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Asset Pricing and the Bid–Ask Spread
Abstract
This paper studies the effect of the bid-ask spread on asset pricing. We analyze a model in which investors with different expected holding periods trade assets with different relative spreads. The resulting testable hypothesis is that market-observed expexted return is an increasing and concave function of the spread. We test this hypothesis, and the empirical results are consistent with the predictions of the model.
... Portfolio returns depends on the characteristics of exchange process of the securities constituents. The wider the bid -ask spread, the higher the returns the investors will demand to hold the securities that have a wide bid -ask spread (Amihud & Mendelson, 1986). ...
... They found that even small transaction costs can have a considerable impact, making investors to cease from trading. Also, from an aggregate perspective, Amihud and Mendelson (1986) show some substantiation that stock returns reveal the impacts of financial markets frictions. Hou and Moskowitz (2005) in their study titled "market frictions, price delay, and the cross-section of expected return" conducted in United States of America; they parsimoniously characterised how financial markets frictions severely affect a stock using the delay with which its price react to information. ...
In reallocating resources from the fund surplus unit to the fund deficit unit, financial markets face some interference which is referred to as financial market frictions. The study examines the micro and macro aspects of the effects of financial markets frictions on portfolio investments decisions and performance of financial market participants (individual firms and the entire economy). The study employs secondary data collected from firms annual reports and accounts and the World Bank data bank for national economic data. The firm level data covers a period of five years while the macro level data covers a period of seven (11) years. The study used EView 8.0 for generating the estimation results for the study. The study uses panel least square and two stage least square estimation techniques for the analysis of the data and to test the hypotheses. The study find, amongst other findings, that financial markets frictions and changes in financial market frictions across specific financial markets significantly affect investor’s portfolio decision and performance at the firm level and national economies. The study concludes that financial market frictions affect both portfolio investment decisions and portfolio investment performance in all financial markets and that exchange rate cheanges and changes in other financial markets frictions result in significant changes in investor’s decisions and performance across the globe. The study also concludes that the portfolio constituent of an investor changes with regards to changes in financial frictions. That portfolio investment decisions in all financial markets are significantly influenced by financial markets frictions at varying degrees and magnitudes and that these frictions changes frequently in financial markets. The study recommends, amongst other recommendations, that investors should give considerable attention to minimizing varied financial markets frictions that affect their investment decisions and the performance of their investment portfolio.
... Cost of illiquidity, or alternatively the shadow price of liquidity, has attracted substantial interest from researchers in financial markets and market microstructure. Amihud and Mendelson (1986) were among the first to identify the role of liquidity in explaining the difference between asset returns and consequently asset prices between the high and low liquidity segments of the market. Their continuing research in this area (Amihud andMendelson 1986, 1991;Amihud 2002;Amihud and Mendelson 2006;Amihud, Hameed, Kang, and Zhang 2015) has been joined by many researchers (e.g., Brennan and Subrahmanyam 1996;Chordia, Roll, and Subrahmanyam 2000;Pastor and Stambaugh 2003;Gibson and Mougeot 2004;Acharya and Pedersen 2005, among others). ...
... In prior empirical research, cost-based measures, the bid-ask spread, and price impact/trading cost have been used to measure relative liquidity (Amihud and Mendelson 1986;Brennan and Subrahmanyam 1996). Trading volume and turnover have also been commonly used as alternative measurements for relative liquidity (Berkman and Eleswarapu 1998;Levine and Schmukler 2006). ...
Market declines of 2008–2009 and 2022–2023 brought renewed attention to the issue of illiquidity and the attendant costs faced by the stockholders. Margrabe exchange option-based models have been employed widely for estimating the cost of illiquidity (price risk). These models estimate the exchange ratio for two assets where the future price of both assets is unknown. Treating one of the assets as a numeraire, or currency in which the other asset is priced, simplifies the model and makes it easily tractable. Some authors have ignored this distinction, leading to inflated estimates for illiquidity discounts (sometimes exceeding 100 percent, a logical fallacy). In this paper, I present a uniform framework (the Margrabe exchange option) comparing the estimated cost of illiquidity under different information asymmetry assumptions. Empirical results presented are consistent with the theoretical predictions in that the expected rank order for estimated costs under different formulations is preserved.
JEL Classifications: C52; D47; D82; G13; K22.
... Generally speaking, there is evidence from two different literature streams that increased disclosures have a negative impact on the costs of equity financing. Demsetz (1968), Copeland and Galai (1983), Glosten and Milgrom (1985), Amihud and Mendelson (1986), Diamond and Verrecchia (1991) all base their arguments on the increased stock market liquidity; Botosan (2006), Barry and Brown (1985), Coles and Loewenstein (1988), Handa and Linn (1993) all base their arguments on the decreased non-diversifiable estimation risk. According to the previous literature stream, companies would attract more long-term investors if they disclosed more corporate information. ...
... Prior studies have documented the adverse effects that information asymmetry between informed and uninformed investors has on the functioning of markets (Akerlof, 1978;Amihud and Mendelson, 1986;Kim and Verrecchia, 1994; Leuz and Verrecchia, 2000). Leuz and Verrecchia (2000) and Kalay (2015) argue that the likelihood of such an imbalance among investors is decreased by a commitment to increased levels of disclosure. ...
The purpose of this study is to examine impact of using the extended audit report (EAR) on the information asymmetry that exists among the shareholders of family firms as compared to non-family firms during the period surrounding the announcement of an audit report. The results show that the adoption of the EAR alleviates the problem of information asymmetry related to family firms. Furthermore, the results show that the inclusion of key audit matters in audit reports also decreases the information asymmetry related to family firms. JEL classification numbers: G32, M42. Keywords: Extended Audit Report, Information Asymmetry, Family Firm.
... Conversely, lack of liquidity will impede future growth capital raising and therefore negatively affect the overall reputation toward the issuing company. Overall, investors demand lower returns, assign a higher valuation to more liquid assets, and therefore pay more (Amihud and Mendelson 1986). ...
