Knowledge that Transforms

[An attempt is made to explain how enforceability is achieved in international debt contracts. Each bank announces the policy of denying credit to borrowers who default and chooses to adhere to it to maintain its reputation of being a tough bank to discipline its other borrowers. Loans are made by syndicates of banks in order to make the penalty for default severe enough so borrowers would choose not to default voluntarily. The model predicts that the interest rate charged on loans is smaller for the larger borrowers. Also, for any given borrower, the interest rate may fall after each successive default.]

[We develop a model of the acquisition market in which the acquirer has a choice between two takeover mechanisms: mergers and tender offers. A merger is modeled as a bargaining game between the acquiring and target firms; whereas a tender offer is modeled as an auction in which bidders arrive sequentially and compete for the target. At any stage of the bargaining game the acquiring firm can stop negotiating and make a tender offer. In equilibrium, there is a unique level of synergy gains below which the acquiring firm makes only a merger attempt as it expects to lose in the competition resulting from a tender offer. For synergy gains above this level, tender offers can occur. However, to get tender offers, target shareholders must give their managers golden parachutes that give higher payoffs in tender offers than in mergers.]

[A general approach to testing serial dependence restrictions implied from financial models is developed. In particular, we discuss joint serial dependence restrictions imposed by random walk, market microstructure, and rational expectations models recently examined in the literature. This approach incorporates more information from the data by explicitly modeling dependencies induced by the use of overlapping observations. Because the estimation problem is sufficiently simple in this framework, the test statistics have simple representations in terms of only a few unknown parameters. As a result, relatively good size properties are attained in small samples. In addition, the benefit to overlapping observations and the advantage of examining multiperiod time series are explicitly quantified.]

[We show that there is an asymmetry in the predictability of the volatilities of large versus small firms. Using both univariate and multivariate ARMA-GARCH-M parameterizations, we find that volatility surprises to large market value firms are important to the future dynamics of their own returns as well as the returns of smaller firms. Conversely, however, shocks to smaller firms have no impact on the behavior of either the mean or the variance of the returns of larger capitalization companies.]

[The effect of financial policy on a firm's incentives to maintain its reputation for producing a high-quality product is analyzed. It is demonstrated that in certain situations debt will reduce a firm's ability to credibly offer high-quality products and, as a consequence, will reduce its value. However, for firms with assets that have high salvage values in liquidation, debt may increase their ability to credibly offer high-quality products and, therefore, increase their values.]

[We present a model in which some of the firm's information ("news") can be disclosed verifiably and some information ("type") cannot, to show that some firms may voluntarily withhold good news and disclose bad news. We describe an equilibrium in which high-type firms withhold good news and disclose bad news, whereas low-type firms disclose good news and withhold bad news. Under some parameter values, this equilibrium exists when other more traditional equilibria are ruled out by standard equilibrium refinements. The model explains some otherwise anomalous empirical evidence concerning stock price reactions to disclosure, provides some new empirical predictions, and suggests that mandatory disclosure requirements may have the undesirable consequence of making it more difficult for firms to reveal information that cannot be disclosed credibly.]

[The Modigliani and Miller propositions on the irrelevancy of capital structure and dividends are shown to be valid in a large class of models with asymmetric information. The main assumption is that managerial compensation is chosen optimally. This differs from most of the recent articles on this topic, which impose by fiat a suboptimal contract. Even when imperfections internal to the firm preclude optimal investment, there is a separation between incentives and financing. We conclude that corporations should move toward contracts with better incentives, and that new models should be built that recognize the limitations to optimal contracting.]

[Stock prices cluster on round fractions. Clustering increases with price level and volatility, and decreases with capitalization and transaction frequency. Clustering is pervasive. Price clustering will occur if traders use discrete price sets to simplify their negotiations. Exchange regulations require that most stocks be traded on eighths. Clustering on larger fractions will occur if traders choose to use discrete price sets based on quarters, halves, or whole numbers. An econometric model of clustering is derived and estimated. Projections from the results suggest that traders would frequently use odd sixteenths when trading low-price stocks, if exchange regulations permitted trading on sixteenths.]

[Marketing costs are introduced into the security design environment outlined in Allen and Gale (1988). It is shown that splitting the firm's cash flow between products enhances their investor appeal and reduces marketing costs. We also explain how the extremal product design in Allen and Gale is thereby avoided and how in simple cases, debt, equity, or warrants can be optimal. Furthermore, we illustrate in general terms how the optimal solution employs portfolios of option-type products, and we give an example of two optimal products that share profits in seven of eight states.]

[An economy is analyzed in which agents first choose whether to acquire costly information about the return to a risky asset, and then choose demand functions that determine the allocation of assets. It is a well-known paradox that if agents are price-takers and prices are fully revealing, then an equilibrium with costly information acquisition does not exist. It is shown that if the price formation process is modeled explicitly and agents are not price-takers, then it is possible to have an equilibrium with fully revealing prices and costly information acquisition.]