We develop a positive theory of the hedging behavior of value-maximizing corporations. We treat hedging by corporations simply as one part of the firm's financing decisions. We examine (1) taxes, (2) contracting costs, and (3) the impact of hedging policy on the firm's investment decisions as explanations of the observed wide diversity of hedging practices among large, widely-held corporations. Our theory provides answers to the questions: (1) why some firms hedge and others do not; (2) why firms hedge some risks but not others; and (3) why some firms hedge their accounting risk exposure while others hedge their economic value.

This paper examines the use of seven mechanisms to control agency problems between managers and shareholders. These mechanisms are: shareholdings of insiders, institutions, and large blockholders; use of outside directors; debt policy; the managerial labor market; and the market for corporate control. We present direct empirical evidence of interdependence among these mechanisms in a large sample of firms. This finding suggests that crosssectional OLS regressions of firm performance on single mechanisms may be misleading. Indeed, we find relationships between firm performance and four of the mechanisms when each is included in a separate OLS regression. These are insider shareholdings, outside directors, debt, and corporate control activity. Importantly, the effect of insider shareholdings disappears when all of the mechanisms are included in a single OLS regression, and the effects of debt and corporate control activity also disappear when estimations are made in a simultaneous systems framework. Together, these findings are consistent with optimal use of each control mechanism except outside directors.

This paper reviews previous and current research on the relation between price changes and trading volume in financial markets, and makes four contributions. First, two empirical relations are established: volume is positively related to the magnitude of the price change and, in equity markets, to the price change per se. Second, previous theoretical research on the price-volume relation is summarized and critiqued, and major insights are emphasized. Third, a simple model of the price-volume relation is proposed that is consistent with several seemingly unrelated or contradictory observations. And fourth, several directions for future research are identified.

When firms adjust their capital structures, they tend to move toward a target debt ratio that is consistent with theories based on tradeoffs between the costs and benefits of debt. In contrast to previous empirical work, out tests explicitly account for the fact that firms may face impediments to movements toward their target ratio, and that the target ratio may change over time as the firm's profitability and stock price change. A separate analysis of the size of the issue and repurchase transactions suggests that the deviation between the actual and the target ratios plays a more important role in the repurchase decision than in the issuance decision.

Most research on hedging has disregarded both the long-run cointegrating relationship between financial assets and the dynamic nature of the distributions of the assets. This study argues that neglecting these affects the hedging performance of the existing models and proposes an alternative model that accounts for both of them. Using a bivariate error correction model with a GARCH error structure, the risk-minimizing futures hedge ratios for several currencies are estimated. Both within-sample comparisons and out-of-sample comparisons reveal that the proposed model provides greater risk reduction than the conventional models. Furthermore, a dynamic hedging strategy is proposed in which the potential risk reduction is more than enough to offset the transactions costs for most investors.

Firms that substantially increase capital investments subsequently achieve negative benchmark-adjusted returns. The negative abnormal capital investment/return relation is shown to be stronger for firms that have greater investment discretion, i.e., firms with higher cash flows and lower debt ratios, and is shown to be significant only in time periods when hostile takeovers were less prevalent. These observations are consistent with the hypothesis that investors tend to underreact to the empire building implications of increased investment expenditures. Although firms that increase capital investments tend to have high past returns and often issue equity, the negative abnormal capital investment/return relation is independent of the previously documented long-term return reversal and secondary equity issue anomalies.

Agency problems are an important determinant of corporate cash holdings. For a sample of more than 11,000 firms from 45 countries, we find that corporations in countries where shareholders rights are not well protected hold up to twice as much cash as corporations in countries with good shareholder protection. In addition, when shareholder protection is poor, factors that generally drive the need for cash holdings, such as investment opportunities and asymmetric information, actually become less important. These results are stronger after controlling for capital market development. Indeed, consistent with the importance of agency costs, we find that firms hold larger cash balances when access to funds is easier. Our evidence is consistent with the conjecture that investors in countries with poor shareholder protection cannot force managers to disgorge excessive cash balances.

We survey two generations of research on corporate governance systems around the world, concentrating on countries other than the U.S. The first generation of international corporate governance research is patterned after the U.S. research that precedes it. These studies examine individual governance mechanisms—particularly board composition and equity ownership—in individual countries. The second generation of international corporate governance research considers the possible impact of differing legal systems on the structure and effectiveness of corporate governance and compares systems across countries.

We examine the penalties imposed on the 585 firms targeted by SEC enforcement actions for financial misrepresentation from 1978–2002, which we track through November 15, 2005. The penalties imposed on firms through the legal system average only $23.5 million per firm. The penalties imposed by the market, in contrast, are huge. Our point estimate of the reputational penalty—which we define as the expected loss in the present value of future cash flows due to lower sales and higher contracting and financing costs—is over 7.5 times the sum of all penalties imposed through the legal and regulatory system. For each dollar that a firm misleadingly inflates its market value, on average, it loses this dollar when its misconduct is revealed, plus an additional $3.08. Of this additional loss, $0.36 is due to expected legal penalties and $2.71 is due to lost reputation. In firms that survive the enforcement process, lost reputation is even greater at $3.83. In the cross section, the reputation loss is positively related to measures of the firm's reliance on implicit contracts. This evidence belies a widespread belief that financial misrepresentation is disciplined lightly. To the contrary, reputation losses impose substantial penalties for cooking the books.

