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Abstract:
This paper studies whether incorporating business cycle predictors is beneficial to a real time optimizing investor who must allocate funds across 3123 NYSE-AMEX stocks and the risk-free asset over the 1972-2003 period. Realized returns are positive when adjusted by the Fama-French and momentum factors as well as by the size, book-to-market, and momentum characteristics. The investor optimally holds small-cap, growth, and momentum stocks and loads less (more) heavily on momentum (small-cap) stocks during recessions. Conditioning on business cycle predictors is beneficial to a real time investor because these variables drive stock-level alpha and beta variations. Indeed, returns on individual stocks are predictable out-of-sample even when the equity premium predictability, the major focus of previous work, is questionable.

Abstract:
This paper studies whether incorporating business cycle predictors is beneficial to a real time optimizing investor who must allocate funds across 3123 NYSE-AMEX stocks and the risk-free asset over the 1972-2003 period. Realized returns are positive when adjusted by the Fama-French and momentum factors as well as by the size, book-to-market, and momentum characteristics. The investor optimally holds small-cap, growth, and momentum stocks and loads less (more) heavily on momentum (small-cap) stocks over recessions. Conditioning on business cycle predictors is beneficial to a real time optimizing investor because such variables drive stock-level alpha and beta variations. Indeed, returns on individual stocks are predictable out-of-sample even when the equity premium predictability, the major focus of previous work, is questionable.

Abstract:
This article explores cross-market liquidity dynamics by estimating a vector autoregressive model for liquidity (bid-ask spread and depth, returns, volatility, and order flow in the stock and Treasury bond markets). Innovations to stock and bond market liquidity and volatility are significantly correlated, implying that common factors drive liquidity and volatility in these markets. Volatility shocks are informative in predicting shifts in liquidity. During crisis periods, monetary expansions are associated with increased liquidity. Moreover, money flows to government bond funds forecast bond market liquidity. The results establish a link between "macro" liquidity, or money flows, and "micro" or transactions liquidity.

Abstract:
We study the joint time-series of daily liquidity in government bond and stock markets over the period 1991 to 1998. Innovations in liquidity are positively and significantly correlated across stock and bond markets. Further, order imbalances in the stock market impact bond and stock liquidity, even after controlling for order imbalances in the bond market. Both results suggest the existence of a common liquidity factor in stock and bond markets. We consider monetary conditions and mutual fund flows as sources of order flow and as primitive determinants of liquidity. Monetary expansion enhances stock market liquidity during crises. U.S. government bond funds see higher inflows and equity funds see higher outflows during financial crises, and these flows are associated with decreased liquidity in stock and bond markets. Our results establish a link between macro liquidity, or money flows, and micro or transactions liquidity.

Abstract:
We study the joint time-series of daily liquidity in government bond and stock markets over the period 1991 to 1998. Innovations in liquidity are positively and significantly correlated across stock and bond markets. Further, order imbalances in the stock market impact bond and stock liquidity, even after controlling for order imbalances in the bond market. Both results suggest the existence of a common liquidity factor in stock and bond markets. We consider monetary conditions and mutual fund flows as sources of order flow and as primitive determinants of liquidity. Monetary expansion enhances stock market liquidity during crises. U.S. government bond funds see higher inflows and equity funds see higher outflows during financial crises, and these flows are associated with decreased liquidity in stock and bond markets. Our results establish a link between "macro" liquidity, or money flows, and "micro" or transactions liquidity.

Abstract:
Spreads, depths and trading activity for US equities are studied over an extended time sample. Daily changes in market averages of liquidity and trading activity are highly volatile, negatively serially correlated and influenced by a variety of factors. Liquidity plummets significantly in down markets but increases weakly in up markets. Trading activity increases in either up or down markets. Recent market volatility induces less trading activity and reduces spreads. There are strong day-of-the-week effects; Fridays are relatively sluggish while Tuesdays are active. Long and short term interest rates influence liquidity and trading activity. Depth and trading activity increase just prior to major macroeconomic announcements.

Liquidity, spreads, depths, trading activity, transactions data

Abstract:
This article develops a framework that applies to single securities to test whether asset pricing models can explain the size, value, and momentum anomalies. Stock level beta is allowed to vary with firm-level size and book-to-market as well as with macroeconomic variables. With constant beta, none of the models examined capture any of the market anomalies. When beta is allowed to vary, the size and value effects are often explained, but the explanatory power of past return remains robust. The past return effect is captured by model mispricing that varies with macroeconomic variables.

Abstract:
This paper derives and implements a framework in which to test whether conditional asset pricing models, applied to single securities, can explain the size, value, turnover, and momentum effects in expected stock returns. In this framework individual stock betas vary with firm level size and book-to-market as well as with macroeconomic variables. The evidence shows that under the extensively studied constant beta framework, none of the models examined capture any of the size, value, turnover, and past return effects, even when returns are risk-adjusted by size, value, liquidity, and momentum factors. In contrast, when beta is allowed to vary, the size and book to market effects are often explained, but the explanatory power of turnover and past return remains robust. The past return or momentum effect is related to model mispricing that varies with macroeconomic variables, whereas turnover shows no business cycle patterns.

Abstract:
This paper derives and implements a framework in which to test whether conditional asset pricing models, applied to single securities, can explain the size, value, turnover, and momentum effects in expected stock returns. In this framework individual stock betas vary with firm level size and book-to-market as well as with macroeconomic variables. The evidence shows that under the extensively studied constant beta framework, none of the models examined capture any of the size, value, turnover, and past return effects, even when returns are risk-adjusted by size, value, liquidity, and momentum factors. In contrast, when beta is allowed to vary, the size and book to market effects are often explained, but the explanatory power of turnover and past return remains robust. The past return or momentum effect is related to model mispricing that varies with macroeconomic variables, whereas turnover shows no business cycle patterns.

