Knowledge that Transforms

We argue that competition between dealers in a classic dealer market is intertemporal: A trader identifies a particular dealer and negotiates a final price with only the intertemporal threat to switch dealers imposing pricing discipline on the dealer. In this kind of market structure, we show that dealers will offer greater price improvement to more regular customers, and, in turn, these customers optimally choose to submit larger orders. Hence, price improvement and trade size should be negatively correlated in a dealer market. We confirm our model's predictions using unique data from the London Stock Exchange during 1991. Copyright 2005, Oxford University Press.

Corporations use a variety of processes to allocate capital. This article studies the benefits and costs of several common budget procedures from the perspective of a model with agency and information problems. Processes that delegate aspects of the decision to the agent result in too many projects being approved, while processes in which the principal retains the right to reject projects cause the agent to strategically distort his information about project quality. We show how the choice of a decision process depends on these two costs, and specifically on severity of the agency problem, quality of information, and project risk.

I develop a model of information spillovers in initial public offerings (IPOs). The outcomes of pioneers' IPOs reflect participating investors' private information on common valuation factors. This makes the pricing of subsequent issues relatively easier and attracts more firms to the IPO market. I show that IPO market timing by the followers emerges as an equilibrium clustering pattern. High offer price realizations for pioneers' IPOs better reflect investors' private information and trigger a larger number of subsequent IPOs than low offer price realizations do. This asymmetry in the spillover effect is more pronounced early on in a hot market. The model provides an explanation for recent empirical findings that illustrate the high sensitivity of going public decision to IPO market conditions. Copyright 2005, Oxford University Press.

This article presents a continuous-time agency model in the presence of adverse selection and moral hazard with a risk-averse agent and a risk-neutral principal. Under the model setup, we show that the optimal controls are constant over time, and thus the optimal menu consists of contracts that are linear in the final outcome. We also show that when a moral hazard problem adds to an adverse selection problem, the monotonicity condition well known in the pure adverse selection literature needs to be modified to ensure the incentive compatibility for information revelation. The model is applied to a few managerial compensation problems involving managerial project selection and capital budgeting decisions. We argue that in the third-best world, the relationship between the volatility of the outcome and the sensitivity of the contract depends on interactions between the managerial cost and the firm's production functions. Contrary to conventional wisdom, sometimes the higher the volatility, the higher the sensitivity of the contract. The firm receiving good news sometimes chooses safer projects or invests less than it does with bad news. We also examine the effects of the observability of the volatility on corporate investment decisions. Copyright 2005, Oxford University Press.

This article uses unique data from the London Stock Exchange to examine how trader anonymity and market liquidity affect dealers' decisions about where to place interdealer trades. During our sample period, dealers could trade with each other in the direct, nonanonymous public market or use one of four anonymous brokered trading systems. Surprisingly, we find that adverse selection is less prevalent in the anonymous brokered markets. We show that this pattern can be explained by the way dealers “price” the adverse selection risk inherent in trading with other dealers. We also relate our findings to recent changes in dealer markets.

Empirically, a price increase accompanies the announcement of an open-market stock repurchase program, even though the announcement is not a commitment. In fact, for many announced programs no shares are ever actually repurchased. This article explores this puzzle. In the single-firm-type version of the model, the option that a firm grants itself by announcing a program does not generate announcement returns. In equilibrium, long-run gains from the informed trading that the option creates are offset by short-run costs from the market's accounting for this adverse selection. Based on this trade-off, I construct a signaling (two-type) model that can deliver announcement returns. In the separating equilibrium, good firms do not incur any cost when they announce programs. Their gains from informed trading in the long run offset the cost of announcement incurred in the short run. Mimicry is costly, because a bad firm's long-run gains from informed trading cannot compensate for the short-run cost of announcing.

This article takes a shrinkage approach to examine the empirical implications of aversion to model uncertainty. The shrinkage approach explicitly shows how predictive distributions incorporate data and prior beliefs. It enables us to solve the optimal portfolios for uncertainty-averse investors. Aversion to uncertainty about the capital asset pricing model leads investors to hold a portfolio that is not mean-variance efficient for any predictive distribution. However, mean-variance efficient portfolios corresponding to extremely strong beliefs in the Fama--French model are approximately optimal for uncertainty-averse investors. The empirical Bayes approach does not result in optimal portfolios for investors who are averse to model uncertainty. Copyright 2005, Oxford University Press.

This study uses the introduction of second-generation antitakeover legislation as a natural experimental setting to infer the value that managers place on the control rights conferred by stock ownership. We conjecture that managers will reduce their stockholdings in the post-legislation period because they can ensure their prior level of control while holding fewer risky shares. Using a variety of specifications, we find robust evidence consistent with this “revealed preference” hypothesis. Further demonstrating the key role played by control considerations in managers' stockholding decisions, the reductions in ownership are concentrated in management teams with higher levels of initial ownership and in firms without poison pills.

We use various stochastic dominance criteria that account for (local) risk seeking to analyze market portfolio efficiency relative to benchmark portfolios formed on market capitalization, book-to-market equity ratio and price momentum. Our results suggest that reverse S-shaped utility functions with risk aversion for losses and risk seeking for gains can explain stock returns. The results are also consistent with a reverse S-shaped pattern of subjective probability transformation. The low average yield on big caps, growth stocks, and past losers may reflect investors’ twin desire for downside protection in bear markets and upside potential in bull markets.

I show that when an issuer has superior information about the value of its assets, it is better off selling assets separately rather than as a pool due to the information destruction effect of pooling. If, however, the issuer can create a derivative security that is collateralized by the assets, pooling and “tranching” may be optimal. If the residual risk of each asset is not highly correlated, tranching allows the issuer to exploit the risk diversification effect of pooling to create a low-risk and highly liquid security. In contrast, for an uninformed seller, pure pooling reduces underpricing and is preferred to separate asset sales. These results lead to a dynamic model of financial intermediation: originators sell pools of assets, some of which are purchased by informed intermediaries who then further pool and tranche them. Pooling and tranching allow intermediaries to leverage their capital more efficiently, enhancing the returns to their private information.