We analyze the optimal mix of debt, common equity, and preferred equity in a model with an investment opportunity and asymmetric information about its quality, and show that an all-equity financed firm will overinvest. Issuing the appropriate amount of debt before the project becomes available resolves this overinvestment problem. Introducing a second motive for debt, such as taxes, leads to a role for preferred stock as a means of enhancing the firm's “debt capacity,” by creating additional incentives to invest. We derive an optimal capital structure involving debt, preferred stock, and common stock.

This paper examines multiperiod corporate financial policy in a world where the only market imperfection is taxation. The optimal financial policy determines the firm's capital structure and debt maturity structure. Two implications of this policy are: (1) there can be a set of debt-asset ratios that is consistent with firm value maximization, and (2) debt maturity structure is irrelevant to firm value.

This paper examines the effects of the delivery basis risk embedded in nearly all futures contracts on efficiency tests of these markets. Examining soybean futures contracts, we show that delivery basis risk has important implications for market efficiency tests. Assuming no delivery basis risk, the market efficiency hypothesis is rejected. However, futures prices contain significant time-varying expected delivery basis and time-varying expected delivery risk premiums. Once these expected delivery basis and delivery risk premiums are accounted for, the apparent inefficiency is eliminated. Equilibrium spot prices also contain significant time-varying expected delivery risk premiums.

This paper provides empirical evidence that the quality option in T-bond futures is much less valuable than previously indicated. In addition, a dynamic trading strategy involving multiple switches of the cash bonds held in a long cash versus short futures position is shown to produce substantially greater profits than the single exercise of the quality option. These findings suggest that the optimal management of long cash/short futures positions is likely to involve dynamic trading strategies while passive strategies appear more appropriate for short cash/long futures positions. It is also shown that required variation margin payments are frequently large and may impact the profitability and risk of such positions to a greater extent than either of these options. Further, evidence is given indicating that observed T-bond futures prices reflect an imputed value for the options and risks inherent in such positions.

This paper suggests a modification to the explicit finite difference method for valuing derivative securities. The modification ensures that, as smaller time intervals are considered, the calculated values of the derivative security converge to the solution of the underlying differential equation. It can be used to value any derivative security dependent on a single state variable and can be extended to deal with many derivative security pricing problems where there are several state variables. The paper illustrates the approach by using it to value bonds and bond options under two different interest rate processes.

We examine empirically the existence of speculative bubbles in U.S. stock prices and, by building on West's procedure, propose direct and computationally simple tests of the “nobubble” hypothesis. These tests are likely to be close to their nominal size in small samples and to have small sample power against a wide class of bubbles including those orthogonal to the dividend process. We apply the tests to long-term annual U.S. stock market data for the 1871–1981 and 1871–1988 periods. Contrary to West, we do not reject the “no-bubble” hypothesis. We offer an explanation as to the cause of discrepancy between the two results.

Recent research finds that the prior period's worst stock return performers (losers) outperform the prior period's best return performers (winners) in the subsequent period. This potential violation of the efficient markets hypothesis is labeled the “overreaction” phenomenon. This paper shows that the tendency for losers to outperform winners is not due to investor overreaction, but to the tendency for losers to be smaller-sized firms than winners. When losers are compared to winners of equal size, there is little evidence of any return discrepancy, and in periods when winners are smaller than losers, winners outperform losers.

This paper develops a methodology for term structure estimation from a no-arbitrage condition in markets with frictions. The methodology unifies existing estimation procedures, such as the regression and linear programming approaches, and substantially broadens the class of useful estimation techniques. The estimators derived in this way are capable of reflecting actual market conditions, such as the asymmetry in the tax treatment of long and short positions and the higher financial cost of establishing a short position. The methodology is derived by applying the conjugate duality theory of mathematical programming.