WORKING PAPER ABSTRACTS - 1999 Listed below are the abstracts for all of the working papers for this year. To see a list of paper titles (with links to available PDF files) click here. 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 01-99 The High Volume Return Premium Simon Gervais, Ron Kaniel, Dan Mingelgrin The idea that extreme trading activity (as measured by trading volume) contains information about the future evolution of stock prices is investigated. We find that stocks experiencing unusually high (low) volume over a period of one day to a week tend to appreciate (depreciate) over the course of the following month. This effect is consistent across firm sizes, portfolio formation strategies, and volume measures. Surprisingly, the effect is even stronger when the unusually high or low trading activity is not accompanied by extreme returns, and appears to be permanent. The significantly positive returns of our volume-based strategies are not due to compensation for excessive risk taking, nor are they due to firm announcement events. Previous studies have documented the positive contemporaneous correlation between a stock's trading volume and its return, and the autocorrelation in returns. The high volume return premium that we document in this paper is not an artifact of these results. Finally, we also show that profitable trading strategies can be implemented to take advantage of the information contained in the trading volume. 02-99 Is the Abnormal Return Following Equity Issuances Anomalous? Alon Brav, Christopher Geczy, Paul A. Gompers We investigate the robustness of the long-term underperformance of initial public offering (IPO) and seasoned equity offering (SEO) firms from 1975-1992. The conclusion that issuer underperformance is unique is questioned by our results. We find that underperformance is largely concentrated in the smallest issuing firms. IPO firms perform similarly to nonissuing firms matched on the basis of firm size and book-to-market ratios. SEO firm returns can be priced by four factor regression models indicating common covariation in SEO returns with nonissuing firms. Furthermore, SEO underperformance disappears for issuances beyond the first SEO. We find that the results are robust to purging benchmarks and factor returns of IPO and SEO firms. 03-99 The Social Security Trust Fund, the Riskless Interest Rate, and Capital Accumulation Andrew B. Abel This paper develops a tractable stochastic overlapping generations model to analyze the equilibrium equity premium and growth rate of the capital stock in the presence of a defined-benefit Social Security system. If the Social Security Trust Fund increases the share of its portfolio held in risky capital, the equilibrium equity premium falls in the following period and along a constant growth path. This change in the portfolio of the Social Security Trust Fund will increase the growth rate of capital in the following period, and, if a certain sufficient condition is satisfied, will increase the growth rate of the capital stock along a constant growth path. Calibration of the model indicates that it can match the historical average equity premium and the historical average growth rate of the capital stock using plausible values of the preference parameters. In addition, the sufficient condition for the growth rate of the capital stock to increase along a constant growth path is satisfied. Quantitatively, the effects on the riskless interest rate and growth rate of capital are small. 04-99 Going Public with Asymmetric Information, Agency Costs, and Dynamic Trading Armando Gomes We study the problem of a firm that is controlled by a large shareholder and is going public in the presence of agency problems, asymmetric information, and trading of shares over time. In this multiperiod signalling game, a shareholder-manager can develop a reputation for expropriating low levels of private benefits, and this effect causes a significant increase in the stock price and in the likelihood that the firm will go public. Also, this reputation effect is unrelated to the firm's needs to raise external financing in the future. Moreover, insiders divest shares gradually over time, at a rate that is negatively related to the degree of moral hazard. We argue that this model of outside equity is empirically relevant and can be important in understanding the workings of emerging stock markets. 05-99 Multiple Large Shareholders in Corporate Governance Armando Gomes Large shareholders of firms with majority blocks are often at the helm of their companies and do not necessarily have the same interests as minority shareholders. We show that bargaining problems led by the presence of multiple controlling shareholders protect minority shareholders. The same bargaining problems, however, prevent efficient decisions. By solving this trade-off we find that i) multiple controlling shareholders should be present in firms with large costs of diluting minority shareholders and in firms with large financing requirements, ii) an optimal ownership structure requires the presence of a class of shareholders - the minority shareholders - with no control over corporate decisions. Evidence on the ownership structure of close corporations in the U.S. is consistent with our model. 