Knowledge that Transforms

The joint determination of capital structure and investment risk is examined. Optimal capital structure reflects both the tax advantages of debt less default costs ( Modigliani and Miller (1958, 1963) ), and the agency costs resulting from asset substitution ( Jensen and Meckling (1976) ). Agency costs restrict leverage and debt maturity and increase yield spreads, but their importance is small for the range of environments considered. Risk management is also examined. Hedging permits greater leverage. Even when a firm cannot precommit to hedging, it will still do so. Surprisingly, hedging benefits often are greater when agency costs are low.

We use unique data from the London Stock Exchange to test whether interdealer trade facilitates inventory risk sharing among dealers. We develop a methodology that focuses on periods of “extreme” inventories—inventory cycles. We further distinguish between inventory cycles that are unanticipated and those that are anticipated because of “worked” orders. The pattern of interdealer trade during inventory cycles matches theoretical predictions for the direction of trade and the inventories of trade counterparts. We also show that London dealers receive higher trading revenues for taking larger positions.

We find that option listings are associated with a decrease in the variance of the pricing error, a decrease in the adverse selection component of the spread, and an increase in the relative weight placed by the specialist on public information in revising prices for the underlying stocks. We also find that there is a decrease in the spread and increases in quoted depth, trading volume, trading frequency, and transaction size after option listings. Overall, our results suggest that option listings improve the market quality of the underlying stocks.

Policymakers in emerging markets are increasingly concerned about the consequences for the domestic equity market when companies list stock abroad. We show that the effects of cross-listing depend on the quality of intermarket information linkages. We investigate these issues with unique data from the Mexican equity market. The impact of cross-listing is complex—balancing the costs of order flow migration against the benefits of increased intermarket competition. These effects are exacerbated by equity investment barriers that induce segmentation of the domestic equity market. Consequently, the benefits and costs of cross-listing are not evenly spread over all classes of shareholders.

We develop a simple commodity model to analyze (i) the effects of hedging with liquidity constraints, due to producers' inability to bear unlimited trading losses, (ii) the role of speculation in the process of risk allocation between consumers and producers, and (iii) the equilibrium implications of government price subsidies to the producers. We find that (1) liquidity constraints can cause futures prices to exhibit mean reversion, which then makes speculation profitable; (2) speculation tends to make futures price volatility an increasing function of futures price; and (3) government price subsidy, if actively hedged by the producers, serves to lower the futures risk premium and reduce futures volatility.

An institution holding shares in a firm can use information about the firm both for trading (“speculation”) and for deciding whether to intervene to improve firm performance. Intervention increases the value of the institution's existing shareholdings, but intervention only increases the institution's trading profits if it enhances the precision of the institution's information relative to that of uninformed traders. Thus, the ability to speculate can increase or decrease institutional intervention. We examine key factors that affect the intervention decision, the usefulness of “short-swing” provisions and restricted shares in encouraging institutional intervention, and implications for ownership structure across different firms.

Using a large database of private firms in Italy, we analyze the determinants of initial public offerings (IPOs) by comparing the ex ante and ex post characteristics of IPOs with those of private firms. The likelihood of an IPO is increasing in the company's size and the industry's market-to-book ratio. Companies appear to go public not to finance future investments and growth, but to rebalance their accounts after high investment and growth. IPOs are also followed by lower cost of credit and increased turnover in control.

Mutual fund splits occur in high-priced funds after unusually high returns. Split factors are related to the deviation of a fund's price from the mean of all fund prices. Post-split prices are below the mean of other funds' prices. Post-split numbers of shareholders and assets do not increase compared with funds having similar rates of asset growth. However, I find evidence that mutual fund splits bring per account shareholdings back up to normal levels. I argue that signaling, liquidity, and tick size theories do not apply to mutual fund splits.

The joint determination of capital structure and investment risk is examined. Optimal capital structure reflects both the tax advantages of debt less default costs (Modigliani and Miller (1958, 1963)), and the agency costs resulting from asset substitution (Jensen and Meckling (1976)). Agency costs restrict leverage and debt maturity and increase yield spreads, but their importance is small for the range of environments considered. Risk management is also examined. Hedging permits greater leverage. Even when a firm cannot precommit to hedging, it will still do so. Surprisingly, hedging benefits often are greater when agency costs are low.

Insider transactions are not random across growth and value stocks. We find that insider buying climbs as stocks change from growth to value categories. Insider buying also is greater after low stock returns, and lower after high stock returns. These findings are consistent with a version of overreaction which says that prices of value stocks tend to lie below fundamental values, and prices of growth stocks tend to lie above fundamental values.