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Abstract:
Using a novel information asymmetry index based on measures of adverse selection developed by the market microstructure literature, we test whether information asymmetry is an important determinant of capital structure decisions, as suggested by the pecking order theory. Our index relies exclusively on measures of the market's assessment of adverse selection risk rather than on ex ante firm characteristics. We find that information asymmetry does affect the capital structure decisions of U.S. firms over the sample period 1973-2002. Our findings are robust to controlling for conventional leverage factors (size, tangibility, Q ratio, profitability), the sources of firms' financing needs, and such firm attributes as stock return volatility, stock turnover, and intensity of insider trading. For example, we estimate that on average, for every dollar of financing deficit to cover, firms in the highest adverse selection decile issue 30 cents of debt more than firms in the lowest decile. Overall, this evidence explains why the pecking order theory is only partially successful in explaining all of firms' capital structure decisions. It also suggests that the theory finds support when its basic assumptions hold in the data, as should reasonably be expected of any theory.

G32

Abstract:
Using a novel information asymmetry index based on measures of adverse selection developed by the market microstructure literature, we test if information asymmetry is an important determinant of capital structure decisions, as suggested by the pecking order theory. Our index relies exclusively on measures of the market's assessment of adverse selection risk rather than on ex ante firm characteristics. We find that information asymmetry does affect the capital structure decisions of U.S. firms over the sample period 1973-2002. Our findings are robust to controlling for conventional leverage factors (size, Q ratio, tangibility, profitability) and several firm attributes, such as funding needs, sales growth, real investment, stock return volatility, stock turnover, and intensity of insider trading. For example, we estimate that on average, for every dollar of financing deficit to cover, firms in the highest adverse selection decile issue 30 cents of debt more than firms in the lowest decile. Overall, this evidence explains why the pecking order theory is only partially successful in explaining all of firms' capital structure decisions. It also suggests that the theory finds support when its basic assumptions hold in the data, as it should reasonably be expected of any theory.

Pecking Order Theory, Capital Structure, Information Asymmetry

Abstract:
This paper analyzes the intra-day relationship between bid-ask spreads and "market" return volatility for U.S. Dollar/Deutschemark quotes. We are able to identify a statistically and economically significant "Reverse U-shaped" pattern in the bid-offer spread in 1996. Tests of the stability and ordering of "market" volatility, performed across several different fractions of the day, reveal that variances of intra-day returns are heterogeneous and ordered, declining around the Asian lunch break, increasing steadily during the London morning trading hours, peaking at the opening of New York to subsequently fall with the closing of the European markets. Results also indicate that "market" volatility is significantly higher during intra-day versus overnight periods. Then, we introduce a structural model that attempts to explain those empirical regularities by capturing some currency-specific features of the data: possibly asymmetric and stochastic trading cost structure, discrete directional updates and parameters' temporal heterogeneity, and by relating the bid-ask spread to different sources of random noise. We evaluate these parameters via GMM using a set of convenient unconditional intra-day moments implied by the basic configuration of the model. Analysis of the resulting estimated patterns reveals that trading costs play a significant role in explaining the intra-day variability of bid and offer currency returns. Inventory considerations appear to be more relevant in the trading morning, while the perceived risk of arrival of informed trades seems more likely to affect the dealers' cost structure in the afternoon. The contribution of the "true" currency risk to the total variability of posted bid and ask quotes' returns is not surprisingly highest with the opening of the European markets.

Market microstructure, exchange rate, bid-ask spread, GMM

Abstract:
This paper is an empirical investigation of the excess comovement of industry indexes in the U.S. stock market over the period January 1973 to December 2001. We define excess comovement as the correlation between two assets beyond what could be explained by fundamental factors. In our analysis, the fundamental factors are sector groupings and the three Fama-French factors. We then estimate excess comovement as the mean absolute correlation of residuals of univariate (OLS) or joint (FGLS) regressions of these fundamentals on industry returns. We show that excess unconditional comovement is surprisingly high (a lower bound of 0.134 and an upper bound of 0.357) and represents between 31% and 83% of the average raw absolute correlation. Excess comovement is also consistently significant across industries and over our entire sample interval. Furthermore, we find that the degree of excess comovement is symmetric, i.e., not significantly different in rising or falling markets. We explain approximately 21% of this excess correlation by its positive relation to market volatility, and reveal a negative relation of its lower bound to the level of the short-term interest rate.

