Journal of Financial and Quantitative Analysis
Vol. 34, No. 2, June 1999


Contents

Non-Informative Tests of the Unbiased Forward Exchange Rate
Scott W. Barnhart, Robert McNown, and Myles S. Wallace

Pricing Lookback and Barrier Options under the CEV Process
Phelim P. Boyle and Yisong "Sam" Tian

Does Insider Trading Really Move Stock Prices?
Sugato Chakravarty and John J. McConnell

Of Smiles and Smirks: A Term Structure Perspective
Sanjiv Ranjan Das and Rangarajan K. Sundaram

Optimal vs. Traditional Securities under Moral Hazard
Michel A. Robe

Abstracts

Non-Informative Tests of the Unbiased Forward Exchange Rate
Scott W. Barnhart, Robert McNown, and Myles S. Wallace

This paper reexamines a familiar but unsettling result in the foreign exchange literature: that the forward rate is not an unbiased predictor of the future spot rate. The paper outlines why some frequently used tests of unbiasedness are non-informative in the sense that they are incapable of correctly testing the hypothesis. Specifically, many of these tests are based on regressions that suffer from simultaneity bias, resulting in biased and inconsistent estimators. This is true whether the tests are conducted using stationary or non-stationary data. We demonstrate this point both analytically and with simulations. Tests of co-integration, which are not subject to the critique presented in the paper, generally fail to reject unbiasedness.


Pricing Lookback and Barrier Options under the CEV Process
Phelim P. Boyle and Yisong "Sam" Tian

This paper examines the pricing of lookback and barrier options when the underlying asset follows the constant elasticity of variance (CEV) process. We construct a trinomial method to approximate the CEV process and use it to price lookback and barrier options. For lookback options, we find that the technique proposed by Babbs for the lognormal case can be modified to value lookbacks when the asset price follows the CEV process. We demonstrate the accuracy of our approach for different parameter values of the CEV process. We find that the prices of barrier and lookback options for the CEV process deviate significantly from those for the lognormal process. For standard options, the corresponding differences between the CEV and Black-Scholes models are relatively small. Our results show that it is much more important to have the correct model specification for options that depend on extrema than for standard options.


Does Insider Trading Really Move Stock Prices?
Sugato Chakravarty and John J. McConnell

Prior studies have reported a positive correlation between insider trading and stock price changes implying that insider (i.e., informed) trades affect price discovery differently than non-insider (i.e., uninformed) trades. Based on these results, various scholars have argued for the legalization of insider trading to facilitate rapid price discovery. We analyze the trading activity of a confessed inside trader, Ivan Boesky, in Carnation's stock just prior to Nestle's 1984 acquisition of Carnation, and find that our tests are unable to distinguish the price effect of Boesky's (i.e., informed) purchases of Carnation's stock from the effect of non-insider (i.e., uninformed) purchases. Our conclusion survives extensive robustness tests and has methodological and public policy implications.


Of Smiles and Smirks: A Term Structure Perspective
Sanjiv Ranjan Das and Rangarajan K. Sundaram

An extensive empirical literature in finance has documented not only the presence of anomalies in the Black-Scholes model, but also the term structures of these anomalies (for instance, the behavior of the volatility smile or of unconditional returns at different maturities). Theoretical efforts in the literature at addressing these anomalies have largely focused on two extensions of the Black-Scholes model: introducing jumps into the return process, and allowing volatility to be stochastic. We employ commonly used versions of these two classes of models to examine the extent to which the models are theoretically capable of resolving the observed anomalies. We find that each model exhibits some term structure patterns that are fundamentally inconsistent with those observed in the data. As a consequence, neither class of models constitutes an adequate explanation of the empirical evidence, although stochastic volatility models fare somewhat better than jumps.


Optimal vs. Traditional Securities under Moral Hazard
Michel A. Robe

This paper provides an explanation for the widespread use of traditional securities by well-established firms. Standard moral hazard models predict that equity, debt, and warrants are almost never optimal financing instruments. I show that issuing these securities is, nevertheless, nearly optimal: the issuer would gain very little by using non-traditional securities instead. Combined with equity, one debt issue (without multiple layers of seniority) and one warrant issue (without multiple exercise prices) suffice to achieve near optimality. The near optimality of traditional financing depends crucially on the issuer's ability to use warrants in addition to debt and equity.