Knowledge that Transforms

ABSTRACT Recent empirical research has identified a significant amount of volatility in stock prices that cannot easily be explained by changes in fundamentals; one interpretation is that asset prices respond not only to news but also to irrational “noise trading.” We assess the welfare effects and incidence of such noice trading using an overlapping‐generations model that gives investors short horizons. We find that the additional risk generated by noise trading can reduce the capital stock and consumption of the economy, and we show that part of that cost may be borne by rational investors. We conclude that the welfare costs of noise trading may be large if the magnitude of noise in aggregate stock prices is as large as suggested by some of the recent empirical litrature on the excess volatility of the market.

ABSTRACT We demonstrate how an auction model can be used in a traditional capital budgeting context to assign a value to the strategic advantage of long‐term forward contracts. Research in the field of industrial organization has pointed to the danger of ex post opportunistic bargaining as a motivation for the use of forward contracts in natural resources and manufactured products, but no operational procedure exists for estimating the value secured by these contracts. Arbitrage methods for valuing forward contracts assume a competitive market in which the factors creating the bargaining problem and motivating the use of long‐term contracts are not present. Use of the model is illustrated in the case of take‐or‐pay contracts for natural gas.

ABSTRACT The ability of capital markets to distinguish firms of different value by the size of their initial equity offerings is attenuated when insiders can sell equity more than once. A model is developed in which there is price risk from holding equity between periods. When the uncertainty is small, there must be pooling in the first period. When uncertainty is large, the pooling equilibria dominate the separating equilibrium.

ABSTRACT The end of favorable tax treatment for long‐term capital gains caused investors to reassess traditional tax‐induced trading strategies. This study compares trading behavior in December 1986 and January 1987 with previous years. Our results indicate that these tax code changes had a powerful effect on trading behavior. Relative trading volume was considerably higher in December 1986 for long‐term winners but not significantly lower for long‐term losers. Results also indicate altered trading patterns based on short‐term gains in December 1986 and for long‐term winners in January 1987.

ABSTRACT The comovements in real stock prices between the U.K. and the U.S. appear to be too large to be accounted for in terms of the comovements of real dividends between the countries even after consideration of the possibility of information pooling. When consideration is made of the comovements of real interest rates between the countries, there is weaker evidence of excess comovement of price.

ABSTRACT The medium of exchange in acquisitions is studied in a model where (i) bidders' offers bring forth potential competition and (ii) targets and bidders are asymmetrically informed. In equilibrium, both securities and cash offers are observed. Securities have the advantage of inducing target management to make an efficient accept/reject decision. Cash has the advantage of serving, in equilibrium, to “preempt” competition by signaling a high valuation for the target. Implications concerning the medium of exchange of an offer, the probability of acceptance, the probability of competing bids, expected profits, and the costs of bidders are derived.

ABSTRACT This paper finds that, for the 1935–1986 period, the market's risk‐return relation does not have a January seasonal. The findings differ from those of other studies due to the use of value‐weighted, rather than equally weighted, portfolios. Inferences are sensitive to the weighting procedure because of the small‐firm return patterns in January. In particular, even in those Januaries for which the market return is negative, small‐firm returns are positive, and they are more positive the higher is beta. This is consistent with the portfolio rebalancing explanation of the turn‐of‐the‐year effect.

ABSTRACT We compare different indexation schemes in terms of their ability to facilitate forgiveness and reduce the investment disincentives associated with the large LDC debt overhang. Indexing to an endogenous variable (e.g., a country's output) has a negative moral hazard effect on investment. This problem does not arise when payments are linked to an exogenous variable such as commodity prices. Nonetheless, indexing payments to output may be useful when debtors know more about their willingness to invest than lenders. We also reach new conclusions about the desirability of default penalties under asymmetric information.