39502 Spring 2007
John H. Cochrane / Lars Hansen / John Heaton
Update April 4 2007
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.
Owen, and Richard Thaler 2003, “Can the
Market Add and Subtract?: Mispricing in Tech-Stock Carve-Outs” Journal of Political Economy 111:
through JPE online edition
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 )
Jianping, José Scheinkman and Wei Xiong, 2005, “Speculative Trading and Stock Prices:
Evidence from Chinese A-B Share Premia,” Manuscript, Princeton University.
Xiong’s website A lovely little case. I think it’s “convenience
yield”. Note the correlation of price with volume.
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?
A. Ronald, Peter E. Rossi, George Tauchen, 1992, "Stock Prices and Volume," The Review of Financial Studies, 5,
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
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
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.
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.
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”
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.
- 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…
Andrei, 1986, “Do Demand Curves
for Stocks Slope Down?” The Journal of Finance, 41, 579-590. JSTOR
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
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)
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.
Eli, and Matthew Richardson, 2001, "Dot Com Mania: The Rise and Fall of
Internet Stock Prices" Journal of Finance 63, Ofek
Paul, “Downward sloping
demand curves, the supply of shares and the collapse of internet prices,’”
Manuscript, University of Notre Dame
- 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.
- Questions to structure class
Week 3, Mon. A stunning finding: prices really do rise
when there is “buying pressure”, in a precise sense. But what does it mean?
D.D. Evans and Richard K. Lyons 2002, “Order
Flow and Exchange Rate Dynamics” Journal of Political Economy, 110:
Skip the “model’’ Section 2.
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.
Froot, Kenneth. A., and Tarun Ramadorai 2005 "Currency Returns, Intrinsic Value, and
Institutional Investor Flows." Journal of Finance 60, 1535-1566. JF
Froot, Kenneth A., and Tarun Ramadorai 2007 "Institutional Portfolio Flows and International
Investments." Review of Financial Studies forthcoming
- Questions to structure class discussion
Week 3, Wed.
Liquidity premia in stocks, expected return models.
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.
Lubos, and Robert F. Stambaugh 2003, "Liquidity Risk and Expected Stock Returns"
Journal of Political Economy
111, 642-685. JPE
Michael and Avanidhar Subrahmanyam, 1996, "Market Microstructure and Asset
Pricing: On the Compensation for Illiquidity in Stock Returns,” Journal of Financial Economics 41,
How are Pastor and Stambaugh different?
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.
- 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.
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
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?”
Francis, Asset Pricing in Markets with
Illiquid assets Mansucript, UCAL.
website Like two trees, but exogenously you can’t trade for a while.
- 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
- Vayanos, Dimitri, Flight to
Quality, Flight to Liquidity, and the Pricing of Risk. Manuscript.
Agents are managers facing drawdowns which makes then want liquidity.
- 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”
W. Lo, Harry Mamaysky and Jiang Wang 2004 “Asset
Prices and Trading Volume Under Fixed Transactions Costs” Journal of Political Economy 112,
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
- 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
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.”
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.
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
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:
- 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.
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.
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.
- 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.
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"
GEIR HOIDAL BJONNES
The Norwegian School
of Management BI
Co-Author: DAGFINN RIME
Central Bank of Norway, Norwegian University
Science and Technology (NTNU) -
Co-Author: HAAKON SOLHEIM
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
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
AFA 2007 Chicago Meetings Paper
University of Singapore -
Finance & Accounting
Co-Author: ALLAUDEEN HAMEED
University of Singapore -
Finance & Accounting
Co-Author: S. VISWANATHAN
University - Fuqua School of Business,
University - Department of
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.