Contagion, Excess Comovement, Correlation

Abstract:
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 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. For that purpose, we estimate several extensions of the parsimonious amended GARCH model of Engle (2002) for the excess holding-period returns on seven portfolios of these asset classes. We find that the process of price formation in the U.S. financial markets appears to be driven by fundamentals; yet, excessive volatility and comovement play an important role in return dynamics as well. Further, 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. However, we also show that stock and bond returns tend to react to the expected component of these announcements. This evidence casts some doubts on the efficiency of the U.S. financial markets with respect to widely anticipated and tracked releases of macroeconomic data. Overall, the above results often differ from earlier studies where the surprise portion of those releases was not identified, and shed new light on the mechanisms by which information is incorporated into prices.

Volatility, comovement, information, market efficiency

Abstract:
This paper analyzes the structural relationship between currency and equity markets in ten Far Eastern countries during the recent Asian crisis. This analysis is done separately for returns and for volatilities. Using a new statistical technology for identifying regime shifts, we are able to demonstrate how information shocks in these markets moved from country to country in the 1992-1998 time period. We also create confidence intervals for when the most significant regime shifts occurred in each country. We find that volatility breaks occur prior to return breaks; more specifically, shifts in the volatility structure occurred in fall 1997 for most countries in our sample, while most shifts in the return structure occurred in mid 1998. The sequential nature of the observed regime shifts is consistent with the notion that return and volatility linkages among Asian markets were created by information spillover effects. Our study also shows that the negative relationship between volatility and returns found by French, Schwert and Stambaugh (1987) for the U.S. market holds for Asian markets. Furthermore, our results indicate that the information shocks in this crisis are related more to equity market movements, in particular, capital flight, than to foreign exchange shocks. An analysis of flow of funds data provides further evidence that information spillover or herding effects generate the observed return and volatility relationships among these countries.

Regime shifts, asian crisis, information spillover, exchange rates

Abstract:
We study the impact of Central Bank intervention on the microstructure of currency markets. We analyze the two major channels of effectiveness of currency management policies, imperfect substitutability and signaling, in a model of sequential trading in which the stylized monetary authority is a rational but not necessarily profit-maximizing player. In the context of our model and consistently with the available empirical literature, intervention has long-lived effects on quotes when informative about policy objectives and economic fundamentals, or when the threat of future government action is significant and credible. A monetary authority attempting to lean against the wind or to chase the trend of the domestic currency is more successful when dealers compete against each other for the incoming trades. The resulting process of intraday price formation and bid-ask spreads are shown to depend crucially on the degree of market power held by the forex dealers, on the sign and magnitude of the announced and realized intervention, on the perceived likelihood of a future intervention to occur, on the transparency of the order flow induced by the intervention, on the direction and heterogeneity of agents' beliefs and expectations, and on the elasticity of risk-averse investors' demand for foreign currency-denominated assets.

Abstract:
We propose a novel theory of the impact of expected, non-secret, sterilized spot interventions on the microstructure of currency markets that focuses on their liquidity. We analyze the effectiveness of intervention operations in a model of sequential trading in which: i) a rational Central Bank faces a trade-off between policy motives and wealth-maximization, ii) currency dealers' sole objective is to provide immediacy at a cost while maintaining a driftless expected foreign currency position, and iii) adverse selection, inventory, signaling, and portfolio balance considerations are absent by construction. In this setting, and consistent with available empirical evidence, we find that the mere likelihood of a future intervention is sufficient to generate endogenous effects on exchange rate levels, to increase exchange rate volatility, and to impact bid-ask spreads. Intuitively, in the presence of occasional intervention operations, currency dealers (whether monopolistic or perfectly competitive) revise their posted quotes at the beginning of every round of trading for a dual purpose: i) to elicit investors' order flow to take the other side of the potential government trade and ii) to simultaneously reduce its expected magnitude by pushing the exchange rate closer to the announced target level. Quote revisions are generally asymmetric, effectiveness of intervention is greater, and exchange rate volatility rises under competitive dealership, since the lack of market power induces the dealers to pass any expected additional rent from potential intervention operations to the incoming investors. These effects are either exacerbated or assuaged depending on the extent of the Central Bank's policy trade-off, and either temporary or persistent depending on whether such is the threat of its future actions.

