Knowledge that Transforms

The presence of traders with superior information leads to a positive bid-ask spread even when the specialist is risk-neutral and makes zero expected profits. The resulting transaction prices convey information, and the expectation of the average spread squared times volume is bounded by a number that is independent of insider activity. The serial correlation of transaction price differences is a function of the proportion of the spread due to adverse selection. A bid-ask spread implies a divergence between observed returns and realizable returns. Observed returns are approximately realizable returns plus what the uninformed anticipate losing to the insiders.

This paper presents a model of stock price reactions to partially anticipated events. The model formalizes the intuition that stock price reactions reflect both the economic importance of events and the extent to which events are surprises. Unbiased estimates of the economic importance of partially anticipated events must combine stock price reactions to events with stock price movements in periods when no event occurs. The model is used to estimate the value of acquisition attempts made by frequently acquiring firms. For a sample of thirty active acquirers, the evidence indicates that acquisition attempts were profitable investment projects.

A ‘cross-sectional regression test’ (CSRT) of the CAPM is developed and its connection to the Hotelling T2 test of multivariate statistical analysis is explored. Algebraic relations between the CSRT, the likehood ratio test and the Langrange multiplier test are derived and a useful small-sample bound on the distribution function of the CSRT is obtained. An application of the CSRT suggests that the CRSP equally-weighted index is inefficient, but that the inefficiency is not explained by a firm size-effect from February to December.

Optimal policies for selling a risky depreciable asset with proportional taxes and transaction costs are derived for a representative investor who maximizes the market value of his investment. Also calculated are the market value of his investment and the competitive price of the depreciable asset. Depending upon the values of various parameters, the investor realizes either capital gains and no losses, capital losses and no gains, or neither gains nor losses. Additional properties of the solution are derived numerically.

We examine the utility of the statistical factor model of the process generating stock returns in the context of event studies. For a variety of estimation procedures and experimental designs we find limited value added relative to the use of a simple market model. We would attribute this finding to misspecification of the statistical factor analysis model, and suspect that there exist more robust procedures for estimating the factor structure of stock returns.

This paper analyzes the pricing of two types of secured debt and shows that secured debt can be used to increase the value of the firm. In particular, it is shown that some profitable projects will not be undertaken by a firm which can use only equity or unsecured debt to finance them but will be undertaken if they can be financed with secured debt. Secured debt is priced for a firm with two assets and some unsecured debt outstanding. The pricing results are used to illustrate the benefits of the security provision of secured debt.

Managers of conglomerates are hypothesized to effect firm-enlarging actions that yield greater remuneration for them but losses for shareholders. This hypothesis is tested by examining the gains and losses to senior managers and shareholders of twenty-nine large conglomerates from 1970 through 1975. The data reveal that the average manager's annual gains and losses from changes in stock returns far exceeded his remuneration. Furthermore, top managers of conglomerates where stock returns decreased left their positions more frequently than did the officers of the other conglomerates. These findings are inconsistent with the self-serving managerial hypothesis as it usually is stated.

This paper investigates the internal managerial control mechanisms at the disposal of a corporation's compensation-setting board or committee. The hypotheses tested are that both compensation changes and management changes are methods used to control top management, and that the use of these control methods is motivated by changes in the firm's stock price performance. Public data from the period 1977–1980 support our hypotheses. We conclude that the firm's board creates managerial incentives consistent with those of the firm's owners, both by setting compensation and following management change policies which benefit shareholders.

Our evidence on the stock price reaction to the announcement of short-term executive compensation plan adoption indicates that: (1) significantly positive abnormal returns occur in the month of announcement and in the four months before the bonus plan adoption, and (2) significantly positive abnormal returns occur 10 months after the adoption announcement, returns that are associated with positive unexpected earnings. This result conflicts with semi-strong market efficiency and indicates the existence of a trading rule based on the news of bonus plan adoption.