Business 35911/Econ 39502 Spring 2007                                   

John H. Cochrane / Lars Hansen / John Heaton

Update April 4 2007

Reading List

The first three weeks of the class, taught by Cochrane, will be about liquidity and related issues.  Hansen and Heaton will follow, focusing on learning and on the intertemporal composition of risk. You can see the preliminary Hansen/Heaton reading list here.  There is a  Chalk website for the official and updated Hansen/Heaton reading list. 

Cochrane Reading list: 

Do the required readings before class.  I’m going to run the class as a reading group, asking you each randomly to present. 

Obviously, we are not going to go through every detail of every paper! Most of these papers make one or two empirical points that we can find while skimming through the rest. No, you will not be up until two in the morning reading papers if you take this class. Stay tuned to the website, I will make changes and give guidance as to which parts of which paper I think are important as the date approaches and as I re-read the papers myself.

Important copyright notice: PDF files are distributed for class use only. You may not redistribute them, post them on the web, etc. or you (and me) will get into big trouble. There are several sources for most files. Most external links require that you are connected through the university or via a proxy server. 

 

Week 1.  3com, palm, bubbles and convenience yield. This is the issue that got me interested in this literature. Maybe microstructure matters; maybe liquidity is not a matter of a few basis points after p=E(mx) is all done. Obviously, much of the course for me is devoted to seeing how much the “convenience yield” view explains of the rest of the literature. We’ll read 1 and 2 closely. Read 3 for the facts. I haven’t read 4 and 5 yet. Read 4 to contrast with 3, and 5 to see what standard price-volume facts are.

  1. Lamont Owen, and Richard Thaler 2003, “Can the Market Add and Subtract?: Mispricing in Tech-Stock Carve-Outs” Journal of Political Economy 111: 227-268 Link through JPE online edition

  2. Cochrane, John H., “Stock as Money: Convenience Yield and the Tech-Stock Bubble” Manuscript. (in William C. Hunter, George G. Kaufman and Michael Pomerleano, Eds., Asset Price Bubbles Cambridge: MIT Press 2003 ; NBER working paper 8987 )

  3. Mei, Jianping, José Scheinkman and Wei Xiong, 2005, “Speculative Trading and Stock Prices: Evidence from Chinese A-B Share Premia,” Manuscript, Princeton University. Link through Xiong’s website A lovely little case. I think it’s “convenience yield”. Note the correlation of price with volume.

  4. Fernald, John and John H. Rogers, 2002, “Puzzles in the Chinese stock market,” 84, 416-432, link through library, ebscohost. More facts. Do they disprove my interpretation or do they manage to miss the elephant in the room?

  5. Gallant, A. Ronald, Peter E. Rossi, George Tauchen, 1992, "Stock Prices and Volume," The Review of Financial Studies, 5, 199-242 JSTOR This is a standard article, listing a lot of volume-price relationships. They don’t see the “convenience yield,” but did they look, or do they contradict it?

  6. Cochrane, John, 2004, Liquidity, Trading and Asset Prices, NBER Reporter This is an overview paper. We won’t go through it in class, but you need to read it. It gives my organizing thoughts on both theory and empirical work, and thus where we’re going for the rest of this section of the class.

 

Week 2, Mon. Really this started in the bond market. I always dismissed liquidity as a few basis points, forgetting that a few basis points times 30 years can add up to a big price difference. Anyway, let’s see some of the effects in the clearest environment. 

  1. Boudoukh, Jacob, and Robert Whitelaw, 1991,"The Benchmark Effect in the Japanese Government Bond Market", 1991, Journal of Fixed Income, Vol. 1, No. 2, pp. 52-59.

  2. Boudoukh, Jacob, and Robert Whitelaw, 1993 "Liquidity as a Choice Variable: A Lesson From the Japanese Government Bond Market"  Review of Financial Studies, Vol. 6, No. 2, pp. 265-292.

  3. Krishnamurthy, Arvind, 2001, "The Bond/Old-Bond Spread," Journal of Financial Economics, 666, 463-506, Northwestern University Manuscript, author’s website. JFE via science direct. This is a study of the 29-5-30 year “convergence trade” that made LTCM so famous and (for a while) so rich. For us, the interesting fact is the existence of the “on the run – off the run” spread.

  4. Francis A. Longstaff   2004, "The Flight to Liquidity Premium in U.S. Treasury Bond Prices" Journal of Business 77, 511-526, 2004, Journal of Business  Longstaff website Contrasts treasury bonds with identical Refcorp bonds to isolate the liquidity premium.

