valuation of an asset. We interpret this deviation as a liquidity effect and develop a new liquidity measure quantifying the price dispersion in the context of the US corporate bond market. This market offers a unique opportunity to study liquidity effects since, from October 2004 onwards, all OTC transactions in this market have to be reported to a common database known as the Trade Reporting and Compliance Engine (TRACE). Furthermore, market-wide average price quotes are available from Markit Group Limited, a financial information provider. Thus, it is possible, for the first time, to directly observe deviations between transaction prices and the expected market valuation of securities. We quantify and analyze our new liquidity measure for this market and find significant price dispersion effects that cannot be simply captured by bid-ask spreads. We show that our new measure is indeed related to liquidity by regressing it on commonly-used liquidity proxies and find a strong relation between our proposed liquidity measure and bond characteristics, as well as trading activity variables. Furthermore, we evaluate the reliability of end-of-day marks that traders use to value their positions. Our evidence suggests that the price deviations from expected market valuations are significantly larger and more volatile than previously assumed. Overall, the results presented here improve our understanding of the drivers of liquidity and are important for many applications in OTC markets, in general.     

The term structure of interest rates: Alternative approaches and their implications for the valuation of contingent claims

One of the most active areas of research in financial economics has been the modeling of the term structure of interest rates and its relationship to the pricing of contingent claims. There is a vast array of issues in the area, as well as a variety of perspectives, ranging from theoretical to practical. This article provides a general framework for the analysis of issues in the modeling of the term structure. Specifically, this article provides an overview of the conceptual issues and the empirical evidence in the area, based on an examination of five seminal models by Black, Scholes, and Merton; Vasicek; Cox, Ingersoll, and Ross; Ho and Lee; and Heath, Jarrow, and Morton. The article provides a synthesis of the area and suggests directions for future research.     

Risk aversion and the intertemporal behavior of asset prices

In this article, we characterize economies in which both cashflows and forward prices follow random walks. We show in thecase of geometric random walks that the preferences of the representativeinvestor are of the constant proportional risk-aversion type.We also show the conditions under which spot prices follow randomwalks and under which the equivalent martingale measure is non-state-dependent.