John J. Merrick

Missing the Marks: Dispersion in Corporate Bond Valuations Across Mutual Funds

We study the dispersion of month-end valuations placed on identical corporate bonds by different mutual funds. Such dispersion is related to bond-specific characteristics associated with liquidity and market volatility. The Trade Reporting and Compliance Engine (TRACE) could have contributed to the general decline in dispersion over our sample period, though other factors most likely played roles. Further tests reveal marking patterns to be consistent with returns smoothing behavior by managers. Funds with ambiguous marking policies and those holding “hard-to-mark” bonds appear more prone to smooth reported returns. From a regulatory perspective, we see little downside to requiring funds to explicitly state their marking standards. JEF classification: G12; G19; G29 Keyword: Mutual Funds; Bonds; Valuation; Fair Value; Corporate Bond Funds

Non-stationarity and stage-of-the-business-cycle effects in consumption-based asset pricing relations☆

Abstract Empirical tests of Euler equations relating security returns and consumption usually appear to reject the model. Using a common specification of aggregate preferences and instrumental variables, this paper examines some potential reasons for rejections. The evidence indicates that maintained stationarity assumptions of previous tests fail for post-war U.S. quarterly and monthly data. Shifts in model parameters are found across policy regimes (pre-1951 and post-1979) and across stages of the business cycle (recession versus non-recession). Controlling for some of these factors, less evidence is found against a simple consumption-based asset pricing model in non-recession periods.

Hedging with mispriced futures

This paper analyzes the correspondence between arbitrage sector pricing efficiency and the short-term hedging costs and effectiveness of futures contracts. Reversals of initial contract mispricings by arbitrage sector trading leads to an important mispricing retum component in the total retum to hedge portfolios. The existence of the mispricing retum has implications for initial hedge ratio selection, hedging effectiveness, and expected hedge retum. The analysis is used to interpret the hedge ratio guidance and performance of short-term hedges between the Standard and Poors 500 stock index futures contract and the underlying S&P 500 cash stock index portfolio over the 1982-1986 period.

International expected real interest rates: New tests of the parity hypothesis and U.S. fiscal policy effects

Abstract This paper investigates the links among expected real interest rates across countries and also those between international expected real interest rates and U.S. fiscal policy. We analyze the cross-sectional mean of international ex-post real interest rates as an estimator for the mean international expected real interest rate. Our results strongly reject the international expected real interest rate parity hypothesis; reveal that U.S. budget deficits have no independent effects on international real rates given the impact of U.S. government defense spending; and suggest that forces other than U.S. fiscal policy account for the post-1980 rise in international real rates.

The anticipated real interest rate, capital utilization and the cyclical pattern of real wages

Abstract This paper develops a channel through which increases in anticipated real interest rates can be ‘expansionary’ for current aggregate labor demand and current output supply. The key feature of the model is the introduction of a user cost of capital utilization which confronts the firm with the intertemporal problem of the optimal choices of capital utilization and depreciation. The resulting variation in capital utilization and capital services in response to fluctuations in the real rate of interest shifts the marginal product of labor and, thus, the demand for labor at the same time and in the same direction that Lucas-Rapping real interest rate effects operate on labor supply. The complete model places no a priori restrictions on the cyclical pattern of real wages, thus avoiding the countercyclical real wage prediction made by Keynes and various classical writers that is rejected by the data. Estimates of a labor demand schedule for the annual U.S. data reveal a significantly positive real interest rate effect.

Financial intermediaries in the midst of market manipulation: Did they protect the fool or help the knave?

We examine a fund managers alleged manipulation of platinum and palladium futures settlement prices. Using benchmarks from parallel electronic markets, we find that the managers market-on-close trading causes significant settlement price artificiality. Defying predictions that competition among floor traders should limit any artificiality, the artificiality increases in the second half of the alleged manipulation period. Between 35% and 52% of the latter-period artificiality is directly attributable to noncompetitive floor prices. Inflated floor volume contributes a similar proportion to artificiality via the exchanges trade-weighted settlement price formula. We estimate that floor counterparties reaped more than

Tracking the U.S. Treasury: Footprints from the Treasury’s Debt Buy-Back Program

6.0 million in excess profits.

Pascal spreading of short-term interest rate contracts

At the turn of the millennium, with its coffers flush from unexpectedly high tax receipts, the U.S. Treasury embarked upon a debt buy-back program, something not seen since 1930. The first question is how well the Treasury did versus its self-espoused goals of minimizing taxpayer financing costs while promoting efficient capital markets. Regarding security selection decisions, give the Treasury solid marks. It made no egregious errors (it avoided buying back the priciest issues) but could have done some additional fine-tuning (it repurchased moderately rich issues as well as cheap ones). The second question is how well the Treasury conducted its business. Here, the good news is that its well-designed reverse auction procedures did not upset the markets for the bonds it actually touched. The bad news is that the buy-backs produced unintended and unwanted reverberations in related markets (those for the single-payment Treasury STRIPS securities). The results presented here confirm that recently proposed reforms of STRIPS market practices may be very good ideas.

Practical Applications of Market Transparency and the Marking Precision of Bond Mutual Fund Managers

This article examines the spreading and pricing of short‐term interest rate futures contracts and shows how traditional types of calendar spread positions can emerge as explicit arbitrage solutions. A specific set of intuitive spreading structures, Pascal’s spreading triangle, arises when the underlying daily risk factors are identified as the stochastic coefficients of a high‐order polynomial approximation to the yield curve. No empirically estimated hedge ratios are required for these arbitrage strategies. Application of this Pascal spread framework to pricing and trading the London International Financial Futures Exchange (LIFFE) short sterling deposit futures market over the 1989 to 1998 sample period revealed that the LIFFE’s short sterling arbitrage sector’s efficiency improved markedly over time. The improvement over the decade coincided with dramatic declines in futures trading transactions costs. As a byproduct, the framework extracts and measures the quantitative impact of the Y2K millennium‐turn pricing distortion on the December 1999 short sterling futures contract.

Strategic trading behavior and price distortion in a manipulated market: anatomy of a squeeze ☆

Recent research in The Journal of Portfolio Management investigates whether the introduction of TRACE—the US corporate bond pricing program run by the Financial Industry Regulatory Authority (FINRA) —has improved bond-valuation precision and price transparency. This report highlights the practical applications of the research findings. It is based on an in-depth interview with co-author John Merrick, Jr . of the College of William and Mary Raymond A. Mason School of Business .“ Our story here is that market transparency matters, in terms of improving valuations,” he says. Merrick and his co-authors, Gjergji Cici and Scott Gibson , (colleagues at the College of William and Mary), and Yalin Gündüz (of Deutsche Bundesbank ), present their findings in Market Transparency and the Marking Precision of Bond Mutual Fund Managers .