Foreign Exchange, Central Bank Intervention, Market Microstructure, Liquidity, Volatility, Bid-Ask Spread

Abstract:
We propose a novel theory of the impact of expected, non-secret, sterilized spot interventions on the microstructure of currency markets that focuses on their liquidity. We analyze the effectiveness of intervention operations in a model of sequential trading in which: i) a rational Central Bank faces a trade-off between policy motives and wealth-maximization, ii) currency dealers' sole objective is to provide immediacy at a cost while maintaining a driftless expected foreign currency position, and iii) adverse selection, inventory, signaling, and portfolio balance considerations are absent by construction. In this setting, and consistent with available empirical evidence, we find that the mere likelihood of a future intervention is sufficient to generate endogenous effects on exchange rate levels, to reduce exchange rate volatility, and to impact bid-ask spreads. Intuitively, in the presence of occasional intervention operations, currency dealers (whether monopolistic or perfectly competitive) revise their posted quotes at the beginning of every round of trading for a dual purpose: i) to elicit investors' order flow to take the other side of the potential government trade and ii) to simultaneously reduce its expected magnitude by pushing the exchange rate closer to the announced target level. Quote revisions are generally asymmetric, effectiveness of intervention is greater, and exchange rate volatility is lower under competitive dealership, since the lack of market power induces the dealers to pass any expected additional rent from potential intervention operations to the incoming investors. These effects are either exacerbated or assuaged depending on the extent of the Central Bank's policy trade-off, and either temporary or persistent depending on whether so is the threat of its future actions.

Abstract:
We analyze the role private and public information play in the U.S. Treasury bond price discovery process. To guide our analysis, we develop a parsimonious model of speculative trading in the presence of two realistic market frictions, information heterogeneity and imperfect competition among informed traders. We test its equilibrium implications by studying the response of 2-year, 5-year, and 10-year U.S. bond yields to order flow and real-time U.S. macroeconomic news. Consistent with the stylized model, we find that unanticipated order flow explains a bigger portion of bond yield changes when the dispersion of beliefs across informed traders is high and public announcements are noisy.

Macroeconomic news announcements, strategic trading, market microstructure, order flow, real-time data, expectations, dispersion of beliefs

Abstract:
We study the impact of Central Bank intervention on the process of price formation in currency markets. We use a unique dataset of tick-by-tick indicative quotes posted by dealers on Reuters terminals and of intraday sterilized spot interventions and customer transactions executed on behalf of the Swiss National Bank (SNB) on the Swiss Franc/U.S. Dollar exchange rate (CHFUSD) between 1986 and 1998. We find that SNB interventions (but not ex post uninformative customer transactions), although being smaller than typical forex trades, had significant and persistent (albeit asymmetric, depending on their sign) effects on daily currency returns, especially when (relatively) large in magnitude, expected by the market, or inconsistent with existing momentum. The market did not anticipate the occurrence of incoming interventions, unless if chasing the trend. The SNB was much less successful in smoothing fluctuations of the currency, for daily CHFUSD volatility always surged in proximity of interventions, as did average absolute and proportional spreads. Decomposition of estimated absolute spread shocks also reveals that SNB actions induced misinformation among market participants, impacted current market liquidity, increased competition among dealers, and reduced trading immediacy. In many cases, these changes translated into higher transaction costs borne by the population of investors.

