Knowledge that Transforms

This article documents an apparent pricing anomaly involving 94 percent, 30-year Treasury bonds during the months of May and June 1986. During this period, the price of the 94s rose sharply relative to the prices of other long-term Treasury bonds and created a potential arbitrage opportunity. In addition, owners of the 94 bonds were able to borrow at a zero interest rate bypledging their bonds. Detailed examination reveals that this relative pricing anomaly cannot be attributed to changes in the level or term structure of interest rates or to differences between the bonds with respect to liquidity, taxation, or duration.

Futures contracts often include a variety of delivery options that allow participants flexibility in satisfying the contract. These options have the potential to broaden the appeal of the contact. However, if these options are valuable, they may reduce the hedging effectiveness of the contract. This article analyzes the GNMA CDR futures contract that appears to have failed because of flaws in the contract's design. For the first 6 years following its introduction, the contract attracted significant and increasing volume, but, subsequently, the volume declined to almost zero. Over the years during which the volume experienced its most dramatic decline, the Treasury-bond futures contract provided a better hedge for current coupon GNMA securities than did the GNMA CDR futures contract. And, over this same period, the value of the quality option embedded in the contract often exceeded 5 percent of the futures price and reached a level of 19 percent at one point. We interpret the evidence to indicate that the contract failed because the delivery options reduced the hedging effectiveness of the contract for current coupon mortgage securities.

This article presents a simple model of the innovation of new futures contracts by transaction volume-maximizing futures exchanges in incomplete markets under uncertainty, with mean-variance preferences and proportional transactions costs. We characterize the set of Nash equilibria for a number of exchanges simultaneously or sequentially choosing contracts. The optimal monopolistic contract design is shown to be Pareto-optimal. An example shows the failure of Pareto optimality for a particular Nash equilibrium. Likewise, in a monopolistic multiperiod setting, an example shows the failure of Pareto optimality given an incentive for the exchange to induce turnover.

We present a model of corporate acquisitions in which initially uninformed bidders must incur costs to learn their (independent) valuations of a potential takeover target. The first bidder makes either a preemptive bid that will deter the second bidderfrom investigating or a lower bid that will induce the second bidder to investigate and possibly compete. We show that the expected price of the target may be higher when the first bidder makes a deterring bid than when there is competitive bidding. Hence, by weakening the first bidder’s incentive to choose a preemptive bid, regulatory and management policies to assist competing bidders may reduce both the expected takeover price and social welfare.

When a firm is in financial distress, in most cases a set of mutually advantageous reorganization plans exist. This article shows that the bankruptcy code, by providing rules governing the negotiation process, yields a unique solution to the reorganization process. In addition, the structure imposed by the code mitigates the holdout problem created by the individual claimant's divergent incentives.

This article develops and estimates a simple model for monthly expected stock returns that relies on the rapidly decaying structure of shorter-horizon (weekly) expected returns. The most striking aspect of our finds is that the rapid mean reversion in short-horizon expected returns implies much greater variation through time in monthly expected returns than has been documented in earlier studies. For instance, during the 1962 to 1985 period, over 25 percent of the return variance of small firms can be explained by time variation in expected returns.

This article develops a model in which patterns in buy and sell volume, order imbalances, and expected price changes arise endogenously. The model covers cases in which the market maker is competitive and is a monopolist. Our results provide an explanation for the existence of patterns in mean returns within the trading day and across trading days.

Most models of financial structure embody an assumption about financial distress that causes debt to be costly to the issuing firm. This approach has been criticized on the grounds that the assumed costs could be avoided by a costless financial reorganization. In this article we show that despite the possibility of costless reorganization, it may be rational for firms to incur significant costs in the resolution of financial distress. The main assumptions that give rise to our results are the existence of asymmetric courts to impose a reorganization on the claimants of a firm. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

Earnings and dividend announcements on Fridays are much more likely to contain reports of declines and to be associated with negative abnormal returns than those on other weekdays. While Friday reports elicit negative average returns for firms in all size classes, announcements by smaller firms have more negative returns associated with them on the following trading day, suggesting that they are more likely to release reports after close of trading or that prices adjust more slowly to the information in these reports. Nevertheless, a comparison of the average returns by weekday, with and without the Friday announcements, leads us to conclude that these announcements explain a surprisingly small proportion (3.4 percent) of the weekend effect.

When management has private information it has an incentive to finance investment by issuing a security that is overpriced in the market. The market's valuation of the issued security may lead management either to forego profitable investments or to invest suboptimally. With investment fixed, there exist fully revealing signaling equilibria in which the covenants of the issued claim serve as signals. A straight bond issue cannot provide the signals but a convertible bond issue can. With investment endogenous, fully revealing equilibria exist in which the par value of a straight bond issue and the announced level of investment jointly serve as signals and investment is optimal. The article also investigates the role of a stock repurchase in these equilibria.