Marti G. Subrahmanyam

Systematic Risk and the Theory of the Firm

The mean-variance capital-asset-pricing model forms the basis for much of the theoretical and empirical work in modern financial economics. While this model defines the relevant measure of the risk of a security β in a general equilibrium context, the relationship between this measure and the microeconomic variables of a firm has not been studied in the literature. This paper develops a model of the firm under uncertainty and derives the relationship between systematic risk and such firm variables as monopoly power, demand elasticity, and the labor-capital ratio. The general conclusions are surprisingly robust and point to several interesting empirically testable hypotheses.

On the Volatility and Comovement of U.S. Financial Markets Around Macroeconomic News Announcements

The objective of this paper is to provide a deeper insight into the links between financial markets and the real economy. To that end, we study the short-term anticipation and response of U.S. stock, Treasury, and corporate bond markets to the first release of surprise U.S. macroeconomic information. Specifically, we focus on the impact of these announcements not only on the level, but also on the volatility and comovement of those assets’ returns. We do so by estimating several extensions of the parsimonious multivariate GARCH-DCC model of Engle (2002) for the excess holding-period returns on seven portfolios of these asset classes. We find that both the process of price formation in each of those financial markets and their interaction appear to be driven by fundamentals. Yet our analysis reveals a statistically and economically significant dichotomy between the reaction of the stock and bond markets to the arrival of unexpected fundamental information. We also show that the conditional mean, volatility, and comovement among stock, Treasury, and corporate bond returns react asymmetrically to the information content of these surprise announcements. Overall, the above results shed new light on the mechanisms by which new information is incorporated into prices within and across U.S. financial markets.

The behavior of prices in the Nikkei spot and futures market

Abstract We examine the relation between the prices of Japanese stocks traded on the Tokyo Stock Exchange (TSE) as reflected in the Nikkei Stock Average (NSA) stock index and the prices of the NSA futures contract traded on the Singapore International Monetary Exchange (SIMEX). Since the inception of trading in September 1986, the NSA futures contract has generally sold at a discount relative to its theoretical value. Trading restrictions and transaction costs may explain some of this mispricing, which has been declining over time, as in the U.S. markets.

Liquidity and Arbitrage in the Market for Credit Risk

The recent credit crisis has highlighted the importance of market liquidity and its interaction with the price of credit risk. We investigate this interaction by relating the liquidity of corporate bonds to the basis between the credit default swap (CDS) spread of the issuer and the par-equivalent bond yield spread. The liquidity of a bond is measured using a recently developed measure called latent liquidity, which is defined as the weighted average turnover of funds holding the bond, where the weights are their fractional holdings of the bond. We find that bonds with higher latent liquidity are more expensive relative to their CDS contracts after controlling for other realized measures of liquidity. Analysis of interaction effects shows that highly illiquid bonds of firms with a greater degree of uncertainty are also expensive, consistent with limits to arbitrage between CDS and bond markets, due to the higher costs of “shorting†illiquid bonds. Additionally, we document the positive effects of liquidity in the CDS market on the CDS-bond basis. We also find that several firm- and bond-level variables related to credit risk affect the basis, indicating that the CDS spread does not fully capture the credit risk of the bond.

The Optimality of a Competitive Stock Market

The findings of Jensen-Long and Stiglitz on the optimality of the stock market allocation have led to a controversy over whether the sources of the nonoptimality of value maximization are noncompetive assumptions about the capital market or are inherent externalities associated with uncertainty which do not disappear even in a competitive market. At least, for the mean-variance model with constant returns to scale technologies, we claim that the answer is the former, and that the sources of the nonoptimality are nonpricetaking behavior by firms, restrictions on the availability of technologies to firms, and restrictions on the number of firms that can enter. Using both tatonnement and nontatonnement processes, it is shown that if firms value maximize, then the Jensen-Long and Stiglitz equilibria are unstable with respect to the number of firms. If the restrictions on the availability of technologies and on the number of firms that can enter are relaxed, then the equilibrium will be a Pareto optimum in most cases, and in no case will the aggregate amount of investment be less than the Pareto optimal amount. If firms act as price takers (with or without the other restrictions), then the equilibrium is a Pareto optimum

When are Options Overpriced? The Black-Scholes Model and Alternative Characterizations of the Pricing Kernel

This paper examines the convexity bias introduced by pricing interest rate swaps off the Eurocurrency futures curve and the markets adjustment of this bias in prices over time. The convexity bias arises because of the difference between a futures contract and a forward contract on interest rates, since the payoff to the latter is non-linear in interest rates. Using daily data from 1987-1996, the differences between market swap rates and the swap rates implied from Eurocurrency futures prices are studied for the four major interest rate swap markets -

Stale Prices and Strategies for Trading Mutual Funds

, £, DM and ¥. The evidence suggests that swaps were being priced off the futures curve (i.e. by ignoring the convexity adjustment) during the earlier years of the study, after which the market swap rates drifted below the rates implied by futures prices. The empirical analysis shows that this spread between the market and futures-implied swap rates cannot be explained by default risk differences, liquidity differences or information asymmetries between the swap and the futures markets. Using alternative term structure models (one-factor Vasicek, Cox-Ingersoll and Ross, Hull and White, Black and Karasinski, and the two-factor Heath, Jarrow and Morton), the theoretical value of the convexity bias is found to be related to the empirically observed swap-futures differential. We interpret these results as evidence of mispricing of swap contracts during the earlier years of the study, with a gradual elimination of that mispricing by incorporation of a convexity adjustment in swap pricing over time.

