Knowledge that Transforms

Past literature has assumed that negative stock returns around Chapter 11 filing are solely due to new adverse information about firm value. This paper argues that there is also a nonlinear wealth transfer from shareholders to creditors causing shareholder loss. The magnitude of the wealth transfer can be quantified in a setting where equity is a call option on firm assets as in the Merton (1974) model. The wealth transfer originates from maturity shortening of the call option as a result of Chapter 11 filing. I present a parsimonious model to explain why Chapter 11 can be voluntarily filed by managers acting in the interest of shareholders with the existence of the wealth transfer. The model-predicted stock return has comparable magnitude as observed stock returns around filing, and explains the cross-sectional variation of the latter.

We study a model in which a capital provider learns from the price of a firm's security in deciding how much capital to provide for new investment. This feedback effect from the financial market to the investment decision gives rise to trading frenzies, in which speculators all wish to trade like others, generating large pressure on prices. Coordination among speculators is sometimes desirable for price informativeness and investment efficiency, but speculators' incentives push in the opposite direction, so that they coordinate exactly when it is undesirable. We analyze the effect of various market parameters on the likelihood of trading frenzies to arise.

Existing studies suggest that systemic crises may arise because banks either hold correlated assets, or are connected by interbank lending. This paper shows that common regulation is also a conduit for interbank contagion. One bank's failure may undermine confidence in the banking regulator's competence, and, hence, in other banks chartered by the same regulator. As a result, depositors withdraw funds from otherwise unconnected banks. The optimal regulatory response to this behavior can be privately to exhibit forbearance to a failing bank. We show that regulatory transparency improves confidence ex ante but impedes regulators' ability to stem panics ex post.

This paper provides a theoretical analysis of the efficiency of prepayment penalties in a dynamic competitive lending model with risky borrowers and costly default. When considering improvements in the borrower's creditworthiness as one of the reasons for refinancing mortgages, we show that refinancing penalties can be welfare improving and that they can be particularly beneficial to riskier borrowers in the form of lower mortgage rates, reduced defaults, and increased availability of credit. Thus, a high concentration of prepayment penalties among the riskiest borrowers can be an outcome of efficient equilibrium in a mortgage market. We also provide empirical evidence that is consistent with the key predictions of our model.

We examine the rewards for experience and ability in the director labor market. We show that large acquisitions are associated with significantly higher numbers of subsequent board seats for the acquiring CEO, target CEO, and the directors. We also find that, in the case of acquisitions, experience is more important than ability. Both value-destroying and value-increasing acquisitions have significant and positive effects on a CEO's future prospects in the director labor market. In addition to increasing our understanding of the director labor market, these results suggest that the ex post settling-up incentives thought to exist in the director labor market are weak for acquisitions.

Knowledge gleaned from previous acquisitions may confer valuation expertise and other benefits. But numerous acquisitions also entail costs, due to problems of incorporating diverse units into an ever larger firm. Such benefits and costs are not directly observable from outside the firm. This article proposes a simple model to infer their relative importance, using the time between successive deals. The data requirements are minimal and allow the use of all mergers and acquisitions during 1992–2009 (more than 300,000 deals). The results provide evidence of learning gains through repetitive acquisitions, especially under CEO continuity and when successive deals are more similar.

This paper investigates whether risks associated with time-varying arrival of jumps and their effect on the dynamics of higher moments of returns are priced in the conditional mean of daily market excess returns. We find that jumps and jump dynamics are significantly related to the market equity premium. The results from our time-series approach reinforce the importance of the skewness premium found in cross-sectional studies using lower-frequency data; and offer a potential resolution to sometimes conflicting results on the intertemporal risk-return relationship. We use a general utility specification, consistent with our pricing kernel, to evaluate the relative value of alternative risk premium models in an out-of-sample portfolio performance application.

The well-established negative correlation between staggered boards (SBs) and firm value could be due to SBs leading to lower value or a reflection of low-value firms' greater propensity to maintain SBs. We analyze the causal question using a natural experiment involving two Delaware court rulings—separated by several weeks and going in opposite directions—that affected the antitakeover force of SBs. We contribute to the long-standing debate on staggered boards by presenting empirical evidence consistent with the market viewing SBs as leading to lower firm value for the affected firms.

Current research shows that firms are more likely to benchmark against peers that pay their Chief Executive Officers (CEOs) higher compensation, reflecting self serving behavior. We propose an alternative explanation: the choice of highly paid peers represents a reward for unobserved CEO talent. We test this hypothesis by decomposing the effect of peer selection into talent and self serving components. Consistent with our prediction, we find that the association between a firm's selection of highly paid peers and CEO pay mostly represents compensation for CEO talent.

We provide one of the first large sample comparisons of cash policies in public and private U.S. firms. We first show that despite higher financing frictions, private firms hold, on average, about half as much cash as public firms do. By examining the drivers of cash policies for each group, we are able to attribute the difference to the much higher agency costs in public firms. By combining evidence from across public and private firms as well as within public firms across different qualities of governance, we are able to reconcile existing mixed evidence on the effects of agency problems on cash policies. Specifically, agency problems affect not only the target level of cash, but also how managers react to cash in excess of the target.