We investigate liquidity and information asymmetry for a sample of non-U.S. stock listings and U.S. IPO listings on the NYSE. We find that non-U.S. stock listings tend to have wider spreads, larger price impact of trades, and higher probability of information-based trading than those of the U.S. IPOs. In addition, our results show that the differences in liquidity and information asymmetry are not transient; it has a long-term implication. Furthermore, liquidity and information asymmetry measures for non-U.S. stock listings are significantly related to the macro-institutional quality of their home countries such as political risk and absence of violence/terrorism, government effectiveness, voice and accountability, control of corruption, and rule of law. We find that non-U.S. stocks from countries with lower institutional quality metrics tend to have lower liquidity and higher information asymmetry. Therefore, improving a country’s institutional quality alleviates information problems and improves market liquidity for non-U.S. stocks listed in NYSE.
... As a result of the neglect effect, sin firms suffer from lower stock liquidity. This lower liquidity leads to a higher expected return or higher cost of capital (Amihud & Mendelson, 1986). According to the supply-side argument, in order to expand the investor pool and lower the cost of capital, sin firms face excessive pressure to entice existing and potential investors. ...
Social norms deter socially responsible investors from investing in sin firms, i.e., firms that sell unethical products and profit from human vice. Existing literature documents that sin firms are less held by institutional investors and less followed by analysts, and this neglect effect leads to higher expected returns than in other firms. Our study explores the earnings management behavior of sin firms. Our empirical findings suggest that compared to others, sin firms are more likely to report small earrings surprises and small earnings increases, but less likely to report superior earnings. Sin firms’ earnings management behavior is exacerbated by lower non-transient institutional ownership, lower analyst coverage, and greater litigation risks. Additional analyses document that sin firms use both accrual-based management and real activity manipulation to report earnings that just meet earnings thresholds. The overall findings suggest that sin firms’ opportunistic behavior likely increases the information risks and contributes to the documented higher expected returns.
... Stock liquidity is recognized as a central component of the capital market [15]. A substantial body of research has been devoted to understanding the factors that influence stock liquidity. ...
... Transaction costs are measured using bid-ask spreads, illiquidity, and trading volume. Market maker competition decreases the transaction costs of stocks, which facilitates the trading of informed orders and a higher efficiency of pricing [9][10][11]. Hypothesis 1. Market maker competition affects price efficiency through transaction costs. ...
The purpose of this study — is to determine the relationship between market maker competition and stock price efficiency in TSE (Tunisian Stock Exchange) market. The proxy for competition was determined as the number of market makers and the parameters investigated were transaction costs, information asymmetry and profit. The high positive correlation between competition and stock price efficiency is demonstrated by the negative impact of competition on all the variables studied. In addition, the price efficiency increased considerably after the introduction of new market makers by using the difference-in-difference (DID) model. Also, the competition between market makers has a significant negative impact on price efficiency through transaction costs, asymmetry information and level of experience. Thus, it can be concluded that the stock price efficiency can be improved by increasing the competition of market makers in Tunisia.
... The higher level of stock's liquidity is, the liquidity risk faced is smaller. Foreign research on measuring stock liquidity and its potential risks originated earlier, so the content is also relatively mature: Roll R. [13] used the covariance of the first order difference of the price sequence to measure the stock liquidity with the daily trading data; Amihud, Y. [7,14] constructed the still widely used illiliquidity indicator: the greater the illiquidity this indicator represents, the weaker the liquidity of stocks; Pastor, L., Stambaugh, R. [15] measured the stock liquidity by the influence of trading volume and trading direction on stock yield, and the stock liquidity risk by the covariance of stock return and market liquidity information. Therefore, referring to the relevant foreign literature, we selected the Amihud index, Roll indexes and Pastor_Stambaugh indexes as liquidity factors for calculation and study. ...
As an emerging market dominated by retail investors, China's stock market is greatly affected by external shocks such as market noise and policy changes, and the traditional fundamental factors have limited ability to predict the future returns of stocks. Stock liquidity is also affected by noise factors and macro factors, which can be regarded as one of their external performance. Based on the multi-factor stock selection model, this paper uses the 2010-2022 CSI 300 stock data to construct a fundamental fusion factor and another fusion factor considering both fundamental and liquidity risk factors, then compares the stock selection effect of the two fusion factors through a variety of test indicators. The empirical results show that the IC value of the fusion factor considering both fundamental and liquidity risk factors is 0.0267, which is greatly improved compared with the fundamental fusion factor with IC value of only 0.0195, and its excess yield of 64.728% is 13.134% higher than the fundamental fusion factor, while the benchmark win rate is increased by nearly 3% and the maximum retracement is reduced by nearly 12%. The research shows that the effectiveness and stability of the fusion factor after adding the liquidity index to predict the future return of the stock and obtain the excess profits are better than the fundamental fusion factor. Therefore, considering the measurement and inclusion of stock liquidity level can improve the yield of stock selection strategy in the Chinese stock market to a certain extent.
... They find that OTCBB firms that were already compliant with the disclosure requirements experience improved liquidity when other OTCBB firms not previously filing with the SEC newly comply with the rule change. As investors price liquidity in the market (e.g., Amihud and Mendelson, 1986;Chordia et al., 2001), this evidence is consistent with the newly-compliant firms' mandatory disclosures having positive externalities on the pricing of their peers in the secondary trading markets. Focusing on the primary issuing markets, Shroff et al. (2017) investigate the role of public peer information in firms approaching public debt or equity capital for the first time. ...
We examine whether the increased quantity of public information has a spillover impact on equity sales by private industry peer firms. To capture an increase in the quantity of public peer information, we use corporate spinoffs as these events cause an increase in the number of independent public entities that mandatorily disclose financial reports. Using a unique dataset on private firms' equity sales extracted from the SEC filings pursuant to Regulation D, we find that private industry peers sell more equity following spinoffs, but the increase is not statistically significant. When we divide our spinoff sample based on the availability of segment information on subsidiaries before spinoffs, however, we find a significant increase in private firms' equity sales after spinoffs when parent firms did not previously disclose segment reports. Additional test results suggest that our inferences regarding private industry peers are not entirely explained by an industry-wide demand shock. Overall, we contribute to the literature by establishing an information spillover channel, incremental to the effect of common industry shocks, flowing from the public to private markets.
