Contents

Option Pricing in a Multi-Asset, Complete Market Economy
Ren-Raw Chen, San-Lin Chung, and Tyler T. Yang

Pricing American Options on Foreign Assets in a Stochastic Interest Rate Economy
San-Lin Chung

The Determinants of the Flow of Funds of Managed Portfolios: Mutual Funds vs. Pension Funds
Diane Del Guercio and Paula A. Tkac

Returns-Chasing Behavior, Mutual Funds, and Beta's Death
Jason Karceski

An Empirical Examination of Call Option Values Implicit in U.S. Corporate Bonds
Tao-Hsien Dolly King

Does Market Structure Affect the Immediacy of Stock Price Responses to News?
Ronald W. Masulis and Lakshmanan Shivakumar

Abstracts

Partial Adjustment to Public Information and IPO Underpricing
Daniel J. Bradley and Bradford D. Jordan

We examine the extent to which offer prices reflect public information for 3,325 IPOs over the period 1990-1999. We focus primarily on four variables: share overhang, file range amendments, venture capital backing, and previous issue underpricing. We show that 35%-50% of the variation in IPO underpricing can be predicted using public information known before the offer date and therefore conclude that IPO offer prices underadjust to widely available public information to a much greater extent than previously documented.

Option Pricing in a Multi-Asset, Complete Market Economy
Ren-Raw Chen, San-Lin Chung, and Tyler T. Yang

This paper extends the seminal Cox-Ross-Rubinstein ((1979), CRR hereafter) binomial model to multiple assets. It differs from previous models in that it is derived under the complete market environment specified by Duffie and Huang (1985) and He (1990).

The complete market assumption requires the number of states to grow linearly with the number of assets. However, the number of correlations grows at a faster rate, causing the CRR model to be indirectly extendable. We solve such a problem by recognizing that the fast growing correlation number is matched by the number of the angles of the edges of a hypercube spanned by the risky assets. As a result, we derive a solution that allows the number of equations to equal the number of risky assets and the riskless bond. The resulting tree structure hence provides the same intuition of pricing and hedging contingent claims as that provided by the CRR model.

Finally, the proposed model is not only as easy to implement as the one-dimensional CRR model but also it is more memory efficient than the existing multi-factor lattice models.

Pricing American Options on Foreign Assets in a Stochastic Interest Rate Economy
San-Lin Chung

This paper values American options on foreign assets in a stochastic interest rate economy using a two-point Geske and Johnson (1984) technique. The method requires the valuation of just two options: a European option and a twice-exercisable option. I first derive the risk-neutral distributions of asset prices under two forward risk-adjusted measures. Closed-form solutions for European options on foreign assets are then obtained by applying these risk-neutral distributions. This article also provides analytic solutions for pricing twice-exercisable options that are at most two-dimensional even though the valuation problem involves four risk factors at two exercise dates. I report the results of numerical evaluations of American option values using my method and show how they vary with the interest rate parameters. I also verify the accuracy of the proposed method by comparing with the benchmark values obtained from the least-square method of Longstaff and Schwartz (2001).

The Determinants of the Flow of Funds of Managed Portfolios: Mutual Funds vs. Pension Funds
Diane Del Guercio and Paula A. Tkac

This study compares the relations between asset flow and performance in the retail mutual fund and fiduciary pension fund segments of the money management industry, and relates empirical differences to fundamental differences in the clientele they serve. A striking difference is the shape of the flow-performance relation. In contrast to mutual fund investors, pension clients punish poorly performing managers by withdrawing assets under management and do not flock disproportionately to recent winners. We interpret these and other empirical differences in the context of the manager evaluation procedures typical in each segment. We conclude that pension managers have little incentive to engage in the risk-shifting behavior previously identified among mutual fund managers.

Returns-Chasing Behavior, Mutual Funds, and Beta's Death
Jason Karceski

I develop an agency model where returns-chasing behavior by mutual fund investors causes beta not to be priced to the degree predicted by the standard CAPM. Mutual fund investors chase returns through time, precipitating unusually large aggregate cash inflows into mutual funds just after dramatic market runups. Mutual fund investors also chase returns cross-sectionally across funds so that the highest-performing funds capture the largest fraction of the aggregate inflows into the mutual fund sector. The interaction of these two flow-performance relationships induces an asymmetry in payoffs to mutual funds where fund managers care most about outperforming peers during bull markets. Since high-beta stocks tend to outperform in up markets, active fund managers tilt their portfolios toward high-beta stocks, reducing the beta risk premium in equilibrium. To support the model's time-series flow-performance assumption, I show empirically that market returns have a large economic impact on subsequent aggregate mutual fund flows. In addition, data on mutual fund holdings suggest that the aggregate stock portfolio held by equity funds is overweighted in high-beta stocks relative to the overall market, though this does not include the cash held by mutual funds. Fama-MacBeth tests indicate that the equity premium falls only slightly as the relative size of mutual funds increases, and the relation is not statistically significant.

An Empirical Examination of Call Option Values Implicit in U.S. Corporate Bonds
Tao-Hsien Dolly King

This study examines call option values implicit in U.S. corporate bonds from 1973 to 1994. The average call option value is 2.25% of par. Over time, call values remain close to zero until one year before the first call date, reach a maximum at the beginning of the callable period, and slowly decrease thereafter. The determinants of call values are examined. The results show that bonds of firms that have called aggressively in the past have larger call values. Additionally, lower interest rates, smaller slopes of the yield curve, and higher interest rate volatility lead to larger call values. The results also show that call values increase with time to maturity in the callable period but decrease with time to maturity in the call protection period. Lower rated, higher coupon bonds have larger call values. There is no evidence that the length of the call protection period affects call values.

Does Market Structure Affect the Immediacy of Stock Price Responses to News?
Ronald W. Masulis and Lakshmanan Shivakumar

This study compares the speed of price adjustments to seasoned equity offering announcements by NYSE/AMEX and Nasdaq stocks. We find that price adjustments are quicker by as much as one hour on Nasdaq. This result is not due to differences in issuer characteristics or announcement effects across the markets, but due to differences in market structures. Greater risk taking by dealers, more rapid order execution, and more frequent informed trading (SOES bandits) on Nasdaq, as well as stale limit orders and a less efficient opening price-setting mechanism on the NYSE/AMEX, all contribute to faster stock price adjustments on Nasdaq.