Asset pricing models, size, value, liquidity, momentum, time varying risk

Abstract:
The market micro-structure literature has typically focussed on single assets. Prior to this paper there has been virtually no empirical work on the common determinants of liquidity. This paper documents that quoted spreads, quoted depth and effective spreads co-move with market-wide and industry-wide liquidity. Significant common influences are documented after controlling for return volatility, trading volume and stock price.

Abstract:
Traditionally and understandably, the microscope of market microstructure has focused on attributes of single assets. Little theoretical attention and virtually no empirical work has been devoted to common determinants of liquidity nor to their empirical manifestation, correlated movements in liquidity. But a wider-angle lens exposes an imposing image of commonality. Quoted spreads, quoted depth, and effective spreads co-move with market- and industry-wide liquidity. After controlling for well-known individual liquidity determinants such as volatility, volume, and price, common influences remain significant and material. Recognizing the existence of commonality is a key to uncovering some suggestive evidence that inventory risks and asymmetric information both affect intertemporal changes in liquidity.

Abstract:
This paper examines whether earnings momentum and price momentum are related. Both, in time-series as well as in cross-sectional asset pricing tests we find that price momentum is captured by the systematic component of earnings momentum. In time-series as well as in cross-sectional asset pricing tests, the predictive power of past returns is subsumed by a zero investment portfolio, PMN, that is long on stocks with high earnings surprises and short on stocks with low earnings surprises. Further, returns to the earnings-based zero investment portfolio are significantly related to future macroeconomic activities, including growth in GDP, industrial production, consumption, labor income, inflation and T-bill returns. Our results have implications for the Carhart four-factor model and suggest that the price-momentum factor in the Carhart model is merely a noisy proxy for the earnings-momentum based hedge portfolio, PMN.

Momentum, post-earnings-announcement-drift, factors

Abstract:
This paper examines whether earnings momentum and price momentum are related. Both in time-series as well as in cross-sectional asset pricing tests, we find that price momentum is captured by the systematic component of earnings momentum. The predictive power of past returns is subsumed by a zero-investment portfolio that is long on stocks with high earnings surprises and short on stocks with low earnings surprises. Further, returns to the earnings-based zero-investment portfolio that is long on stocks with high earnings surprises. Further, returns to the earnings-based zero-investment portfolio are significantly related to future macroeconomic activities, including growth in GDP, industrial production, consumption, labor income, inflation, and T-bill returns. Our results have implications for the Carhart four-factor model and suggest that the price-momentum factor in the Carhart model is merely a noisy proxy for the earnings-momentum based hedge portfolio, PMN.

Momentum, earnings momentum, post-earnings-announcement drift

Abstract:
This paper documents a strong relationship between short-run reversals and stock illiquidity, even after controlling for trading volume. The largest reversals and the potential contrarian trading strategy profits occur in the high turnover, low liquidity stocks, as the price pressures caused by non-informational demands for immediacy are accommodated. Thus, the high frequency negative autocorrelations are more likely to result from stresses in the market for liquidity. The contrarian trading strategy profits are smaller than the likely transactions costs because the high turnover, low liquidity stocks face large transaction and market impact costs. This lack of profitability and the fact that the overall findings are consistent with rational equilibrium paradigms suggest that the violation of the efficient market hypothesis due to short-term reversals is not so egregious after all.

Abstract:
This paper documents a strong relationship between short-run reversals and stock return illiquidity, even after controlling for trading volume. The largest reversals and the potential contrarian trading strategy profits occur in the high turnover, low liquidity stocks, as the price pressures caused by non-informational demands for immediacy are accommodated. Thus, the high frequency negative autocorrelations are more likely to result from stresses in the market for liquidity. The contrarian trading strategy profits are smaller than the likely transactions costs because the high turnover, low liquidity stocks face large transaction and market impact costs. This lack of profitability and the fact that the overall findings are consistent with rational equilibrium paradigms suggest that the violation of the efficient market hypothesis due to short-term reversals is not so egregious after all.

Abstract:
In recent years there has been a dramatic growth in academic interest in the predictability of asset returns based on past history. A growing number of researchers argue that time-series patterns in returns are due to investor irrationality, and thus can be translated into abnormal profits. Continuation of short-term returns or momentum is one such pattern that has defied any rational explanation, and is at odds with market efficiency. This paper argues that profits to momentum strategies are a result of persistent differences in conditionally expected returns, and are consistent with time-varying expected returns. Standard macroeconomic variables are able to predict momentum payoffs, and these payoffs disappear once returns are adjusted for variations in expected returns.

Abstract:
This paper establishes a robust link between momentum and credit rating. Momentum profitability is large and significant among low-grade firms, but it is nonexistent among high-grade firms. The momentum payoffs documented in the literature are generated by low-grade firms that account for less than 4% of the overall market capitalization of rated firms. The momentum payoff differential across credit rating groups is unexplained by firm size, firm age, analyst forecast dispersion, leverage, return volatility, and cash flow volatility.

Momentum, asset-pricing anomalies, credit risk

Abstract:
This paper establishes a robust link between momentum and credit rating. Momentum profitability is large and significant among low-grade firms, but it is nonexistent among high-grade firms. The momentum payoffs documented in the literature are generated by low-grade firms that account for less than 4% of the overall market capitalization of rated firms. The momentum payoff differential across credit rating groups is unexplained by firm size, firm age, analyst forecast dispersion, leverage, return volatility, and cash flow volatility.

momentum, credit risk, credit rating

Abstract:
We construct an earnings based zero-investment portfolio that is related to the business cycle. The portfolio, PMN, is long in stocks that have had high earnings changes in the last quarter and is short in stocks that have had low earnings changes in the last quarter. PMN is related to future macroeconomic conditions including growth in GDP, industrial production, consumption, labor income, inflation and T-bill returns and is not subsumed by the Fama-French factors. The results are consistent with the presence of a common macroeconomic factor in stock returns. Both in time-series as well as cross-sectional asset pricing tests, the momentum phenomenon is primarily attributable to PMN. Finally, we show that the post-earnings-announcement drift is related to macroeconomic conditions and that payoffs to trading strategies based on the drift may not be as profitable once macroeconomic information in stock returns is controlled for.