06-99 Value-at-Risk Based Risk Management: Optimal Policies and Asset Prices Suleyman Basak and Alex Shapiro This paper analyzes optimal, dynamic portfolio and wealth / consumption policies of utility maximizing investors who must also manage market-risk exposure using a given risk-management model. We focus on the industry standard, the Value-at-Risk (VaR) based risk management, and find that VaR risk managers often optimally choose a larger exposure to risky assets than non risk managers, and consequently incur larger losses, when losses occur. We suggest an alternative risk management model, based on the expectation of a loss, to remedy the shortcomings of VaR. A general-equilibrium analysis reveals that the presence of VaR risk managers in a pure-exchange economy amplifies the stock-market volatility at times of down markets (and low output) and attenuates the volatility at times of up markets. 07-99 Nonlinear Taxation, Tax Arbitrage and Equilibrium Asset Prices Suleyman Basak and Benjamin Croitoru This paper investigates implications of the presence of nonlinearly taxed, redundant securities, and of the resulting tax arbitrage opportunities. Heterogeneity in taxation leads to discrepancies in assets' pre-tax market prices of risk. We show that this mispricing is set so that agents effectively cooperate to minimize aggregate taxes, even though individually each agent may not minimize his own tax bill. Unlike the bulk of the existing tax arbitrage literature, but consistent with empirical evidence, equilibrium in our model allows discrepancy between agents' marginal tax rates. Equilibrium with a zero net supply derivative reveals financial innovation to alleviate taxation, in particular when the derivative is taxed linearly or is taxes less heterogeneously across agents than is the stock itself. In the presence of two redundant, positive supply securities, clientele effects arise, where one agent holds the aggregate supply of each risky security, and only the bond is traded across agents. Clientele effects are shown to arise when agents' tax rates are highly heterogeneous and when the aggregate wealth is divided fairly evenly across agents. 08-99 The Cross Section of Common Stock Returns: A Review of the Evidence and Some New Findings Gabriel Hawawini, Donald B. Keim A growing number of empirical studies suggest that betas of common stocks do not adequately explain cross-sectional differences in stock returns. Instead, a number of other variables (e.g., size, ratio of book to market, earnings/price) that have no basis in extant theoretical models seem to have significantly predictive ability. Some interpret the findings as evidence of market efficiency. Others argue that the Capital Asset Pricing Model is an incomplete description of equilibrium price formation and these variables are proxies for additional risk factors. In this paper we review the evidence on the cross-sectional behavior of common stock returns on the U.S. and other equity markets around the world. We also report some new evidence on these cross-sectional relations using data from both U.S. and international stock markets. We find, among other results, that although the return premia associated with these ad hoc variables are significant in most international stock markets, the premia are uncorrelated across markets. The accumulating evidence prompts the following question: If these return premia occur primarily in January and are uncorrelated across major international equity markets, is it reasonable to characterize them as compensation for risk? 09-99 Organizational Design Choices in Retail Banking Venky Nagar Using a database of branch managers in retail banks, this study finds some empirical support for the two main predictions of Jensen and Meckling’s (1992) theory on organizational design choices: a) the allocation of decision rights to branch managers is associated with control systems that measure their performance and reward them based on these performance measures, and b) these decision rights and control systems are associated with the costs of transferring knowledge from branch managers to the top management. A simultaneous equation of these organizational design choices indicates that the causal relation among these choices is unidirectional, with decision rights determining control systems. The implications of this finding are discussed. 10-99 Quantitative Asset Pricing Implications of Endogenous Solvency Constraints Fernando Alvarez, Urban J. Jermann We study the asset pricing implications of an economy where solvency constraints are determined to efficiently deter agents from defaulting. We present a simple example for which efficient allocations and all equilibrium elements are characterized analytically. The main model produces large equity premia and risk premia for long term bonds with low risk aversion and a plausibly calibrated income process. We characterize the deviations from independence of aggregate and individual income uncertainty that produce equity and term premia. 11-99 Mutual Fund Returns and Market Microstructure Mark M. Carhart, Ron Kaniel, David K. Musto, Adam Reed Equity mutual funds earn large positive returns on the last day of the year, and large negative returns on the following day. The same applies on a smaller scale at quarter-ends that aren’t month-ends. Empirical evidence from a variety of sources, including portfolio disclosures and intra-day equity transactions, supports the hypothesis proposed in Zweig (1997) that a subset of fund managers deliberately cause the price shifts with buy orders, intending to move return to the current period from the next. Cross-sectional tests show the largest effect in the period’s best performers, consistent with their extra incentive to add to their current returns. 