Managers frequently cite the desire to mitigate asymmetric information as a motivation for increasing firm focus. The information benefits of focus appear relevant for the subset of firms that actually increase their focus; however, the relevance of focus-related information benefits for the population of diversified firms is an open question. This paper examines the relation between corporate diversification and asymmetric information proxies derived from analysts’ forecasts and abnormal returns associated with earnings announcements. I find that greater diversification is not associated with increased asymmetric information. These results call into question the notion that corporate diversification strictly exacerbates information problems.

This paper derives a multibeta representation theorem for pricing assets using arbitrary reference variables that are not necessarily the true factors. Under this theorem, the upper bound on pricing deviations depends upon the correlations not only between the reference variables and the factors but also between the reference variables and the residual risks. A new concept of a well-diversified variable is introduced, which though free of residual risk, may be less than perfectly correlated with the true factors. Welldiversified variables correlated with the factors play a key role in the pricing of assets, since these variables can replace the factors without any loss in pricing accuracy under all linear asset pricing theories.

In the perfect markets corporate finance theory (Modigliani–Miller), public corporations (firms) have no economic function. Their existence therefore cannot be justified. An unsettling implication is that the extant corporate finance theory applies to an economy in which firms are irrelevant. This research precludes this implication by identifying an economic function for firms in perfect markets. Specifically, I show that firms exist to intermediate between “Main Street” (the real sector that supplies non-financial inputs) and “Wall Street” (the financial sector that supplies cash), and that this intermediation maximizes an investment's operating cash flows by minimizing the cost of the non-financial inputs. Key implications of this rationale for the firm include: i) an investment's NPV depends on the firm's cash holdings; working capital policy is an integral part of investment policy, ii) operating characteristics determine the firm's minimum size (equity capitalization) and “boundaries,” and iii) cash on corporate balance sheets is a “fundamental” for stock-pricing.

We present a theory of capital structure based on the power of shareholders, bondholders and managers to control the incentive conflicts in large corporations. The manager–owner conflict produces a trade-off between inefficiency in the low state and rents in the high state, and the shareholder–bondholder conflict produces under-investment as in Myers [Journal of Financial Economics 19 (1997) 147]. Since managers and bondholders both prefer more efficient actions in the low state, the two conflicts are interdependent. With risk-less levels of debt, there are no shareholder–bondholder agency costs, but managerial control over the incentive-setting process produces excessive rents. With risky debt, shareholders focus more on returns in the high state so that shareholder–bondholder agency costs increase but managerial rents decrease. Efficient levels of debt holder protection facilitate a reduction in manager–owner agency costs that outweighs shareholder–bondholder agency costs, and are decreasing in firm performance. The results are consistent with the separate empirical results relating control to both compensation and leverage, and suggest how future studies can be integrated.

This paper studies financial policy, investment decisions and the threat of dismissal when managers value control and investments generate manager-specific value. A high probability of investigation focuses the manager on the profitability of replacement and therefore manager-specific value. The probability of an investigation increases when the firm enters bankruptcy. Thus, high debt levels focus the manager on investments that dissuade replacement during bankruptcy procedures. Dividends relax the manager's focus on manager-specific value since there is a lower probability of an investigation following a missed dividend. The ability to make dividend payments, however, is related to ex-post performance and can improve replacement decisions. When managerial quality is commonly known, the expected value of the firm is maximized with a combination of debt and dividend commitments. When managerial quality is hidden information, it is optimal for the combination of debt and dividend commitments to signal quality.

We investigate the joint optimal risk management and capital structure decisions of banks when they use contingent-convertible (CoCo) futures contracts to hedge financial-sector risk. In spite of banks choosing significantly higher leverage ratios, their default probabilities drop appreciably while their equity values increase, allowing banks to compete more favorably with the shadow-banking system. Banks’ value-maximizing decision to hedge financial-sector risk unintentionally leads to an economy with extremely low aggregate bank default rates across all future states of nature. Thus, CoCo futures offer a powerful microprudential and macroprudential policy tool. That banks choose not to hedge financial-sector risk in practice is consistent with managers internalizing bank bailouts.

We argue that anomalies may experience prolonged decay after discovery and propose a Bayesian framework to study how that impacts portfolio decisions. Using the January effect and short-term index autocorrelations as examples of disappearing anomalies, we find that prolonged decay is empirically important, particularly for small-cap anomalies. Papers that document new anomalies without accounting for such decay may actually underestimate the original strength of the anomaly and imply an overstated level of the anomaly out of sample. We show that allowing for potential decay in the context of portfolio choice leads to out-of-sample outperformance relative to other approaches.

Motivated by the rising importance of international sourcing by US firms in recent decades, we study the influence of international sourcing on capital structure. We find that international sourcing has a significant negative influence on financial leverage. The negative influence is stronger in industries that have high R&D intensities and are financially constrained. However, the negative relation is mitigated when suppliers are from countries with strong legal environments and when the supplier markets are more competitive. Overall, our findings suggest that relationship-specific investments, supplier market characteristics, and financial market conditions are key determinants of the sourcing–leverage relation.

We evaluate financial assets with payoffs linked to individual labor income, as conceived by Shiller (2003) and others. Using a realistically calibrated life-cycle model, we find that such assets can generate nontrivial welfare benefits, depending on the precise structure of the instrument. However, the assets we consider can only eliminate a relatively small fraction of the welfare costs of labor income risk over the life cycle. We highlight the fact that although the purpose of such assets is to smooth consumption across states of nature, one must also consider the assets' effects on households' ability to smooth consumption over time.

This paper provides an in depth analysis of an investor's reluctance to realize losses and his propensity to realize gains – a behavior known as the disposition effect. Together, sophistication (static differences across investors) and trading experience (evolving behavior of a single investor) eliminate the reluctance to realize losses. However, an asymmetry exists as sophistication and trading experience reduce the propensity to realize gains by 37% (but fail to eliminate this part of the behavior.) Our research design allows us to follow an individual's behavior from the start of his investing life/career. This ability makes it possible to track the evolution of the disposition effect as it is reduced and/or disappears.Our results are robust to alternative explanations including feedback trading, calendar effects, and frequency of observation.