Louis H. Ederington

The Short-Run Dynamics of the Price Adjustment to New Information

We examine how prices in interest rate and foreign exchange futures markets adjust to the new information contained in scheduled macroeconomic news releases in the very short run. Using 10-second returns and tick-by-tick data, we find that prices adjust in a series of numerous small, but rapid, price changes that begin within 10 seconds of the news release and are basically completed within 40 seconds of the release. There is some evidence that prices overreact in the first 40 seconds but that this is corrected in the second or third minute after the release. While volatility tends to be higher than normal just before the news release, there is no evidence of information leakage. In our analysis, we correct for the biases created by bid-ask spreads and tick-by-tick data.

Reputation, Certification, Warranties, and Information as Remedies for Seller-Buyer Information Asymmetries: Lessons from the Online Comic Book Market

Signaling strategies that sellers of higher-quality products or securities employ to differentiate their products include (1) development of a reputation for quality, (2) third-party certification, (3) warranties, and (4) information disclosure. These signaling strategies are compared using data from the online auction market for classic comic books. This markets advantages include that (1) the information asymmetry is substantial, (2) good measures of reputation are available, and (3) all four signals are common. We explore which signals are strongest and why, which are substitutes or complements, and how choice among the other three strategies depends on the reputation of the seller.

Cross-sectional variation in the stock market reaction to bond rating changes

Abstract Previous research has found that the stock market reacts negatively to bond rating downgrades and that downgrades tend to follow periods of negative returns, indicating that at least some downgrades are partially predictable. Hypothesizing that the reaction to a downgrade depends on both the implications for cash flows and the degree of surprise, we explore how the reaction to downgrade announcements varies across bond issues. We find that the equity market reacts much more negatively to bond rating downgrades to and within the speculative bond category than to downgrades within the investment grade category. Within the speculative category, the reaction is stronger, the lower the old and new ratings are. The reaction to multiple-level downgrades is not very different from that to single-level downgrades. The market reaction is also stronger if the firm has experienced negative pre-downgrade abnormal returns. Our evidence indicates that downgrades are viewed by the market as providing information on likely future earnings before interest charges, not just likely future interest charges. It is also consistent with Billetts (1996) hypothesis that low rated debt makes a firm less attractive as a takeover target.

Is implied volatility an informationally efficient and effective predictor of future volatility

This paper examines (1) whether implied volatility is an unbiased informationally efficient predictor of actual future volatility and (2) its predictive power. If markets are efficient and the option pricing model is correct, then the implied volatility calculated from option prices should be an unbiased and informationally efficient estimator of future volatility, that is, it should correctly impound all available information including the assets price history. However, numerous studies have found that implied volatility is not informationally efficient and that historical volatilities have incremental predictive power -- often out-predicting implied volatilities. For the S&P 500 options on futures we find the following. One, at least part of the apparent inefficiency of implied volatility from past studies stems from measurement error which biases estimates of the importance of implied volatility downward and of the importance of historical volatility upward. Once we correct for this error, there is no significant inefficiency. Two, implied volatility has strong predictive power -- considerably stronger than found by previous equity index studies. Three, stock market volatility prediction results are quite sensitive to (1) the forecasting horizon and (2) whether the data period covers the October 1987 stock market crash.

Is a Convertible Bond Call Really Bad News

We test and reject the hypothesis that managers call in-the-money convertibles when they view a decline in the value of the firm as likely. Inconsistent with this view, we find that insiders generally buy equity before conversion-forcing calls. Also, analysts tend to raise their earnings forecasts following a call. Thus, our evidence supports the alternative hypothesis that the price decline immediately following conversion-forcing calls is a purely transitory decline caused by the anticipated increase in the supply of equity. Indeed, our evidence confirms that the initial price decline is reversed in the weeks following the announcement. Copyright 2001 by University of Chicago Press.

How Asymmetric is U.S. Stock Market Volatility

This paper explores differences in the impact of equally large positive and negative surprise return shocks in the aggregate U.S. stock market on: (1) the volatility predictions of asymmetric time-series models, (2) implied volatility, and (3) realized volatility. Following large negative surprise return shocks, both asymmetric time-series models (such as the EGARCH and GJR models) and implied volatility predict an increase in volatility and, consistent with this, ex post realized volatility normally rises as predicted. Following large positive return shocks, asymmetric time-series models predict an increase in volatility (albeit a much smaller increase than following a negative shock of the same magnitude), but both implied and realized volatilities generally fall sharply. While asymmetric time-series models predict a decline in volatility following near-zero returns, both implied and realized volatility are normally little changed from levels observed prior to the stable market. The reasons for the differences are explored.