  5. Krishnamurthy, Arvind, and Annette Vissing-Jorgenson, 2006, The Demand for Treasury Debt (author’s website)  Manuscript. The graph says it all, but do we believe it? Generations of researchers have found no “supply of debt” effect on interest rates.

 

Week 2, Wed. Limited liquidity is related to the idea that “demand curves slope down” at least in the short run, and at least in response to certain kinds of trades. Shleifer’s paper was one of the originals, noting that S&P500 inclusion boosts prices a bit. Hmm…there’s also a lot more volume in S&P500 firms because of arbitrage between the firm and the index and many funds who are sworn to track the index…

  1. Shleifer, Andrei, 1986, “Do Demand Curves for Stocks Slope Down?” The Journal of Finance, 41, 579-590. JSTOR

  2. Nicholas Barberis Andrei Shleifer  and Jeffrey Wurgler, 2005 “Comovement” Journal of Financial Economics,  75,  283-317   This follows up on Shleifer’s original, showing stocks start to move together more when they get included. ScienceDirect

  3. Harris, Lawrence and  Eitan Gurel, 1986, "Price and Volume Effects Associated with Changes in the S&P 500: New Evidence for the Existence of Price Pressure," Journal of Finance 41, 851-860. JSTOR (Note: We should look up some of the follow up literature and see how it works after cleaning up. See Mitchell et al footnote 1) 

  4. Mitchell, Mark, Todd Pulvino and Erik Stafford, 2004, “Price Pressure Around Mergers” Journal of Finance, 59, 31-63. Stafford’s websiteWhen A tries to buy B, a lot of traders try to buy B and short A. They claim that this lowers the price of A.

  5. Ofek, Eli, and Matthew Richardson, 2001, "Dot Com Mania: The Rise and Fall of Internet Stock Prices" Journal of Finance 63, Ofek website

  6. Schulz, Paul, “Downward sloping demand curves, the supply of shares and the collapse of internet prices,’” Manuscript, University of Notre Dame

  7. Mitchell, Mark, Lasse Heje Pedersen and Todd Pulvino, 2007, “Slow Moving Capital” NBER Working paper 12877. Price crashes can leave hedge funds needing to sell quickly. A good analysis of this phenomenon.

  8. Questions to structure class discussion

 

Week 3, Mon.  A stunning finding: prices really do rise when there is “buying pressure”, in a precise sense. But what does it mean?

  1. Martin D.D. Evans and Richard K. Lyons 2002, “Order Flow and Exchange Rate Dynamics”  Journal of Political Economy, 110: 170-180. JPE Skip the “model’’ Section 2.

  2. Brandt Michael and Kenneth A. Kavajecz, 2004, “Price Discovery in the U.S. Treasury Market” The impact of Orderflow and Liquidity on the Yield Curve” Journal of Finance 59, (Dec) 2623-2654. Read this one carefully. Stop reading at section III p. 2644.

  3. *DROPPED Froot, Kenneth. A., and Tarun Ramadorai 2005 "Currency Returns, Intrinsic Value, and Institutional Investor Flows." Journal of Finance  60, 1535-1566. JF

  4. *DROPPED Froot, Kenneth A., and Tarun Ramadorai 2007 "Institutional Portfolio Flows and International Investments." Review of Financial Studies  forthcoming

  5. Questions to structure class discussion

  

Week 3, Wed. Liquidity premia in stocks, expected return models.

Now that I've (re) read the papers, the class will cover only  Acharya and Petersen and Pastor and Stambaugh. Since both papers are  straightforward asset pricing model tests, I won't put up the formal "questions". I do want to think hard about how these tests are conducted: first of all, we have to understand clearly how each paper measures individual stock liquidity and then market liquidity, then how portfolios are formed, the characteristics of the portfolios, and then the nature of the asset pricing tests. Are they time series regressions, cross sectional regressions, with or without a free constant, is the spread in betas meaningful, do they properly test whether the additional factor helps to price assets, do you believe the betas, and so forth. So, be ready to discuss this standard range of issues. It's not easy, as the papers are not very clear about what they're doing, but it will be good practice for all of us to ferret this out.

  1. Pastor, Lubos, and Robert F. Stambaugh 2003, "Liquidity Risk and Expected Stock Returns" Journal of Political Economy 111, 642-685. JPE

  2. Brennan, Michael and Avanidhar Subrahmanyam, 1996, "Market Microstructure and Asset Pricing: On the Compensation for Illiquidity in Stock Returns,” Journal of Financial Economics 41, 441-464. ScienceDirect How are Pastor and Stambaugh different?

