Knowledge that Transforms

This paper examines the relation between information differences across investors (i.e., information asymmetry) and the cost of capital and establishes that with perfect competition information asymmetry makes no difference. Instead, a firm’s cost of capital is governed solely by the average precision of investors’ information. With imperfect competition, however, information asymmetry affects the cost of capital even after controlling for investors’ average precision. In other words, the capital market’s degree of competition plays a critical role for the relation between information asymmetry and the cost of capital. This point is important to empirical research in finance and accounting.

Stock market volatility clusters in time, appears fractionally integrated, carries a risk premium, and exhibits asymmetric leverage effects. At the same time, the volatility risk premium, defined by the difference between the risk-neutral and objective expectations of the volatility, features short memory. This paper develops the first internally consistent equilibrium-based explanation for all these empirical facts. Using newly available high-frequency intraday data for the S&P 500 and the VIX volatility index, the authors show that the qualitative implications from the new theoretical continuous-time model match remarkably well with the distinct shapes and patterns in the sample autocorrelations and dynamic cross-correlations actually observed in the data.

Prices observed in the European sovereign credit default swap (CDS) market have severely increased since the beginning of the financial crisis. We document that the state of a country’s financial system and, since the beginning of the crisis, also the state of the world financial system have strong explanatory power for the behavior of CDS spreads, and the magnitude of this impact depends on the importance of a country’s financial system pre-crisis. Furthermore, Economic and Monetary Union member countries exhibit higher sensitivities to the health of the financial system. Our results suggest the presence of a private-to-public risk transfer through which market participants incorporate their expectations about financial industry bailouts.

We exploit a unique data set of executive turnovers in community banks to test the micro-mechanisms of discipline by examining the monitoring and influencing role of different stakeholders. We find executives are more likely to be dismissed in risky institutions. Examining the roles of shareholders, debtholders, and regulators as monitors, we obtain evidence for shareholder discipline. However, there is no evidence that risk affects dismissals more if debtholders have a larger stake in the bank or when regulators are aware of distress. Examining the roles of shareholders, debtholders, and regulators as monitors, we obtain evidence for shareholder discipline. However, there is no evidence that risk affects dismissals more if debtholders have a larger stake in the bank or when regulators are aware of distress. When we analyze risk, losses, and profitability following turnovers, we obtain no evidence that replacing executives improves performance.

Better measurement of the output produced and capital employed by firms substantially improves the ability to explain capital structure variation in the cross section. For every firm, we construct the set of other firms producing the same output using the set of product market competitors listed in the firm’s public Securities and Exchange Commission filings. In addition, we improve measurement of capital structure by explicitly accounting for leased capital. These two steps increase the explanatory power of the average capital structure of other firms producing similar output on a firm’s capital structure by 50% compared to using only the average unadjusted debt ratio of other firms in the same three-digit Standard Industrial Classification (SIC) code. We provide evidence that the large explanatory power of the capital structure of other firms producing similar output is related to the assets used in the production process. Our findings suggest that what a firm produces and the assets used in production are the most important determinants of capital structure in the cross section.