12-99 Econometric Models of Limit-Order Executions Andrew W. Lo, A. Craig MacKinlay, June Zhang Limit orders incur no price impact, however, their execution time is uncertain. We develop several econometric models of limit-order execution times using survival analysis, and estimate them with actual limit-order data. We estimate models for time-to-first-fill and time-to-completion, and for limit-sells and limit-buys, and incorporate the effects of explanatory variables such as the limit price, the limit size, the bid/offer spread, and market volatility. We find that execution times are very sensitive to limit price and several other explanatory variables, but not sensitive to limit size. We also show that hypothetical limit-order executions, constructed either theoretically from first-passage times or empirically from transactions data, are very poor proxies for actual limit-order executions. 13-99 Asset Pricing Models: Implications for Expected Returns and Portfolio Selection A. Craig MacKinlay, Lubos Pastor Implications of factor-based asset pricing models for estimation of expected returns and for portfolio selection are investigated. In the presence of model mispricing due to a missing risk factor, the mispricing and the residual covariance matrix are linked together. Imposing a strong form of this link leads to expected return estimates that are more precise and more stable over time than unrestricted estimates. Optimal portfolio weights that incorporate the link when no factors are observable are proportional to expected return estimates, effectively using an identity matrix as a covariance matrix. The resulting portfolios perform well both in simulations and in out-of-sample comparisons. [PUBLISHED] #14-99 Adverse Selection and Competitive Market Making: Empirical Evidence from a Pure Limit Order Market Patrik Sandas Review of Financial Studies, Volume 14, 2001, pp. 705-734                             In this paper, I estimate and test a model of liquidity provision in a pure limit order market based on Glosten (1994). The estimation strategy is directly based on restrictions on quotes and depths in the limit order book implied by the theoretical model. I find strong evidence of insufficient depth in the limit order books relative to the model predictions. For most stocks, an extended version of the model with a state dependent market order distribution predicts depths and price revisions that are closer to the empirically observed ones. [PUBLISHED] 15-99 Imperfect Market Monitoring and SOES Trading Thierry Foucalt, Ailsa Roell, Patrik Sandas We develop a model of price formation in a dealership market where monitoring of the information flow requires costly effort. The result is imperfect monitoring, which creates profit opportunities for speculators, who do not act as dealers but simply monitor the information flow and quote updates in order to pick off "stale quotes." Externalities associated with monitoring can help to sustain non-competitive spreads. We show that protecting dealers against the execution of stale quotes can result in larger spreads and be detrimental to price discovery due to externalities in monitoring. A reduction in the minimum quoted depth will reduce the spread and speculators’ trading frequency. Our analysis is relevant for the SOES debate given that the behavior of speculators in our model is very similar to the alleged behavior of the real world SOES "bandits." 16-99 Comparing Asset Pricing Models: An Investment Perspective Lubos Pastor, Robert F. Stambaugh We investigate the portfolio choices of mean-variance-optimizing investors who use sample evidence to update prior beliefs centered on either risk-based or characteristic-based pricing models. With dogmatic beliefs in such models and an unconstrained ratio of position size to capital, optimal portfolios can differ across models to economically significant degrees. The differences are substantially reduced by modest uncertainty about the models’ pricing abilities. When the ratio of position size to capital is subject to realistic constraints, the differences in portfolios across models become even less important, nonexistent in some cases. 17-99  Equilibrium Mispricing in a Capital Market with Portfolio Constraints Suleyman Basak, Benjamin Croitoru This paper develops a general equilibrium, continuous time model where portfolio constraints generate mispricing between redundant securities. Constrained consumption-portfolio optimization techniques are adapted to incorporate redundant, possibly mispriced, securities. Under logarithmic preferences, we provide explicit conditions for mispricing and closed-form expressions for all economic quantities. Existence of an equilibrium where mispricing occurs with positive probability is verified in a specific case. In a more general setting, we demonstrate the necessity of mispricing for equilibrium when agents are heterogeneous enough. The construction of a representative agent with stochastic weights allows us to characterize prices and allocations, given mispricing occurs. 18-99 Should Investors Avoid All Actively Managed Mutual Funds? A Study in Bayesian Performance Evaluation Klaas Baks, Andrew Metrick, Jessica Wachter This paper analyzes mutual-fund performance from an investor’s perspective. We study the one-period portfolio allocation for mean-variance investor choosing from a risk-free asset, benchmark assets (passively managed index funds) and non-benchmark assets (actively managed mutual funds). To solve this problem, we propose and employ a Bayesian method of performance evaluation; the main innovation in our approach is the development of a flexible set of prior beliefs about managers’ abnormal performance ("alphas"). We motivate this Bayesian approach by demonstrating unrealistic results for an investor who ignores prior beliefs and relies only on the data. We then apply our methodology to a sample of domestic diversified equity mutual funds and ask, "what prior beliefs would imply zero investment in active managers?" In this sample, it is not possible to reject the null hypothesis that