  3. Acharya, Viral V. and  Lasse H. Pedersen, 2005 “Asset pricing with liquidity risk” Journal of Financial Economics, 77, 375-410 ScienceDirect This one estimates the four kinds of correlation of price with liquidity. The “theory” assumes people live two days, a convenient but obviously, er, simplified motive for trade.

  4. Bekaert, Geert, Cambpell R. Harvey and Christian T. Lundblad “ Liquidity and Expected Returns: Lessons from Emerging Markets” Manuscript Lundblad’s website This is an interesting variation. They use zero daily returns as a signal of liquidity.

  5. Guillermo Llorente, Roni Michaely, Gideon Saar and Jiang Wang  2002, "Dynamic Volume-Return Relation of Individual Stocks" Review of Financial Studies 15(4): 1005-1047. JSTOR

 

Recommendations for further reading:

Theory papers. Get the structure of the model and the results, before you wade through the algebra. This is part of our culture in “what simplified models are people using to talk about liquidity?” A big question to ask is, “why do agents need to trade so much in the first place?” and then, “how does the model escape the no-trade theorem?”

  1. Longstaff, Francis, Asset Pricing in Markets with Illiquid assets Mansucript, UCAL.  Longstaff’s website Like two trees, but exogenously you can’t trade for a while.

  2. Vaynos, Dimitri, Equilibrium Interest Rate and Liquidity Premium With Transaction Costs, Economic Theory, 1999, 13, 509-539. (With Jean-Luc Vila) Overlapping generations, transaction costs, as the costs get larger liquidity premia emerge

  3. Vayanos, Dimitri, Flight to Quality, Flight to Liquidity, and the Pricing of Risk. Manuscript. Agents are managers facing drawdowns which makes then want liquidity.

  4. Vayanos, Dimitri and Tan Wang, Search and Endogenous Concentration of Liquidity in Asset Markets, Journal of Economic Theory, forthcoming. A search model that produces identical securities but one gets used for trading and is thus “overpriced”

  5. Andrew W. Lo, Harry Mamaysky and Jiang Wang 2004 “Asset Prices and Trading Volume Under Fixed Transactions Costs” Journal of Political Economy 112, 1054-90  JPE

  6. Hong, Harrison José Scheinkman Wei Xiong,  2006, "Asset Float and Speculative Bubbles" Journal of Finance 61, 1073-1117 xiong website A model following up on ofek and Richardson, and in the style of Xiong and Scheinkman their JPE model

  7. Scheinkman, José and Wei Xiong, 2003,  Overconfidence and Speculative Bubbles  Journal of Political Economy 111, 2003, 1183-1219.

 

3com palm also leads to a large literature on “short sales constraints”. The puzzle is, why are prices too high in the first place? Most of this literature just says there are (statically) optimists and pessimists, and that with short constraints only the optimist views are expressed. I want to know about trading volume, obviously! Anyway, here are some good papers with the facts.

  1. Lamont, Owen, (2004) “Go Down Fighting: Short Sellers vs. Firms” Manuscript, Yale University. Great stories and some remarkable alphas showing firms with short constraints are “overpriced.”

  2. Lamont, Owen, and Jeremy C Stein, "Aggregate Short Interest and Market Valuations"  American Economic Review, May 2004. Very short, and a useful reminder that short interest is the opposite of a short constraint.

  3. Charles Jones and Owen Lamont, “Short sale constraints and stock returns” Journal of Financial Economics,  66, 207-239 JFE website (only for subscribers) This paper looks at cool data from the 1920s when the short selling market was a lot better developed than it is now.  Jones’ website also has the data.

  4. Cohen, Lauren, Karl Diether and Christopher Malloy, 2006, “Supply and Demand Shifts in the Shorting Market” Forthcoming Journal of Finance. Link through Cohen’s website  One thing 3com palm made people more aware of was that you can make money lending out shares to shorts, so many large investors have a program of lending out shares. This paper looks at the short lending practices of a large passive fund that holds a lot of small hard to short stocks

 

Other papers, extensions of what we read: 

  1. Sadka, Ronnie, "Momentum and Post-Earnings-Announcement Drift Anomalies: The Role of Liquidity Risk" Journal of Financial Economics, SSRN: http://ssrn.com/abstract=428160 The next paper to read after Pastor and Stambaugh. Sadka’s website also has data on liquidity factors.