On the optimality of international capital market integration

We demonstrate that an institutional feature of numerous mutual funds—funds managing billions in assets—generates fund net asset values that reflect stale prices. Because investors can trade at these NAVs with limited transaction costs in many cases, obvious trading opportunities exist. These opportunities are especially prevalent in funds that buy Japanese or European equities. Simple, feasible strategies generate Sharpe ratios (excess return divided by standard deviation) that are many times greater than the Sharpe ratio of the underlying fund. We illustrate the potential of the strategy for three Vanguard Group mutual funds. A particular issue to keep in mind is that when the strategies are implemented, the gains from these strategies are matched by offsetting losses incurred by buy-and-hold investors in these funds. In the past few years, the financial press has produced numerous articles about large cash flows into and out of certain mutual funds over short time periods. Most of the funds have had one major identifying characteristic: They invest in international—that is, non-U.S.—assets. We attempted to explain this phenomenon and documented the performance of trading strategies that are consistent with these fund flows. Two key institutional features underlie the trading strategies that lead to the rapid in-and-out trading. First, with the proliferation of mutual funds, a U.S. investor can buy into and exchange out of no-load mutual funds at essentially zero cost. Moreover, the opportunities abound; approximately 700 no-load mutual funds invest in international equities, and a number of them are very large. For example, at least 25 international equity funds have assets under management exceeding

A Simple Technique for the Valuation and Hedging of American Options

1 billion. The second institutional feature is that when U.S. investors buy/sell mutual funds during the day, they do so at the prices prevailing at the close of trading in the United States. Those prices are based on the last transaction prices of the stocks in the fund. For Japanese and other Asian equities, the last transaction could have been at the previous 1:00 a.m. (U.S. Eastern Standard Time), and for many European equities, it could have been 12:00 noon. When these markets are closed, information flow does not cease; information relevant for valuation of the securities traded in the closed markets is still being released. For example, the literature contains considerable evidence that international equity returns are correlated at all times, even when one of the markets is closed. Moreover, the magnitude of the correlations may be quite large. This phenomenon induces large correlations between observed security prices during the U.S. trading day and the next days return on these funds. In some cases, derivatives on international markets trading in the United States provide even more informative signals (than U.S. market returns) about the unobserved movements in the prices of securities in the non-U.S. equity funds. This knowledge can be used to generate considerable excess return in the buying and selling of mutual funds. With no transaction costs and perfect liquidity, an investor can purchase funds at stale prices. In the most extreme case, one can use 1:00 a.m. prices to buy a Japan fund while one has information about the “true” price some 15 hours later at 4:00 p.m. Given these facts, it is perhaps no surprise that we document extraordinarily high excess profits and Sharpe ratios for two categories of investment funds: Pacific/Japan equity funds and international/Europe equity funds. Our sample of funds was chosen for the staleness of their underlying prices, the size of the fund, and the ease of implementing the trading strategy. We studied a strategy of switching between a money market account and the underlying fund in response to signals during U.S. market hours. We also studied the effect of the various trading costs from various types of implementation procedures. Because mutual funds do place some limits on the frequency and amount of exchanges between funds, although the limits are not always enforced, we examined strategies with particularly strong signals. We found for both types of fund that, although the strategy recommended active trading only 5–10 percent of the time, the return, on average, substantially exceeded the return to a buy-and-hold strategy during an ex post very good market for equities. More interesting is the fact that for both types of fund, we could predict the next days movement more than 75 percent of the time. Sharpe ratios generally ranged between 5 and 10 on the days the investor was in the market. The range of Sharpe ratios depended on whether the strategy included hedging of equity price movements during non-U.S. trading hours. To illustrate in a detailed manner the mechanics and results of the trading strategy, we provide a case study using three mutual funds from the Vanguard family of funds. This analysis is of special interest to academic readers because these funds are available through the retirement plans of numerous educational institutions and can be easily traded on the Internet or over the phone.

Transmission of Swap Spreads and Volatilities in the Japanese Swap Market

Abstract The focus of this paper is on the benefits to investors, arising out of the integration of the capital markets of different countries. The notion that an expansion in the opportunity set of individual investors causes improvements in their welfare is analyzed to take account of the effects on their wealth. With the supplies of investments held constant, the effects of changes in the macroparameters of the risk-return pricing relationship, caused by the merger of capital markets, on the wealth of individuals in the new equilibrium, are determined. Using three specific utility functions – quadratic, exponential and logarithmic – it is shown that international capital market integration is Pareto-optimal, i.e., the welfare of individuals in the economies considered never declines, and will generally improve. The effect of expansion of the opportunity set, due to the integration of capital markets, nullifies the effect of a possible negative change in wealth.