Sterilized Central Bank Intervention; Market Microstructure; Foreign Exchange; Information; Inventory

Abstract:
We study the determinants of liquidity and price differentials between on-the-run and off-the-run U.S. Treasury bond markets. To guide our analysis, we develop a parsimonious model of multi-asset speculative trading in which endowment shocks separate the on-the-run security from an otherwise identical off-the-run security. We then explore the equilibrium implications of these shocks on both off/on-the-run price and liquidity differentials in the presence of two realistic market frictions - information heterogeneity and imperfect competition among informed traders - and a public signal. We test these implications by analyzing daily differences in market liquidity and yields for on-the-run and off-the-run three-month, six-month, and one-year U.S. Treasury bills and two-year, five-year, and ten-year U.S. Treasury notes. Our evidence suggests that i) off/on-the-run bid-ask spread differentials are economically and statistically significant, even after controlling for differences in several of the bonds' intrinsic characteristics (such as duration, convexity, or repo rates); ii) their corresponding yield differentials are neither, inconsistent with the illiquidity premium hypothesis; and iii) off/on-the-run liquidity differentials are larger for bonds of shorter maturity, immediately following bond auction dates, when the uncertainty surrounding the ensuing auction allocations is high, when the dispersion of beliefs across informed traders is high, and when macroeconomic announcements are noisy, consistent with our stylized model.

Treasury Bond Markets, Strategic Trading, Market Microstructure, Liquidity, Order Flow, On-The-Run Bonds, Off-The-Run Bonds, Macroeconomic News Announcements, Expectations, Dispersion of Beliefs

Abstract:
This study examines the reaction of the financial markets to the terrorist attack on the World Trade Center and how their behavior compared to the subsequent resolution in the corresponding real asset markets. This event provides an ideal setting to evaluate the accuracy of the market's reaction to external shocks since, unlike almost all studies of economic events, this tragedy was certainly unanticipated and thus absent from pre-existing market expectations, its overall impact was unclear, and the subsequent week of market closure gave market participants sufficient time to sort out the complex impact of the event on market prices. Our analysis of Real Estate Investment Trusts (REITs) with New York office exposure outside of the downtown area shows that, during the period of market closure and the first trading day, the equity market did not accurately anticipate how this event would impact office REITs. Specifically, we find that REITs with significant exposure to the New York market showed significant gains relative to REITs without New York exposure (an average difference of 4.057% of market value from the close on September 10 to the opening on September 17), and that this abnormal return disappeared only in November 2001. However, an examination of the underlying real asset market's performance over the first few months after September 11 shows that New York properties significantly under-performed similar office properties in the U.S. This evidence provides little support for the notion that financial markets can rapidly and correctly price significant shocks to the underlying economy.

Abnormal Returns, Market Over-Reaction, Nonresidential Real Estate, REITs

Abstract:
This study examines how heterogeneity of private information may induce financial contagion. Using a model of multi-asset trading in which the three main channels of contagion through financial linkages in the literature (correlated information, correlated liquidity, and portfolio rebalancing) are ruled out by construction, I show that financial contagion can still be an equilibrium outcome when speculators receive heterogeneous fundamental information. Risk-neutral speculators trade strategically across many assets to mask their information advantage about one asset. Asymmetric sharing of information among them prevents rational market makers from learning about their individual signals and trades with sufficient accuracy. Incorrect cross-inference about terminal payoffs and contagion ensue. When used to analyze the transmission of shocks across countries, my model suggests that the process of generation and disclosure of information in emerging markets may explain their vulnerability to financial contagion.