the best performance is due to chance. Nevertheless, we find that the policy of zero investment in active managers can only be supported by extremely skeptical prior beliefs about the probability of skill; such extreme skepticism could not possibly be "proved" using current methods and data. 19-99  Estimating the Returns to Insider Trading Leslie A. Jeng, Andrew Metrick, Richard Zeckhauser This paper estimates the returns to insiders when they trade their company’s stock. We first construct a rolling "purchase portfolio" that holds all shares purchased by insiders for a six-month period, and an analogous "sale portfolio" that holds all shares sold by insiders for six months. The six-month horizon is chosen to coincide with the "short-swing" rule of the Securities and Exchange Act of 1934; a rule that prohibits profit-taking by insiders for offsetting trades within six months. We then employ performance-evaluation methods to analyze the returns to the purchase and sale portfolios. This approach yields a proxy for the value-weighted returns to insider transactions beginning on the day after their execution and avoids the statistical difficulties that plague event studies on long-horizon returns. Our methods are designed to estimate the returns earned by insiders themselves and thereby differ from the previous insider-trading literature, which focuses on the "informativeness" of insider trades for other investors. Using a comprehensive sample of reported insider transactions from 1975-1996, we find that the purchase portfolio earns abnormal returns of more than 50 basis points per month. About one-quarter of these abnormal returns accrue within the first five days after the initial transaction, and one-half accrue within the first month. The sale portfolio does not earn abnormal returns. Our portfolio-based approach also allows for straightforward decompositions of performance by various characteristics; we find that the abnormal returns to insider trades in small firms are not significantly different from those in large firms, and that top executives do not earn higher abnormal returns than do other insiders. 20-99 Institutional Investors and Equity Prices Paul A. Gompers, Andrew Metrick This paper analyzes institutional investors' demand for stock characteristics and the implications that this demand has for stock-market prices and returns. We find that "large" institutional investors -- a category including all managers with greater than $100 million under discretionary control -- have nearly doubled their share of the common-stock market from 1980 to 1996, with most of this increase driven by the growth in holdings of the largest one-hundred institutions. We find that the level of institutional ownership in a stock can help to forecast its future return, and we provide evidence that this predictive power is due to demand shocks resulting from the compositional shift in ownership towards institutions. Overall, this compositional shift tends to increase demand for the stock of large corporations and decrease the demand for the stock of small corporations. With unit-elastic demand for both types of stock, the compositional shift can, by itself, account for a nearly 50 percent increase in the price of large-company stock relative to small-company stock. This price appreciation translates into an extra return of 2.3 percent over the sample period, and can explain part of the disappearance of the historical small-company stock premium. These results also show how co-movement in stock prices can be driven by a mechanism that has nothing to do with risk or expected cash flows. 21-99  A Theory of Negotiations and Formation of Coalitions Armando Gomes This paper proposes a new solution concept to three-player coalitional bargaining problems where the underlying economic opportunities are described by a partition function. This classic bargaining problem is modeled as a dynamic non-cooperative game in which players make conditional or unconditional offers, and coalitions continue to negotiate as long as there are gains from trade. The theory yields a unique stationary perfect equilibrium outcome-the negotiation value-and provide a unified framework that selects an economically intuitive solution and endogenous coalition structure. For such games as pure bargaining games the negotiation value coincides with the Nash bargaining solution, and for such games as zero-sum and majority voting games the negotiation value coincides with the Shapley value. However, a novel situation arises where the outcome is determined by pairwise sequential bargaining sessions in which a pair of players forms a natural match. In addition, another novel situation exists where the outcome is determined by one pivotal player bargaining unconditionally with the other players, and only the pairwise coalitions between the pivotal player and the other players can form. 22-99  On the Formation and Structure of International Exchanges Matthew J. Clayton, Bjorn N. Jorgensen, Kenneth A. Kavajecz We investigate the formation and structure of 248 financial exchanges throughout the world. First, we empirically analyze the determinants of exchange formation as well as the impact of exchange formation on the domestic country’s economy. Second, conditional on formation, we use a probit model to relate the choice of trading mechanism to the characteristics of the economic environment in which the exchange exists. We find that the main determinants of exchange formation in a country are the degree of economic freedom, the size of the economy, the availability of technology, and the legal system. In addition, we find that the impact of exchange formation on the macro economy is limited to a reduction in the growth of the monetary aggregates with no significant impact on productivity. Lastly, our results show that the choice of trading mechanism depends on the country’s economic development, the degree of competition, and the extent of economic freedom. 