... Consequently, an investor should be "inspired" to trade bigger volumes to suffer bigger losses on transaction costs and to demand a bigger risk premium. Amihud and Mendelson (1986) show that transaction costs can change the stock price by the order of ten percent by exogenously making investors undergo heavy losses on transaction costs. Isaenko (2023a) shows in the equilibrium framework that in a stationary stock market where all investors pay transaction costs, these costs can have the impact on the first two unconditional moments of the rates of stock returns of the order of tens of percent from their values in the absence of transaction costs. ...
I solve a dynamic equilibrium in a competitive economy where investors trade stock shares with market makers. Investors trade frequently and have to pay small transaction costs. I find that the moments of the rates of stock returns can change by hundreds of percent after transaction costs are introduced. Specifically, assuming that market makers have the same risk aversion as investors, but their weight in the economy is three times smaller than the weight of investors, and applying the calibration from Campell and Kyle (1993), the model predicts that the risk premium and the standard deviation of the rates of de-trended stock returns should be 5.5% and 9.8%, while in the market without costs these moments are 0.5% and 2.0%, respectively. These changes in stock returns are due to a significant downsizing in the stock demand from investors in the presence of transaction costs and are defined by the risk aversion of market makers and their weight in the economy.
... Studies have shown that liquidity can have a significant impact on equity valuation. For example, research by Stoll and Whaley (1983); and Amihud and Mendelson (1986) found that illiquid stocks tend to have higher required rates of return, due to the higher transaction costs associated with trading them. Previous research has examined the nexus between liquidity and firm performance. ...
Purpose: The aim of this research is to investigate the association between financial leverage, firm liquidity, and firm size with the performance of companies in China. Design/Methodology/Approach: The study adopted a quantitative approach and gathered secondary data from 2010 to 2022 from firms listed on the China Stock Exchange via the wind database. Using a fixed effect model, we empirically tested our hypotheses. Findings: The study's outcomes indicate that firm liquidity and firm size significantly affect a company's performance in China. Moreover, the study claims that financial leverage also plays a significant role in influencing firm performance. Conclusion: In conclusion, findings indicate the importance for corporate managers, policymakers, and investors to consider factors such as financial liquidity and firm size when making decisions related to firm performance, particularly in an emerging stock market.
... We also examine the liquidity impacts sourced from heterogeneous institutional ownership, as stock liquidity and liquidity risk are indispensable factors in investors' decisions and have significant impacts on stock returns (Amihud and Mendelson 1986;Amihud 2002;Amihud and Mendelson 2012). Table 7 Panel B presents the results on the liquidity impacts of different investors across different channels. ...
Existing literature has extensively discussed the impact of economic policy uncertainty (EPU) on firm-related activities, but there is sparse evidence of its impact on the behavior of institutional investors. Using quarterly U.S firm-level data for 1980Q1-2020Q4, we find heterogeneous responses of institutional investors to EPU shocks to different horizons. Specifically, long-term institutional investors respond positively to EPU shocks, while short-term institutional investors reduce their holdings during periods of uncertainty. We posit that different expectations about the future of firms between long- and short-term investors may account for the heterogeneous responses. We test this hypothesis by investigating how firm growth opportunities, volatility, and investment activity influence the relationship between EPU and institutional investor horizons. The results show that the positive (negative) effect of EPU on long-term (short-term) institutional investors becomes stronger for firms with higher growth opportunities, higher volatility, and more investment. Our paper has important economic implications that the countercyclical behavior of long-term institutional investors improves firm value and liquidity during uncertain periods.
... 3. Among many others, see, for example, Amihud and Mendelson (1986), Brennan et al. (1998), Chordia et al. (2000Chordia et al. ( , 2001Chordia et al. ( , 2002, Glosten and Harris (1988), Lillo et al. (2003), Lo et al. (2001), Lo and Wang (2000), Pastor and Stambaugh (2003), Sadka (2006) ...
The authors estimate systemic risk in the Korean economy using the econometric measures of commonality and connectedness applied to stock returns. To assess potential systemic risk concerns arising from the high concentration of the economy in large business groups and a few export-oriented sectors, the authors perform three levels of estimation using individual stocks, business groups, and industry returns. The results show that the measures perform well over the study’s sample period by indicating heightened levels of commonality and interconnectedness during crisis periods. In out-of-sample tests, the measures can predict future losses in the stock market during the crises. The authors also provide the recent readings of their measures at the market, chaebol, and industry levels. Although the measures indicate systemic risk is not a major concern in Korea, as they tend to be at the lowest level since 1998, there is an increasing trend in commonality and connectedness since 2017. Samsung and SK exhibit increasing degrees of commonality and connectedness, perhaps because of their heavy dependence on a few major member firms. Commonality in the finance industry has not subsided since the financial crisis, suggesting that systemic risk is still a concern in the banking sector.
... From a theoretical point of view, it has been argued that disclosure reduces information asymmetry and, consequently, the cost of equity capital for companies by reducing bid/ask spreads (Amihud and Mendelson 1986) or by increasing demand for a company's shares (Diamond and Verrecchia 1991). Another advantage of improving the quality of information is that it reduces the estimation risk of potential investors regarding the parameters of a stock's future performance. ...
This study analyzes the impact of adopting International Financial Reporting Standards (IFRS) on the cost of equity capital for firms listed on STOXX Europe 600 using a sample of 9773 firm-year observations between 1994 and 2022. We estimate the cost of equity capital using the modified price-earnings-growth ratio model and employ the GMM system to investigate the effect of IFRS Standards on the cost of equity capital. Our results indicate that IFRS adoption reduces firms' cost of equity capital. We performed various sensitivity analyses to ensure the reliability of our results. Overall, this study contributes to the extant literature on the cost of equity capital implications of IFRS adoption and provides valuable insights for investors, regulators, and policymakers.