Abstract:
Financial contagion is the propagation of a shock to one security across other fundamentally unrelated securities. In this paper, we examine how heterogeneity of insiders' information about fundamentals may induce excess comovement among asset prices, i.e., beyond the extent justified by the structure of the economy. We develop a model of multi-asset trading, populated by a number of informed strategic speculators facing a trade-off between the maximization of short- versus long-term utility of their wealth, uninformed market-makers, and liquidity traders, in which the liquidation values of the available securities depend on idiosyncratic as well as systematic sources of risk. We show that, even in a setting where such insiders are rational, risk-neutral, and financially unconstrained, financial contagion can be an equilibrium outcome of a semi-strong efficient market, if and only if they receive heterogeneous information about those sources of risk and strategically trade on it. Rational market-makers use the observed aggregate order flow to update their beliefs about the random terminal payoffs of the assets. Imperfectly competitive speculators engage in portfolio rebalancing activity to mask their information advantage. Asymmetric sharing of information among insiders prevents the market-makers from learning about their individual signals and trades with sufficient accuracy. Incorrect cross-inference about fundamentals and contagion then ensue. When used to analyze the transmission of shocks across countries, our model suggests that more adequate regulation of the process of generation and disclosure of information in emerging markets may reduce their vulnerability to international financial contagion.

Contagion, Strategic Trading, Information Heterogeneity

Abstract:
The recent episodes of financial turmoil in Mexico, East Asia, Russia, Brazil, and Argentina are often dubbed financial crises. However, the severe downturns in equity markets, abrupt currency devaluations, and massive capital flight that characterize these events can still be deemed compatible with efficient and functioning financial markets. Thus, why is a financial crisis a "crisis?" To answer this question, we conduct an empirical investigation of the efficiency and pricing of the emerging ADR market. More specifically, using a non-parametric technique, we test for regime shifts in two basic structural relationships for ADR returns in 20 emerging countries, identified via arbitrage and capital mobility considerations. We find that "normal" market conditions were violated in proximity of financial crises: The law of one price often ceased to hold, and domestic sources of risk became more important for many depositary receipts in our sample. We also find that some popular explanations for the occurrence of financial crises in emerging economies, in particular uncertainty among investors, exchange rate volatility, economic integration, and liquidity (but not financial integration, currency devaluations, or capital flight) made their equity markets less efficient as well. Based on this evidence, we can state with greater confidence that those episodes of financial turmoil were indeed "crises."

Regime Shifts, Financial Crises, ADRs, Market Efficiency

Abstract:
This study analyzes how three groups of market participants - insiders, analysts, and investors - revised their expected returns on New York Real Estate Investment Trusts (REITs) in response to the catastrophic events of September 11, 2001. The attack on the WTC represents a unique experimental setting to evaluate financial markets' reaction to external shocks for several reasons. First, these events, of a totally unanticipated and unprecedented nature, could not have been built into the market's expectations; hence, market participants had to learn something new rather than just recalibrate their expectations on past occurrences. Second, unlike other studies of market reactions, the impact of the terrorist attacks on REIT returns was ambiguous, since it was uncertain if the effect of reduced supply of office space in New York would outweigh the impact of the negative shocks to the local and national economy on its demand. Finally, the period of market closure that followed 9/11 gave these players ample opportunity to reassess their expectations. Our analysis reveals that, on the day when markets reopened, REITs with significant exposure to the New York area outperformed a broad REIT office index by 4.1%. However, we find that, according to several metrics of real market behavior, this anticipated superior performance of New York office properties did not materialize. Consistent with notions of market efficiency, we find that insiders were the first to lower their expectations (99.9% of their trades in REITs with New York exposure were sales in the month following 9/11), followed by analysts (the vast majority of them revised downward their expectations of NY REIT performance in the first weeks of November 2001), and finally market prices adjusted to reflect the underlying real market behavior; indeed, abnormal REIT returns had disappeared by mid November 2001.

Abnormal Returns, Market Over-Reaction, Nonresidential Real Estate, REITs

Abstract:
We study equilibrium trading strategies, market liquidity, and price efficiency in an economy in which a fraction of better-informed speculators displays preferences consistent with Kahneman and Tversky's (1979) Prospect Theory, i.e., loss aversion, risk seeking over losses, and nonlinear and asymmetric probability weighting (in the spirit of Jullien and Salanie, 2000). Loss aversion induces those speculators to trade more cautiously, while risk seeking induces them to trade more aggressively, with their private signals. We demonstrate that the latter effect dominates the former in equilibrium, leading to lower and (because of procyclical subjective loss probabilities) countercyclical adverse selection-based market liquidity and higher price efficiency. We also find that the presence of those speculators affects the extent to which the release of public news about the traded asset's terminal payoff improves adverse selection-based market liquidity and price efficiency and makes such improvement procyclical.