Earnings momentum; Stock momentum; Post-earnings announcement drift; Macroeconomic factor; Business cycle

Abstract:
Daily returns for stocks listed on the New York Exchange (NYSE) are not serially dependent. In contrast, order imbalances on the same stocks are highly persistent from day to day. These two empirical facts can be reconciled if sophisticated investors react to order imbalances within the trading day by engaging in countervailing trades sufficient to remove serial dependence over the daily horizon. How long does this actually take? The pattern of intra-day serial dependence, over intervals ranging from five minutes to one hour, reveals traces of efficiency-creating actions. For the actively traded NYSE stocks in our sample, it takes longer than five minutes for astute investors to begin such activities. By thirty minutes, they are well along on their daily quest.

Market efficiency, order imbalances, autocorrelations

Abstract:
Daily returns for stocks listed on the New York Exchange (NYSE) are not serially dependent. In contrast, order imbalances on the same stocks are highly persistent from day to day. These two empirical facts can be reconciled if sophisticated investors react to order imbalances within the trading day by engaging in countervailing trades sufficient to remove serial dependence over the daily horizon. How long does this actually take? The pattern of intra-day serial dependence, over intervals ranging from five minutes to one hour, reveals traces of efficiency-creating actions. For the actively-traded NYSE stocks in our sample, it takes longer than five minutes for astute investors to begin such activities. By thirty minutes, they are well along on their daily quest.

Abstract:
We analyze the relation between expected equity returns and the level as well as the volatility of trading activity. We document a negative cross-sectional relationship between stock returns and the variability of dollar trading volume and share turnover, after controlling for size, book-to-market, momentum, and the level of dollar volume or share turnover. This effect survives a number of robustness checks and is statistically and economically significant. Our analysis highlights the importance of trading activity related variables in the cross-section of expected stock returns.

Abstract:
Given the evidence that the level of liquidity affects asset returns, a reasonable hypothesis is that the second moment of liquidity should be positively related to asset returns, provided agents care about the risk associated with fluctuations in liquidity. Motivated by this observation, we analyze the relation between expected equity returns and the level as well as the volatility of trading activity (a proxy for liquidity). We document a result contrary to our initial hypothesis, namely, a negative and surprisingly strong cross-sectional relationship between stock returns and the variability of dollar trading volume and share turnover, after controlling for size, book-to-market, momentum, and the level of dollar volume or share turnover. This effect survives a number of robustness checks and is statistically and economically significant. Our analysis demonstrates the importance of trading activity-related variables in the cross-section of expected stock returns.

Abstract:
Market efficiency, the timely incorporation of information into prices, remains a central and controversial issue in finance. The short-horizon predictability of returns from past order flows is an inverse indicator of efficiency. We analyze this predictability for NYSE stocks that traded every day from 1993 through 2002. Mid-quote return predictability is diminished when bid-ask spreads are narrower. Such predictability has declined over time with the minimum tick size. Variance ratios of five-minute and daily returns suggest that prices were closer to random walk benchmarks during decimal regimes than during regimes with higher tick sizes (and wider spreads). These findings support the notion that liquidity stimulates arbitrage activity, which, in turn, enhances market efficiency. Further, as the tick size decreased, open-close/close-open return variance ratios increased, while return autocorrelations decreased. This suggests an increased incorporation of private information into prices during more liquid regimes.

Market efficiency, liquidity, order imbalance

Abstract:
We focus on an intuitive measure of trading activity: the aggregate daily order imbalance, buy orders less sell orders, on the NYSE. Order imbalance increases following market declines and vice versa, which reveals that investors are contrarians in aggregate. Order imbalances in either direction, excess buy or sell orders, reduce liquidity. Market-wide returns are strongly affected by contemporaneous and lagged order imbalances. Market returns reverse themselves after high negative imbalance, large negative return days. Even after controlling for aggregate volume and liquidity, market returns are affected by order imbalance.

Order Imbalance, Liquidity, Trading Volume, Transactions

Abstract:
Low credit risk firms realize higher returns than high credit risk firms. This effect is puzzling because investors seem to pay a premium for bearing credit risk. This paper shows that the credit risk effect manifests itself due to the poor performance of low-rated stocks during periods of financial distress at least three months before and after credit rating downgrades. Around downgrades, low-rated firms experience considerable negative returns amid strong institutional selling, whereas returns do not differ across credit risk groups in stable or improving credit conditions. Remarkably, the group of low-rated stocks driving the credit risk effect accounts for about 4.2% of the total market capitalization. Isolating the credit risk effect to a limited number of firms in a specific set of circumstance allows us to distinguish between its potential explanations. Our evidence points away from risk-based explanations, and towards mispricing generated by retail investors and sustained by illiquidity and short sell constraints.

credit risk effect, credit rating, asset-pricing anomalies

Abstract:
This paper finds that trading volume is a significant determinant of the lead-lag patterns observed in stock returns. Daily and weekly returns on high volume portfolios lead returns on low volume portfolios, controlling for firm size. Nonsynchronous trading or low volume portfolio autocorrelations cannot explain these findings. These patterns arise because returns on low volume portfolios respond more slowly to information in market returns. The speed of adjustment of individual stocks confirms these findings. Overall, the results indicate that differential speed of adjustment to information is a significant source of the cross-autocorrelation patterns in short-horizon stock returns.

