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• Longstaff, F. A., & Schwartz, E. S. (1992). Interest Rate Volatility and the Term Structure: A Two-Factor General Equilibrium Model. The Journal of Finance, 47, 1259–1282.

  The authors develop a two-factor general equilibrium model of the term structure. The factors are the short-term interest rate and the volatility of the short-term interest rate. The authors derive closed-form expressions for discount bonds and study the properties of the term structure implied by the model. The dependence of yields on volatility allows the model to capture many observed properties of the term structure. The authors also derive closed-form expressions for discount bond options. The authors use Hansen's generalized method of moments framework to test the cross-sectional restrictions imposed by the model. The tests support the two-factor model.

• Eberhart, A. C., & Sweeney, R. J. (1992). Does the Bond Market Predict Bankruptcy Settlements? The Journal of Finance, 47, 943–980.

  This study shows the extent to which deviations from the absolute priority rule increase or decrease the bankruptcy emergence payoff to traded (i.e., usually junior claimants) bondholders. The data indicate that, on average, bondholders benefit, albeit slightly, from absolute priority rule violations. This paper also examines the degree to which the bond market, in the bankruptcy filing month, anticipates departures from the absolute priority rule and other influences on the payoff to bondholders. In other words, the authors investigate the informational efficiency of the market for bankrupt bonds. Overall, despite the complex and lengthy nature of bankruptcy proceedings, the results support efficiency.

• Hand, J. R. M., Holthausen, R. W., & Leftwich, R. W. (1992). The Effect of Bond Rating Agency Announcements on Bond and Stock Prices. The Journal of Finance, 47, 733–752.

  This paper examines daily excess bond returns associated with announcements of additions to Standard and Poor's Credit Watch List, and to rating changes by Moody's and Standard and Poor's. Reliably nonzero average excess bond returns are observed for additions to Standard and Poor's Credit Watch List when an expectations model is used to classify additions as either expected or unexpected. Bond price effects are also observed for actual downgrade and upgrade announcements by rating agencies. Excluding announcements with concurrent disclosures weakens the results for downgrades, but not upgrades. The stock price effects of rating agency announcements are also examined and contrasted with the bond price effects.

• Mian, S. L., & Smith, C. W. (1992). Accounts Receivable Management Policy: Theory and Evidence. The Journal of Finance, 47, 169–200.

  This paper develops and tests hypotheses that explain the choice of accounts receivable management policies. The tests focus on both cross-sectional explanations of policy-choice determinants, as well as incentives to establish captives. The authors find size, concentration, and credit standing of the firm's traded debt and commercial paper are each important in explaining the use of factoring, accounts receivable secured debt, captive finance subsidiaries, and general corporate credit. They also offer evidence that captive formation allows more flexible financial contracting. However, the authors find no evidence that captive formation expropriates bondholder wealth.

• Chen, R.-R., & Scott, L. O. (1992). Pricing Interest Rate Options in a Two-Factor Cox-Ingersoll-Ross Model of the Term Structure. Review of Financial Studies, 5, 613–636.

  Solutions are presented for prices on interest rate options in a two-factor version of the Cox-Ingersoll-Ross model of the term structure. Specific solutions are developed for caps on floating interest rates and for European options on discount bonds, coupon bonds, coupon bond futures, and Euro-dollar futures. The solutions for the options are expressed as multivariate integrals, and we show how to reduce the calculations to univariate numerical integrations, which can be calculated very quickly. The two-factor model provides more flexibility in fitting observed term structures, and the fixed parameters of the model can be set to capture the variability of the term structure over time.

• Constantinides, G. M. (1992). A Theory of the Nominal Term Structure of Interest Rates. Review of Financial Studies, 5, 531–552.

  A model of the nominal term structure of interest rates is developed that has a positive and stationary process for the interest rate and delivers closed-form expressions for the prices of discount bonds and European options on bonds. Unlike the one-state-variable version of the Cox, Ingersoll, and Ross (1985) model, this model–even in its one-state-variable version–allows the term premium to change sign as a function of the state and the term to maturity, and also allows for shapes of the yield curve that are observed in the U.S. data but that are disallowed in the Cox, Ingersoll, and Ross model.

• Hirshleifer, D., & Thakor, A. V. (1992). Managerial Conservatism, Project Choice, and Debt. Review of Financial Studies, 5, 437–470.

  The authors show that the incentive for managers to build their reputations distorts firms' investment policies in favor of relatively safe projects, thereby aligning managers' interests with those of bondholders, even though managers are hired and fired by shareholders. This effect opposes the familiar agency problem of risky debt that is imperfectly covenant-protected, wherein shareholders are tempted to favor excessively risky projects in order to expropriate bondholders. Consequently, when managerial concern for reputation results in conservatism, it can actually make shareholders better off ex ante by allowing the firm to issue more debt. They examine how the optimal choice of leverage from the shareholders' standpoint is influenced by takeover activity, and how the adoption of anti-takeover measures affects a firm's investment policy and leverage choice.

• Kazemi, H. B. (1992). An Intertemporal Model of Asset Prices in a Markov Economy with a Limiting Stationary Distribution. Review of Financial Studies, 5, 85–104.

  A testable single-beta model of asset prices is presented. If state variables have a long-run stationary joint density function, then the rate return on a very long-term default-free discount bond will be perfectly correlated with the representative investor's marginal utility of consumption. Thus, the covariance of an asset's return with the return on such a bond will be an appropriate measure of the asset's riskiness. The model can be, therefore, applied.or tested even though the market portfolio or aggregate consumption may not be observable. It also is shown that the expected rate of return on a very long-term bond is equal to its variance. This proposition can be tested to determine whether state variables follow stationary processes.

• Stein, J. C. (1992). Convertible Bonds As Backdoor Equity Financing. Journal of Financial Economics, 32, 3–21.
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• Sun, T. (1992). Real and Nominal Interest Rates: A Discrete-Time Model and Its Continuous-Time Limit. Review of Financial Studies, 5, 581–611.

  I provide a general equilibrium theory of the term structure of real interest rates in a discrete-time economy. I derive the prices for one-period and two-period real bonds and a simple recursive formula for general k-period bonds, and prove that the price formula with appropriately specified parameters converges to that of the Cox, Ingersoll, and Ross model (1985). In addition, I consider the behavior of nominal bond prices in a partial equilibrium setting in which an exogenous price level process is correlated with the real economy. Finally, I provide an illustrative empirical investigation of the model. The results indicate a significant correlation between the price level and the growth rate of consumption, which does not support the "money nuetrality" assumption underlying Cox, Ingersoll, and Ross's nominal bond prices and related empirical studies, such as Gibbons and Ramaswamyu (1992), Heston(1991), and Pearson and Sun (1991).