In the setting of a dynamic panel data framework, we investigate the international five‐factor Fama–French (2017) model augmented with traditional illiquidity factors (Amihud, Journal of Financial Markets, 2002, 5, 31–56; Amihud, Critical Finance Review, 2019, 8, 203–221; Pástor and Stambaugh, Journal of Political Economy, 2003, 111, 642–685; Pástor and Stambaugh, Critical Finance Review, 2019, 8, 277–299) to determine if any of these factors are priced. Since illiquidity measures are endogenous, we propose an algorithm that generates robust instruments which are combined with a GMM estimator to cope with both the endogeneity issues surrounding illiquidity and other eventual specification errors. In this dynamic framework, we generally find that the most significant factors correspond to market and size but illiquidity may matter depending on the level of the beta. We find that illiquidity has more impact on returns in expansion than in recession. However, the bid‐ask spread seems to behave differently from the other illiquidity measures.
Liquidity is an important characteristic of financial markets, affecting portfolio decisions and priced risk. During periods of market turmoil, such as occurs during financial crisis, investors have an elevated need for cash and so understanding how liquidity differs during those periods is important. We examine how stock market liquidity was impacted by two crises with distinct origins, the global financial crisis (GFC) and the COVID‐pandemic. Our sample includes the S&P/ASX200 constituents for the period January 2005–December 2020. We find that the Australian stock market is less liquid during both crisis periods; spreads are wider, depth is lower, and price impact is larger (stock prices move a lot in response to small amounts of volume). Although the magnitude of the liquidity change is greater at the onset of COVID, the duration of the impact is longer during the GFC, resulting in a larger average effect. While trading volume declines during the GFC, it increases during COVID. Our results are robust to alternate liquidity proxies, methodologies and crisis period identification, and generally applicable across stock sectors.
In this study we offer fresh insights into liquidity resiliency. We empirically study the resiliency of the euro area sovereign bond market across the maturity spectrum. We measure resiliency using a standard Ordinary Least Squares regression approach, along with the least absolute shrinkage and selection operator (LASSO) machine learning approach. We find both spread-based
and depth-based resiliency are negatively correlated with spreads and positively correlated with depths. Moreover, we study the interrelationships among resiliency, volatility, returns, and credit default swap (CDS) spreads. Lastly, we document strong commonalities in resiliency for core and periphery euro area markets in both calm and turbulent periods.
Illiquid assets require a return premium; illiquidity is also a limit‐to‐arbitrage. We find that Amihud's illiquidity premium is significantly higher among underpriced stocks than among overpriced stocks. Excluding the most mispriced stocks leads to a higher and more reliably estimated illiquidity premium. Amihud's illiquidity measure is positively correlated with overpricing, consistent with arbitrage asymmetry, while inconsistent with Lou and Shu's contention that the return premium associated with the Amihud measure reflects mispricing rather than compensation for illiquidity. Our results demonstrate that it is important to account for their role as limits‐to‐arbitrage when evaluating the pricing of illiquidity measures.
The return of assets and various investment opportunities are two of the most basic principles of optimal allocation of resources in the economy. Liquidity is one of the most important factors affecting the risk and expected return of assets, and liquidity risks arise from it. The main purpose of this study is to determine the effect of different liquidity risks on the stock returns using the LCAPM model with the most optimal illiquidity measure. To test the hypotheses of research, a sample of 167 companies listed on the Tehran Stock Exchange during the years 1389 to 1398 has been selected. In order to select the optimal illiquidity measure from among six different measures, Principal Component Analysis approach is used and PSpread measure has been chosen. For estimating the model, the Generalized Method of Moments method has been used. The results of this study show that investors price liquidity risks in bearish markets in addition to the illiquidity effect, however, they do not pay much attention to these risks in the bullish markets.
This study demonstrates that skewness preference of investors is an important driver of various market anomalies. Using a combined measure of mispricing based on 11 prominent anomaly strategies, we show that return predictability associated with the mispricing component of market anomalies is stronger among firms with higher idiosyncratic skewness. The predictability differences are driven by the higher underperformance of high-skewness firms in short anomaly portfolios. Skewness does not affect the performance of long anomaly portfolios. Portfolio holdings data from a retail brokerage firm show that investors with stronger skewness preferences assign relatively larger weights to stocks in short anomaly portfolios.
This paper was accepted by Karl Diether, finance.
Supplemental Material: The data files and online appendix are available at https://doi.org/10.1287/mnsc.2023.4898 .
Based on the data of listed small and medium‐sized enterprises (SMEs) from 2011 to 2020, this paper studies the effects of fintech on the financing constraints of SMEs in China. The results denote that fintech can significantly ease financing constraints of SMEs; with a 1% increase in fintech, the financing constraints of SMEs decrease by 0.0767%. The intermediary mechanism analysis illustrates that fintech can ease the financing constraints of SMEs by alleviating financial industry concentration and information asymmetry. Besides, regions with a higher degree of marketization and industries with relatively free competition are both more conducive to fintech alleviating the financing constraints of SMEs.
This paper documents that in distress periods, liquidity constrained investors sell liquid corporate bonds and hold onto illiquid ones, a phenomenon which we refer to as flight from liquidity. Performing within issuer‐time analysis to properly control for credit risk, we find that flight from liquidity results in a decline in the liquidity premium. In other words, liquid bonds that are significantly more expensive in normal market conditions, lose more value in distress periods and trade at a closer, and sometimes at an indistinguishable, yield spread to their illiquid peers from the same issuer. We also find that these shocks to the liquidity premium are short‐lived and do not have a long‐lasting pricing impact. We provide suggestive evidence that the liquidity clientele effect derives these results. Our findings suggest that investment exposure to liquid bonds entails a unique risk arising during periods of distress.
The managements of many public companies do not pay much attention to the liquidity of their securities. Many if not most CEOs and CFOs feel powerless to affect what goes on in financial markets, and a common attitude among top executives is that maintaining liquidity is the concern of the securities exchanges and the Securities and Exchange Commission. This approach may work for those companies whose stocks are already highly liquid—a group made up mainly of large‐cap companies, as well as a number of smaller high‐flying, high‐tech firms. But, for the vast majority of public companies—especially smaller and mid‐sized firms—this is likely to be the wrong policy.
