Knowledge that Transforms

Abstract In this paper we set up a model of start-up finance under double moral hazard. Entrepreneurs lack own resources and business experience to develop their ideas. Venture capitalists can provide start-up finance and commercial support. The effort put forth by either agent contributes to the firm's success, but is not verifiable. As a result, the market equilibrium is biased towards inefficiently low venture capital support. The capital gains tax becomes especially harmful, as it further impairs advice and causes a first-order welfare loss. Once the capital gains tax is in place, limitations on loss off-set may paradoxically contribute to higher quality of venture capital finance and welfare. Subsidies to physical investment in VC-backed start-ups are detrimental in our framework. JEL classification codes: D82, G24, H24, H25

Abstract Using a panel of Dutch listed firms this paper provides empirical evidence for the hypothesis that more risky firms are confronted with more severe capital market constraints than relatively less risky firms. The paper also contributes to the discussion on the usefulness of cash flow as a measure of financial constraints. We present a stochastic version of the Kaplan-Zingales (1997) model. We show that cash flow sensitivity can be used as a meaningful indicator of financing constraints if firms are classified by the degree of uncertainty they face and if the uncertainty originates from cost uncertainty. JEL classification codes: E22, G32.

Abstract The 2000 implementation of float-capitalization index weights in the Dow Jones STOXX SM indices changed the demand for large European stocks. In this paper, we test for imperfect-substitution and price-pressure effects due to the change in the demand for stocks. Our results show that we cannot reject complete reversal after eight weeks of abnormal trading volume for companies with both decreased or increased index weights. This result is consistent with the existence of downward sloping demand curves for stocks. Contrary to the fundamental assumption of perfectly elastic demand curves in asset pricing theories, our findings suggest that a price pressure effect is not a plausible explanation. JEL classification codes: G11; G14

The strength of economic theory is that it can look at the hypothetical rather than merely ex-post rationalize observed behavior. In particular, it can ask the 'what if' question of how changes in model parameters might affect efficiency and social welfare. Based on the answer, it can then suggest welfare-improving policy measures in situations in which privately optimal outcomes are socially inefficient.

Abstract This paper studies the effect of investor-specific differential dividend taxation on the dynamics of equilibrium security prices and allocations. In order to deal with the inherent Pareto inefficiency of such an equilibrium as well as the preclusion of tax arbitrage, we construct a continuous-time equilibrium via a representative investor with state-dependent utility. Investors differ in their pricing of risk, inducing investor-specific consumption-based CAPMs, with differential taxation appearing as an additional factor. The interest rate, stock price, and consumption dynamics are also impacted. Under logarithmic preferences, risk is transferred from the higher-taxed to the lower-taxed investor, and the interest rate decreases to counteract extra precautionary savings against this suboptimally shared risk. Numerical analysis reveals further tax rate, time-to-horizon, and dividend risk effects on equilibrium quantities. For most wealth allocations, the stock return volatility is increased above the no-tax benchmark. JEL classification codes: G10, G12, D51, D58, H20

Abstract The paper presents an incomplete market pricing methodology generating asset price bounds conditional on the absence of attractive investment opportunities in equilibrium. The paper extends and generalises the seminal article of Cochrane and Saá-Requejo who pioneered option pricing based on the absence of arbitrage and high Sharpe Ratios. Our contribution is threefold: We base the equilibrium restrictions on an arbitrary utility function, obtaining the Cochrane and Saá-Requejo analysis as a special case with truncated quadratic utility. We extend the definition of Sharpe Ratio from quadratic utility to the entire family of CRRA utility functions and restate the equilibrium restrictions in terms of Generalised Sharpe Ratios which, unlike the standard Sharpe Ratio, provide a consistent ranking of investment opportunities even when asset returns are highly non-normal. Last but not least, we demonstrate that for Itô processes the Cochrane and Saá-Requejo price bounds are invariant to the choice of the utility function, and that in the limit they tend to a unique price determined by the minimal martingale measure. JEL classification codes: G12, D40, C61