When monitoring is not contractible—so investors monitor only when, at that time, they expect to benefit from doing so—efficient contracts sometimes induce managers to makefalsereports to investors. Because of monitoring discretion, management misrepresentation can produce Pareto improvements by reducing monitoring costs. When costs of renegotiation are small, optimal contracts necessarily induce misrepresentation. Discretionary monitoring also generates an equilibrium role for multiple-security capital structures. When an optimal contract has two investors, securityholder conflict arises endogenously as a means of reducing monitoring costs. It is efficient to write the contract so that one investor's decision to monitor hurts the other investor.Journal of Economic LiteratureClassification Number: G32.

Abstract In this paper we present and estimate a model of short-term interest rate volatility that encompasses both the level effect of Chan, Karolyi, Longstaff and Sanders (1992) and the conditional heteroskedasticity effect of the GARCH class of models. This flexible specification allows different effects to dominate as the level of the interest rate varies. We also investigate implications for the pricing of bond options. Our findings indicate that the inclusion of a volatility effect reduces the estimate of the level effect, and has option implications that differ significantly from the Chan, Karolyi, Longstaff and Sanders (1992) model.

This paper shows the simultaneous optimally of debt and equity contracts in a principal-agent model. The agent (an entrepreneur) has an investment project but does not have the necessary funds to finance it. There is moral hazard in the model, generated by the dependence of the project's expected return on the (unobservable) agent's effort. Key to the optimality of these financial instruments is the nonassignable rent produced by the project and captured by the entrepreneur when the investment is successful.

Swedish government lottery bonds have coupon payments determined by lottery. They offer a unique opportunity to study a security with uncertain payoffs having a known, observable distribution. The risk associated with the lotteries is idiosyncratic by construction and should not command a risk premium in equilibrium. The bonds are traded in two forms, allowing us to evaluate the rewards to bearing extra lottery risk. Despite its idiosyncratic nature, we find prices appear to reflect aversion to this risk. We evaluate the empirical determinants of this differential pricing and possible explanations for it.

Maureen McNichols, Patricia C. O'Brien, Self-Selection and Analyst Coverage, Journal of Accounting Research, Vol. 35, Studies on Experts and the Application of Expertise in Accounting, Auditing, and Tax (1997), pp. 167-199

Abstract This study investigates the separate and joint effects of prior knowledge and accountability on performance in the information search phase of a tax research task. An experiment is reported in which 63 tax professionals performed a computer-based tax research task. The results indicate that increases in effort duration, which are partly attributable to the accountability manipulation, improved search effectiveness regardless of the level of prior knowledge. In addition, after controlling for the effect of effort duration, accountability had an incremental positive effect on performance among the more knowledgeable professionals. These results suggest that effort can substitute for knowledge in performing information search tasks, but this substitution does not appear to be complete. The results also support the hypothesis that the effect of accountability on performance depends upon the level of knowledge, which suggests that certain aspects of effort and knowledge act as complements in improving performance.

This study tests assertions that Economic Value Added (EVA®) is more highly associated with stock returns and firm values than accrual earnings, and evaluates which components of EVA, if any, contribute to these associations. Relative information content tests reveal earnings to be more highly associated with returns and firm values than EVA, residual income, or cash flow from operations. Incremental tests suggest that EVA components add only marginally to information content beyond earnings. Considered together, these results do not support claims that EVA dominates earnings in relative information content, and suggest rather that earnings generally outperforms EVA.

We value American options on bonds using a generalization of the Geske–Johnson (Geske, R., Johnson, H., 1984. Journal of Finance 39, 1151–1542) (GJ) technique. The method requires the valuation of European options, and options with multiple exercise dates. It is shown that a risk-neutral valuation relationship (RNVR) along the lines of Black–Scholes (Black, F., Scholes, M., 1973. Journal of Political Economy 81, 637–659) model holds for options exercisable on multiple dates, even under stochastic interest rates, when the price of the underlying asset is lognormally distributed. The proposed computational procedure uses the maximized value of these options, where the maximization is over all possible exercise dates. The value of the American option is then computed by Richardson extrapolation. The volatility of the underlying default-free bond is modeled using a two-factor model, with a short-term and a long-term interest rate factor. We report the results of simulations of American option values using our method and show how they vary with the key parameter inputs, such as the maturity of the bond, its volatility, and the option strike price.

Abstract This paper develops and tests an option-style valuation model, whose main prediction is that equity value is a convex function of both earnings and book value, where the function depends on the relative values of earnings and book value. Earnings provides a measure of how the firm's resources are currently used. Book value provides a measure of the value of the firm's resources, independent of how the resources are currently used. When the ratio earnings/book value is high, the firm is likely to continue its current way of using resources, and earnings is the more important determinant of equity value. When earnings/book value is low, the firm is more likely to exercise the option to adapt its resources to a superior alternative use, and book value becomes the more important determinant of equity value. Evidence from a variety of empirical specifications is consistent with the convexity prediction.

Abstract This paper examines the relationship between the incidence of litigation events with potentially large damage awards and managers' accounting choices. We argue that the size of damage awards is a function of reported net income and net worth, and that this relationship provides management an incentive to manipulate accounting numbers. Our results indicate that managers of oil firms facing potentially large damage awards choose income decreasing non-working capital accruals relative to managers of other oil firms. Further, the results indicate that the management of these firms makes accounting choices that result in lower non-working capital accruals during the litigation period than in other years. These negative non-working capital accruals appear to result from the under-estimation of new reserves.