23-99  Asset Pricing with Heterogeneous Consumers and Limited Participation: Empirical Evidence Alon Brav, George M. Constantinides, Christopher C. Geczy The Euler equations of consumption are tested on the household consumption of non-durables and services, reconstructed from the CEX database. The estimated relative risk aversion coefficient of the respective household decreases, and the estimated unexplained mean equity premium decreases, as infra marginal asset holders are eliminated from the sample. These results provide evidence of limited capital market participation. The estimated unexplained mean equity premium decreases when the assumption of complete consumption insurance is relaxed. The estimated correlation between the equity premium and the cross-sectional variance of the households’ consumption growth is negative, a required, if the relaxation of market completeness is to contribute towards the explanation of the premium. The overall evidence from asset prices in favor of relaxing the assumption of complete consumption insurance is weak. An extensive Monte Carlo investigation suggests that this may be attributed to observation error in consumption and to the small-sample properties of the statistics.  24-99  Household Securities Purchases, Transactions Costs, and Hedging Motives Nicholas S. Souleles This paper estimates threshold (S,s) models of household securities purchases, allowing for transactions costs. Purchases are related to excess market returns, the ratio of securities holdings to total wealth, and other variables capturing labor market and demographic transitions. Purchases are also related to various summary measures of households’ hedging motives. In contrast to previous focus on income risk, the measures here include consumption-risk, which is more consistent with theoretical models of portfolio choice. The Consumer Expenditure Survey is used to calculate the standard deviation of household consumption growth and the correlation of consumption growth with market returns. A second, higher frequency set of measures is taken from the monthly Michigan consumer sentiment surveys. The survey questions have households themselves identify the financial risks they believe they will face in the future, and so provide more informative and forward-looking measures of their hedging motives. Securities purchases are found to increase with excess market returns and decrease with the securities-to-total-wealth ratio. Even controlling for these variables, securities purchases vary significantly with the measures of hedging motives. Household with more volatile consumption, or a larger consumption-return correlation, buy fewer securities. Households that are pessimistic about the future, expecting a deterioration in financial conditions or an increase in unemployment risk, also buy fewer securities. The marginal effects of the hedging motives are greater than the marginal effect of returns. However, the sensitivity of investors to returns has increased in recent years, even controlling for changes in the composition of investors.  25-99  The Wildcard option in transacting mutual-fund shares John M.R. Chalmers, Roger M. Edelen, Gregory B. Kadlec This study documents high-frequency (daily) mutual-fund return autocorrelations and examines the cause and consequences. We assert the cause to be nonsynchronous trading in the underlying assets of the fund, which presents investors with an option to (indirectly) trade those assets at stale prices. We refer to this option as the mutual-fund wildcard option. We show that investors who exploit this option can make abnormal returns of about 1.20% per year with only four (roundtrip) trades in fund shares. Approximately 45% of the equity fund universe allow this frequency of transacting without load or transaction fees. Using data on the daily flow into and out of individual mutual funds, we find some evidence that investors exploit this wildcard option, but that the total resources extracted from exercise of the option amounts to only 6 basis points per year. Thus, investors appear to be generally unaware of the mutual-fund wildcard option.  26-99  Aggregate Price Effects of Institutional Trading: A Study of Mutual Fund Flow and Market Returns Roger M. Edelen, Jerold B. Warner We study the relation between market returns and aggregate flow into U.S. equity funds, using daily flow data. The concurrent daily relation is positive. Our tests show that this concurrent relation reflects flow and institutional trading affecting returns. This daily relation is similar in magnitude to the price impact reported for an individual institution’s trades in a stock. Aggregate flow also follows market returns with a one-day lag. The lagged response of flow suggests either a common response of both returns and flow to new information, or positive feedback trading.  27-99  Mutual fund trading costs John M.R. Chalmers, Roger M. Edelen, Gregory B. Kadlec We estimate trading costs for a sample of equity mutual funds and find that these costs average 0.7% of fund assets per year. There is substantial cross sectional variation in these costs, with an inter-quartile range of 0.59%. Trading costs are negatively related to fund returns. In fact, the explanatory power of trading costs is as strong as that of the expense ratio. We find that the cross-sectional variation in trading costs is greater than that implied by turnover, and trading costs have more explanatory power for fund returns. Nonetheless, we find that turnover is an important factor in assessing mutual fund trading costs.  