  2. Maureen O'Hara 2003, "Presidential Address: Liquidity and Price Discovery," Journal of Finance 58, 1335-1354. An overview of why Ohara thinks microstructure matters to the rest of finance.

  3. Bryan R. Routledge Stanley E. Zin  "Model Uncertainty and Liquidity" (Revision of NBER WP 8683). This adds model uncertainty to try to explain why trading collapses after big price drops. If you want something that unites Hansen style ambiguity aversion to liquidity, this is it.

  4. Garleanu, Nicolae, Darrell Duffie and Lasse Heje Pedersen 20002,  “Securities Lending, Shorting, and Pricing" Journal of Financial Economics vol. 66 (2002), pp. 307-339. A nice model of 3 com / palm in which it’s rational to buy a security to lend it to shorts. It gives a foundation for “convenience yield” – even the guy buying it to lend it to shorts, and the guy borrowing it in order to short it,  have to hold it for a while.

  5. Evans, Martin D. D. and Richard K. Lyons, 2005 Understanding Order Flow NBER working paper 11748. This is an ambitious model of the Evans-Lyons orderflow-exchange rate correlation.

 

More interesting-looking papers, completely unedited 

"The Impact of Different Players on the Volume-Volatility  Relation in the Foreign Exchange Market"

  Contact:  GEIR HOIDAL BJONNES

              The Norwegian School of Management BI

    Email:  GEIR.BJONNES@BI.NO

Auth-Page:  http://ssrn.com/author=245980

Co-Author:  DAGFINN RIME

              Central Bank of Norway, Norwegian University of

              Science and Technology (NTNU) - Department of

              Economics

    Email:  dagfinn.rime@norges-bank.no

Auth-Page:  http://ssrn.com/author=245983

Co-Author:  HAAKON SOLHEIM

              Norwegian Government

    Email:  Haakon.solheim@nhd.dep.no

Auth-Page:  http://ssrn.com/author=292478

 

Full Text:  http://ssrn.com/abstract=967749

 

ABSTRACT: We examine the volume-volatility relation in the foreign exchange (FX) market using a unique data set from the Swedish krona (SEK) market that contains observations of 90-95 percent of all transactions from 1995 until 2002. We show that the strength of the volume-volatility relation depends on the group of market participants trading. Financial trading volume has the highest correlation with volatility. Interbank trading between the largest Market making banks is also positively correlated with volatility, while trading among Other market making banks show no correlation with volatility. Trading by Non-Financial customers is not correlated with volatility at all when controlling for trading by other market participants.

Interestingly, we show that (unexpected) spot volume and changes in net positions (spot and forward) by Financial customers Granger cause spot volume and changes in net positions by Non-Financial customers. Our results clearly show that market participants in the FX market are heterogenous, suggesting that differences in trading strategies and information may explain the volume-volatility relation.

 

"Stock Market Decline and Liquidity"

     AFA 2007 Chicago Meetings Paper 

  Contact:  WENJIN KANG

              National University of Singapore - Department of

              Finance & Accounting

    Email:  bizkwj@nus.edu.sg

Auth-Page:  http://ssrn.com/author=399993

 Co-Author:  ALLAUDEEN HAMEED

              National University of Singapore - Department of

              Finance & Accounting

    Email:  allaudeen@nus.edu.sg

Auth-Page:  http://ssrn.com/author=50233

 Co-Author:  S. VISWANATHAN

              Duke University - Fuqua School of Business, Duke

              University - Department of Economics

    Email:  VISWANAT@MAIL.DUKE.EDU

Auth-Page:  http://ssrn.com/author=30633

 Full Text:  http://ssrn.com/abstract=889241

 

ABSTRACT: Recent theoretical work suggests that commonality in liquidity and variation in liquidity levels can be explained by supply side shocks affecting the funding available to financial intermediaries. Consistent with this prediction, we find that liquidity levels and commonality in liquidity respond asymmetrically to positive and negative market returns. Stock liquidity decreases while commonality in liquidity increases following large negative market returns. We document that a large drop in aggregate value of securities creates greater liquidity commonality due to the inter-industry spill-over effects of capital constraints. We also show that the cost of supplying liquidity is highest following market downturns by examining the correlation between short-term price reversals on heavy trading volume and market states. These results cannot be explained by imbalances in buy-sell orders, institutional trading and market volatility which may proxy for changes in demand for liquidity.

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