Knowledge that Transforms

The authors examine whether the value loss from diversification affects takeover and breakup probabilities. They estimate diversification's value effect by imputing stand-alone values for individual business segments and find that firms with greater value losses are more likely to be taken over. Moreover, those acquired firms whose losses are greatest are most likely to be bought by leveraged buyouts associations, which frequently break up their targets. For a subsample of large diversified targets, higher value losses increase the extent of posttakeover bustup and post-takeover bustup generally results in divested divisions being operated as part of a focused, stand-alone firm.

Past research explains observed spreads between futures and forward Eurodollar yields as being due to the futures contract's mark-to-market feature. The authors derive closed-form solutions for this yield spread and show that, theoretically, it should be small. Also, differences in liquidity, taxation, and default risk cannot account for the large spreads observed. The authors also present evidence that the spreads, which are nonneglible primarily in the first half of the sample period, are likely to be attributable to the mispricing of futures contracts relative to the forward rates and that the mispricing was gradually eliminated over time.

The authors document the determinants of the term to maturity of 7,369 bonds and notes issued between 1982 and 1993. Their main finding is that large firms with investment grade credit ratings typically borrow at the short end and at the long end of the maturity spectrum, while firms with speculative grade credit ratings typically borrow in the middle of the maturity spectrum. This pattern is consistent with the theory that risky firms do not issue short-term debt in order to avoid inefficient liquidation, but are screened out of the long-term debt market because of the prospect of risky asset substitution.

The authors investigate the nature and magnitude of short-selling activity around seasoned equity offerings, the relation between short-selling activity and issue discounts, and the consequences of the Securities and Exchange Commission adoption of Rule 10b-21 in response to concerns about manipulative short-selling practices. Seasoned offerings are characterized by abnormally high levels of short selling and option open interest. Higher levels of such activity are related to lower expected proceeds from the issuance of new shares. Where it could not be circumvented, Rule 10b-21 appears to have curbed short-selling activity and reduced issue discounts.

The author studies an intertemporal asset market where insiders coexist with 'nonfundamental' speculators. Nonfundamental speculators possess no private information on fundamental values of assets but have superior knowledge about some aspect of the market environment. The author shows that the entry of these (rational) speculators can lead to reductions in market liquidity and in the information content of prices, even in an efficient market. Also, equilibrium trades display patterns of empirical interest. For example, speculators appear to chase trends and lose money after market 'overreactions,' while insiders trade as contrarians and profit after such overreactions.

The authors analyze the effect of financing announcements of highly leveraged transactions on the stock prices of the banks that lead highly leveraged transaction lending syndicates. For their sample of forty-one highly leveraged transactions, the authors document that the first highly leveraged transaction and bank financing announcements result in positive wealth effects for the lending banks. They also find that these wealth effects are lower in 1985, for smaller highly leveraged transactions, and for banks with a high loan loss reserve to total asset ratio. Finally, they report that leveraged buyout targets gain about 2 percent, whereas leveraged recap targets lose about 2 percent, when the first bank financing agreement is announced.

This study investigates the behavior of the components of the bid-ask spread around earnings announcements. The authors find that the adverse selection cost component significantly increases surrounding the announcements, while the inventory holding and order processing components significantly decline during the same periods. Their results suggest that the directional change in the total bid-ask spread depends on the relative magnitudes of the changes in these three components. Specifically, the decreases in inventory holding costs and order processing costs imply that earnings announcements may have an insignificant impact on the total bid-ask spread, even when they result in increased information asymmetry.

The author examines the relative performance of call and continuous auctions under asymmetric information by manipulating trading rules and information sets in laboratory asset markets. He finds significant differences in an environment that extends the A. S. Kyle (1985) framework to permit the exogenous liquidity trading motive to have a natural economic interpretation. The adverse selection costs incurred by noise traders are significantly lower under the call auction, despite no significant reduction in average price efficiency. This result suggests that discussions of the costs and benefits of insider trading should take place within the context of a specific trading mechanism.

We examine whether the predictability of future returns from past returns is due to the market's underreaction to information, in particular to past earnings news. Past return and past earnings surprise each predict large drifts in future returns after controlling for the other. Market risk, size, and book-to-market effects do not explain the drifts. There is little evidence of subsequent reversals in the returns of stocks with high price and earnings momentum. Security analysts' earnings forecasts also respond sluggishly to past news, especially in the case of stocks with the worst past performance. The results suggest a market that responds only gradually to new information.

During the 1980s, insolvency of individual thrifts and the thrift deposit insurer created severe incentive problems. Lacking cash to close insolvent thrifts, regulators induced nearly $10 billion of private capital to flow into the industry through mutual-to-stock conversions. The authors test a theory of how regulators encouraged capital-impaired mutual thrifts to convert by permitting them to pay dividends rather than rebuild capital. They estimate the costs of this policy and interpret the 1991 Federal Deposit Insurance Corporation Improvement Act as requiring regulators to impose restraints on depository institutions parallel to debt covenants that prevent capital distributions by nonfinancial firms experiencing distress.