As the authors of this article demonstrated in their pioneering study (published in the Journal of Financial Economics in 1986), liquidity appears to be a major determinant of a company's cost of capital. As their theory suggests and their empirical tests confirmed, the more liquid a company's securities, the lower its cost of capital and the higher its stock price. And, as discussed in this article, academic research since then has produced a large and impressive body of evidence linking greater liquidity to higher stock prices.
Although recent technological innovations such as Internet‐based trading have increased liquidity generally, not all companies appear to have benefited equally. The authors offer a number of suggestions for companies intent on increasing the liquidity of their stock. Specifically, they propose that managers do the following: (1) consider measures, such as stock splits, designed to increase their investor base by attracting small investors; (2) seek trading venues for their securities that promise to increase liquidity; and (3) take advantage of the new Internet technology to provide more and better information to investors.
Moreover, for smaller companies with little or no analyst coverage, the authors offer the radical suggestion that such companies actually pay analysts to cover their stock , much as companies pay Moody's or Standard & Poors to rate their bonds. This, in the authors' view, would be a more efficient alternative to the current practice of using stock splits to encourage intermediaries to make markets in the firm's shares.
ABSTRACT Two easily measured variables, size and book-to-market equity, combine to capture the cross-sectional variation in average stock returns associated with market {3, size, leverage, book-to-market equity, and earnings-price ratios. Moreover, when the tests allow for variation in {3 that is unrelated to size, the relation between market {3 and average return is flat, even when {3 is the only explanatory variable. THE ASSET-PRICING MODEL OF Sharpe (1964), Lintner (1965), and Black (1972)
This study considers the problem of a price-setting monopolistic market-maker in a dealership market where the stochastic demand and supply are depicted by price-dependent Poisson processes [following Garman (1976)]. The crux of the analysis is the dependence of the bid-ask prices on the market-maker's stock inventory position. We derive the optimal policy and its characteristics and compare it to Garman's. The results are shown to be consistent with some conjectures and observed phenomena, like the existence of a ‘preferred’ inventory position and the downward monotonicity of the bid-ask prices. For linear demand and supply functions we derive the behavior of the bid-ask spread and show that the transaction-to-transaction price behavior is intertemporally dependent. However, we prove that it is impossible to make a profit on this price dependence by trading against the market-maker. Thus, in this situation, serially dependent price-changes are consistent with the market efficiency hypothesis.
This paper empirically investigates the seasonal behavior of the liquidity premium in asset pricing. The evidence suggests a strong seasonal component. In the 1961–1990 period, the liquidity premium is reliably positive only during the month of January. For the non-January months, one cannot detect a positive liquidity premium. The impact of the relative bid-ask spreads on asset pricing in non-January months cannot be reliably distinguished from zero. In contrast to Amihud and Mendelson (1986), however, our evidence suggests that the size effect is significant, even after controlling for spreads.
Considerable attention has recently been given to general equilibrium models of the pricing of capital assets. Of these, perhaps the best known is the mean-variance formulation originally developed by Sharpe (1964) and Treynor (1961), and extended and clarified by Lintner (1965a; 1965b), Mossin (1966), Fama (1968a; 1968b), and Long (1972). In addition Treynor (1965), Sharpe (1966), and Jensen (1968; 1969) have developed portfolio evaluation models which are either based on this asset pricing model or bear a close relation to it. In the development of the asset pricing model it is assumed that (1) all investors are single period risk-averse utility of terminal wealth maximizers and can choose among portfolios solely on the basis of mean and variance, (2) there are no taxes or transactions costs, (3) all investors have homogeneous views regarding the parameters of the joint probability distribution of all security returns, and (4) all investors can borrow and lend at a given riskless rate of interest. The main result of the model is a statement of the relation between the expected risk premiums on individual assets and their "systematic risk." Our main purpose is to present some additional tests of this asset pricing model which avoid some of the problems of earlier studies and which, we believe, provide additional insights into the nature of the structure of security returns. The evidence presented in Section II indicates the expected excess return on an asset is not strictly proportional to its B, and we believe that this evidence, coupled with that given in Section IV, is sufficiently strong to warrant rejection of the traditional form of the model given by (1). We then show in Section III how the cross-sectional tests are subject to measurement error bias, provide a solution to this problem through grouping procedures, and show how cross-sectional methods are relevant to testing the expanded two-factor form of the model. We show in Section IV that the mean of the beta factor has had a positive trend over the period 1931-65 and was on the order of 1.0 to 1.3% per month in the two sample intervals we examined in the period 1948-65. This seems to have been significantly different from the average risk-free rate and indeed is roughly the same size as the average market return of 1.3 and 1.2% per month over the two sample intervals in this period. This evidence seems to be sufficiently strong enough to warrant rejection of the traditional form of the model given by (1). In addition, the standard deviation of the beta factor over these two sample intervals was 2.0 and 2.2% per month, as compared with the standard deviation of the market factor of 3.6 and 3.8% per month. Thus the beta factor seems to be an important determinant of security returns.
This paper reexamines the anomalous evidence concerning the efficiency of the listed options exchanges. We focus on the structure of trading costs in that market, and note several costs which generally have been ignored, the largest of which is the bid-ask spread. When we adjust the published trading rules for our estimates of these trading costs, the reported abnormal returns are eliminated.
This paper studies the impact of market consolidation or fragmentation on its performance, examining four alternative models of exchange: a consolidated clearing house, fragmented clearing houses, a monopoly dealer market, and an interdealer market. The effects of the market mechanism on the expected quantity traded, the price variance faced by individual traders, the quality of market price signals, the expected gains from trade, and the exchange implementation costs are studied.
This paper studies the behavior of a competitive exchange under uncertain preferences and random indivisible endowments. We obtain explicit closed-form results for the price distribution and expected gains from trade, both for case where the market is “thin” and the number of traders is low, and for the asymptotic case where the number of traders tends to infinity. We demonstrate that increasing the number of traders reduces price variability and increases the expected gains from trade, and that increasing the variability of traders' reservation prices increases price variability as well as the expected asymptotic gains from trade.
