Knowledge that Transforms

In this study, we examine the effect of pre-trade transparency on market quality using data before and after the introduction of SuperMontage. Our results show that both bid–ask spreads and return volatility declined significantly after the implementation of SuperMontage. In addition, SuperMontage led to significant improvements in the SEC Rule 605 execution quality measures (e.g., faster executions and higher fill rates). Overall, our results indicate that SuperMontage improved market and execution quality on NASDAQ through greater pre-trade transparency and the integrated, more efficient quotation and trading system.

We theorize and confirm a new channel by means of which liquidity costs are embedded in CDS spreads. We show that credit default swap (CDS) spreads are directly related to equity market liquidity in the Merton [Merton, R.C., 1974. On the pricing of corporate debt: The risk structure of interest rates. J. Finance 29, 449–470] model via hedging. We confirm this relationship empirically using a sample of 1452 quarterly CDS spreads over 2001–2005. In the model, this relationship is monotone increasing when credit quality worsens. These results are robust to alternative measures of equity liquidity and other possible determinants of CDS spreads.

The paper studies outside finance in a model of two-dimensional moral hazard, involving risk choices as well as effort choices. If the entrepreneur has insufficient funds, a first-best outcome cannot be implemented. Second-best outcomes involve greater failure risk than first-best outcomes. For a Cobb-Douglas technology, second-best effort and investment levels are smaller than first-best; for other technologies, the comparison depends on the elasticity of substitution. If firm returns are not too noisy as signals of behaviour, the optimal incentive scheme corresponds to some mix of debt and equity finance. If firm returns are too noisy, this interpretation is not available.

This paper uses proprietary data on European IPOs with detailed information on the demand at different points of time and allocation for institutional and retail investors. The nature of the data allows us to analyze the reason of why institutional investors as a group get more allocations of underpriced issues than retail investors. By explicitly examining institutional and retail demand for different kinds of stocks, we find that this is due to institutional investors' superior ability to detect underpriced stocks rather than the underwriter's preferential treatment. At the same time, the subset of domestic institutional investors supports the underwriter in issues with weak demand and receives in turn favorable allocations in underpriced issues.

We evaluate the impact of corporate governance on the valuation of firms in a large cross-section of countries. Unlike previous work, we differentiate between minimally accepted governance attributes that are satisfied by all firms in a given country and governance attributes that are adopted at the firm level. This approach allows us to differentiate between firm-level and country-level corporate governance, thus contributing to an ongoing debate in the literature about whether governance attributes are largely determined by country factors or firm characteristics. Despite the costs associated with improving corporate governance at the firm level, we find that many firms choose to adopt governance provisions beyond those that are adopted by all firms in the country, and that these improvements in corporate governance are positively associated with firm valuation. Firms that choose not to adopt sound governance mechanisms tend to have concentrated ownership and sizeable free cash flow, consistent with agency theories based on self-interested managers and controlling shareholders. Our results indicate that the market rewards companies that are prepared to adopt governance attributes beyond those required by laws and common corporate practices in the home country.

We examine the effects of regulations designed to address the potential conflict of interest that arises when sell-side analyst research is not independent of investment banking. We focus on two types of regulation: (1) internal barriers between equity research and investment banking that restrict communication; and (2) disclosure requirements relating to analyst compensation. We find that information barriers can increase research effort and improve report quality by limiting an investment bank's ability to distort its analyst's incentives. However, this type of regulation can also reduce information production and lower the quality of reports if an investment bank benefits directly from research activity. Disclosure requirements, on the other hand, unambiguously lead to more informative prices and a higher report quality relative to either information barriers or no regulation.

We develop a theory’ and empirical test of how the legal system affects the relationship between venture capitalists and entrepreneurs. The theory uses a double moral hazard framework to show how optimal contracts and investor actions depend on the quality of the legal system. The empirical evidence is based on a sample of European venture capital deals. The main results are that with better legal protection, investors give more non-contractible support and demand more downside protection. These predictions are supported by the empirical analysis. Using a new empirical approach of comparing two sets of fixed-effect regressions, we also find that the investor’s legal system is more important than that of the company in determining investor behavior.

The paper seeks to explain the huge cross country variation in private pension funding, shaped by historical choice made when universal pension systems were created after the Great Depression. According to Perotti and von Thadden [Perotti, E., von Thadden, E.-L., 2006. The political economy of corporate control and labor rents. J. Polit. Econ., 145–175], large inflationary shocks due to war damage devastated middle class savings in some countries in the first half of the XX century. This shaped political preferences over the role of capital markets and social insurance, and contributed to the Great Reversals documented by Rajan and Zingales [Rajan, R.G., Zingales, L., 2003. The great reversals: The politics of financial development in the 20th century. J. Finan. Econ. 69 (1), 5–50]. Wealth distribution shocks are indeed strongly related to private pension funding, as a large shock reduces the stock of private retirement assets by 58% of GDP. While the sample size is limited, the results are robust to other explanations, such as legal origin, original financial development, past and current demographics, religion, electoral voting rules, redistributive politics, national experiences with financial market performance, or other major financial shocks that were not specifically redistributive. Corroborating evidence indicates that such redistributive shocks help explain the cross country variation in social expenditures, state ownership of industry, financial development and employment protection measures as predicted by the political shift hypothesis.

In this paper, we propose a model where N strategic informed traders who are endowed with heterogeneous noisy signals with different precisions compete in a market with a single risky asset. We explicitly describe the unique linear equilibrium that exists in this setup and derive its properties. Moreover, we focus on the effects of noise on the competition between traders. We show that noise softens the competition between traders. In particular, for N exceeding three and for certain sets of noise in traders' signals, each trader's individual profit is greater than the one obtained in the case of perfect information.