Abstract:
This paper finds that trading volume is a significant determinant of the lead-lag patterns observed in stock returns. Daily and weekly returns on high volume portfolios lead returns on low volume portfolios, controlling for firm size. Nonsynchronous trading or low volume portfolio autocorrelations cannot explain these findings. These patterns arise because returns on low volume portfolios respond more slowly to information in market returns. The speed of adjustment of individual stocks confirms these findings. Overall, the results indicate that differential speed of adjustment to information is a significant source of the cross-autocorrelation patterns in short-horizon stock returns.

Abstract:
In this paper, we analyze cross-sectional heterogeneity in the time-series variation of liquidity. Average daily changes in liquidity exhibit significant heterogeneity in the cross-section; the liquidity of small firms varies more on a daily basis than that of large firms. A steady increase in aggregate market liquidity over the past decade is more strongly manifest in large firms than in small firms. We investigate cross-sectional differences in the resilience of a firm?s liquidity to information shocks. We use the sensitivity of stock liquidity to absolute stock returns as an inverse measure of this resilience, and find that the measure exhibits considerable cross-sectional variation. Firm size, return volatility, institutional holdings, and volume are all significant cross-sectional determinants of this measure.

Abstract:
This paper shows that the puzzling negative cross-sectional relation between dispersion in analysts' earnings forecasts and future stock returns may be explained by financial distress, as proxied by credit rating downgrades. Focusing on a sample of firms rated by S&P, we show that the profitability of dispersion-based trading strategies concentrates in a small number of the worst-rated firms and is significant only during periods of deteriorating credit conditions. In such periods, the negative dispersion-return relation emerges as low-rated firms experience substantial price drop along with considerable increase in forecast dispersion. Moreover, even for this small universe of worst-rated firms, the dispersion-return relation is nonexistent when either the dispersion measure or return is adjusted by credit risk. The results are robust to previously proposed explanations for the dispersion effect such as short-sale constraints and leverage.

Dispersion in analyst forecasts, asset-pricing anomalies, credit risk, credit rating

Abstract:
This paper shows that the puzzling negative cross-sectional relation between dispersion in analysts' earnings forecasts and future stock returns is a manifestation of financial distress, as proxied by credit rating downgrades. Focusing on a sample of firms rated by S&P, we show that the profitability of dispersion based trading strategies concentrates in a small number of the worst-rated firms and is significant only during periods of deteriorating credit conditions. In such periods, the negative dispersion-return relation emerges as low-rated firms experience substantial price drop along with considerable increase in forecast dispersion. Moreover, even for this small universe of worst-rated firms, the dispersion-return relation is nonexistent when either the dispersion measure or return is adjusted by credit risk. The results are robust to previously proposed explanations for the dispersion effect such as short-sale constraints, illiquidity, and leverage.

Dispersion in analyst forecasts, asset-pricing anomalies, credit risk, credit rating

Abstract:
This article proposes a trading-based explanation for the asymmetric effect in daily volatility of individual stock returns. Previous studies propose two major hypotheses for this phenomenon: leverage effect and time-varying expected returns. However, leverage has no impact on asymmetric volatility at the daily frequency and, moreover, we observe asymmetric volatility for stocks with no leverage. Also, expected returns may vary with the business cycle, that is, at a lower than daily frequency. Trading activity of contrarian and herding investors has a robust effect on the relationship between daily volatility and lagged return. Consistent with the predictions of the rational expectation models, the non-informational liquidity-driven (herding) trades increase volatility following stock price declines, and the informed (contrarian) trades reduce volatility following stock price increases. The results are robust to different measures of volatility and trading activity. (JEL C30, G11, G12)

Abstract:
This paper proposes a trading-based explanation for the asymmetric effect in daily volatility of individual stock returns. Previous studies propose two major hypotheses for this phenomenon: leverage effect and time varying expected returns. However, leverage has no impact on asymmetric volatility at the daily frequency and, moreover, we observe asymmetric volatility for stocks with no leverage. Also, expected returns may vary with the business cycle, i.e., at a lower than daily frequency. Trading activity of contrarian and herding investors has a robust effect on the relationship between daily volatility and lagged return. Consistent with the predictions of the rational expectations models, the non-informational liquidity driven (herding) trades increase volatility following stock price declines and the informed (contrarian) trades reduce volatility following stock price increases. The results are robust to different measures of volatility and trading activity.

Abstract:
This paper proposes a trading-based explanation for the asymmetric effect in daily volatility of individual stock returns. Previous studies propose two major hypotheses for this phenomenon: leverage effect and time varying expected returns. However, leverage has no impact on asymmetric volatility at the daily frequency and, moreover, we observe asymmetric volatility for stocks with no leverage. Also, expected returns may vary with the business cycle, i.e., at a lower than daily frequency. Trading activity of contrarian and herding investors has a robust effect on the relationship between daily volatility and lagged return. Consistent with the predictions of the rational expectations models, non-informational liquidity driven (herding) trades increase volatility following stock price declines and informed (contrarian) trades reduce volatility following stock price increases. The results are robust to different measures of volatility and trading activity.

asymmetric volatility, informed trades, liquidity based trades

Abstract:
The post-earnings-announcement-drift is a long standing anomaly that is in conflict with market efficiency. This paper documents that the post-earnings-announcement drift occurs mainly in the highly illiquid stocks. A trading strategy that goes long the high earnings surprise stocks and short the low earnings surprise stocks provides a value-weighted return of 0.14% in the most liquid stocks and 1.60% per month in the most illiquid stocks. The illiquid stocks have high trading costs and market impact costs. Using a multitude of estimates we find that transaction costs account for anywhere from 63% to 100% of the paper profits from the long-short strategy designed to exploit the earnings momentum anomaly. This paper provides support for the argument that transactions costs could be the source of the drift.