It is assumed that a collection of market agents can be treated as a statistical ensemble. Their market activities are depicted as the stochastic generation of market orders according to a Poisson process. The objective is to effectively describe the ‘temporal microstructure’, or moment-to-moment trading activities in asset markets. Two basic models, ‘dealership’ vs. ‘auction’ markets (and their variants) are put forth. Implications are drawn from each model. The implications include several testable hypotheses regarding the aggregate behavior of markets and market-makers as well as some qualitative insight into the transaction-to-transaction nature of realistic exchange processes.
Security market regulators, among others, are concerned to know whether or not dealers are natural monopolists. Based on a randomly drawn sample of 314 over-the-counter stocks, the results of this study suggest that while there are economies of scale, they are not on the dealer level. In addition, both systematic and unsystematic risk were tested for association with the transaction costs in this market. The evidence suggests unsystematic risk is related to spread.
In this paper we develop a CAPM-based model to demonstrate that the true measure of systematic risk – when considering liquidity costs – is based on net (after bid–ask spread) returns. We further examine the relationship between the expected return and the future spread cost within the CAPM framework. This positive relationship in our model is found to be convex. This finding differs from Amihud and Mendelson's (1986) concave relationship, but it agrees with empirical evidence obtained by Brennan and Subrahmanyam (1996).
The mean return computational method has a substantial effect on the estimated small firm premium. The buy-and-hold method, which best mimics actual investment experience, produces an estimated small-firm premium only one-half as large as the arithmetic and re-balanced methods which are often used in empirical studies. Similar biases can be expected in mean returns when securities are classified by any variable related to trading volume.
This paper explores investors portfolio behavior when security returns can be described by one of the forms of the CAPM model and investors pay taxes. The conditions under which an investor holds the market portfolio are explored. In addition the extent to which securities are held in proportions which differ from market weights are shown to be functions of tax rates, dividend policies, and the variance covariance structure between all securities.
Stoll and Whaley (1983) suggest large transaction costs may be responsible for the large risk-adjusted returns earned by small firm stocks. This study, using data from the AMEX as well as the NYSE, shows that investors can earn risk-adjusted excess returns after transaction costs by holding small firms for relatively short holding periods. Other literature that provides evidence that is inconsistent with the transaction costs hypothesis is cited.
Models of price formation in securities markets suggest that privately informed investors create significant illiquidity costs for uninformed investors, implying that the required rates of return should be higher for securities that are relatively illiquid. We investigate the empirical relation between monthly stock returns and measures of illiquity obtained from intraday data. We find a significant relation between required rates of return and these measures after adjusting for the Fama and French risk factors, and also after accounting for the effects of the stock price level.
This paper suggests that it is not possible to demonstrate, using the best available empirical methods, that the expected returns on high yield common stocks differ from the expected returns on low yield common stocks either before or after taxes. A taxable investor who concentrates his portfolio in low yield securities cannot tell from the data whether he is increasing or decreasing his expected after-tax return by so doing. A tax exempt investor who concentrates his portfolio in high yield securities cannot tell from the data whether he is increasing or decreasing his expected return. We argue that the best method for testing the effects of dividend policy on stock prices is to test the effects of dividend yield on stock returns. Thus the fact that we cannot tell, using the best available methods, what effects dividend yield has on stock returns implies that we cannot tell what effect, if any, a change in dividend policy will have on a corporation's stock price.
In the past few decades, methods of linear algebra have become central to economic analysis, replacing older tools such as the calculus. David Gale has provided the first complete and lucid treatment of important topics in mathematical economics which can be analyzed by linear models. This self-contained work requires few mathematical prerequisites and provides all necessary groundwork in the first few chapters. After introducing basic geometric concepts of vectors and vector spaces, Gale proceeds to give the main theorems on linear inequalitiesâtheorems underpinning the theory of games, linear programming, and the Neumann model of growth. He then explores such subjects as linear programming; the theory of two-person games; static and dynamic theories of linear exchange models, including problems of equilibrium prices and dynamic stability; and methods of play, optimal strategies, and solutions of matrix games. This book should prove an invaluable reference source and text for mathematicians, engineers, economists, and those in many related areas.
Photocopy. Thesis (Ph. D.)--University of Chicago, 1979. Bibliography: leaves 91-94.
The main purpose of this study is the development of a model for evaluating the performance of portfolios of risky assets taking into account the effects of differential risk on required returns. The portfolio evaluation model developed here incorporates these risk aspects explicitly by utilizing and extending recent theoretical results by Sharpe (1964) and Lintner (1965) on the pricing of capital assets under uncertainty. Given these results, a measure of portfolio performance (which measures only a manager's ability to forecast security prices) is defined as the difference between the actual returns on a portfolio in any particular holding period and the expected returns on that portfolio conditional on the riskless rate, its level of systematic risk, and the actual returns on the market portfolio. Criteria for judging a portfolio's performance to be neutral, superior, or inferior are established. A measure of a portfolio's efficiency is also derived, and the criteria for judging a portfolio to be efficient, superefficient, or inefficient are defined. I also show that it is strictly impossible to define a measure of efficiency solely in terms of ex post observable variables. I define two forms of the efficient market hypothesis, the weak form and the strong form (following terminology introduced by Harry Roberts, who used these terms in an unpublished speech entitled Clinical vs. Statistical Forecasts of Security Prices, given at the Seminar on the Analysis of Security Prices sponsored by the Center for Research in Security Prices at the Univ. of Chicago, May 1967. One can define a weakly efficient market in the following sense: Consider the arrival in the market of a new piece of information concerning the value of a security. A weakly efficient market is a market in which it may take time to evaluate this information with regard to its implications for the value of the security. Once this evaluation is complete, however, the price of the security immediately adjusts (in an unbiased fashion) to the new value implied by the information. In such a weakly efficient market, the past price series of a security will contain no information not already impounded in the current price. In such a market, forecasting techniques which use only the sequence of past prices to forecast future prices are doomed to failure. The best