Prospect Theory, Market Liquidity, Price Efficiency, Adverse Selection, Loss Aversion, Risk Seeking, Probability Weighting

Abstract:
The problem of measuring the precision of signals generated by fundamental macroeconomic models is not trivial. In this paper we suggest three different approaches for the estimation of the true and unknown distribution of the population signal. We focus on two applications of the Bootstrapping procedure described by Efron and Tibshirani (1986) to estimate the empirical distribution of the signal and measure its precision at a specific point in time with confidence intervals. Direct and Indirect Bootstrapping methods are devised as a way to capture the unknown variability of the signal without altering the information content of the historical data. We implement this framework for a simple fundamental model for the CAD/$ exchange rate. The results lead to the exclusion of a naive Historical approach from the analyst's set of options, for it does not satisfy the need for a measure of precision in the model's recommendations. No clear-cut selection criterion seems to be available in selecting between the two proposed forms of Bootstrapping. Factor-decomposition in the confidence-interval generation procedure is suggested as an additional analysis tool.

Abstract:
The problem of measuring the precision of signals generated by fundamental macroeconomic models is not trivial. In this paper we suggest three different approaches for the estimation of the true and unknown distribution of the population signal. We focus on two applications of the Bootstrapping procedure described by Efron and Tibshirani (1986) to estimate the empirical distribution of the signal and measure its precision at a specific point in time with confidence intervals. Direct and Indirect Bootstrapping methods are devised as a way to capture the unknown variability of the signal without altering the information content of the historical data. We implement this framework for a simple fundamental model for the CAD/$ exchange rate. The results lead to the exclusion of a naive Historical approach from the analyst's set of options, for it does not satisfy the need for a measure of precision in the model's recommendations. No clear-cut selection criterion seems to be available in selecting between the two proposed forms of Bootstrapping. Factor-decomposition in the confidence-interval generation procedure is suggested as an additional analysis tool.

Exchange rate forecasting, bootstrapping, factor decomposition

Abstract:
We study the role played by private and public information in the process of price formation in the U.S. Treasury bond market. To guide our analysis, we develop a parsimonious model of speculative trading in the presence of two realistic market frictions - information heterogeneity and imperfect competition among informed traders - and a public signal. We test its equilibrium implications by analyzing the response of two-year, five-year, and ten-year U.S. bond yields to order flow and real-time U.S. macroeconomic news. We find strong evidence of informational effects in the U.S. Treasury bond market: unanticipated order flow has a significant and permanent impact on daily bond yield changes during both announcement and non-announcement days. Our analysis further shows that, consistent with our stylized model, the contemporaneous correlation between order flow and yield changes is higher when the dispersion of beliefs among market participants is high and public announcements are noisy.

Treasury Bond Markets, Macroeconomic News Announcements, Strategic Trading, Market Microstructure, Order Flow, Real-Time Data, Expectations, Dispersion of Beliefs

Abstract:
We provide a theory and novel empirical evidence of cross-price impact -- the permanent impact of informed trades in one asset on the prices of other (either related or fundamentally unrelated) assets -- in the U.S. stock market. To guide our analysis, we develop a parsimonious model of multi-asset trading in the presence of two realistic market frictions -- information heterogeneity and imperfect competition among informed traders -- but in which extant channels of trade and price co-formation in the literature are ruled out by construction. In that setting, we show cross-price impact to be the equilibrium outcome of strategic trading activity of risk-neutral speculators across many assets to mask their information advantage about some other assets. We find strong evidence of cross-asset informational effects in a comprehensive sample of the trading activity in NYSE and NASDAQ stocks between 1993 and 2004: Net order flow in one industry or random stock has a significant, persistent, and robust impact on daily returns of other industries or random stocks. Our empirical analysis further indicates that, consistent with our stylized model, both direct (i.e., an asset's own) and absolute cross-price impact are i) smaller when speculators are more numerous; ii) greater when marketwide dispersion of beliefs is higher; iii) greater among stocks dealt by the same specialist; and iv) smaller when macroeconomic news of good quality is released.

