A dynamic model of strategic trading with two asymmetrically informed traders is analyzed where one informed trader knows the information seen by both informed traders, and the other informed trader only knows his private information. While the first informed trader is better informed, the second informed trader can make inferences about this extra information; in fact, the second informed trader can make sharper inferences from the order flow than the market maker about the extra information. In this setting, competition among the informed traders has a very interesting form. The informed trader with the additional information trades less intensely on that information early on, and both informed traders trade very intensely on their common information. This makes it more difficult for the trader with less information to learn about the information he does not have. When there are only a few remaining trading periods and the information known to both traders has largely been revealed through their trading, then the trader with the additional information trades more intensely on the basis of his private information.

This paper develops a capital asset pricing theory in a market where noise traders interact with information traders. Noise traders are traders who commit cognitive errors while information traders are free of cognitive errors. The theory includes the determination of the mean-variance efficient frontier, the return on the market portfolio, the term structure, and option prices. The paper derives a necessary and sufficient condition for the existence of price efficiency in the presence of noise traders and analyzes the effects of noise traders on price efficiency, volatility, return anomalies, volume, and noise trader survival.

This paper examines the relation between the market reaction to primary seasoned equity offerings and alternative measures of the profitability of the issuing firm's growth opportunities. While the sample offerings display a positive relation between announcement period prediction errors and several ex ante measures of growth opportunities, this relation is not monotonic and appears to be driven by a small subset of younger, higher growth firms, whose announcement effects are insignificantly different from zero. For the remainder of the sample firms, there is no relation between the estimated profitability of new investment and the market reaction to announced equity offerings. Moreover, announcement effects are nonpositive regardless of how profitable investment opportunities are expected to be. These findings collectively suggest that investment opportunities play, at best, a minor role in explaining the cross-sectional distribution of equity offering announcement effects.

The concern of this paper is with the effects of insider trading on ex ante managerial behavior. Specifically, the paper focuses on how insider trading affects insiders' choice among investment projects. Other things equal, insider trading leads insiders to choose riskier investment projects, because increased volatility of results enables insiders to make greater trading profits if they learn these results in advance of the market. Thiseffect might be beneficial, however, because insiders' risk aversion pulls them toward aconservative investment policy. Insiders' choices of projects are identified and compared with insider trading and those without such trading. Using these results, the conditions under which insider trading increases or decreases corporate value by affecting the choice of projects with uncertain returns are identified.

This paper addresses the problem of testing financial models in the presence of market micro structure effects. The moment restrictions implied by the financial and market microstructure models are jointly tested using Hansen's (1982) GMM approach. To illustrate the methodology, I consider the random walk model in combination with the bid-ask price effect model of Blume and Stambaugh (1983). Within this sufficiently simple framework, I obtain closed-form expressions for the estimators, standard errors of the estimators, and the test statistic, which affords an opportunity to examine the precision of the estimators and the power of the test as the return interval increases. I show that apparent rejections of the random walk model cannot be sustained when tests of the model are adjusted for market micro structure effects, and I discuss other applications of the methodology.

This study considers a model in which a corporate manager has private information and engages in i) anonymous trading on personal account in the secondary market, and ii) the corporate issuance of new shares in the primary market. The paper examines the equilibrium tradeoff of insider trading profits against the manager's share of the corporate consequences of the primary issue. In the resulting equilibrium, managers, acting in their own best interests, seem to behave according to differing objective functions. In some cases, they seem to maximize intrinsic value, in others, insider trading profits seem to dominate, and still others seem to be concerned with both. Hence, the presence of anonymous trading around corporate financings brings into question the use of corporate objective functions with exogenously fixed weights.

This paper tests conditional capital asset pricing models in a multivariate GARCH framework employing both constant and time-varying prices of market and bond risk. Depending on the interpretation of the market portfolio, the ICAPM with one hedge portfolio or the two-factor myopic CAPM are supported using weekly data from July 1983 to December 1989. In contrast, we reject the myopic single-factor CAPM under a constant price of market risk. We find that interest rate risk is highly significant, which suggests that previous rejections of the conditional CAPM using only stock market data may be due to omitted hedge terms or an incomplete market factor.

This paper provides an explanation for why firms may choose to simultaneously issue multiple debt claims with varying maturities. The optimal mix of short- and long-term debt allows the firm to precommit to a more efficient liquidation policy. Even in risk-neutral settings, the optimal mix hinges critically on the mean and the variability of the firm's liquidation value. Determining the optimal mix of debt is more complex than just weighing the costs of issuing short- or long-term debt exclusively. The implications of alternate priority structures, informational settings, interest rate uncertainty, and maturity matching strategies are also considered.

From various empirical work, it is well known that the volatility of asset returns changes over time. This might be one of the reasons that implied volatilities differ for options that only differ in time to maturity. We construct models for the relation between short- and long-term implied volatilities based on three different assumptions of stock return volatility behavior, i.e., mean-reverting, GARCH, and EGARCH models. We test these relations on option price data and conclude that EGARCH gives the best description of asset prices and the term structure of options' implied volatilities.

We examine 38 takeovers of distressed firms and find that these takeovers are more likely to involve firms in the same industry and less likely to be hostile takeovers than are acquisitions in general. We use five different measures to evaluate post-merger performance of the combined bidder and target firms. All performance measures suggest that bidders are unable to successfully restructure targets. The market demonstrates an ability to forecast the success of restructuring. Restructuring success is negatively related to the size of premium paid by the bidder for the target and positively related to the financial distress of the target.