forecast of future price is merely the present price plus the normal expected return over the period. The available evidence suggests that it is highly unlikely that an investor or portfolio manager will be able to use the past history of stock prices alone (and hence mechanical trading rules based on these prices) to increase his profits. However, the conclusion that stock prices follow the weak form of the efficient market hypothesis allows for an investor to increase his profits by improving his ability to predict and evaluate the consequences of future events affecting stock prices. This brings us to the strong form definition of an efficient market, that is, one in which all past information available up to time t is impounded in the current price. If security prices conform to the strong form of the hypothesis, no analyst will be able to earn above-average returns by attempting to predict future prices on the basis of past information. The only individual able to earn superior returns will be that person who occasionally is the first to acquire a new piece of information not generally available to others in the market. But as Roll (1968) argues, in attempting to act immediately on this information, this individual will insure that the effects of this new information are quickly impounded in the security's price. Furthermore, if new information of this type arises randomly, no individual will be able to assure himself of systematic receipt of such information. Therefore, while an individual may occasionally realize such windfall returns, he will be unable to earn them systematically through time. While the weak form of the hypothesis is well substantiated by empirical evidence, the strong form of the hypothesis has not as yet been subjected to extensive empirical tests. The model developed in this paper allows us to submit the strong form of the hypothesis to such an empirical test - at least to the extent that its implications are manifested in the success or failure of one particular class of extremely well-endowed security analysts. I use the portfolio evaluation model developed here to examine the results achieved by the managers of 115 open end mutual funds. The main conclusions are: 1) The observed historical patterns of systematic risk and return for the mutual funds in the sample are consistent with the joint hypothesis that the capital asset pricing model is valid and that the mutual fund managers on average are unable to forecast future security prices. 2) If we assume that the capital asset pricing model is valid, then the empirical estimates of fund performance indicate that the fund portfolios were inferior after deduction of all management expenses and brokerage commissions generated in trading activity. When all management expenses and brokerage commissions are added back to the fund returns and the average cash balances of the funds are assumed to earn the riskless rate, the fund portfolios appeared to be just neutral. Thus, on the average the resources spent by the funds in to forecast security prices do not yield higher portfolio returns than those which could have been earned by equivalent risk portfolios selected (a) by random selection policies or (b) by combined investments in a market portfolio and government bonds. 3) I conclude that as far as these 115 mutual funds are concerned, prices of securities seem to behave according to the strong form of the efficient market hypothesis. That is, it appears that the current prices of securities completely capture the effects of all information available to these 115 mutual funds. Although these results certainly do not imply that the strong form of the hypothesis holds for all investors and for all time, they provide strong evidence in support of that hypothesis. 4) The evidence also indicates that, while the portfolios of the funds on the average are inferior and inefficient, this is due mainly to the generation of excessive expenses.
Previous estimates of a "size effect" based on daily returns data are biased. Several properties of quoted closing prices impart an upward bias to computed returns on individual stocks. Returns computed for buy-and-hold portfolios largely avoid the bias induced by closing prices. Based on such buy-and-hold returns, the full-year size effect is half as large as previously reported, and all of the full-year effect is, on average, due to the month of January.
Stock exchange seats are important assets for securities brokers since they provide access to centralized secondary trading markets for corporate securities at a reduced cost. This paper provides empirical evidence on the dynamic behavior of monthly New York and American Stock Exchange seat prices over the 1926–1972 period. Specifically, evidence is presented which: (a) is consistent with a multiplicative random walk model for seat prices; (b) indicates that unexpected changes in the prices of exchange-listed stocks or in the volume of shares traded on the exchange are important new information about the value of seats in each month; and (c) indicates that the market for seats is efficient in assimilating new information and quickly incorporates new information into the prices of seats. In addition, we examine the effect of the infrequent trading of seats on the statistical properties of the models.
In this paper, the portfolio and the liquidity planning problems are unified and analyzed in one model. Stochastic cash demands have a significant impact on both the composition of an individual's optimal portfolio and the pricing of capital assets in market equilibrium. The derived capital asset pricing model with cash demands and liquidation costs shows that both the market price of risk and the systematic risk of an asset are affected by the aggregate cash demands and liquidity risk. The modified model does not require that all investors hold an identical risky portfolio as implied by the Sharpe-Lintner-Mossin model. Furthermore, it provides a possible explanation for the noted discrepancies between the empirical evidence and the prediction of the traditional capital asset pricing model.
This paper calculates indices of central bank autonomy (CBA) for 163 central banks as of end-2003, and comparable indices for a subgroup of 68 central banks as of the end of the 1980s. The results confirm strong improvements in both economic and political CBA over the past couple of decades, although more progress is needed to boost political autonomy of the central banks in emerging market and developing countries. Our analysis confirms that greater CBA has on average helped to maintain low inflation levels. The paper identifies four broad principles of CBA that have been shared by the majority of countries. Significant differences exist in the area of banking supervision where many central banks have retained a key role. Finally, we discuss the sequencing of reforms to separate the conduct of monetary and fiscal policies. IMF Staff Papers (2009) 56, 263–296. doi:10.1057/imfsp.2008.25; published online 23 September 2008
Previous estimates of a 'size effect' based on daily returns data are biased. The use of quoted closing prices in computing returns on individual stocks imparts an upward bias. Returns computed for buy-and-hold portfolios largely avoid the bias induced by closing prices. Based on such buy-and-hold returns, the full-year size effect is half as large as previously reported, and all of the full-year effect is, on average, due to the month of January.
Recent empirical work by Banz (1981) and Reinganum (1981) documents abnormally large risk-adjusted returns for small firms listed on the NYSE and the AMEX. The strength and persistence with which the returns appear lead both authors to conclude the single-period, two-parameter capital asset pricing model is misspecified. This study (1) confirms that total market value of common stock equity varies inversely with risk-adjusted returns, (2) demonstrates that price per share does also, and (3) finds that transaction costs at least partially account for the abnormality.