Volatility trade design

Using data from the Eurodollar options on futures market, this paper examines six volatility trades: straddles, strangles, guts, butterflies, iron butterflies, and condors. We argue that straddles and strangles should have lower transaction costs than the other four strategies, and that (when constructed to be delta neutral) straddles, strangles, and guts should have higher vegas and gammas with a straddle’s gamma and vega being the highest of the three. Consequently, we predict that in most situations volatility traders should prefer straddles and strangles to the other four strategies and that they should tend to favor straddles over strangles. Consistent with this we find that straddles account for 73.1% of all large volatility trades, strangles 20.8%, and butterflies 4.7% while the other three are rarely traded. In general we find that most straddles and strangles are designed so that their delta is low and their gamma and vega are high (in absolute terms) but that they are not always constructed so that delta is minimized and vega and gamma maximized. Specifically, we find that most straddle traders choose the closest-to-the-money strike and that most strangle strikes are centered around the underlying asset price. While delta is low and gamma and vega high at these strikes, they may not be the delta minimizing and gamma/vega maximizing strikes. On the other hand, we find that when futures are added to a straddle position it is almost always in the ratio that reduces the delta of the position to zero and that the volatility trader’s choice of whether to use a straddle or strangle depends on which can be designed with the lower delta. There is little evidence that the shape of the smile impacts the strike price choices of straddle and strangle traders or that it impacts the straddle/strangle choice. We do find that the straddle/strangle choice depends on the time to expiration and whether the trader longs or shorts volatility.

A Comparison of Reputation, Certification, Warranties, and Information Disclosure as Remedies for Information Asymmetries: Lessons from the On-line Comic Book Market

Signaling strategies which sellers of high quality securities, goods, or services employ to differentiate their securities or products from those of lower quality include: (1) developing a reputation for high quality, (2) certification by a respected third party (e.g., underwriters, bond rating agencies, and auditors, for securities, and testing laboratories for goods), (3) warranties (for goods), and (4) information disclosure (such as financial statements for securities and specifications and test results for goods). These signaling strategies are compared using data from the online comic book auction market. This market has a number of important advantages: (1) the information asymmetry is substantial, (2) good measures of reputation are available, and (3) there are many sellers employing different combinations of the four strategies. Of the four strategies, we find certification by a respected third party sends the strongest signal. On average certified comics sell for over 50% more than otherwise equivalent uncertified comics. Moreover it appears that part of this price premium is due to risk reduction, i.e., not all is due to differences in the expected quality of certified and uncertified books. We find that both how positive or negative the sellers reputation is and how well established that reputation is significantly impact the price though reputation is less important than certification. We find no evidence that warranties in the form of money-back guarantees impact the price. Apparently buyers reason that sellers of truly high quality books should seek certification so discount the presence of both warranties and positive reputations. Virtually all sellers disclose information in the form of scans and failure to do so lowers the price a modest amount. Since for a single sale, the sellers reputation is exogenous while the other three strategies are endogenous, we explore how a sellers strategy choices depend on her reputation.

Minimum Variance Hedging when Spot Price Changes are Partially Predictable

In many markets, changes in the spot price are partially predictable. We show that when this is the case: (1) although unbiased, traditional regression estimates of the minimum variance hedge ratio are inefficient, (2) estimates of the riskiness of both hedged and unhedged positions are biased upward, and (3) estimates of the percentage risk reduction achievable through hedging are biased downward. For natural gas cross hedges, we find that both the inefficiency and bias are substantial. We further find that incorporating the expected change in the spot price, as measured by the futures-spot price spread at the beginning of the hedge, into the regression results in a substantial increase in efficiency and reduction in the bias.

Impact of Call Features on Corporate Bond Yields

Financial research has often found that the impact of a call provision on bond required yield is statistically insignificant, despite the fact that fundamental theory maintains that optionality controlled by the issuer should increase the required yield. Theories of why issuers include a call provision suggest a possible explanation in that call provisions may reduce agency costs and provide signaling effects. These agency and signaling effects may serve to reduce the required yield, thus offsetting the conventional optionality effects of the call. This research supports this view—inclusion of a call provision does signal positive prospects.