Knowledge that Transforms

ABSTRACT We estimate and compare a variety of continuous‐time models of the short‐term riskless rate using the Generalized Method of Moments. We find that the most successful models in capturing the dynamics of the short‐term interest rate are those that allow the volatility of interest rate changes to be highly sensitive to the level of the riskless rate. A number of well‐known models perform poorly in the comparisons because of their implicit restrictions on term structure volatility. We show that these results have important implications for the use of different term structure models in valuing interest rate contingent claims and in hedging interest rate risk.

ABSTRACT This paper presents evidence supporting the theory that problems of asymmetric information in debt markets affect financially unhealthy firms' ability to obtain outside finance and, consequently, their allocation of real investment expenditure over time. I test this hypothesis by estimating the Euler equation of an optimizing model of investment. Including the effect of a debt constraint greatly improves the Euler equation's performance in comparison to the standard specification. When the sample is split on the basis of two measures of financial distress, the standard Euler equation fits well for the a priori unconstrained groups, but is rejected for the others.

ABSTRACT This paper tests two of the simplest and most popular trading rules—moving average and trading range break—by utilizing the Dow Jones Index from 1897 to 1986. Standard statistical analysis is extended through the use of bootstrap techniques. Overall, our results provide strong support for the technical strategies. The returns obtained from these strategies are not consistent with four popular null models: the random walk, the AR(1), the GARCH‐M, and the Exponential GARCH. Buy signals consistently generate higher returns than sell signals, and further, the returns following buy signals are less volatile than returns following sell signals, and further, the returns following buy signals are less volatile than returns following sell signals. Moreover, returns following sell signals are negative, which is not easily explained by any of the currently existing equilibrium models.

ABSTRACT We explore the determinants of liquidation values of assets, particularly focusing on the potential buyers of assets. When a firm in financial distress needs to sell assets, its industry peers are likely to be experiencing problems themselves, leading to asset sales at prices below value in best use. Such illiquidity makes assets cheap in bad times, and so ex ante is a significant private cost of leverage. We use this focus on asset buyers to explain variation in debt capacity across industries and over the business cycle, as well as the rise in U.S. corporate leverage in the 1980s.

ABSTRACT While the benefits of bank financing are relatively well understood, the costs are not. This paper argues that while informed banks make flexible financial decisions which prevent a firm's projects from going awry, the cost of this credit is that banks have bargaining power over the firm's profits, once projects have begun. The firm's portfolio choice of borrowing source and the choice of priority for its debt claims attempt to optimally circumscribe the powers of banks.

ABSTRACT Two easily measured variables, size and book‐to‐market equity, combine to capture the cross‐sectional variation in average stock returns associated with market β , size, leverage, book‐to‐market equity, and earnings‐price ratios. Moreover, when the tests allow for variation in β that is unrelated to size, the relation between market β and average return is flat, even when β is the only explanatory variable.

In the article Theory of Capital Structure, by Milton Harris and Artur Raviv (The Journal of Finance, March 1991, vol. 46, no. 1, pp. 297-355) there is an error in Tables IV, V, and VII concerning the description of results reported in Investment-Financing Nexus: Some Empirical Evidence, by Michael Long and Ileen Malitz (Midland Corporate Finance Journal, 1985). While the text of Theory of Capital Structure (p. 334) correctly states that Long and Malitz find a negative relationship between leverage and profitability, in Tables IV, V, and VII, a positive, but insignificant, relationship is incorrectly reported. The authors apologize for this error and thank Professor Michael Long of Rutgers University for bringing it to their attention.