Knowledge that Transforms

We examine differences in financial leverage between parent and spun-off firms that emerge from corporate spin-offs. Our tests control for past financing choices and the costs of adjusting capital structure, factors that can obscure cross-sectional patterns among firms' target leverage ratios. We find that firms that emerge from spin-offs with more financial leverage have a higher cash flow return on assets, lower variability of industry operating income, and a greater proportion of fixed assets. The positive relation between profitability and the use of financial leverage, in a setting that is free of pecking order effects, is particularly important because it contrasts with existing evidence. Our results indicate that the ability to cover debt payments and default-related costs are important determinants of the use of financial leverage, as implied by the trade-off theory of capital structure. We find no evidence that managerial incentives or governance characteristics affect the difference in leverage ratios in firms that emerge from spin-offs.

We analyze how two dimensions of technological progress affect competition in financial services. While better technology may result in improved information processing, it might also lead to low-cost or even free access to information through, for example, informational spillovers. In the context of credit screening, we show that better access to information decreases interest rates and the returns from screening. However, an improved ability to process information increases interest rates and bank profits. Hence predictions regarding financial claims' pricing hinge on the overall effect ascribed to technological progress. Our results generalize to other financial markets where informational asymmetries drive profitability, such as insurance and securities markets.

This article examines the link between several well-known asset pricing "anomalies" and the covariance structure of returns. I find size, book-to-market, and momentum strategies exhibit a strong, weak, and negligible relation to covariance risk, respectively. A size factor helps predict future volatility and covariation, improving the efficiency of investment strategies. Moreover, its premium rises following increases in both its volatility and covariation with other assets. These effects are amplified in recessions. No such relations exist for book-to-market or momentum. These findings may shed light on explanations for these premia and present a challenging set of facts for future theory.

This article proposes a new approach to evaluate contagion in financial markets. Our measure of contagion captures the coincidence of extreme return shocks across countries within a region and across regions. We characterize the extent of contagion, its economic significance, and its determinants using a multinomial logistic regression model. Applying our approach to daily returns of emerging markets during the 1990s, we find that contagion is predictable and depends on regional interest rates, exchange rate changes, and conditional stock return volatility. Evidence that contagion is stronger for extreme negative returns than for extreme positive returns is mixed.

We develop a theory of market crashes based on differences of opinion among investors. Because of short-sales constraints, bearish investors do not initially participate in the market and their information is not revealed in prices. However, if other previously bullish investors bail out of the market, the originally bearish group may become the marginal "support buyers," and more will be learned about their signals. Thus accumulated hidden information comes out during market declines. The model explains a variety of stylized facts about crashes and also makes a distinctive new prediction—that returns will be more negatively skewed conditional on high trading volume.

This article develops restrictions that arbitrage-constrained bond prices impose on the short-term rate process in order to be consistent with given dynamic properties of the term structure of interest rates. The central focus is the relationship between bond prices and the short-term rate volatility. In both scalar and multidimensional diffusion settings, typical relationships between bond prices and volatility are generated by joint restrictions on the risk-neutralized drift functions of the state variables and convexity of bond prices with respect to the short-term rate. The theory is illustrated by several examples and is partially extended to accommodate the occurrence of jumps and default.

This article considers why a manager would choose to submit himself to the discipline of bank monitoring. This issue is analyzed within the context of a model where the manager enjoys private benefits, which can be restricted by the monitor, and is optimally compensated by shareholders. Within this setting we find that managers will submit to monitoring when they receive favorable private information. This result is consistent with event study evidence that suggests that the market has a favorable view of financing choices that increase monitoring.

This article studies the contracting problem between an individual investor and a professional portfolio manager in a continuous-time principal-agent framework. Optimal contracts are obtained in closed form. These contracts are of a symmetric form and suggest that a portfolio manager should receive a fixed fee, a fraction of the total assets under management, plus a bonus or a penalty depending upon the portfolio's excess return relative to a benchmark portfolio. The appropriate benchmark portfolio is an active index that contains risky assets where the number of shares invested in each asset can vary over time, rather than a passive index in which the number of shares invested in each asset remains constant over time.

We examine the costs and benefits of the global integration of initial public offering (IPO) markets associated with the diffusion of U.S. underwriting methods in the 1990s. Bookbuilding is becoming increasingly popular outside the United States and typically costs twice as much as a fixed-price offer. However, on its own, bookbuilding only leads to lower underpricing when conducted by U.S. banks and/or targeted at U.S. investors. For most issuers, the gains associated with lower underpricing outweighed the additional costs associated with hiring U.S. banks or marketing in the United States. This suggests a quality/price trade-off contrasting with the findings of Chen and Ritter, particularly since non-U.S. issuers raising US20 million-US80 million also typically pay a 7% spread when U.S. banks and investors are involved.

This article provides several new insights into the economic sources of skewness. First, we document the differential pricing of individual equity options versus the market index and relate it to variations in return skewness. Second, we show how risk aversion introduces skewness in the risk-neutral density. Third, we derive laws that decompose individual return skewness into a systematic component and an idiosyncratic component. Empirical analysis of OEX options and 30 stocks demonstrates that individual risk-neutral distributions differ from that of the market index by being far less negatively skewed. This article explains the presence and evolution of risk-neutral skewness over time and in the cross section of individual stocks.