Lawrence R. Klein pioneered the work on aggregation, in particular in production functions, in the 1940s. He paved the way for researchers to establish the conditions under which a series of micro production functions can be aggregated so as to yield an aggregate production function. This work is fundamental in order to establish the legitimacy of theoretical (neoclassical) growth models and empirical work in this area (e.g., growth accounting exercises, econometric estimation of aggregate production functions). This is because these models depend on the assumption that the technology of an economy can be represented by an aggregate production function, i.e., that the aggregate production function exists. However, without proper aggregation one cannot interpret the properties an aggregate production function. The aggregation literature showed that the conditions under which micro production functions can be aggregated so as to yield an aggregate production function are so stringent that it is difficult to believe that actual economies can satisfy them. These results question the legitimacy of growth models and their policy implications. Scientifi c work cannot proceed as if production functions existed. For this reason, the profession should pause before continuing to do theoretical and applied work with no sound foundations and dedicate some time to studying other approaches to estimating the impact of economic policies in order to understand what questions can legitimately be posed to the empirical aggregate data. Lawrence R. Klein fue uno de los pioneros del campo de la agregaci�n, en particular en el �rea de las funciones de producci�n, durante la d�cada de los 40. Sus contribuciones ayudaron a defi nir el problema de la agregaci�n para que investigadores posteriores establecieran formalmente las condiciones formales bajo las que funciones de producci�n microecon�micas con propiedades neocl�sicas pudieran ser agregadas con el fi n de generar una funci�n
One of the most fundamental market mechanisms is the clearing house, where orders are accumulated over time and the market is cleared periodically. The issue addressed in this study is the statistical behavior of the market under this neutral mechanism in the framework of a tractable stochastic model which captures the underlying uncertainties and indivisibilities in the demand and supply schedules. Applying renewal theory, we derive closed-form results for the behavior of prices and quantities, and pursue the implications of the possibility of no-trade and the multiplicity of market-clearing prices.
The paper examines the optimal behavior of a single dealer who is faced with a stochastic demand to trade (modeled by a continuous time Poisson jump process) and facing return risk on his stock and on the rest of his portfolio (modeled by diffusion processes). Using stochastic dynamic programming, we derive the optimal bid and ask prices that maximize the dealer's expected utility of terminal wealth as a function of the state in which he finds himself. The relationship of the bid and ask prices to inventory of the dealer, instantaneous variance of return, stochastic arrival of transactions and other variables is examined.
This study examines the empirical relationship between the return and the total market value of NYSE common stocks. It is found that smaller firms have had higher risk adjusted returns, on average, than larger firms. This ‘size effect’ has been in existence for at least forty years and is evidence that the capital asset pricing model is misspecified. The size effect is not linear in the market value; the main effect occurs for very small firms while there is little difference in return between average sized and large firms. It is not known whether size per se is responsible for the effect or whether size is just a proxy for one or more true unknown factors correlated with size.
This study documents empirical anomalies which suggest that either the simple one-period capital asset pricing model (CAPM) is misspecified or that capital markets are inefficient. In particular, portfolios based on firm size or earnings/price (E/P) ratios experience average returns systematically different from those predicted by the CAPM. Furthermore, the ‘abnormal’ returns persist for at least two years. This persistence reduces the likelihood that these results are being generated by a market inefficiency. Rather, the evidence seems to indicate that the equilibrium pricing model is misspecified. However, the data also reveals that an E/P effect does not emerge after returns are controlled for the firm size effect; the firm size effect largely subsumes the E/P effect. Thus, while the E/P anomaly and value anomaly exist when each variable is considered separately, the two anomalies seem to be related to the same set of missing factors, and these factors appear to be more closely associated with firm size than E/P ratios.
Two easily measured variables, size and book-to-market equity, combine to capture the cross-sectional variation in average stock returns associated with market "beta", size, leverage, book-to-market equity, and earnings-price ratios. Moreover, when the tests allow for variation in "beta" that is unrelated to size, t he relation between market "beta" and average return is flat, even when "beta" is the only explanatory variable. Copyright 1992 by American Finance Association.
This paper examines the effects of the mechanism by which securities are traded on their price behavior. We compare the behavior of open‐to‐open and close‐to‐close returns on NYSE stocks, given the differences in execution methods applied in the opening and closing transactions. Opening returns are found to exhibit greater dispersion, greater deviations from normality and a more negative and significant autocorrelation pattern than closing returns. We study the effects of the bid‐ask spread and the price‐adjustment process on the estimated return variances and covariances and discuss the associated biases. We conclude that the trading mechanism has a significant effect on stock price behavior.
income is taxed at a higher rate than capital gains, and tax rates vary across investors, corporations would adjust their dividend policies until, in equilibrium, such policies coincided with the desires of shareholders. That is, tax-induced shareholder clienteles would form, with low (high) yielding stocks being held by investors in high (low) marginal tax brackets. Black and Scholes (1974) argue for a 'supply effect', such that in equilibrium, a marginal change in a corporation's dividend distribution would leave its stock price unaffected. Brennan (1970) was the first to derive an After-Tax Capital Asset Pricing Model (CAPM) that accounted for the differential taxation of dividend and capital gains, and for a progressive tax scheme. The model was later extended by Litzenberger and Ramaswamy (1979) to account for restrictions on investors' borrowing. While in both models investors' tax brackets do influence their portfolio choices, it turns out that in equilibrium the expected return per unit of dividend yield is a constant across securities and independent of dividend yield. It is shown in the present study that this result obtains only in the absence of any restrictions on short sales. While Brennan took corporate dividend policies as exogenous, his analysis under pure exchange indicates that an equilibrium where corporations are paying positive dividends is inconsistent with the required return per unit of dividend yield being zero. Put another way, the weighted average (using investors' global risk tolerances as weights) of investors' marginal tax brackets determines the expected return per unit of dividend yield. Since corporations1 and tax-exempt investors would be indifferent between dividends and capital gains while other investors have a preference for capital gains, this weighted average tax rate would be positive. Litzenberger and Ramaswamy (1979) demonstrate that an equilibrium where corporations are paying positive dividends is consistent with the expected return per unit of yield being zero, if there are dividend related
The behavior of competing dealers in securities markets is analyzed. Securities are characterized by stochastic returns and stochastic transactions. Reservation bid and ask prices of dealers are derived under alternative assumptions about the degree to which transactions are correlated across stocks at a given time and over time in a given stock. The conditions for interdealer trading are specified, and the equilibrium distribution of dealer inventories and the equilibrium market spread are derived. Implications for the structure of securities markets are examined.