Gerald R. Jensen, Donald P. Solberg, Thomas S. Zorn, Simultaneous Determination of Insider Ownership, Debt, and Dividend Policies, The Journal of Financial and Quantitative Analysis, Vol. 27, No. 2 (Jun., 1992), pp. 247-263

We find evidence of a systematic link between monetary conditions and inter-temporal variation in the price of liquidity. Specifically, following an expansive monetary policy shift, funding conditions improve and market-wide liquidity increases, which is especially beneficial for illiquid securities. The improved liquidity and funding conditions reduce the returns required for holding illiquid securities. Consequently, illiquid stocks experience relatively large price increases when monetary conditions become expansive, and thus, the measured return spread between illiquid and liquid stocks expands substantially. Overall, our evidence supports the claim that the price of asset liquidity is dependent on monetary conditions.

Dividend reductions have long been considered a “last resort” action for firm managers. Managerial reluctance to reduce dividends emanates from the view that dividend drops signal managerial pessimism regarding future earnings. Contrary to expectations, studies show that earnings rebound significantly following a dividend reduction; yet investors react negatively to the dividend-drop announcement. We present an explanation for the anomalous behavior of earnings and returns around the time of a dividend drop. Our evidence suggests that a reduction in a firm's established dividend coincides with a decrease in the value of the firm's real options. Earnings rebound following the dividend reduction due to the savings that result as the firm allows growth options to expire; however, announcement period returns suggest that investors recognize the lost value associated with the forthcoming expiration of growth options.

We examine the evidence that expected security returns can be forecasted by the term premium, default premium, and dividend yield, in light of recent findings that similar security return patterns are associated with Federal Reserve monetary policy developments. We extend Fama and French's (1989) analysis by suggesting that the monetary environment influences investors' required returns, and hence the robustness of the models they propose. Our findings indicate that Fama and French's results vary dramatically across monetary environments; that is, the behavior of the business-conditions proxies and their influence on expected security returns is significantly affected by the monetary sector.

We find evidence linking return momentum with macroeconomic conditions, namely, the funding environment. We show that winners outperform losers by a significant amount in restrictive funding states, while in expansive states, winners and losers perform similarly. This pattern is consistent with changing investor preferences for winners and losers following signaled shifts in funding availability. One plausible channel for this relation is the interaction between stock-level illiquidity and funding conditions. We find that liquidity risk is significantly priced during restrictive states, especially in loser stocks. Furthermore, loser stocks become more illiquid during restrictive conditions. Both effects help explain the relative performance difference between losers and winners across funding environments. Moreover, the funding environment influences the relationship between momentum and firm characteristics, after controlling for the influence of sentiment, market states and return dispersion. Overall, transitions in funding states appear to encourage investors to revise their factor pricing decisions, which produces inter-temporal variation in momentum.

Previous research documents that US stock returns are related to the US monetary environment. The focus of this paper is to determine whether stock returns in foreign markets are associated with both local and US monetary environments. Consistent with the US market results, we find that foreign stock returns are generally higher in expansive US and local monetary environments than they are in restrictive environments. Further, these higher returns are generally not accompanied by increases in risk. Interestingly, several of the stock markets are more strongly related to the US monetary environment than to local monetary conditions. For seven of the 15 foreign countries examined, the local and US monetary environment explain 4% or more of the variation in monthly stock returns.