Knowledge that Transforms

[We develop a model wherein the choice between adjustable- and fixed-rate debt can serve as a signal of firm quality. The nature of the signal depends on expected inflation volatility relative to other risk parameters. Evidence from a matched sample of debt announcements over the period 1978 to 1986 shows a difference of -2.05 percent between stock price reactions to adjustable rate and fixed rate announcements when expected inflation volatility is above an estimated threshold. Below this threshold, the difference is +0.98 percent. The evidence supports the hypothesis that the riskier debt choice serves as a favorable signal of firm quality.]

[In this article, we suggest an efficient method of approximating a general, multivariate log-normal distribution by a multivariate binomial process. There are two important features of such multivariate distributions. First, the state variables may have volatilities that change over time. Second, the two or more relevant state variables involved may covary with each other in a specified manner, with a time-varying covariance structure. We discuss the asymptotic properties of the resulting processes and show how the methodology can be used to value a complex, multiple exerciseable option whose payoff depends on the prices of two assets.]

[Corporate finance researchers have long been puzzled by low corporate debt ratios given debt's corporate tax advantage. This article recognizes that firm value typically reflects a growing stream of earnings, while current debt reflects a nongrowing stream of interest payments. Debt to value is therefore a distorted measure of corporate tax shielding. Even with very small debt-related costs, this may explain the observed magnitude and cross-sectional variation of debt ratios. Since this variation may be independent of tax shielding, debt ratios provide an inappropriate framework for empirically examining the trade-off theory of capital structure.]

[The classic option pricing model is generalized to a more realistic, imperfect, dynamically incomplete capital market with different interest rates for borrowing and for lending and a return differential between long and short positions in stock. It is found that, in the absence of arbitrage opportunities, the equilibrium price of any contingent claim must lie within an arbitrage-band. The boundaries of an arbitrage-band are computed as solutions to a quasi-linear partial differential equation, and, in general, each end-point of such a band depends on both interest rates for borrowing and for lending. This, in turn, implies that the vector of concurrent equilibrium prices of different contingent claims--even claims that are written on different underlying assets--must lie within a computable arbitrage-oval in the price space.]

[Nonprofit, mutually owned insurance and banking organizations have significant market shares in the insurance and banking industries. A first step in a systematic study of these financial mutuals is to examine the reasons for their formation. Doing so provides empirical support for the view that these mutuals arose as an efficient means of addressing contracting challenges caused by aggregate uncertainties and moral hazard. A formal model with this property is presented. We argue that information asymmetries do more to explain the kinds of contracts offered by financial mutuals than do agency problems between owners, managers, and customers.]

[This article examines the contribution of stock price overreaction and delayed reaction to the profitability of contrarian strategies. The evidence indicates that stock prices overreact to firm-specific information, but react with a delay to common factors. Delayed reactions to common factors give rise to a size-related lead-lag effect in stock returns. In sharp contrast with the conclusions in the extant literature, however, this article finds that most of the contrarian profit is due to stock price overreaction and a very small fraction of the profit can be attributed to the lead-lag effect.]

[Financial market regulations require various "insiders" to disclose their trades after the trades are made. We show that such mandatory disclosure rules can increase insiders' expected trading profits. This is because disclosure leads to profitable trading opportunities for insiders even if they possess no private information on the asset's value. We also show that insiders will generally not voluntarily disclose their trades, so for disclosure to be forthcoming, it must be mandatory. Key to the analysis is that the market cannot observe whether an insider is trading on private information regarding asset value or is trading for personal portfolio reasons.]

[Closed-end country funds can trade at large premiums and discounts from their foreign asset values (NAVs). Investigating this anomaly, we find that individual fund premiums move together, primarily because of the comovement of their stock prices with the U.S. market. Moreover, an index of country fund premiums differentiates size-ranked U.S. portfolio returns and forecasts country fund stock returns. These findings suggest that international equity prices are affected by local risk. In particular, we show that country fund premium movements reflect a U.S.-specific risk, which may be interpreted as U.S. market sentiment.]

[A subgame perfect Nash equilibrium is characterized for an industry with dissipative costs of agency. In sequence, firms can enter the industry, raise capital with external debt and/or equity, invest in a capital-intensive technology or dissipate capital in perquisites, and finally produce output. For plausible values of two critical parameters, some firms forego in equilibrium investments with positive net present values. Although more managers would like their firms to invest in the capital-intensive technology, they cannot raise the required cash in the capital market. In equilibrium, the industry can have both a profitable core of large, secure, capital-intensive firms, with some debt but no unique optimal capital structure, and a competitive fringe of small, risky, labor-intensive firms. Even as the cost of entry converges to zero, capital-intensive firms can earn extraordinary profits, while all labor-intensive firms fail. With costly agency, access to capital can become a barrier to entry.]

[A dynamic finite-horizon market for a risky asset with a continuum of risk-averse heterogeneously informed investors and a risk-neutral competitive market-making sector is examined. The article analyzes the effect of investors' horizons on the information content of prices. It is shown that short horizons enhance or reduce accumulated price informativeness depending on the temporal pattern of private information arrival. With concentrated arrival of information, short horizons reduce final price informativeness; with diffuse arrival of information, short horizons enhance it. In the process closed-form solution to the dynamic equilibrium with long-term investors is derived.]