Knowledge that Transforms

A complete understanding of security markets requires a simultaneous explanation of price behavior, trading volume, portfolio composition (ie., asset allocation), and bid‐ask spreads. In this paper, these variables are observed in a controlled setting—a computerized double auction market, similar to NASDAQ. Our laboratory allows experimental control of information arrival—whether simultaneously or sequentially received, and whether homogeneous or heterogeneous. We compare the price, volume, and share allocations of three market equilibrium models: telepathic rational expectations, which assumes that traders can read each others minds (strong‐form market efficiency); ordinary rational expectations, which assumes traders can use (some) market price information, (a type of semi‐strong form efficiency); and private information, where traders use no market information. We conclude 1) that stronger‐form market models predict equilibrium prices better than weaker‐form models, 2) that there were fewer misallocation forecasts in simultaneous information arrival ( SIM ) environments, 3) that trading volume was significantly higher in SIM environments, 4) and that bid‐ask spreads widen significantly when traders are exposed to price uncertainty resulting from information heterogeneity.

The divesting of corporate assets has become quite popular. Previous studies of divestitures have found conflicting impacts upon shareholders' wealth of the buying firm. This study measures the impacts of product‐line relatedness between the acquiring firm and the divested unit and financial weakness of the selling firm upon the abnormal returns to the acquiring firm. Although the study finds that the impact of financial strength of the seller is ambiguous, the purchase of related assets produces more wealth than does the purchase of unrelated divested units. Further, firms that purchase related divested units have larger proportions of insider ownership.

The development of organized markets for speculative‐grade corporate debt has provided financial researchers with an opportunity to examine the pricing of default risk. By incorporating previous work on the default experience of low‐rated corporate debt, this paper presents an introduction to risk‐neutral models of risky‐bond pricing and uses these to examine the relationship between the default premium embodied in bond yields and actual default rates. The contribution of macroeconomic information to the default premium is also examined. The author finds that holders of low‐grade bonds have, on average, been compensated for losses due to default.

Commonly used trade credit terms implicitly define a high interest rate that operates as an efficient screening device where information about buyer default risk is asymmetrically held. By offering trade credit, a seller can identify prospective defaults more quickly than if financial institutions were the sole providers of short-term financing. The information is valuable in cases where the seller has made nonsalvageable investments in buyers since it enables the seller to take actions to protect such investments.

In a corporate agency problem, perquisites and risk interact to produce novel, complex comparative statics. For example, even if additional debt induces risk‐neutral insiders to increase risk, they never seek to increase the market value of their stock; instead, insiders decrease the present value of their subsequent, conditionally optimal perquisites. Also, the firm's optimal capital structure includes a risky bond with an agreement to remove insiders whenever the bond defaults. However, the optimal sharing rule between corporate claimants cannot be supported solely by standard securities such as bonds, stocks, options, and their hybrids.

The authors propose a likelihood-ratio test of the hypothesis that the minimum-variance frontier of a set of K assets coincides with the frontier of this set and another set of N assets. They study the relation between this hypothesis, exact arbitrage pricing, and mutual fund separation. The exact distribution of the test statistic is available. The authors test the hypothesis that the frontier spanned by three size-sorted stock portfolios is the same as the frontier spanned by thirty-three size-sorted stock portfolios.

Financial classification issues, and particularly the financial distress problem, continue to be subject to vigorous investigation. The corporate credit granting process has not received as much attention in the literature. This paper examines the relative effectiveness of parametric, nonparametric and judgemental classification procedures on a sample of corporate credit data. The judgemental model is based on the Analytic Hierarchy Process. Evidence indicates that (nonparametric) recursive partitioning methods provide greater information than simultaneous partitioning procedures. The judgemental model is found to perform as well as statistical models. A complementary relationship is proposed between the statistical and the judgemental models as an effective paradigm for granting credit.