Academic journal article NBER Reporter

Asset Pricing: Liquidity, Trading, and Asset Prices

Academic journal article NBER Reporter

Asset Pricing: Liquidity, Trading, and Asset Prices

Article excerpt

Members of the NBER's Asset Pricing Program produce over 100 working papers in a typical year. These papers are spread over an astonishing range of topic areas. Naming the papers written in the four and a half years since the last program report, let alone providing any sort of intelligible summary of their contents, would quickly fill the available space and exhaust the most dedicated reader's patience. Therefore, I'll describe in depth one area that strikes me as particularly interesting and that may be novel to likely readers of this report. I proceed with an apology to all the authors whose papers are thus omitted. In addition, I confine myself to papers in the NBER Working Paper series or presented at Asset Pricing Program Meetings in the last four and a half years. I apologize in advance to non-NBER authors and to authors of older papers whose work should be discussed in a comprehensive literature review.

My focus here goes by a variety of names, including liquidity, trading, volume, market frictions, short-sales constraints, and limits to arbitrage. For a long time, there has been an implicit separation of effort in asset pricing: Researchers operating in the frictionless macroeconomics--based tradition study the broad level of prices, while researchers in the market microstructure tradition--filled with non-Walrasian trading, asymmetric information; and so on--pretty much study small (but interesting) refinements, where prices fall in the bid-ask spread rather than where the spread is in the first place.

Recently, this separation has begun to erode. At one level, this erosion is the beginning of a long-expected understanding of trading and volume. The classic theory of finance has no volume at all: prices adjust until investors are happy to continue doing what they were doing all along, holding the market portfolio. Simple modifications, such as lifecycle and rebalancing motives, don't come near to explaining observed volume. Put bluntly, the classic theory of finance predicts that the NYSE and NASDAQ do not exist. Lifecycle stock trading could be handled at a retail level, like (say) life insurance. The markets exist to support high frequency trading. They are at bottom markets of information (or, some might say, opinion), not really markets for stocks and bonds.

Now, perhaps prices are set as if volume is zero, and then volume and the attendant microstructure issues can be studied separately. But perhaps not; perhaps volume, trading, liquidity, and market structure effects spill over to affect the level of prices. This is the issue I focus on. I start with empirical work, and follow with economic modeling that tries to understand the emerging set of facts.

Empirical Work

3Com, Palm and Convenience Yield

Work by Owen A. Lamont and Richard H. Thaler most vividly brought this constellation of ideas to my attention. They start with the case of 3Com and Palm. On March 2, 2000, 3Com sold 5 percent of Palm in an initial public offering. 3Com retained about 95 percent of the shares, and announced that it would distribute those shares to 3Com shareholders by the end of the year at about 1.5 shares per one 3Com share. Thus, one could obtain 150 Palm shares in two ways: buy 150 Palm shares directly or buy 100 3Com shares and end up in six months with 150 Palm as well as 100 3Com.

Surely the latter strategy should cost more. But in fact, the latter strategy was cheaper. Palm prices exploded, 3Com prices fell, and at the end of the first day of trading the "stub value" of 3Com shares (the value of 3Com less the embedded Palm shares) was negative $63! This violation of the law of one price lasted for quite a while, as shown in Lamont and Thaler's Figure 3. The event was not unique. Lamont and Thaler study six additional cases of persistent negative stub values in a carve-out followed by a spin-off.

Lamont and Thaler carefully document that these events did not present exploitable arbitrage opportunities. …

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