We examine communication in laboratory games with asymmetric information. Sellers know true asset qualities. Potential buyers only know the quality distribution. Prohibiting communication, we document the degree of adverse selection. Then we examine two alternative communication mechanisms. Under “cheap talk”, each seller can announce any subset of qualities. Under “antifraud”, the subset must include the true quality. Both mechanisms improve market efficiency, but very differently. Relying on sellers' frequently exaggerated claims, buyers often overpay under cheap talk. Efficiency gains come at the buyer's expense. The antifraud rule improves efficiency further and eliminates the wealth transfer from buyers to sellers.

Brokerage analysts frequently comment on and sometimes recommend companies that their firms have recently taken public. We show that stocks that underwriter analysts recommend perform more poorly than “buy” recommendations by unaffiliated brokers prior to, at the time of, and subsequent to the recommendation date. We conclude that the recommendations by underwriter analysts show significant evidence of bias. We show also that the market does not recognize the full extent of this bias. The results suggest a potential conflict of interest inherent in the different functions that investment bankers perform.

This article investigates the long-term equity performance of Japanese firms issuing convertible debt and equity. We find that issuing firms perform poorly (except for equity rights issues) compared to nonissuing firms even though the stock-price reaction to convertible debt and equity issues is not negative for Japanese firms. This underperformance is strongest for firms issuing public convertible debt. In contrast to the United States, poor performance is not concentrated in smaller firms and in firms with a high market-to-book ratio. Simple behavioral explanations advanced for the new issue puzzle in the United States do not seem consistent with the Japanese experience.

A firm's instantaneous probability of default is modeled as a translated square-root diffusion process modified to allow the process to be correlated with default-free interest rates. The parameters of the process are estimated for 161 firms. An extended Kalman filter approach is used that incorporates both the time-series and cross-sectional (term structure) properties of the individual firms' bond prices. The model is reasonably successful at fitting corporate bond yields, while key features of the term structures of yield spreads are captured in the signs and magnitudes of the resulting parameter estimates.

This article presents a dynamic, rational expectations equilibrium model of asset prices where the drift of fundamentals (dividends) shifts between two unobservable states at random times. I show that in equilibrium, investors' willingness to hedge against changes in their own "uncertainty" on the true state makes stock prices overreact to bad news in good times and underreact to good news in bad times. I then show that this model is better able than conventional models with no regime shifts to explain features of stock returns, including volatility clustering, "leverage effects," excess volatility, and time-varying expected returns.

Transaction costs are important for a host of empirical analyses from market efficiency to international market research. But transaction costs estimates are not always available, or where available, are cumbersome to use and expensive to purchase. We present a model that requires only the time series of daily security returns to endogenously estimate the effective transaction costs for any firm, exchange, or time period. The feature of the data that allows for the estimation of transaction costs is the incidence of zero returns. Incorporating zero returns in the return-generating process, the model provides continuous estimates of average round-trip transaction costs from 1963 to 1990 that are 1.2% and 10.3% for large and small decile firms, respectively. These estimates are highly correlated (85%), with the most commonly used transaction cost estimators.

The dynamics of the unobservable short rate are frequently estimated directly using a proxy. We examine the biases resulting from this practice (the “proxy problem”). Analytic results show that the proxy problem is not economically significant for single-factor affine models. In the two-factor affine model of Longstaff and Schwartz (1992), the proxy problem is only economically significant for pricing discount bonds with maturities of more than five years. We also describe two different numerical procedures for assessing the magnitude of the proxy problem in a general interest rate model. When applied to a nonlinear single-factor model, they suggest that the proxy problem can be economically significant.

We evaluate the performance of models for the covariance structure of stock returns, focusing on their use for optimal portfolio selection. We compare the models' forecasts of future covariances and the optimized portfolios' out-of-sample performance. A few factors capture the general covariance structure. Portfolio optimization helps for risk control, and a three-factor model is adequate for selecting the minimum-variance portfolio. Under a tracking error volatility criterion, which is widely used in practice, larger differences emerge across the models. In general more factors are necessary when the objective is to minimize tracking error volatility.

This article presents convenient reduced-form models of the valuation of contingent claims subject to default risk, focusing on applications to the term structure of interest rates for corporate or sovereign bonds. Examples include the valuation of a credit-spread option.