G11, G12, C11

Abstract:
This paper exploits the intuition of the ICAPM to propose a measure that formally compares the empirical performance of competing asset pricing models in the presence of short selling constraints. In a multifactor context, portfolios are said to be efficient if they yield the highest expected return for a given variance and for a given degree of sensitivity to state variables that capture future investment-consumption risks. The measure of model misspecification is the maximal expected return loss caused by holding the market portfolio instead of the multifactor efficient portfolio. Including a proxy for liquidity in intertemporal pricing models takes the market portfolio closer to multifactor efficiency relative to scenarios that discard liquidity. Indeed, when no short positions are allowed, including a liquidity proxy in an intertemporal asset pricing model results in near exact multifactor efficiency of the market portfolio. Our empirical results can be explained by noting that liquidity risk is typically of major concern whenever the market declines. Investors who take short positions implicitly hedge against liquidity risk, thus a proxy for liquidity plays only a secondary role when such positions are allowed. In contrast, the liquidity proxy plays a major role when short selling is precluded.

Liquidity, Short Selling, Multifactor Efficiency, Intertemporal Asset Pricing Model, hedging

Abstract:
This paper studies the relation between order imbalances and daily returns of individual stocks. Our tests are motivated by a theoretical framework, whose distinguishing feature is that it explicitly considers how market makers with inventory concerns dynamically accommodate autocorrelated imbalances. Persistence in imbalances arises because agents split their orders over time to minimize expected trading costs. In equilibrium, continuing price pressures caused by autocorrelated imbalances cause a positive relation between lagged imbalances and returns over daily horizons. However, this positive relation reverses sign after controlling for the current imbalance. We find empirical evidence consistent with all of these implications of the model. We also find that imbalance-based trading strategies yield statistically significant returns, the magnitude of which is moderate enough to be consistent with an equilibrium wherein intermediaries with inventory concerns accommodate persistent trader demands. Our results shed light on the role of inventory effects in daily stock price movements.

Microstructure, Order Imbalance, Individual Stock Returns

Abstract:
A manager who wants to be viewed favorably has an incentive to advance or delay the arrival of information about his firm's profitability. In the model, a high ability manager tries to advance resolution of a likely-favorable outcome, while a low ability manager may defer resolution. Such manipulation of information arrival causes greater investment in execution projects (which tend to resolve early) than exploratory projects (which tend to resolve late), and affects investment in hastening or retarding project resolution. In contrast with previous literature, in some cases managers may secretly overinvest. The model offers empirical implications about innovative versus conventional investments, associated stock price reactions, and corporate control. The theory also implies a perverse sorting of high ability managers to conventional activities and low ability managers to visionary enterprises.

Abstract:
Stocks and other financial assets are traded at prices that lie on a fixed grid determined by the minimum tick size permitted in the market. Consequently, observed prices and quoted spreads do not correspond to the equilibrium prices and true spreads that would exist in a market with no minimum tick size. This paper models the equilibrium movements of two latent variables: equilibrium price and spread by a bivariate autoregressive process with correlated errors. We estimate the parameters governing their movements using transaction prices and information on quoted bid-ask spreads. Due to the econometric complexities created by the rounding to a discrete grid we use Monte Carlo Markov Chain methods to implement the parameter estimation. The empirical analysis is performed on a selection of large, heavily-traded U.S. stocks. The results indicate that most of the quoted spread is attributable to the rounding of prices and the adverse selection component is small.

Abstract:
This paper studies cross-sectional variations in stock trading activity for a comprehensive sample of NYSE/AMEX and Nasdaq stocks over a period of thirty-six years. Our theoretical framework indicates that trading activity depends on the extent of liquidity trading, the mass of informed agents, and dispersion of opinion about the stock's fundamental value. We further postulate that liquidity or noise trading depends both on a stock's visibility and on portfolio rebalancing needs triggered by past stock price performance. We use size, firm age, price, and the book-to-market ratio as proxies for a firm's visibility. The mass of informed agents is proxied by the number of analysts following the stock, while analyst forecast dispersion, systematic risk, and firm leverage proxy for divergence of opinion. Past return is by far the most significant predictor of stock turnover. Forecast dispersion and systematic risk also play important roles in predicting the cross-section of expected trading activity. Stocks that have performed well in a given year experience aggressive buying pressure in the subsequent year, which points to the presence of momentum investing. Overall, the results support theories of trading based on differences of opinion and stock visibility.

Volume, Market Efficiency, Liquidity

Abstract:
We study common determinants of daily bid-ask spreads and trading volume for the bond and stock markets over the 1991-98 period. We find that spread changes in one market are affected by lagged spread and volume changes in both markets. Further, spread and volume changes are predictable to a considerable degree using lagged market returns, lagged interest rates, lagged spreads, and lagged volume. During periods of financial crisis, stock and bond spreads and volume are more volatile and become more highly correlated; moreover, at these times, money supply positively affects financial market liquidity, albeit with a lag of two weeks. During normal times, increases in mutual fund flows enhance stock market liquidity and trading volume, but during financial crises, U.S. government bond funds see higher inflows, resulting in increased bond market liquidity. Overall, this study deepens our understanding of the dynamics of liquidity in financial markets and suggests how asset allocation strategies might be designed to reduce trading costs.

stock bond liquidity, crises, money supply

Abstract:
Recent asset pricing research has suggested that expected returns are determined not only by systematic risk factors as proposed by equilibrium pricing theories but also by non-risk characteristics such as firm size and book-to-market. In a recent study, Gomes, Kogan, and Zhang (2001) reconcile the ability of such characteristics to predict returns within a dynamic pricing paradigm. Firm characteristics can appear to predict stock returns because they may be correlated with the true conditional factor loadings, thereby motivating the scaling of betas by firm specific variables. We test whether such a scaling procedure improves the performance of the theoretically motivated CAPM and consumption CAPM. The evidence shows that equity characteristics often enter beta significantly. However, 'characteristic scaled factor models' do not outperform their unscaled counterparts. The results are robust to various specifications including different proxies for the market portfolio and using both time-series and cross-sectional regressions.

