Knowledge that Transforms

We investigate product-market competition when managers maximize shareholder value rather than their expected discounted value of profits. If shareholders are imperfectly informed about future profitability, shareholder-value maximization can lead to either more or less aggressive product-market strategies. Lower rivals’ profits lead investors to believe that the firm’s costs are low relative to those of its rivals and that the industry’s prospects are poor. If the former (latter) inference dominates, each firm tries to lower (raise) its rivals’ profits to increase its own stock price. We also consider implications for corporate financial structure.

The stock market crash of October 1987 led to a boom in conferences, commissions, and studies of the stock market. In almost each case, the participants would try to understand the events of October 1987 by a detailed analysis or description of events during the particular days of high volatility. Of course, to us economists there was nothing qualitatively unusual about October 19, 1987; the stock market moved, and we have no model that succeeds in explaining the magnitude or sources of daily stock market volatility for that day or any other day. When asked by the National Bureau of Economic Research to organize yet another conference on this subject, I decided that it was time to put these events in a historical perspective and try to understand them in the context of longer time periods and broader models. The papers collected in this symposium issue admirably succeed in broadening...

This study investigates experimental financial markets in which firms possess more information than do potential investors. Firms were given opportunities to undertake positive net present value projects which they could either forgo or finance by selling equity. Auctions were conducted among the investors for the right to finance the projects. When the theoretical equilibrium was unique, theory predicted well. When theory permitted pooling, separation, and semiseparation, only the more efficient pooling equilibrium was observed. The domination of the pooling equilibrium was robust to different experimental experiences by participants. When available, signals were used by good firms to distinguish themselves from bad.

The downside risk in a leveraged stock position can be eliminated by using stop-loss orders. The upside potential of such a position can be captured using contingent buy orders. The terminal payoff to this stop-loss start-gain strategy is identical to that of a call option, but the strategy costs less initially. This article resolves this paradox by showing that the strategy is not self-financing for continuous stock-price processes of unbounded variation. The resolution of the paradox leads to a new decomposition of an option’s price into its intrinsic and time value. When the stock price follows geometric Brownian motion, this decomposition is proven to be mathematically equivalent to the Black–Scholes (1973) formula.

Examination of 41 closed-end fund intial public offerings (IPOs) during the period from January 1986 to June 1987 reveals that the mean intial day's return is not significantly different from zero in contrast to previous findings for nonfund IPOs. New funds also show significant negative after- market returns unlike other new issues. Despite the disparity between our findings and previous results, our results are consistent with existing models. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

This article is a reexamination of the clearing and settlement process in financial markets (particularly the futures market) and its performance during the 1987 stock market crash. It provides both some institutional background and some conceptual perspective on the problems faced by the system during the week of October 19. Much of the discussion is based on the useful analogies that can be drawn between the clearinghouse and other financial intermediaries, such as banks and insurance companies. A major conclusion is that the Federal Reserve played a vital role in protecting the integrity of the clearing and settlements system during the crash.

This article generalizes the Cox, Ross, and Rubinstein (1979) binomial option-pricing model, and establishes a convergence from discrete-time multivariate multinomial models to continuous-time multidimensional diffusion models for contingent claims prices. The key to the approach is to approximate the N-dimensional diffusion price process by a sequence of N-variate, (N+1)-nomial processes. It is shown that contingent claims prices and dynamic replicating portfolio strategies derived from the discrete time models converge to their corresponding continuous-time limits.

In a model of takeovers under asymmetric information, we identify a separating equilibrium in which the value of the bidder firm is revealed by the mix of cash and securities used as payment for the target. The model predicts that the revealed bidder value is monotonically increasing and convex in the fraction of the total offer that consists of cash. We examine the model restrictions using data from Canada, where mixed offers are both relatively frequent and free of the confounding tax-related options characterizing mixed offers in the United States. We find that the average announcement-month bidder abnormal return in mixed offers is large and significant. However, maximum likelihood estimates of parameters in both linear and nonlinear cross-sectional regressions fail to support the model predictions.

The role of the medium of exchange in competition among bidders and its effect on returns to stockholders in corporate takeovers are investigated. Consistent with recent empirical evidence, our model shows that stockholders of both acquiring and target firms obtain higher returns when a takeover is financed with cash rather than equity, and that returns to target shareholders increase with competition. The model predicts that the fraction of synergy captured by the target decreases with the level of synergy. Finally, it is shown that, as competition increases, the cash component of the offer as well as the proportion of cash offered increases.