David K. Whitcomb

Friction in the trading process and the estimation of systematic risk

Abstract This paper considers how estimates of the market model beta parameter can be biased by friction in the trading process (information, decision, and transaction costs) that (a) leads to a distinction between observed and ‘true’ returns; (b) causes observed returns to be generated asynchronously for a set of interdependent securities; and (c) thereby introduces serial cross-correlation into security returns. Several propositions are derived from which consistent estimators of beta are obtained, and the effect of differencing interval length on beta estimates is specified. The formulation is contrasted with the related analyses of Scholes-Williams (1977) and Dimson (1979).

Market Maker Quotation Behavior and Pretrade Transparency

We examine the impact of differing levels of pretrade transparency on the quotation behavior of Nasdaq market makers. We find that market makers are more likely to quote on odd ticks, and to actively narrow the spread, when they can do so anonymously by posting limit orders on Electronic Communication Networks (ECNs). From a public policy perspective, our findings suggest that making the level of pretrade transparency on Nasdaq more opaque by allowing anonymous quotes could improve price competition and narrow spreads further.

Abstract: Evidence on the Presence and Causes of Serial Correlation in Market Model Residuals

Studies of returns on common stocks have observed positive market index autocorrelation (see Fisher [10] and Dimson [6]), negative autocorrelation of market model residuals (see Fisher [10] and Fama, Fisher, Jensen, and Roll [9]), and a deterioration in the market model R2 as the returns measurement period is shortened (see Pogue and Solnik [17], Altman, Jacquillat, and Levasseur [1], and Schwartz and Whitcomb [19]). We present further evidence on the strength of these findings and show that they are concurrent events. That is, common factors can explain both positive index and negative residual autocorrelation, and these correlation patterns in turn cause R2 to fall as the differencing interval is shortened.

Market Makers and the Market Spread: A Review of Recent Literature

Academic attention has increasingly been focused on the operation of security markets. This is largely due to the impetus provided by the Institutional Investor Study (see U.S. Securities and Exchange Commission [35]), by the Securities Act Amendments of 1975 whereby Congress mandated the development of a national market system (NMS), and by the expanding computer technology of the 1970s. Not surprisingly, much of the attention has focused on the role of dealers and stock exchange specialists as market makers. The literature has generally viewed these market makers as suppliers of immediacy to ordinary traders, and has taken the bid-ask spread to be the price they impose for the provision of this service.

An analysis of the economic justification for consolidation in a secondary security market

Abstract This paper considers whether all trading in a listed security should be required to go through an exchange. To this end, the incentives for a brokerage firm to offer in-house execution services are discussed, and an analytical framework is developed which shows that, under idealized conditions, fragmentation of the market through in-house execution services would not result in any overall deterioration of market performance characteristics. However, when some of the idealized conditions are relaxed, the market fragmentation arising from in-house execution causes the gains to some customers to be more than overcome by the losses to others. The analysis, which also takes account of the desirability of enforcing reasonable trading priority rules (such as priority by price and time) across all traders, yields several public policy implications. For some unlikely scenarios, it would be possible, through appropriate commission sharing and a perfectly operating intermarket trading system, for optimal overall market performance to be consistent with the market fragmentation inherent in in-house execution services. However, for most realistic scenarios, fragmentation would cause a deterioration in the quality of the market. Thus it seems desirable to require that all trading go through a central exchange with a consolidated limit order book.

Adjusting for the intervalling effect bias in beta : A Test using Paris Bourse Data

Abstract This paper uses a sample of daily returns data from the Paris Bourse to test the predictions of and adjustment procedures implied by the Cohen-Hawawini-Maier-Schwartz-Whitcomb (1983a,b) model of the intervalling effect bias in OLS beta estimates. CHMSW show that the bias diminishes asymptotically to zero as the differencing interval increases and that the sign of the bias depends on a stocks relative value of shares outstanding. We employ the three-pass regression procedure of CHMSW (1983b), but we test a broader set of second pass functional forms and use the Box-Cox (1964) transformation model to verify our chosen form. The CHMSW adjustment procedures are compared with that of Scholes-Williams (1977), and the latter is shown to contain a significant intervalling effect bias.

Externality Production Functions

Publisher Summary This chapter presents a general framework for the estimation of externality production functions. It discusses the generalized joint supply model developed by Whitcomb as the abstract model of externality. The chapter also discusses the problems involved in empirical specification of alternative joint product models, depending on the nature of the joint production process and the availability of data on the possibilities of input allocation among salable commodities and externalities. The chapter reviews alternative statistical estimation techniques for multivariate models in terms of their relative merits in regard to taking full account of the jointness in production and the stability of the estimates they produce. It highlights the issue of specification of proper functional forms. For joint product externality models, conventional production function forms such as Cobb–Douglas, CES, homothetic, and CRES may be even more restrictive than in ordinary cases.

Comment: Assessing the Impact of Stock Exchange Specialists on Stock Volatility

In a recent article in this Journal, Amir Barnea [1] proposes a criterion for assessing the market-making efficiency of New York Stock Exchange specialists. The appealing aspects of Barneas method are that it uses publicly available data (common stock prices) and operates on a variable of primary concern to investors, the variance of returns on common stock. The difficulty we see in applying his approach, however, is that Barneas performance criterion can be sensitive to a number of factors in addition to any impact the specialist might have, and that effective specialist intervention might have either a positive or negative impact on the performance measure. Thus, his specialist ranking seems to be quite misleading, and his empirical findings appear to be amenable to a substantially different interpretation than that which he provides.

Externality Taxes and Subsidies

Publisher Summary Most economists consider taxes on externalities a feasible means of control when outright prohibition would result in excessive reduction of desirable activities (such as electricity production which jointly supplies various pollutants). However, the literature lacks a rigorous and general externality tax model. This chapter presents a tax–subsidy algorithm that is valid under very general conditions —convex production functions allowing for many products and firms and permitting externalities to be varied independently of salable commodity levels. The prevailing pessimistic conclusions concerning tax–subsidy schemes are wrong. The chapter presents a justification of several specific suggestions for the (approximate) taxes and subsidies on some pollutants toward which the political process is moving. When many are affected by the same pollutant, the tax share going to each injured party (generally different for each) may be paid to the government and not redistributed. This convenience in a world of positive administrative costs makes particular sense when the parties ultimately responsible for the pollution such as consumers of electricity form the majority of those injured by it. The optimal tax will typically be less for one polluter farther from pollution centers than another producer of identical pollutants.