Abstract:
This paper examines the cross-sectional implications of the inflation illusion hypothesis for the post-earnings-announcement drift. The inflation illusion hypothesis, which was proposed by Modigliani and Cohn (1979), suggests that stock market investors fail to incorporate inflation in forecasting future earnings growth rate, and this causes firms whose earnings growth is positively (negatively) related to inflation to be undervalued (overvalued). We argue and show that the sensitivity of earnings growth to inflation varies monotonically across stocks sorted on standardized unexpected earnings (SUE) and, consistent with the inflation illusion hypothesis, show that lagged inflation predicts future earnings growth, abnormal returns and earnings announcement returns of SUE-sorted stocks. Interestingly, controlling for the return predictive ability of inflation weakens the results of Bernard and Thomas (1989) on the ability of lagged SUE to predict future returns of SUE-sorted stocks.

inflation illusion, money illusion, post-earnings-announcement drift, earnings momentum, market efficiency

Abstract:
Share turnover has increased dramatically over the past few years. We explore patterns in the microstructure of trading activity underlying this increase, and analyze possible causes and consequences of this trend. Higher turnover has been associated with more frequent smaller trades. Lower trading costs play an important role in causing these trends. An increase in institutional trading seems to be a key contributor. Turnover and serial dependence in large trades have increased the most for stocks with the greatest level of institutional holdings. An increase in the volatility of equity fund flows also appears to be related to the increase in turnover. Variance ratio tests suggest that greater institutional trading has led to increased information production. The sensitivity of turnover to past returns has increased in recent years, revealing a more widespread use of quantitative trading strategies.

Trading Volume, Turnover, Liquidity, Institutions, Hedge Funds

Abstract:
Many proxies of illiquidity have been used in the literature that relates illiquidity to asset prices. These proxies have been motivated from an empirical standpoint. In this study, we approach liquidity estimation from a theoretical perspective. Our method explicitly recognizes the analytic dependence of illiquidity on more primitive drivers such as trading activity and information asymmetry. More specifically, we estimate illiquidity using structural formulae in line with Kyle's (1985) lambda for a comprehensive sample of stocks. The empirical results provide evidence that theory-based estimates of illiquidity are priced in the cross-section of expected stock returns, even after accounting for risk factors, firm characteristics known to influence returns, and other illiquidity proxies prevalent in the literature.

illiquidity, Kyle lambda, theory-based illiquidity, asset pricing

Abstract:
This paper explores liquidity spillovers in market-capitalization based portfolios of NYSE stocks as well as the value-weighted Nasdaq portfolio to gain insight about dynamic movements in returns, volatility, and liquidity. We find that lead and lag patterns across small and large cap stocks are stronger when spreads in the large cap sector are wider.

Consistent with the notion that trading on common information in large cap stocks is transmitted to other stocks with a lag, order flows in large cap stocks significantly predict both transaction price-based and mid-quote returns of small cap deciles when large-cap spreads are high. Impulse response functions indicate the existence of persistent liquidity,
return, and volatility spillovers across large and small cap stocks.

Liquidity dynamics, small firms, large firms, cross-autocorrelations

Abstract:
This paper examines the mechanism through which the incorporation of information into prices leads to cross-autocorrelations in stock returns. The lead-lag relation between large and small stocks increases with lagged spreads of large stocks. Further, order flows in large stocks significantly predict the returns of small stocks when large stock spreads are high. This effect is consistent with the notion that trading on common information takes place first in the large stocks and is then transmitted to smaller stocks with a lag, suggesting that price discovery takes place in the large stocks.

lead-lag, returns, small stocks, large stocks, microstructure, information

Abstract:
The post-earnings-announcement drift is a longstanding anomaly that conflicts with market efficiency. This study documents that the post-earnings-announcement drift occurs mainly in highly illiquid stocks. A trading strategy that goes long high-earnings-surprise stocks and short low-earnings-surprise stocks provides a monthly value-weighted return of 0.04 percent in the most liquid stocks and 2.43 percent in the most illiquid stocks. The illiquid stocks have high trading costs and high market impact costs. By using a multitude of estimates, the study finds that transaction costs account for 70-100 percent of the paper profits from a long-short strategy designed to exploit the earnings momentum anomaly.

Research Sources, Equity Investments, Technical Analysis, Investment Theory, Efficient Market Theory, Portfolio Management, Equity Strategies

Abstract:
The demand for immediacy is likely to be stronger for sellers of securities than for buyers since investors are more likely to have a pressing need to raise cash than to exchange cash for securities. Secondly, previous literature suggests that market makers will react asymmetrically to orders for the purchase and sale of securities. We estimate separate buy- and sell-side price impact measures for a large cross-section of stocks over more than 20 years, and find pervasive evidence that sell-side illiquidity exceeds buy-side illiquidity. Thus, the time-series of the value weighted average difference between buy- and sell-side illiquidity is overwhelmingly positive over our sample period. Further, both illiquidity measures co-move significantly with the TED spread, a measure of funding liquidity. In the cross-section, sell-side illiquidity is priced far more strongly than buy-side illiquidity. Indeed, our evidence indicates that the illiquidity premium in asset returns emanates almost entirely from the sell side.

Liquidity, Kyle Lambda, Trading costs, Asset pricing

Abstract:
This paper provides an economic rationale for the cross-autocorrelation patterns in stock returns in the context of a microstructure model in which investors have incomplete information. The paper shows that in a market in which investors are informed about only a sub-set of stocks, the emergence of lead-lag, cross-autocorrelations is a function of the cost of trading in other stocks based on information about the sub-set of stocks. If cross-trading costs are high, informed investors will trade only in the sub-set of stocks they are informed about; if cross-trading costs are moderate, informed investors will randomize between trading and not trading in other stocks; and if cross-trading costs are low, they will trade in all stocks. When informed investors trade only in a sub-set of stocks, prices of stocks with more informed trading will adjust to common factor information faster than the prices of stocks with less informed trading giving rise to asymmetric leadlag cross-autocorrelations. When informed investors trade in all stocks, asymmetric lead-lag cross-autocorrelations will disappear as a result of their cross-market arbitrage trading. These results provide a number of testable implications for lead-lag cross-autocorrelation patterns. The data is consistent with the empirical predictions.