28-99  Choices Among Alternative Risk Management Strategies: Evidence from the Natural Gas Industry Christopher C. Geczy, Bernadette A. Minton, Catherine Schrand This paper examines the substitutability and complementarity of a variety of risk management strategies that firms can use to reduce price risk exposure. Time-series analysis over a period of significant regulatory changes indicates that natural gas companies increased diversification and started using derivatives as price risk increased following price deregulation and the regulated unbundling of sale and transmission activities. The use of derivatives is a substitute both for holding internal cash and for storing gas underground. The latter two activities are complements. In choosing between derivatives and storage or cash holdings, less profitable and more financially distressed firms are more likely to manage risk using derivatives. Accounting earnings management strategies, however, are not complements to activities that have a “real” effect on cash flow volatility and diversification is not related to financial hedging activities. Market-based estimates of wellhead gas price sensitivities are negative prior to deregulation and become significantly positive following price deregulation. The change in exposure is consistent with the changing role of pipelines from buyers of gas for transport to only transporter of gas resulting from deregulation. Cross-sectional variation in price sensitivities is related to firms’ use of combinations of operational (non-accounting) and financial hedging activities. Firms that pursue these activities have smaller and less variable risk-adjusted wellhead gas return exposures than firms that do not, especially post-deregulation.  29-99  An Empirical Analysis of Limit Order Markets Burton Hollifield, Robert A. Miller, Patrik Sandas This paper analyzes order placement strategies in a limit order market. Trades submitting market or limit orders to the limit book trade off the order price, the execution probability, and the winner’s curse risk associated with different feasible order choices. Their optimal order strategy is characterized by a monotone function which maps the liquidity demand of the investors into their subjective execution probabilities. We provide conditions for the existence of a Markov perfect equilibria to the model whose outcome satisfy a mixing condition. The primitive of this model are the time varying shock that is common to all valuations, as well as the probability distribution of private valuations, assumed to be a time invariant, independently and identically distributed random variable. Using data from the Stockholm Stock Exchange, we compute a semiparametric estimator of the primitives underlying the model, adapting previous work on linear index models to time dependent data. The estimated order strategies are consistent with the theoretical trade-offs. Specification tests based on the monotonicity of the optimal order strategy finds little evidence against the monotonicity restrictions. Overidentifying restrictions between equations are not rejected, and the coefficients on the linear factor structure are significant with the predicted signs. However exclusion tests find that other variables related to the limit order book and market conditions predict order choices after accounting for the trade-off between price, execution probability and winner’s curse. The observed order choices are combined with estimates of the primitives to bound the potential and realized gains from trade in the market. The current trading system leads traders to sometimes take the opposite side of the market to what the social surplus maximizing outcome requires in order to capitalize on recent movements in the common shock, and traders also willingly risk failure to execute trades by submitting limit orders too far from the bid ask spread. About two thirds of these social losses, or transaction costs, are attributed to traders executing on the wrong side of the market. We estimate that the current trading mechanism achieves at least 57 percent of the potential gains from trade.  30-99  The Role of Trading Halts in Monitoring a Specialist Market Roger Edelen, Simon Gervais We model an exchange as a collection of specialists, each a monopolist market maker in a subset of the stocks listed on the exchange. We show that specialists can obtain net private benefits at the expense of the exchange (the collection of all specialists) by quoting a privately optimal pricing schedule. Conversely, a coordinated pricing schedule makes all specialists and customers better off. However, coordination requires a system of monitoring and punishment, which can break down when information asymmetries between the exchange and a specialist are high. This breakdown can cause the specialist to seek a temporary halt to trading to alleviate unjustified punishment, or the exchange to halt trading to prevent the quoting of damaging privately optimal pricing schedules. We use a sample of over 2,000 NYSE halts and a proxy for the exchange-specialist information asymmetry constructed from transaction-level data to test this theory. As predicted, we find a dramatic increase in estimated information asymmetry immediately preceding trading halts, which is far larger than the abnormal volatility or volume preceding the halt.
Rodney L. White Center for Financial Research Telephone: (215) 898-7616 Facsimile: (215) 573-8084 Email: rlwctr@finance.wharton.upenn.edu Copyright ©1998 The Wharton School of the University of Pennsylvania. All rights reserved. Site designed by Singularity Design.