Smaller Pricing Errors Research Articles

Assessing Asset Pricing Model Misspecification with a Returns Decomposition

Asset returns implicitly contain information about the systematic and nonsystematic risks in an economy. Based solely on the law of one price condition, we extract this information by using a mean-variance frontier decomposition of returns, and exploit it to improve the assessment of specification errors of stochastic discount factor models. Our empirical results document a large and significant mispricing of both the systematic and nonsystematic risks in industry returns, even for models not rejected by a test of over-identifying restrictions. Furthermore, models with smaller pricing errors on the pervasive portion of returns generally obtain larger pricing errors on the idiosyncratic portion of returns. We explain why this tradeoff is likely to occur and how it affects the evaluation of asset pricing models.

Round-the-clock market efficiency and home bias: Evidence from the international Japanese government bonds futures markets

This paper examines how information is processed between almost identical international futures markets: London (LIFFE) and Tokyo (TSE) JGB futures. In these markets, variations in open-to-open changes are virtually the same as those of close-to-close changes, suggesting that information is transmitted efficiently across markets with small opening pricing errors. The overall results confirm market efficiency around the clock, yet the intraday U-shaped patterns in volume/volatility of the London JGB futures suggest home bias in international investments, indicating a less global view of trading than expected. Specifically, at the LIFFE open, London investors rush to rebalance portfolios instead of doing so at the TSE close, which is only one hour before the LIFFE opens.

Market Structure, Informational Efficiency and Liquidity: An Experimental Comparison of Auction and Dealer Markets

This paper reports the results of 18 market experiments that were conducted in order to compare the call market, the continuous auction and the dealer market. The design incorporates asymmetric information but guarantees that the ex-ante quality of the private signals of all traders is identical. Therefore, the aggregation of diverse information can be analyzed in the absence of insider trading. Single transaction prices in the call and continuous auction market are found to be much more efficient than prices in the dealer market. The latter is, however, very efficient when average prices are analyzed. Averaging the prices of a trading period largely eliminates the bid-ask spread. The conclusion is therefore that prices in a dealer market convey high quality information, but at the expense of high transaction costs. The call market, although exhibiting small pricing errors, shows a systematic tendency towards underadjustment to new information. An analysis of market liquidity using various measures proposed in the literature shows that execution costs are lowest in the call market and highest in the dealer market. The analysis also reveals that both the trading volume and Roll's (1984) serial covariance estimator are inappropriate measures of execution costs in the present context. The quality of the private signals traders receive influences portfolio structure but does not influence end-of-period wealth. This result is consistent with efficient price discovery in the experimental markets.

Misspecification and the pricing and hedging of long-term foreign currency options

This study examines the effects of stochastic volatility upon the pricing and hedging of long-term foreign currency options. The traditional method of pricing such options uses a constant volatility option model with an implicit volatility derived from a short-term traded option. We show that the traditional method leads to small pricing errors for short- and medium-term options, but does a poor job in pricing long-term options. The traditional method also does a poor job for all maturities in determining the derivatives of the option's value with respect to the exchange rate (delta) and the volatility (vega). The errors in calculating these derivatives, which are used in forming the replicating portfolio, lead to large and costly errors in error hedging.