Abstract:
In this paper, we analyse cross-sectional heterogeneity in the time-series variation of liquidity in equity markets. Our analysis uses a broad time-series and cross-section of liquidity data. We find that average daily changes in liquidity exhibit significant heterogeneity in the cross-section; the liquidity of small firms varies more on a daily basis than that of large firms. A steady increase in aggregate market liquidity over the past decade is more strongly manifest in large firms than in small firms. Absolute stock returns are an important determinant of liquidity. We investigate cross-sectional differences in the resilience of a firm's liquidity to information shocks. We use the sensitivity of stock liquidity to absolute stock returns as an inverse measure of this resilience, and find that the measure exhibits considerable cross-sectional variation. Firm size, return volatility, institutional holdings, and volume are all significant cross-sectional determinants of this measure.

Abstract:
This paper examines the cross-sectional implications of the inflation illusion hypothesis for the post-earnings-announcement drift. The inflation illusion hypothesis suggests that stock market investors fail to incorporate inflation in forecasting future earnings growth rates, and this causes firms whose earnings growths are positively (negatively) related to inflation to be undervalued (overvalued). We argue and show that the sensitivity of earnings growth to inflation varies monotonically across stocks sorted on standardized unexpected earnings (SUE) and, consistent with the inflation illusion hypothesis, show that lagged inflation predicts future earnings growth, abnormal returns, and earnings announcement returns of SUE-sorted stocks. Interestingly, controlling for the return predictive ability of inflation weakens the ability of lagged SUE to predict future returns of SUE-sorted stocks.

Abstract:
This paper examines the cross-sectional implications of the inflation illusion hypothesis for the post-earnings-announcement drift. The inflation illusion hypothesis, which was proposed by Modigliani and Cohn (1979), suggests that stock market investors fail to incorporate inflation in forecasting future earnings growth rate, and this causes firms whose earnings growth is positively (negatively) related to inflation to be undervalued (overvalued). We argue and show that the sensitivity of earnings growth to inflation varies monotonically across stocks sorted on standardized unexpected earnings (SUE) and, consistent with the inflation illusion hypothesis, show that lagged inflation predicts future earnings growth, abnormal returns and earnings announcement returns of SUE-sorted stocks. Interestingly, controlling for the return predictive ability of inflation weakens the results of Bernard and Thomas (1989) on the ability of lagged SUE to predict future returns of SUE-sorted stocks.

Inflation illusion, earnings momentum, post-earnings-announcement drift, market efficiency

Abstract:
While working on our forthcoming Journal of Finance paper entitled "Momentum and Credit Rating," we found that the dispersion effect where high dispersion stocks earn lower returns is related to the credit ratings of the companies. Moreover, the profitability of dispersion based trading strategies is concentrated in a small number of the worst-rated firms and is significant only during periods of deteriorating credit conditions. Thus, it is the financial distress related to deteriorating credit conditions that drives the dispersion effect.

dispersion in analyst forecasts, abnormal returns, credit ratings

Abstract:
Following the recent financial crisis, a number of commentators have suggested that liquidity disappears in falling markets. It is when investors try to convert assets to cash that a lack of liquidity is felt most acutely. In other words, investor sales receive lower liquidity than investor buys. In this paper, we will attempt to verify whether this is indeed true.

Since this will be an asset pricing study that will examine the effect of price impact measures on asset returns, we will need to obtain sufficient data, given that a long time series is needed to measure the first moment of returns accurately. In order to compute the price impact measures of investor sales and purchases we will examine transactions data. Transactions data is limited to the ISSM and the TAQ data series and begins in 1983. There are no publicly available datasets that provide data prior to 1983. We will examine every transaction on the NYSE from 1983 onwards in order to compute price impact measures for investor sales and purchases.

liquidity, asset pricing, price impact

Abstract:
Many proxies of illiquidity have been used in the literature that relates illiquidity to asset prices. These proxies have been motivated from an empirical standpoint. In this study, we approach liquidity estimation from a theoretical perspective. Our method explicitly recognizes the analytic dependence of illiquidity on more primitive drivers such as trading activity and information asymmetry. More specifically, we estimate illiquidity using structural formulae in line with Kyle's (1985) lambda for a comprehensive sample of stocks. The empirical results provide evidence that theory-based estimates of illiquidity are priced in the cross-section of expected stock returns, even after accounting for risk factors, firm characteristics known to influence returns, and other illiquidity proxies prevalent in the literature.

G12, G14

Abstract:
The post-earnings-announcement drift is a longstanding anomaly that conflicts with market efficiency. This study documents that the post-earnings-announcement drift occurs mainly in highly illiquid stocks. A trading strategy that goes long high-earnings-surprise stocks and short low-earnings-surprise stocks provides a monthly value-weighted return of 0.04 percent in the most liquid stocks and 2.43 percent in the most illiquid stocks. The illiquid stocks have high trading costs and high market impact costs. By using a multitude of estimates, the study finds that transaction costs account for 70-100 percent of the paper profits from a long-short strategy designed to exploit the earnings momentum anomaly.

Equity Investments, Research Sources, Investment Theory, Efficient Market Theory, Portfolio Management, Equity Strategies

Abstract:
This paper studies the relation between order imbalances and daily returns of individual stocks. Our tests are motivated by a theoretical framework, whose distinguishing feature is that it explicitly considers how market makers with inventory concerns dynamically accommodate autocorrelated imbalances. Persistence in imbalances arises because agents split their orders over time to minimize expected trading costs. In equilibrium, continuing price pressures caused by autocorrelated imbalances cause a positive relation between lagged imbalances and returns over daily horizons. However, this positive relation reverses sign after controlling for the current imbalance. We find empirical evidence consistent with all of these implications of the model. We also find that imbalance-based trading strategies yield statistically significant returns, the magnitude of which is moderate enough to be consistent with an equilibrium wherein intermediaries with inventory concerns accommodate persistent trader demands.

