Knowledge that Transforms

Can discretely sampled financial data help us decide which continuous‐time models are sensible? Diffusion processes are characterized by the continuity of their sample paths. This cannot be verified from the discrete sample path: Even if the underlying path were continuous, data sampled at discrete times will always appear as a succession of jumps. Instead, I rely on the transition density to determine whether the discontinuities observed are the result of the discreteness of sampling, or rather evidence of genuine jump dynamics for the underlying continuous‐time process. I then focus on the implications of this approach for option pricing models.

Spot power prices are volatile and since electricity cannot be economically stored, familiar arbitrage‐based methods are not applicable for pricing power derivative contracts. This paper presents an equilibrium model implying that the forward power price is a downward biased predictor of the future spot price if expected power demand is low and demand risk is moderate. However, the equilibrium forward premium increases when either expected demand or demand variance is high, because of positive skewness in the spot power price distribution. Preliminary empirical evidence indicates that the premium in forward power prices is greatest during the summer months.

We examine the long‐term stock performance following dividend initiations and resumptions from 1927 to 1998. We show that postannouncement abnormal returns are significantly positive for equally weighted calendar time portfolios, but become insignificant when the portfolios are value weighted. Moreover, the equally weighted results are not robust across subsamples. We also document postannouncement reductions in the risk factor loadings of underlying stocks. Cross‐sectionally, these reductions are negatively related to the contemporaneous price drifts, suggesting the price drifts may be a sample‐specific result of chance. Our results underscore the importance of testing for changes in risk loadings in future long‐term event studies.

We investigate the relationship between the ownership structure and returns of firms on days when the absolute value of the market's return is two percent or more. We find that a firm's abnormal return on these days is related to the percentage of institutional ownership, that there is abnormally high turnover in the firm's shares on these days, and that this abnormal turnover is significantly related to the percentage of institutional ownership in the firm. Taken together, these results are consistent with positive feedback herding behavior on the part of some institutions, particularly mutual and pension funds.

We develop a profit‐maximizing neoclassical model of optimal firm size and growth across different industries based on differences in industry fundamentals and firm productivity. In the model, a conglomerate discount is consistent with profit maximization. The model predicts how conglomerate firms will allocate resources across divisions over the business cycle and how their responses to industry shocks will differ from those of single‐segment firms. Using plant level data, we find that growth and investment of conglomerate and single‐segment firms is related to fundamental industry factors and individual segment level productivity. The majority of conglomerate firms exhibit growth across industry segments that is consistent with optimal behavior.

This paper examines the relationship between book‐to‐market equity, distress risk, and stock returns. Among firms with the highest distress risk as proxied by Ohlson's (1980) O‐score, the difference in returns between high and low book‐to market securities is more than twice as large as that in other firms. This large return differential cannot be explained by the three‐factor model or by differences in economic fundamentals. Consistent with mispricing arguments, firms with high distress risk exhibit the largest return reversals around earnings announcements, and the book‐to‐market effect is largest in small firms with low analyst coverage.

There are two tax incentives for corporations to hedge: to increase debt capacity and interest tax deductions, and to reduce expected tax liability if the tax function is convex. We test whether these incentives affect the extent of corporate hedging with derivatives. Using an explicit measure of tax function convexity, we find no evidence that firms hedge in response to tax convexity. Our analysis does, however, indicate that firms hedge to increase debt capacity, with increased tax benefits averaging 1.1 percent of firm value. Our results also indicate that firms hedge because of expected financial distress costs and firm size.

This paper examines the impact venture capital can have on the development of new firms. Using a hand‐collected data set on Silicon Valley start‐ups, we find that venture capital is related to a variety of professionalization measures, such as human resource policies, the adoption of stock option plans, and the hiring of a marketing VP. Venture‐capital‐backed companies are also more likely and faster to replace the founder with an outside CEO, both in situations that appear adversarial and those mutually agreed to. The evidence suggests that venture capitalists play roles over and beyond those of traditional financial intermediaries.

This paper studies the effects of banking mergers on individual business borrowers. Using information on individual loan contracts between banks and companies, I analyze the effect of banking consolidation on banks' credit policies. I find that inmarket mergers benefit borrowers if these mergers involve the acquisition of banks with small market shares. Interest rates charged by the consolidated banks decrease, but as the local market share of the acquired bank increases, the efficiency effect is offset by market power. Mergers have different distributional effects across borrowers. When banks become larger, they reduce the supply of loans to small borrowers.

We analyze several hundred firms that expand via acquisition and/or increase their number of business segments. The combined market reaction to acquisition announcements is positive but acquiring firm excess values decline after the diversifying event. Much of the excess value reduction occurs because our sample firms acquire already discounted business units, and not because diversifying destroys value. This implies that the standard assumption that conglomerate divisions can be benchmarked to typical stand‐alone firms should be carefully reconsidered. We also show that excess value does not decline when firms increase their number of business segments because of pure reporting changes.