Knowledge that Transforms

We contend that security design should be approached as a problem of game design. That is, contracts should specify the procedures that govern the behavior of contract participants in determining outcomes as well as the allocations resulting from those outcomes. We characterize optimal contracts in two nested classes: all contracts (including those that depend on the state) and state-independent contracts. We demonstrate that, in situations in which the dependence of contracts on the state is limited, contracts designed as games can improve the allocation of resources relative to nonstrategic allocation rules.

We study insider trading in a dynamic setting. Rational, but uninformed, traders choose between investment projects with different levels of insider trading. Insider trading distorts investment toward assets with less private information. However, when investment is sufficiently information elastic, insider trading can be welfare-enhancing because of more informative prices. When insiders repeatedly receive information, they trade to reveal it when investment is information elastic because good news increases investment and hence future insider profits. Thus, more information is revealed and uninformed agents are exploited less frequently by insiders. Both effects are Pareto-improving. Finally, we consider various insider-trading regulations.

A subgame perfect Nash equilibrium is characterized for an industry with dissipative costs of agency. In sequence, firms can enter the industry, raise capital with external debt and/or equity, invest in a capital-intensive technology or dissipate capital in perquisites, and finally produce output. For plausible values of two critical parameters, some firms forego in equilibrium investments with positive net present values. Although more managers would like their firms to invest in the capital-intensive technology, they cannot raise the required cash in the capital market. In equilibrium, the industry can have both a profitable core of large, secure, capital-intensive firms, with some debt but no unique optimal capital structure, and a competitive fringe of small, risky, labor-intensive firms. Even as the cost of entry converges to zero, capital-intensive firms can earn extraordinary profits, while all labor-intensive firms fail. With costly agency, access to capital can become a barrier to entry.

The classic option pricing model is generalized to a more realistic, imperfect, dynamically incomplete capital market with different interest rates for borrowing and for lending and a return differential between long and short positions in stock. It is found that, in the absence of arbitrage opportunities, the equilibrium price of any contingent claim must lie within an arbitrage-band. The boundaries of an arbitrage-band are computed as solutions to a quasi-linear partial differential equation, and, in general, each end-point of such a band depends on both interest rates for borrowing and for lending. This, in turn, implies that the vector of concurrent equilibrium prices of different contingent claims—even claims that are written on different underlying assets—must lie within a computable arbitrage-oval in the price space.

This article addresses the problem of valuing American call options with caps on dividend-paying assets. Since early exercise is allowed, the valuation problem requires the determination of optimal exercise policies. Options with two types of caps are analyzed: constant caps and caps with a constant growth rate. For constant caps, it is optimal to exercise at the first time at which the underlying asset’s price equals or exceeds the minimum of the cap and the optimal exercise boundary for the corresponding uncapped option. For caps that grow at a constant rate, the optimal exercise strategy can be specified by three endogenous parameters.

To investigate the effect of taxation on stock price and trading volume around the ex-dividend day, we use the Italian stock market, where dividends on two classes of stock are taxed differently. We find that the weighted average of investors' tax rates is reflected in the ex-day prices and the variance of the relative tax rate across investors is reflected in the volume of trades. We also show that higher transaction costs result in higher ex-dividend day excess returns and lower abnormal volume. This finding is consistent with ''profit elimination'' activity by institutions and corporations.

Corporate finance researchers have long been puzzled by low corporate debt ratios given debt's corporate tax advantage. This article recognizes that firm value typically reflects a growing stream of earnings, while current debt reflects a nongrowing stream of interest payments. Debt to value is therefore a distorted measure of corporate tax shielding. Even with very small debt-related costs, this may explain the observed magnitude and cross-sectional variation of debt ratios. Since this variation may be independent of tax shielding, debt ratios provide an inappropriate framework for empirically examining the trade-off theory of capital structure.

Nonprofit, mutually owned insurance and banking organizations have significant market shares in the insurance and banking industries. A first step in a systematic study of these financial mutuals is to examine the reasons for their formation. Doing so provides empirical support for the view that these mutuals arose as an efficient means of addressing contracting challenges caused by aggregate uncertainties and moral hazard. A formal model with this property is presented. We argue that information asymmetries do more to explain the kinds of contracts offered by financial mutuals than do agency problems between owners, managers, and customers.

We provide a comprehensive empirical analysis of stock price behavior around the ex-dividend day in Japan. We find that prices rise on the ex-day and that dividend-related tax effects appear to be secondary. Returns around ex-dividend days are dominated by the proximity of many ex-days to the fiscal year end. Excess returns of 1 percent, which are independent of any dividend-related considerations, are higher than round-trip transaction costs on medium-sized transactions. Prices seem to imply selling pressure before and buying pressure at the start of the new fiscal year. These trading patterns appear to be motivated by intercorporate manipulative trading around the end of the firms’ fiscal year, which are unrelated to dividends.

Markets for many real assets are characterized by sequential search followed by bilateral bargaining between matched buyers and sellers. For a category of real assets, the joint, intertemporal valuation problems of buyers, owners, and sellers, and the associated Nash pricing function are solved explicitly. In equilibrium, the average transaction price is a noisy, proportional random walk, and the liquidity premium is positive for matched owners. Depending on the values of the parameters, the liquidity premium can be substantial. In a related problem of optimal development with costly search, the optimal exercise point, cost of development, and value of the undeveloped asset are calculated analytically. With search, development can occur sooner and undeveloped assets have lower market values than the standard solution without search.