Knowledge that Transforms

In a credit market characterized by a priori asymmetric information, collateral not only can identify credit applicants but also can result in moral hazard involving the borrower's use of pledged assets. The borrower's other alternatives are to apply for unsecured bank credit and be priced as “average, ” or to acquire financing by selling an asset and subsequently renting it for continued use. The optimal secured loan contract for higher quality firms is shown to involve overcollateralization. There is underinvestment relative to first best in maintenance of the pledged assets but overinvestment relative to the level that would be chosen without bank monitoring. Self-financing and unsecured credit are chosen by the intermediate and lowest quality groups, respectively.

This paper examines multiperiod corporate financial policy in a world where the only market imperfection is taxation. The optimal financial policy determines the firm's capital structure and debt maturity structure. Two implications of this policy are: (1) there can be a set of debt-asset ratios that is consistent with firm value maximization, and (2) debt maturity structure is irrelevant to firm value.

Robert Heinkel, Josef Zechner, The Role of Debt and Preferred Stock as a Solution to Adverse Investment Incentives, The Journal of Financial and Quantitative Analysis, Vol. 25, No. 1 (Mar., 1990), pp. 1-24

Using the FPE/multivariate Granger-causality modeling technique, this paper tests whether changes in Canadian stock returns are caused by a number of economic variables, including base money and fiscal deficits. The empirical results from monthly data show that lagged changes in fiscal deficits, in particular, Granger-cause stock returns. If expected returns to equity are not time-varying, such a finding appears inconsistent with market efficiency.

This paper analyzes the impact of changes in monetary policy regimes on the relation between stock returns and changes in expected inflation. Post-war evidence from four countries reveals a direct link between these relations and the central banks' operating targets (i.e., money supply or interest rates). Specifically, the post-war negative relations between stock returns and changes in expected inflation are significantly stronger during interest rate regimes.

Critics argue that shelf registration greatly reduces the ability of underwriters to perform adequate due diligence. This argument suggests underwriters will demand greater compensation for shelf issues compared to such traditional issues as an insurance premium for protection against potential litigation or loss of reputation caused by inadequate due diligence. Our findings suggest the presence of such a premium, that the premium is higher for firms with higher expected due diligence liabilities, and that underwriters perceive that shelf registration erodes due diligence and, subsequently, price the due diligence erosion accordingly. This pricing behavior is consistent with our findings that firms with higher expected due diligence liabilities are more likely to choose traditional registration.

Stock price discreteness adds noise to price series. The noise increases return variances and adds negative serial correlation to return series. Standard variance and serial covariance estimators therefore overestimate the variance and serial covariance of the underlying stock values. Discreteness-induced variance and serial covariance depend on underlying volatility and on the size of the bid/ask spread. Simple formulas for approximating the effects of discreteness on variance and serial correlation are derived and presented. The approximations, which are accurate in daily data, can be used to adjust the standard variance and serial covariance estimators.

This paper presents an empirical analysis of firms that are delisted from a major stock exchange. The delisting process is described and stock price movements surrounding delisting are analyzed. For firms with prior announcements, equity values decline by approximately 8.5 percent on announcement day. For firms without prior announcements, a similar adjustment takes place between the last day of trading in the initial market and the close of the first day of trading in the new market. Four hypotheses concerning the decline in firm value are examined. These are the liquidity hypothesis, the management signalling hypothesis, the exchange certification hypothesis, and the downward sloping demand curve hypothesis. Evidence consistent with the liquidity hypothesis is presented in the paper. Unlike evidence onstock exchange listings, returns in the post-delisting period do not appear to be anomalous.

Pu Liu, Stanley D. Smith, Azmat A. Syed, Stock Price Reactions to The Wall Street Journal's Securities Recommendations, The Journal of Financial and Quantitative Analysis, Vol. 25, No. 3 (Sep., 1990), pp. 399-410

Cross-sectional and time series tests are performed to explain levels and changes in short interest. Explanatory variables and tests are chosen based on tax, arbitrage, and speculative reasons for going short. Short interest is found to follow a seasonal pattern that is weakly consistent with tax-based trading. Stocks with high betas and the existence of convertible securities or options tend to have higher levels of short interest, which is consistent with arbitrage efforts. For firms with traded options, there is a positive association between the month-to-month changes in option open interest and short interest. Prior months' returns and changes in short interest are positively related, but there is no relationship between changes in short interest and returns in the subsequent month.