Knowledge that Transforms

We examine optimal capital allocation and managerial compensation in a firm with two investment projects (divisions) each run by a risk-neutral manager who can provide (i) (unverifiable) information about project quality and (ii) (unverifiable) access to value-enhancing, but privately costly resources. The optimal managerial compensation contract offers greater performance pay and a lower salary when managers report that their project is higher quality. The firm generally underinvests in capital and managers underutilize resources (relative to first-best). We also derive cross-sectional predictions about the sensitivity of investment in one division to the quality of investment opportunities in the other division, and the relative importance of division-level and firm-level performance-based pay in managerial compensation contracts.

This article empirically tests five structural models of corporate bond pricing: those of Merton (1974), Geske (1977), Longstaff and Schwartz (1995), Leland and Toft (1996), and Collin-Dufresne and Goldstein (2001). We implement the models using a sample of 182 bond prices from firms with simple capital structures during the period 1986-1997. The conventional wisdom is that structural models do not generate spreads as high as those seen in the bond market, and true to expectations, we find that the predicted spreads in our implementation of the Merton model are too low. However, most of the other structural models predict spreads that are too high on average. Nevertheless, accuracy is a problem, as the newer models tend to severely overstate the credit risk of firms with high leverage or volatility and yet suffer from a spread underprediction problem with safer bonds. The Leland and Toft model is an exception in that it overpredicts spreads on most bonds, particularly those with high coupons. More accurate structural models must avoid features that increase the credit risk on the riskier bonds while scarcely affecting the spreads of the safest bonds.

We study endogenous liquidity trading in a market with long-lived asymmetric information. We distinguish between public information, tractable information that can be acquired, and intractable information that cannot be acquired. Besides information asymmetry and noise, the adverse-selection spread depends on the diffusion of intractable information and on the interest rate. With endogenous liquidity trading, efficiency is lower than that implied by noise-trading models. Liquidity traders benefit from the information released through the insider's trades in spite of their monetary losses. We study factors that affect the insider's information acquisition decision, including the amount of intractable information, observability, and information acquisition costs.

We show that bidding firms consider target board characteristics when deciding takeover offer types and initial offer premiums. We study a sample of 436 proposed negotiated mergers and bypass offers. Firms with individuals holding the titles of both chief executive officer (CEO) and board chair are more likely to receive bypass offers. These offers are more likely to be successful and generate higher target shareholder gains over the takeover offer period. When the target's board is independent, the target is less likely to receive a high premium and the offer is less likely to succeed.

We use a moral hazard model to compare monitored (nontraded) bank loans and traded (nonmonitored) bonds as sources of external funds for industry. We contrast the theoretical conditions that favor each system with the historical conditions prevailing when these financial systems evolved during the British and German industrial revolutions. To study persistence, we consider an entry model where financiers take the industrial structure as given when they lend and firms take the financial system as given when they borrow. We show multiple equilibria can exist, compare equilibria in welfare terms, and discuss their robustness to coordination between lenders and borrowers.

This article studies equilibrium asset pricing when agents face nonnegative wealth constraints. In the presence of these constraints it is shown that options on the market portfolio are nonredundant securities and the economy's pricing kernel is a function of both the market portfolio and the nonredundant options. This implies that the options should be useful for explaining risky asset returns. To test the theory, a model is derived in which the expected excess return on any risky asset is linearly related (via a collection of betas) to the expected excess return on the market portfolio and to the expected excess returns on the nonredundant options. The empirical results indicate that the returns on traded index options are relevant for explaining the returns on risky asset portfolios.

We develop a preference-based equilibrium asset pricing model that explains low-frequency conditional volatility. Similar to Barberis, Huang, and Santos (2001), agents in our model care about wealth changes, experience loss aversion, and keep a mental scorecard that affects their level of risk aversion. A new feature of our model is that when perturbed by unexpected returns, investors become temporarily more sensitive to news. Gradually investors become accustomed to the new level of wealth, restoring prior levels of risk aversion and news sensitivity. The state-dependent sensitivity to news creates the type of volatility clustering found in low-frequency stock returns. We find empirical support for our model's predictions that relate the scorecard to conditional volatility and skewness.

This article characterizes the systematic risk exposures of hedge funds using buy-and-hold and option-based strategies. Our results show that a large number of equity-oriented hedge fund strategies exhibit payoffs resembling a short position in a put option on the market index and therefore bear significant left-tail risk, risk that is ignored by the commonly used mean-variance framework. Using a mean-conditional value-at-risk framework, we demonstrate the extent to which the mean-variance framework underestimates the tail risk. Finally, working with the systematic risk exposures of hedge funds, we show that their recent performance appears significantly better than their long-run performance.

I solve (with an approximation) a Grossman-Stiglitz economy under general preferences, thus allowing for wealth effects. Because information generates increasing returns, decreasing absolute risk aversion, in conjunction with the availability of costly information, is sufficient to explain why wealthier households invest a larger fraction of their wealth in risky assets. One no longer needs to resort to decreasing relative risk aversion, an empirically questionable assumption. Furthermore, I show how to distinguish empirically between these two explanations. Finally, I find that the availability of costly information exacerbates wealth inequalities.

Using a cross section of effectively the entire universe of overseas listings across world markets, we examine the market preferences of firms listing their stock abroad. We find that geographic, economic, cultural, and industrial proximity play the dominant role in the choice of overseas listing venue. Contrary to the notion that firms maximize international portfolio diversification gains in listing abroad, cross-listing activity is more common across markets for which diversification gains are relatively low. Our findings imply that the same proximity constraints that are believed to lead to "home bias" in investment portfolio decisions also exert a profound influence on financing decisions.