Contents

A Methodology for Assessing Model Risk and its Application to the Implied Volatility Function Model
John Hull and Wulin Suo

Agency Conflicts in Closed-End Funds: The Case of Rights Offerings
Ajay Khorana, Sunil Wahal, and Marc Zenner

Intraday Market Price Integration for Shares Cross-Listed Internationally
Lawrence Kryzanowski and Hao Zhang

Asset Pricing under the Quadratic Class
Markus Leippold and Liuren Wu

How Large are the Benefits from Using Options?
Anthony Neuberger and Stewart Hodges

Order Submission Strategy and the Curious Case of Marketable Limit Orders
Mark Peterson and Erik Sirri

Abstracts

How Stock Flippers Affect IPO Pricing and Stabilization
Raymond P. H. Fishe

Stock flippers pose a problem for underwriters of initial public offerings (IPOs). They subscribe to the issue, but immediately resell their shares, which may depress the after-market price. This paper presents a model of how stock flippers affect IPO pricing. The model shows that the underwriter chooses whether to price the issue as a cold, weak, or hot IPO. Stock flippers have the greatest effect on pricing in weak IPOs and provide an explanation for underwriter stabilization. In contrast to existing models of stabilization, the underwriter gains from after-market purchases, particularly if the contract with the issuer includes an over-allotment option. The over-allotment option encourages a lower offer price, which may lead to under-pricing. These results correspond to recent findings on IPO returns and underwriter stabilization activities.

A Methodology for Assessing Model Risk and its Application to the Implied Volatility Function Model
John Hull and Wulin Suo

We propose a methodology for assessing model risk and apply it to the implied volatility function (IVF) model. This is a popular model among traders for valuing exotic options. Our research is different from other tests of the IVF model in that we reflect the traders' practice of using the model for the relative pricing of exotic and plain vanilla options at one point in time. We find little evidence of model risk when the IVF model is used to price and hedge compound options. However, there is significant model risk when it is used to price and hedge some barrier options.

Agency Conflicts in Closed-End Funds: The Case of Rights Offerings
Ajay Khorana, Sunil Wahal, and Marc Zenner

We study 120 rights offerings by closed-end funds from 1988-1998. On average, rights offerings are announced when funds trade at a premium. This premium turns into a discount over the course of the offering. The premium decline is more severe when increases in the investment advisor's compensation are larger and when the fund uses affiliated broker-dealers to solicit subscriptions to the offer. A clinical analysis shows that rights offerings allow investment advisors to sidestep fee rebates and increase pecuniary benefits to affiliated entities. Overall, our results suggest the presence of significant conflicts of interest in rights offerings by closed-end funds.

Intraday Market Price Integration for Shares Cross-Listed Internationally
Lawrence Kryzanowski and Hao Zhang

This study investigates market price integration by testing per-share trade execution price or cost (TEP/C) differentials for matched intraday trades for a sample of Canadian shares cross-listed in the U.S. The TSE trade price advantage over the entire time period changed significantly after both the TSE's own minimum quotation increment reduction and that of its U.S. competitors. We show that the differential TEP/C is equivalent to the international effective spread differential and that market quality comparisons, which benchmark using the National instead of the International BBO, need to compare both national effective half-spread and midspread differences. Our cross-sectional regression results support our predictions that TEP/C differentials can be explained by differences in national midspreads and by ex ante proxies of national effective half-spreads. The TEP/C differentials vary inversely with increasing levels of our measure of signed market nonfragmentation.

Asset Pricing under the Quadratic Class
Markus Leippold and Liuren Wu

We identify and characterize a class of term structure models where bond yields are quadratic functions of the state vector. We label this class the quadratic class and aim to lay a solid theoretical foundation for its future empirical application. We consider asset pricing in general and derivative pricing in particular under the quadratic class. We provide two general transform methods in pricing a wide variety of fixed income derivatives in closed or semi-closed form. We further illustrate how the quadratic model and the transform methods can be applied to more general settings.

How Large are the Benefits from Using Options?
Anthony Neuberger and Stewart Hodges

The paper explores the economic value of being able to span market outcomes through the use of options. We model an economy with a single risky asset. Consumption takes place at one date, corresponding to the horizon of all investors. Options on the consumption good are not redundant securities in the economy because volatility is uncertain. The model enables us to examine the benefits to investors of using options to optimize their investments. Within this model, the gains from the use of options appear to be relatively minor.

Order Submission Strategy and the Curious Case of Marketable Limit Orders
Mark Peterson and Erik Sirri

We provide empirical evidence on order submission strategy of investors with similar commitments to trade by comparing the execution costs of market orders and marketable limit orders (i.e., limit orders with the same trading priority as market orders). The results indicate the unconditional trading costs of marketable limit orders are significantly greater than market orders. We attribute the difference in costs to a selection bias and provide evidence suggesting the order submission strategy decision is based on prevailing market conditions and stock characteristics. After correcting for the selection bias, the results show the average trader chooses the order type with lower conditional trading costs.