Equity Market, Market Liquidity, Strategic Trading, Information Heterogeneity, Public News

Abstract:
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 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. For that purpose, we estimate several extensions of the parsimonious amended GARCH model of Engle (2002) for the excess holding-period returns on seven portfolios of these asset classes. We find that the process of price formation in the U.S. financial markets appears to be driven by fundamentals; yet, "excessive" volatility and comovement play an important role in return dynamics as well. Further, 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. However, we also show that stock and bond returns tend to react to the expected component of these announcements. This evidence casts some doubts on the efficiency of the U.S. financial markets with respect to widely anticipated and tracked releases of macroeconomic data. Overall, the above results often differ from earlier studies where the surprise portion of those releases was not identified, and shed new light on the mechanisms by which information is incorporated into prices.

Abstract:
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 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. Forthat purpose, we estimate several extensions of the parsimonious amended GARCH model of Engle (2002) for the excess holding-period returns on seven portfolios of these asset classes. We find that the process of price formation in the U.S. financial markets appears to be driven by fundamentals; yet, "excessive" volatility and comovement play an important role in return dynamics as well. Further, 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. However, we also show that stock and bond returns tend to react to the expected component of these announcements. Overall, the above results often differ from earlier studies where the surprise portion of those releases was not identified, and shed new light on the mechanisms by which information is incorporated into prices.

Volatility, Comovement, Information, Market Efficiency

Abstract:
We study the impact of Central Bank intervention on the process of price formation in currency markets. We use a unique dataset of tick-by-tick indicative quotes posted by dealers on Reuters terminals and of intraday sterilized spot interventions and customer transactions executed on behalf of the Swiss National Bank (SNB) on the Swiss Franc/U.S. Dollar exchange rate (CHFUSD) between 1986 and 1998. We find that potentially informative SNB interventions (but not ex post uninformative customer transactions), although small relative to daily trading volumes in the CHFUSD market, had significant and persistent (albeit asymmetric, depending on their sign) effects on daily currency returns, especially when (relatively) large in magnitude, expected by the market, or inconsistent with existing momentum. The market did not anticipate the occurrence of incoming interventions un-less if chasing the trend. The SNB was much less successful in smoothing fluctuations of the currency, for daily CHFUSD volatility always surged in proximity of interventions, as did average absolute and proportional spreads. Decomposition of estimated absolute spread shocks also reveals that SNB actions induced misinformation among market participants, impacted trading immediacy, and increased market liquidity and competition among dealers. Many of these changes translated into higher transaction costs borne by the population of investors.

Sterilized Central Bank Intervention, Market Microstructure, Foreign Exchange, Information, Inventory

Abstract:
This study analyzes how three groups of market participants - insiders, analysts, and investors - revised their expected returns on New York Real Estate Investment Trusts (REITs) in response to the catastrophic events of September 11, 2001. The attack on the WTC represents a unique experimental setting to evaluate financial markets' reaction to external shocks for several reasons. First, these events, of a totally unanticipated and unprecedented nature, could not have been built into the market's expectations; hence, market participants had to learn something new rather than just recalibrate their expectations on past occurrences. Second, unlike other studies of market reactions, the impact of the terrorist attacks on REIT returns was ambiguous, since it was uncertain if the effect of reduced supply of office space in New York would outweigh the impact of the negative shocks to the local and national economy on its demand. Finally, the period of market closure that followed 9/11 gave these players ample opportunity to reassess their expectations. Our analysis reveals that, on the day when markets reopened, REITs with significant exposure to the New York area outperformed a broad REIT office index by 4.1%. However, we find that, according to several metrics of real market behavior, this anticipated superior performance of New York office properties did not materialize. Consistent with notions of market efficiency, we find that insiders were the first to lower their expectations (99.9% of their trades in REITs with New York exposure were sales in the month following 9/11), followed by analysts (the vast majority of them revised downward their expectations of NY REIT performance in the first weeks of November 2001), and finally market prices adjusted to reflect the underlying real market behavior; indeed, abnormal REIT returns had disappeared by mid November 2001.

