Knowledge that Transforms

This paper studies the use of cash and credit for making transactions when there is asymmetric information in credit markets. For relatively low inflation rates, equilibria are of the pooling variety and low-credit-risk consumers signal their riskiness to lenders only indirectly by establishing a good track record in credit markets. For higher inflation rates there may exist a separating equilibrium in which low-credit-risk consumers directly signal their type to lenders by specializing in cash early in life and specializing in credit later in life. The greater the degree of adverse selection in credit markets, the wider the range of inflation rates for which a separating equilibrium exists. Credit usage is increasing in the inflation rate, but greater adverse selection may increase or decrease credit usage depending on the parameterization. Journal of Economic Literature Classification Number: E44.

According to conventional theory, insurance premiums should be informationally efficient predictors of the present value of policy claims and expenses. This paper develops an alternative theory of insurance market dynamics based on two assumptions. First, insured risks are dependent. Under this assumption, insurers′ net worth determines the market capacity since it is necessary to back the contractual promises to pay claims. Second, in raising net worth, external equity is more costly than internal equity. The theory explains the variation in premiums and insurance contracts over the "insurance cycle" and is supported by tests on postwar data. Journal of Economic Literature Classification Numbers: G1, G22.

It is shown that the models of Spiegel and Subrahmanyam (1992, Rev. Finan. Stud.5(2), 307–329) and Kyle (1985, Econometrica53, 1315–1335) are equivalent in the following sense: the equilibrium values of market depth, the expected total trading volume and the expected price level are the same in the two models. Equivalence exists whenever the uniformed traders hedge all of their endowments of risky shares. This occurs under two sets of parameter configurations. In both cases, the linear equilibrium in the hedger model always exists. Journal of Economic Literature Classification Numbers; G12, G14, D82.

This paper demonstrates how managers with private information about firms′ exposure to risk may, in the best interest of shareholders, engage in speculation instead of hedging as the conventional wisdom tells us. The reason is that when profits serve as a signal of firms′ values, speculative trades can be used to distort profits and hence manipulate stock prices to the shareholders′ advantage. A consequence of such corporate speculation is that stock prices become less informative about firms′ true worth. Journal of Economic Literature Classification Numbers: D82, G14, G32.

This paper considers the extent to which loan commitments mitigate the problems of information monopolies that arise when the firm contracts with a private lender. Loan commitments in conjunction with short-term debt often provide the firm with superior investment incentives by influencing both the states in which bargaining occurs as well as the outcomes from bargaining. Commitment contracts are particularly valuable when there is a high likelihood that information about the firm will be publicly revealed ex post. We also identify circumstances under which the firm foregoes commitment financing, relying on short-term debt instead. Journal of Economic Literature Classification Numbers G21, G32, D82.

This paper considers the costs and benefits of inflation using a stochastic version of Townsend′s turnpike model in which agents of each type are allowed to remain at a trading post for multiple periods. Numerical results show that moderate rates of inflation can be welfare-improving, but only when private credit markets are extremely limited. More generally, the existence of private credit markets curtails the ability of inflationary policy to do both harm and good. In addition, the welfare consequences of inflation depend on how much information about the economy the government has access to when implementing its policies. Journal of Economic Literature Classification Numbers: D52, E31.

We study the aftermarket for 72 initial public offerings (IPOs) using comprehensive trade and quote-change data from every market maker for the first three days of trading. Underwriters quote higher bid prices than other market makers for issues that commence trading at or below the offer price. Underwriters repurchase large quantities of stock in the aftermarket without risk by overselling the issue by the amount of the overallotment option. If the IPO is hot, the overallotment option is exercised. If not, the short position is covered with aftermarket selling. We discuss several reasons for underwriter support.

In April 1991, regulators seized the major subsidiaries of First Executive Corporation (FE), an insurer that invested heavily in junk bonds. During the junk bond market turmoil of 1989–1990, adverse publicity fueled a bank run at FE, forcing a $4 billion portfolio liquidation before the market rose 50–60% in 1991–1992. More traditional insurers did not receive commensurate press coverage, despite their substantial exposure to real estate declines, which were roughly 2.5 times the junk bond decline. Seizure of FE's subsidiaries was defensible, although FE would have become solvent within a year, given average junk bond market appreciation.

This paper compares the leveraged recapitalization of Kroger Co. with the leveraged buyout of Safeway Stores. While both transactions dramatically increased leverage, Safeway's also altered managerial ownership, board composition, and executive compensation, while Kroger's did not. My analysis suggests that these differences in organizational form lead to large differences in post-HLT restructuring actions and value creation. I conclude that the improved incentive structure and increased monitoring provided by the LBO specialist at Safeway lead managers to generate cash in a more productive manner than the organizational structure employed by Kroger.

We examine the influence of industrial structure on the cross-sectional volatility and correlation structure of country index returns for 12 European countries between 1978 and 1992. We find that industrial structure explains very little of the cross-sectional difference in country return volatility, and that the low correlation between country indices is almost completely due to country-specific sources of return variation. Diversification across countries within an industry is a much more effective tool for risk reduction than industry diversification within a country.