Knowledge that Transforms

We address the question: At what stage in its life should a firm go public rather than undertake its projects using private equity financing? In our model a firm may raise external financing either by placing shares privately with a risk-averse venture capitalist or by selling shares in an IPO to numerous small investors. The entrepreneur has private information about his firm's value, but outsiders can reduce this informational disadvantage by evaluating the firm at a cost. The equilibrium timing of the going-public decision is determined by the firm's trade-off between minimizing the duplication in information production by outsiders (unavoidable in the IPO market, but mitigated by a publicly observable share price) and avoiding the risk-premium demanded by venture capitalists. Testable implications are developed for the cross-sectional variations in the age of going-public across industries and countries.

A firm's instantaneous probability of default is modeled as a translated square-root diffusion process modified to allow the process to be correlated with default-free interest rates. The parameters of the process are estimated for 161 firms. An extended Kalman filter approach is used that incorporates both the time-series and cross-sectional (term structure) properties of the individual firms' bond prices. The model is reasonably successful at fitting corporate bond yields, while key features of the term structures of yield spreads are captured in the signs and magnitudes of the resulting parameter estimates.

This article presents a dynamic, rational expectations equilibrium model of asset prices where the drift of fundamentals (dividends) shifts between two unobservable states at random times. I show that in equilibrium, investors' willingness to hedge against changes in their own "uncertainty" on the true state makes stock prices overreact to bad news in good times and underreact to good news in bad times. I then show that this model is better able than conventional models with no regime shifts to explain features of stock returns, including volatility clustering, "leverage effects," excess volatility, and time-varying expected returns.

Transaction costs are important for a host of empirical analyses from market efficiency to international market research. But transaction costs estimates are not always available, or where available, are cumbersome to use and expensive to purchase. We present a model that requires only the time series of daily security returns to endogenously estimate the effective transaction costs for any firm, exchange, or time period. The feature of the data that allows for the estimation of transaction costs is the incidence of zero returns. Incorporating zero returns in the return-generating process, the model provides continuous estimates of average round-trip transaction costs from 1963 to 1990 that are 1.2% and 10.3% for large and small decile firms, respectively. These estimates are highly correlated (85%), with the most commonly used transaction cost estimators.

Brokerage analysts frequently comment on and sometimes recommend companies that their firms have recently taken public. We show that stocks that underwriter analysts recommend perform more poorly than “buy” recommendations by unaffiliated brokers prior to, at the time of, and subsequent to the recommendation date. We conclude that the recommendations by underwriter analysts show significant evidence of bias. We show also that the market does not recognize the full extent of this bias. The results suggest a potential conflict of interest inherent in the different functions that investment bankers perform.

This article presents convenient reduced-form models of the valuation of contingent claims subject to default risk, focusing on applications to the term structure of interest rates for corporate or sovereign bonds. Examples include the valuation of a credit-spread option.