Price Formation

Joshua D. Coval; Erik   Stafford

Background Note | HBS Case Collection | October 2007

Price Formation

Abstract

Investigates how prices are formed in competitive capital markets. Focuses on a single security called AOE. Students compete with computer traders and each other for market making and informed trading profits. Participants receive a variety of public news in the form of a research report on AOE, as well as subscriptions to news announcements and public quarterly earnings forecasts and releases. Participants also have access to costly private information in the form of one-week-ahead price targets for a per-use fee. The market structure is one with a centralized limit order book, but the ability to place limit orders is limited. The simulation of AOE is based on an actual security that has been disguised in time and industry to prevent students from anticipating the price path. All public news and contextual market information presented to students during the simulation correspond to actual information available to market participants in the real world at the time.

Keywords: Capital Markets; Price; Profit; Corporate Disclosure; Newsletters; Industry Structures; Business Processes; Competitive Strategy;

Format: Print

7 pages

Educators

Citation:

Coval, Joshua D., and Erik Stafford. "Price Formation." Harvard Business School Background Note 208-040, October 2007.

Overall, no! We show that the level and time series variation in cash flows for most bank activities are well matched by capital market portfolios with similar interest rate and credit risk to what banks report to hold. Ignoring operating expenses, bank loans earn high returns and transaction deposits pay low interest rates, consistent with these activities having a potential edge. The edge among these activities is insufficient to cover the large operating expenses of banks. A large portion of the aggregate U.S. banking sector closely resembles a tax inefficient passive mutual fund. The residual risks of bank activities, presumably generated by the unique components of the bank business model, generate systematic risks that are uncompensated.

While we commend the initiative of Snyder and Welch (2017), we lay out in this short reply why we remain highly confident in our results and our interpretation thereof. We welcome authors to continue to explore the data for themselves and look forward to the new questions they can tackle with it.

Private equity funds tend to select relatively small firms with low EBITDA multiples. Publicly traded equities with these characteristics have high risk-adjusted returns after controlling for common factors typically associated with value stocks. Hold-to-maturity accounting of portfolio net asset value eliminates the majority of measured risk. A passive portfolio of small, low EBITDA multiple stocks with modest amounts of leverage and hold-to-maturity accounting of net asset value produces an unconditional return distribution that is highly consistent with that of the pre-fee aggregate private equity index. The passive replicating strategy represents an economically large improvement in risk- and liquidity-adjusted returns over direct allocations to private equity funds, which charge average fees of 6% per year.

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Price Formation

Abstract

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