Order Imbalance, Inventory Models, Market Makers, Autocorrelation in Order Flow

Abstract:
In this paper, we focus on a previously unexplored but an intuitive measure of trading activity: the aggregate daily order imbalance, buy orders less sell orders, on the NYSE. Order imbalance increases following market declines and vice versa, which reveals that investors are contrarians on aggregate. Order imbalances in either direction reduce liquidity. Market-wide returns are strongly affected by contemporaneous and lagged order imbalances. Market returns reverse themselves after high negative imbalance, large negative return days. Even after controlling for aggregate volume and liquidity, market returns are affected by order imbalance.

Market Order Imbalance, Liquidity, Trading Volume, Contrarian

Abstract:
In recent years there has been a dramatic growth in academic interest in the predictability of asset returns based on past history. A growing number of researchers argue that time-series patterns in returns are due to investor irrationality, and thus can be translated into abnormal profits. Continuation of short-term returns or momentum is one such pattern that has defied any rational explanation, and is at odds with market efficiency. This paper shows that profits to momentum strategies can be explained by a set of lagged macro-economic variables and payoffs to momentum strategies disappear once stock returns are adjusted for their predictability based on these macro-economic variables. Our results provide a possible role for time-varying expected returns as an explanation for momentum payoffs.

Momentum, business cycle, time-varying expected returns

Abstract:
Stocks and other financial assets are traded at prices that lie on a fixed grid determined by the minimum tick size permitted in the market. Consequently, observed prices and quoted spreads do not correspond to the equilibrium prices and true spreads that would exist in a market with no minimum tick size. This paper models the equilibrium movements of two latent variables: equilibrium price and spread by a bivariate autoregressive process with correlated errors and some key structural variables. We estimate the parameters governing their movements using transaction prices and information on quoted bid-ask spreads. Due to the econometric complexities created by the rounding to a discrete grid we use Monte Carlo Markov Chain methods to implement the parameter estimation. The empirical analysis is performed on a selection of large, heavily-traded U.S. stocks before and after the reduction of the minimum tick size in June 1997. We also examine a selection of mid-sized stocks around the same period and a selection of large stocks from 1992. The results indicate that most of the quoted spread is attributable to the rounding of prices and the adverse selection component is small. The true spread and the adverse selection component is greater for the mid-sized stocks.

Tick size, Rounding, Discretization, Monte Carlo Markov Chain, Gibbs sampler, Market Microstructure

Abstract:
This paper analyzes the effects of a finite tick size and the practice of 'payment-for-order-flow' on competition between NYSE and non-NYSE market makers. Due to the presence of non-specialist market makers, order submitters find that their NYSE orders are sometimes executed at better than quoted prices. Our analysis implies that even if the NYSE reservation price is superior to its non-NYSE counterpart, brokers may, due to payment-for-order-flow, prefer to execute orders off the NYSE floor. Further, if, unlike NYSE specialists, non-NYSE market makers can more easily offset their inventory exposure (using, for example, options markets), they offer more competitive prices. In accordance with the implications of the model, we provide empirical evidence that non-NYSE market makers trade a larger fraction of the smaller order sizes and offer fewer price improvement opportunities. Also, large companies appear to have enhanced price improvement opportunities on the NYSE, suggesting that the number of non-specialist market positively affects such opportunities.

Abstract:
This article analyzes the effects of a finite tick size and the practice of "payment-for-order flow" on market maker competition. Even if the NYSE reservation price is superior to its non-NYSE counterpart, brokers may, due to payment-for-order flow, prefer to execute orders off the NYSE floor. In accordance with the implications of the model, empirical analysis suggests that the non-NYSE market makers trade a larger fraction of the smaller order sizes and offer fewer price improvement opportunities; and large companies appear to have enhanced price improvement opportunities on the NYSE.

Abstract:
This paper considers three reasons for the increasing popularity of mutual funds: diversification, transaction cost savings and risk sharing. Mutual funds represent a commingling of assets and are required to pay each redeeming investor a pro-rata share of the net asset value of the fund. This results in a better allocation of the liquidity risk amongst the investors. However, investors who redeem their holdings in mutual funds impose an externality on those that don't. Mutual funds will thus seek to dissuade redemptions through front-end and back-end (redemption) load fees. The empirical evidence is consistent with the predictions of the model that load and redemption fees dissuade redemptions in open-end funds and that funds hold more cash when there is increased uncertainty about redemptions. Furthermore, funds with load and redemption fees hold less cash than their no-load counterparts. The results suggest that aggressive growth funds are sensitive to cash flow and are likely to rely on fees to dissuade redemptions because they hold more of the smaller, less liquid stocks.

Abstract:
We analyze the relation between equity returns, risk, and a rich set of security characteristics that includes institutional ownership, S&P 500 index membership, analyst following, and dispersion in analyst forecasts, in addition to previously examined variables such as the book-to-market ratio, firm size, the bid-ask spread, and lagged returns. Our primary objective is to determine whether these characteristics have marginal explanatory power relative to the Connor and Korajczyk (1988) risk factors. We also compare the different approaches that have been used to test asset pricing models against specific alternatives. We find that inferences are extremely sensitive to the sorting criteria used for portfolio formation, so that results based on regressions using portfolio returns should be interpreted with caution. Fama-MacBeth type regressions for individual securities suggest some new findings: risk-adjusted stock returns show a puzzling negative (and strongly significant) relation to the bid-ask spread, a negative relation with both size and share turnover, and a positive relation with both S&P 500 membership and analyst following. However, previously noted book-to-market and size effects are eliminated once account is taken of the above characteristics.