Knowledge that Transforms

Using the model structure of Easley and O'Hara (Journal of Finance, 47, 577–604), we demonstrate how the parameters of the market-maker's beliefs can be estimated from trade data. We show how to extract information from both trade and no-trade intervals, and how intraday and interday data provide information. We derive and evaluate tests of model specification and estimate the information content of differential trade sizes. Our work provides a framework for testing extant microstructure models, shows how to extract the information contained in the trading process, and demonstrates the empirical importance of symmetric information models for asset prices.

Asymmetric information between banks and firms can preclude financing of valuable projects. Trade credit can alleviate this problem by incorporating in the lending relation the private information held by suppliers about their customers. Incentive compatibility conditions prevent collusion between two of the agents (e.g., the buyer and the seller) against the third (e.g., the bank). Consistent with the empirical findings of Petersen and Rajan (1995), firms without relationships with banks resort more to trade credit, and sellers with greater ability to generate cash flows provide more trade credit. Finally small firms react to monetary contractions by using trade credit, consistent with the empirical results of Nilsen (1994).

A simple time-series market microstructure model is constructed within which existing models of spread components are reconciled. We show that existing models fail to decompose the spread into all its components. Two alternative extensions of the simple model are developed to identify all the components of the spread and to estimate the spread at which trades occur. The empirical results support the presence of a large order processing component and smaller, albeit significant, adverse selection and inventory components. The spread components differ significantly according to trade size and are also sensitive to assumptions about the relation between orders and trades.

This article presents some new results on an unexplored dataset on hedge fund performance. The results indicate that hedge funds follow strategies that are dramatically different from mutual funds, and support the claim that these strategies are highly dynamic. The article finds five dominant investment styles in hedge funds, which when added to Sharpe’s (1992) asset class factor model can provide an integrated framework for style analysis of both buy-and-hold and dynamic trading strategies.

This article provides a Markov model for the term structure of credit risk spreads. The model is based on Jarrow and Turnbull (1995), with the bankruptcy process following a discrete state space Markov chain in credit ratings. The parameters of this process are easily estimated using observable data. This model is useful for pricing and hedging corporate debt with imbedded options, for pricing and hedging OTC derivatives with counterparty risk, for pricing and hedging (foreign) government bonds subject to default risk (e.g., municipal bonds), for pricing and hedging credit derivatives, and for risk management.

[A simple time-series market microstructure model is constructed within which existing models of spread components are reconciled. We show that existing models fail to decompose the spread into all its components. Two alternative extensions of the simple model are developed to identify all the components of the spread and to estimate the spread at which trades occur. The empirical results support the presence of a large order processing component and smaller, albeit significant, adverse selection and inventory components. The spread components differ significantly according to trade size and are also sensitive to assumptions about the relation between orders and trades.]

[This article examines debt securities underwritten by Section 20 subsidiaries of bank holding companies relative to those underwritten by investment houses. Consistent with a net certification effect for banks, bank underwriting of lower credit rated firms to whom the bank lends results in relatively higher prices (lower yields). We find no evidence of conflicts of interest even when an issue is used to repay bank debt. Further, banks bring a relatively larger proportion of small issues to the market. Contrary to the contention that universal banking stunts availability of finance to small firms, bank underwritings appear to benefit small firms.]

This article presents some new results on an unexplored dataset on hedge fund performance. The results indicate that hedge funds follow strategies that are dramatically different from mutual funds, and support the claim that these strategies are highly dynamic. The article finds five dominant investment styles in hedge funds, which when added to Sharpe's (1992) asset class factor model can provide an integrated framework for style analysis of both buy-and-hold and dynamic trading strategies.

This article shows (1) how entry and exit of firms in a competitive industry affect the valuation of securities and optimal capital structure, and (2) how, given a trade-off between tax advantages and agency costs, a firm will optimally adjust its leverage level after it is set up. We derive simple pricing expressions for corporate debt in which the price elasticity of demand for industry output plays a crucial role. When a firm optimally adjusts its leverage over time, we show that total firm value comprises the value of discounted cash flows assuming fixed capital structure, plus a continuum of options for marginal increases in debt.

[This theory can explain why bank debt is universally senior, consistent with the presence of conflict (lawyers) and absolute priority violations in financial distress: Better organized banks would more strongly contest priority in financial distress if they were junior. Because "deterrence" can reduce creditors' total expenses in a priority contest, the ex post stronger lobbyist/litigant should be senior ex ante. For equivalent reasons, the theory can advise when public debt should be senior to trade credit and/or implicit contracts, and can even suggest one rationale for the absolute priority rule (APR). This article further shows that Chapter 11 creditor reimbursement procedures can lower overall costs.]