Knowledge that Transforms

When information is sold, there is often a reliability problem since anyone can claim to have superior knowledge. Optimal strategies which allow a seller to establish that he is informed are considered in a standard one-period, two-asset model. When risk aversion is unobservable, an information market is viable and both the seller and the buyers are better off participating. However, the seller cannot obtain the full value of his information because of the reliability problem. This provides an opportunity for intermediation since an intermediary may be able to capture some of the remaining value.

This paper addresses the First Theorem of Welfare Economics in a moral hazard environment. An entrepreneur sells equity in a firm which he supplies with an unobservable, costly input. How much equity he retains determines his incentives and is observed by investors. The investors have rational expectaions which cause the equity price to increase in the amount of equity the entrepreneur retains. This gives the entrepreneur an incentive to retain equity and hence supply input. The entrepreneur may also be bound by an explicit incentive contract. In this framework, not all competitive equilibria are efficient, as defined relative to the moral hazard constraint. However, equilibria can be inefficient only if the entrepreneur's optimal input is nonunique or exhibits positive income effects.

We examine delivery systems that disseminate market timing information either through newsletters or by setting up timing funds in which investors can invest. Absent market imperfections, both systems produce the same result. With restrictions on borrowing, or with other nonlinearities, the newletter system is superior. This result does not depend on the cost of obtaining information or uncertainty about, or the manipulation of, the quality of the information. Institutional restrictions on borrowing, and preferences that lead to nonlinear responses to information signals, provide one explanation for the plethora of market timing newsletters and the paucity of market timing funds.

This paper considers a securities market in which orders are channeled through professional broker-dealers such as London's market makers or the large banks operating on continental exchanges. If these dual-capacity dealers can judge the motives behind their customers' orders, they can trade profitably on their own account (even if they cannot “front run,” that is, trade on their own account before executing a customer order). It is shown that the dealers have an incentive to satisfy roughly half of their customers' orders from their own inventory if they are sure that orders are liquidity-motivated and not based on inside information. As a result of dual-capacity dealing, transaction costs for liquidity-motivated traders in the aggregate fall, but they rise for those traders who are unable to convince any dealer that they have no inside information. The liquidity of the main market worsens, even though its effective liquidity for customers whose orders are partly filled from broker-dealer inventories improves.

We examine a general equilibrium model of asset prices in the presence of a simple informational imperfection. Assets are productive only when combined with managerial services. A manager “controls” an asset; he can conceal some of the output at a cost. This limits the extent to which managers can shed risk by issuing claims. Incentive compatibility drives a wedge, the “value of control”, between physical and financial asset values. Equilibrium allocations can be supported by alternative specifications of the right to “name the next manager”. If this right is assigned to holders of claims, then financial asset prices exhibit “excess volatility.”

The algorithms of three automated trade execution systems are compared with respect to price discovery and quantity determination in markets for futures, options, and stocks. Efficiency of these systems is measured using the classical benchmark of Walrasian equilibrium pricing; welfare is measured in terms of trader and customer surplus. Floor trading is analyzed similarly and provides another benchmark for comparison of system performance. Journal of Economic Literature Classification Number: 314.

Recent theories of corporate organization hold that mutually owned firms arise to remedy agency problems associated with ownership by a separate class of stockholders. We propose an alternative theory of mutuality, in which mutuals arise endogenously as a self-selection mechanism to cope with adverse selection and systematic risk. This theory makes predictions about the nature of customer contracts and the pattern of dividend payments adopted by mutuals. We do not systematically test this theory against others. But the behavior of the Farm Credit System, a large financial mutual, is shown to be more in accord with our theory.

This paper examines the effects of employee stock ownership plans (ESOPs) on shareholder wealth. ESOPs established in the presence of takeover activity reduce share values, by approximately 4% on average. ESOPs also reduce share values if they are structured to transfer control away from outside shareholders, by creating a new ownership block with veto power over takeover bids. Large ESOPs established with nonvoting stock, so as to preclude any immediate control transfers, result in a significant increase in share values. The wealth effect of any given ESOP thus depends upon both its incentive and control effects on the corporation.

This study investigates the incentives of financially distressed firms to restructure their debt privately rather than through formal bankruptcy. In a sample of 169 financially distressed companies, about half successfully restructure their debt outside of Chapter 11. Firms more likely to restructure their debt privately have more intangible assets, owe more of their debt to banks, and owe fewer lenders. Analysis of stock returns suggests that the market is also able to discriminate ex ante between the two sets of firms, and that stockholders are systematically better off when debt is restructured privately.

Dual-class recapitalizations and leveraged buyouts have similar effects on ownership of corporate voting rights but very different effects on ownership of residual claims. We predict that firms with greater growth opportunities, lower agency costs, and lower tax liability are more likely to consolidate control through dual-class recapitalizations. We find strong support for the growth hypothesis and weaker support for the other hypotheses. These results increase our understanding of the causes of change in organizational form by illustrating that the method and effects of consolidating corporate control are systematically related to firm attributes.