Finance Working Papers

The Impact of Options on Stock Price Performance Around the Expiration of Share Lockup Provisions

Asli Ascioglu et al. — Tue, 21 Mar 2006 09:38:22 PST

Studies by Field and Hanka (2001) and others have documented negative excess returns following the expiration of IPO lockup arrangements and assert they are due to selling pressure as insiders unwind positions after the lockup expiration. The existence of options trading prior to the lockup expiration however would allow insiders to hedge their positions and should result in lower excess volume and smaller price impacts after the unlock date. We examine price and volume behavior around 400 IPO lockup expirations between 2000 and 2001. For the 64 firms for which options traded prior to the unlock date, we find lower abnormal volume prior to the lockup expiration and positive abnormal returns in the two days following the unlock date, indicating that the presence of options trading has an impact on price behavior around the lockup expiration date.

Price Experimentation with Depth in a Specialist Market

Asli Ascioglu — Tue, 21 Mar 2006 06:48:53 PST

We investigate how a market maker actively influences order flow and induces information from traders in a market that includes both traders with private information about the security and uninformed liquidity traders. Market maker?s learning from the trades, i.e., price experimentation, has been studied previously by considering the market maker?s use of only the bid and ask prices. We introduce a framework that takes into account the use of bid and ask depths, in addition to the bid and ask prices, in explaining the price discovery by a monopolistic market maker. We use a dynamic programming model to show that the market maker experiments with prices and depths in the earlier rounds of trading, then recoups any losses in later rounds. According to the model, the market maker only learns about the true value of the security when informed traders are trading. The market maker attempts to encourage informed trading in the ޲st round, when information asymmetry is high. Since informed traders prefer to trade in large sizes and liquidity traders prefer to trade when the spread is narrow, the specialist encourages informed trading by widening the spread and increasing the depth. In the second period, the market maker faces less information asymmetry, since prices already reflect the private infor- mation obtained in the ޲st round. Therefore, the specialist sets narrower spreads, making the market more attractive to liquidity traders. Thus, our model predicts that when information asymmetry declines, the market maker simultaneously reduces both spreads and depths. Further, as a consequence of the market maker?s actions, both depths and spreads exhibit large variations from one quote to the next. We test our model?s predictions with the NYSE data and find supporting empirical results for a specialist?s experimentation with depth.

What Role Do International Funds Play in Your Mutual Funds Portfolio?

Hakan Saraoglu — Tue, 21 Mar 2006 06:27:26 PST

Mutual funds provide diversification benefits for small investors. The continual quest for introducing new fund types with different investment objectives has resulted in investors forming fund portfolios. With equity funds typically including well more than the ten to forty stocks required to be well diversified, it would be interesting to find that further diversification benefits are possible through combinations of funds, or mutual fund portfolios. We explore the diversification benefits of adding foreign to domestic equity fund portfolios. During the period of December 1993 to June 1999, we find that diversifying internationally did not provide incremental benefits to those attained by diversifying within domestic fund types. This result may be specific to the time period that our sample covers.

Adjusting Positive Earnings Forecasts for Bias: A Multiple Discriminant Analysis Approach

Hakan Saraoglu — Tue, 21 Mar 2006 06:27:25 PST

In this study, a methodology is tested to adjust positive forecasts that are predicted to correspond to negative earnings outcomes. The methodology involves using consensus forecasts of annual earnings with the sum of the first three quarters' earnings to predict the sign of an earnings announcement. First, the coefficients and the cut-off discriminant values from a multiple discriminant analysis (MDA) for each annual sample period are estimated between 1984 and 1990. OLS regression parameters of the forecast errors against the discriminant scores are obtained for those earnings predicted as negative by MDA in the estimation period. Coefficient values of the MDA function and cut-off discriminant scores are then used in an out-of-sample test period to predict the sign of actual earnings outcomes. An adjustment factor is obtained by using the previously estimated regression parameters of the forecasts errors versus the discriminant scores. Earnings that are predicted as negative in the test period are then adjusted using the adjustment factor. Test period results indicate that this methodology provides forecasts that outperform security analysts' consensus forecasts. Mean square error before adjustment is greatly reduced in all but one test year.

Teaching Dynamic Processes in Finance: How Can We Prepare Students for an Age of Rapid and Continual Chance?

Hakan Saraoglu et al. — Mon, 20 Mar 2006 13:00:52 PST

Preparing students to function in a business environment characterized by rapid and continual change requires the nurturing of proactive and critical thinking skills, and a deeper understanding of the relationships between key business variables. Bringing this perspective into the classroom means allowing students to experience the evolution of a given system as time progresses and inputs affecting the system change. We contend that these objectives can be achieved best by involving students in hands-on and interactive exercises that can potentially accelerate the development of mature business skills and intuition. In this paper we explore system dynamics modeling, and present two examples to demonstrate its power and appropriateness as a pedagogical tool that facilitates the teaching of dynamic processes in finance.