This paper considers the problem of a financial institution that needs to hedge a stream of state-contingent cash flows while facing borrowing and short-sales restrictions. The study determines analytically the strategy that minimizes the initial cost of hedging the desired cash flow, which is also the upper bound on its market price, and shows that the impact of leverage constraints on the cost of hedging call and put options is significant and, therefore, the biases detected by tests of option pricing models may not represent arbitrage opportunities. The paper also shows that with credit limits, it is optimal to reduce the rate of trading; thus, these constraints need to be recognized when estimating the trading volume generated in replicating contingent payoffs such as portfolio insurance.

A new testable implication is derived from the rational speculative bubbles model stating that the presence of bubbles implies positive duration dependence in runs of high returns. Specifically, the probability of observing an end to a run of high returns declines with the length of the run. Traditional duration dependence tests are adapted for use with discrete stock runs data and, consistent with the existence of bubbles, evidence of duration dependence in monthly real stock returns is found.

We examine the cash flow signaling, overinvestment, and dividend clientele explanations for the information content of dividend change announcements. After simultaneously controlling for the standardized dividend change, dividend yield, and Tobin's Q, we find that announcement period excess returns are positively related to the magnitude of the standardized dividend change and to the dividend yield, but unrelated to Tobin's Q. We provide further evidence on the cash flow signaling and overinvestment hypotheses by examining revisions in analysts' earnings forecasts and changes in capital expenditures following dividend change announcements. We find that analysts significantly revise their earnings forecasts following dividend changes and that Q < 1 firms actually increase their capital expenditures following dividend increases and decrease them following dividend decreases. Overall, our findings support the cash flow signaling and dividend clientele hypotheses for stock price reactions to dividend change announcements, but provide little support for the overinvestment hypothesis.

This article investigates differences in yields on identical Treasury notes and bills and shows that they reflect differences in liquidity (immediacy) risk and taxes. It proposes an empirical measure for differences in the liquidity risk of notes and bills: the volatility of the underlying rate times the ratio of bills' turnover to notes' turnover. Because differential taxes affect sellers but not buyers of bills and notes, the results reject, free of informational problems, the hypothesis that the notes' demand curve is horizonta. Note-bill yield differences also decrease with inventories of notes—the less liquid asset.

This paper develops the parametric restrictions imposed on diffusion state processes by the requirement of arbitrage-free asset pricing. Using the equivalent martingale measure as a starting point, the diffusion property is exploited to specify the shadow pricing function, which takes conditional state variable probabilities under the reference measure into arbitrage-free contingent claim prices. The main results of the paper provide differential equations associated with the shadow price function that are used to identify restrictions on the parameters of assumed diffusion processes. The paper concludes with an application to the CIR model where the state variable, the instantaneous interest rate, is assumed to follow a square root process. Calculations are also provided for the parametric restrictions imposed on the Brownian bridge and OU state variable processes.

This paper illustrates regression and Kalman filtering methods for estimating the time-varying term structure of volatility expectations revealed by options prices. Short- and long-term expectations are estimated for four currencies using daily PHLX options prices from 1985 to 1989. Throughout this period, there were important differences between shortand long-term expectations. The slope of the term structure changed frequently and there were significant variations in long-term volatility expectations. The expectation estimates can be used to value OTC options, to improve hedging strategies, and to test the hypothesis that the options market overreacts.

Small sample t-test results are reported in the literature that indicate the difference between futures and forward exchange rates are statistically insignificant. Much research draws on this finding, which is in contrast with theory. The evidence presented here suggests this difference does not follow a normal distribution, so the small sample inferences based on the t-tests may be suspect. As appropriate alternatives, nonparametric distribution-free tests are used to reexamine the difference for two sample periods, one covering the 1970s and the other the 1970s and 1980s. A significant divergence is observed for several currencies as well as for a sample of pooled currencies. The results are stronger for samples covering the 1980s. The economic significance of the forward-futures differentials is examined and theoretical justifications are discussed.

This paper empirically contrasts the Jensen Measure, the Positive Period Weighting Measure, developed in Grinblatt and Titman (1989b), and a measure developed from the Treynor-Mazuy (1966) quadratic regression on a sample of 279 mutual funds and 109 passive portfolios, using a variety of benchmark portfolios. The study finds that the measures generally yield similar inferences when using the same benchmark and that inferences can vary, even from the same measure, when using different benchmarks. This paper also analyzes the determinants of mutual fund performance. Tests of fund performance that employ fund characteristics, such as net asset value, load, expenses, portfolio turnover, and management fee are reported. These tests surprisingly suggest that turnover is significantly positively related to the ability of fund managers to earn abnormal returns.

This paper examines alternative methods for pricing options when the underlying security volatility is stochastic. We show that when there is no correlation between innovations in security price and volatility, the characteristic function of the average variance of the price process plays a pivotal role. It may be used to simplify Fourier option pricing techniques and to implement simple power series methods. We compare these methods for the alternative mean-reverting stochastic volatility models introduced by Stein and Stein (1991) and Heston (1993). We also examine the biases in the Black-Scholes model that are eliminated by allowing for stochastic volatility, and we correct some errors in the Stein and Stein (1991) analysis of this issue.

This paper studies a new theory for pricing options in a large trader economy. This theory necessitates studying the impact that derivative security markets have on market manipulation. In an economy with a stock, money market account, and a derivative security, it is shown, by example, that the introduction of the derivative security generates market manipulation trading strategies that would otherwise not exist. A sufficient condition is provided on the price process such that no additional market manipulation trading strategies are introduced by a derivative security. Options are priced under this condition, where it is shown that the standard binomial option model still applies but with random volatilities.