Abnormal Returns, Market Over-Reaction

Abstract:
We study the impact of Central Bank intervention on the process of priceformation in currency markets. We use a unique dataset of tick-by-tick indicativequotes posted by dealers on Reuters terminals and of intraday sterilized spot interventions and customer transactions executed on behalf of the Swiss National Bank (SNB) on the Swiss Franc/U.S. Dollar exchange rate (CHFUSD) between 1986 and 1998. We find that potentially informative SNB interventions (but not ex post uninformative customer transactions), although small relative to daily trading volumes in the CHFUSD market,had significant and persistent (albeit asymmetric, depending on their sign)effects on daily currency returns, especially when (relatively) large in magnitude,expected by the market, or inconsistent with existing momentum. The market did not anticipate the occurrence of incoming interventions unless if chasing the trend. The SNB was much less successful in smoothingfluctuations of the currency, for daily CHFUSD volatility always surged inproximity of interventions, as did average absolute and proportional spreads.Decomposition of estimated absolute spread shocks also reveals that SNB actionsinduced misinformation among market participants, impacted trading immediacy, and increased market liquidity and competition among dealers. Many of these changes translated into higher transaction costs borne by the population of investors.

Sterilized Central Bank Intervention, Market Microstructure, Market Microstructure, Information, Inventory

Abstract:
We study the determinants of liquidity differentials between on-the-run and off-the-run U.S. Treasury bonds. To guide our analysis, we develop a parsimonious model of multi-asset speculative trading in which endowment shocks separate the on-the-run security from an otherwise identical off-the-run security. We then explore the equilibrium implications of these shocks on off/on-the-run liquidity differentials in the presence of two realistic market frictions - information heterogeneity and imperfect competition among informed traders - and a public signal. We test these implications by analyzing daily averages of intraday differences in bid-ask spreads for on-the-run and off-the-run three-month, six-month, and one-year U.S. Treasury bills and two-year, five-year, and ten-year U.S. Treasury notes. Our evidence suggests that i) off/on-the run liquidity differentials are economically and statistically significant, even after controlling for several of the bonds' intrinsic characteristics (such as duration, convexity, repo rates, or term premia), and ii) off/on-the-run liquidity differentials are smaller immediately following bond auction dates, and larger when the uncertainty surrounding the ensuing auction allocations is high, when the dispersion of beliefs across informed traders is high, and when macroeconomic announcements are noisy, consistent with our stylized model.

Treasury Bond Markets, Strategic Trading, Market Microstructure, Liquidity, Order Flow, On-The-Run Bonds, Off-The-Run Bonds, Macroeconomic News Announcements, Expectations, Dispersion of Beliefs

Abstract:
This study addresses the recent performance of the U.S. residential real estate markets. We investigate the comovement among Case-Shiller Home Price Indices for 14 metropolitan areas between 1992 and 2008. We identify the portion of this comovement deemed as fundamental (excessive), which we define as the covariation that can (cannot) be attributed to common fundamental factors directly influencing real estate prices. We find that the degree of comovement in these markets increased over the sample period, most significantly so in the late 1990s, but that this increase is largely due to systematic sources of risk; the degree of excess comovement is a less important factor. Further analysis indicates that the dynamics of comovement among metropolitan U.S. residential real estate markets within the sample period are mostly attributable to underlying systematic real and financial factors, consistent with a greater fundamental integration of those markets. We discuss the implications of these results for the evolution of U.S. real estate prices over the last two decades and the ongoing credit crisis.

Real Estate, Correlation, Contagion, Housing Bubble, Credit Crisis