This paper explores the effect of exclusionary ethical investing on corporate behavior in a risk-averse, equilibrium setting. While arguments exist that ethical investing can influence a firm's cost of capital, and so affect investment, no equilibrium model has been presented to do so. We show that exclusionary ethical investing leads to polluting firms being held by fewer investors since green investors eschew polluting firms' stock. This lack of risk sharing among non-green investors leads to lower stock prices for polluting firms, thus raising their cost of capital. If the higher cost of capital more than overcomes a cost of reforming (i.e., a polluting firm cleaning up its activities), then polluting firms will become socially responsible because of exclusionary ethical investing. A key determinant of the incentive for polluting firms to reform is the fraction of funds controlled by green investors. In our model, empirically reasonable parameter estimates indicate, that more than 20 % green investors are required to induce any polluting firmss to reform. Existing empirical evidence indicates that at most 10% of funds are invested by green investors.

This paper investigates the international transmission mechanism of stock market movements by estimating a nine-market vector autoregression (VAR) system. Using simulated responses of the estimated VAR system, we (i) locate all the main channels of interactions among national stock markets, and (ii) trace out the dynamic responses of one market to innovations in another. Generally speaking, a substantial amount of multi-lateral interaction is detected among national stock markets. Innovations in the U.S. are rapidly transmitted to other markets in a clearly recognizable fashion, whereas no single foreign market can significantly explain the U.S. market movements. Also, the dynamic response pattern is found to be generally consistent with the notion of informationally efficient international stock markets.

This paper models the interaction of firm insiders and outsiders on a corporate board and addresses the question of the board's ideal size and composition. In the model, the board is responsible for monitoring projects and making CEO succession decisions. Inside directors are better informed regarding the quality of firm investment projects, but outsiders can use CEO succession to motivate insiders to reveal their superior information and help the board implement higher value projects. The optimal board structure is determined by the trade-off between maximizing the incentive for insiders to reveal their private information, minimizing coordination costs among outsiders and maximizing the ability of outsiders to reject inferior projects. I show that optimal board size and composition are functions of the directors' and the firm's characteristics. I also develop testable implications for crosssectional variations in the optimal board structure across firms.

The characteristics of the mean-variance, efficient portfolio frontier have been discussed at length in the literature. However, for more than three assets, the general approach has been to display qualitative results in terms of graphs. In this paper, the efficient portfolio frontiers are derived explicitly, and the characteristics claimed for these frontiers are verified. The most important implication derived from these characteristics, the separation theorem, is stated and proved in the context of a mutual fund theorem. It is shown that under certain conditions, the classic graphical technique for deriving the efficient portfolio frontier is incorrect.

In portfolio analysis, uncertainty about parameter values leads to suboptimal portfolio choices. The resulting loss in the investor's utility is a function of the particular estimator chosen for expected returns. So, this is a problem of simultaneous estimation of normal means under a well-specified loss function. In this situation, as Stein has shown, the classical sample mean is inadmissible. This paper presents a simple empirical Bayes estimator that should outperform the sample mean in the context of a portfolio. Simulation analysis shows that these Bayes-Stein estimators provide significant gains in portfolio selection problems.

We model the firm's decision to invest in liquid assets when external financing is costly. The optimal amount of liquidity is determined by a tradeoff between the low return earned on liquid assets and the benefit of minimizing the need for costly external financing. The model predicts that the optimal investment in liquidity is increasing in the cost of external financing, the variance of future cash flows, and the return on future investment opportunities, while it is decreasing in the return differential between the firm's physical assets and liquid assets. Empirical tests on a large panel of U.S. industrial firms support the model's predictions.

This paper investigates whether management stock ownership and large non-management blockholder share ownership are related to firm value across a sample of 1433 firms from 18 emerging markets. When a management group's control rights exceed its cash flow rights, I find that firm values are lower. I also find that large non-management control rights blockholdings are positively related to firm value. Both of these effects are significantly more pronounced in countries with low shareholder protection. One interpretation of these results is that external shareholder protection mechanisms play a role in restraining managerial agency costs and that large non-management blockholders can act as a partial substitute for missing institutional governance mechanisms.

In this paper, we examine the pricing of European call options on stocks that have variance rates that change randomly. We study continuous time diffusion processes for the stock return and the standard deviation parameter, and we find that one must use the stock and two options to form a riskless hedge. The riskless hedge does not lead to a unique option pricing function because the random standard deviation is not a traded security. One must appeal to an equilibrium asset pricing model to derive a unique option pricing function. In general, the option price depends on the risk premium associated with the random standard deviation. We find that the problem can be simplified by assuming that volatility risk can be diversified away and that changes in volatility are uncorrelated with the stock return. The resulting solution is an integral of the Black-Scholes formula and the distribution function for the variance of the stock price. We show that accurate option prices can be computed via Monte Carlo simulations and we apply the model to a set of actual prices.

This Paper uses intraday data from the interdealer government bond market to investigate the effects of scheduled macroeconomic announcements on prices, trading volume, and bid-ask spreads. We find that 17 public news releases, as measured by the surprise in the announcced quantity, have a significant impact on the price of the following instruments: a three-month bill, a two-year note, a 10-year, anda 30-year bond. These effects vary significantly according to maturity. Public news can explain a substantial fraction of price volantility in the after math of announcements, and the adjustment to news generally occurs within one minute after the announcement. We document significant and persistent increases in volatility and trading volume after the announcements. Bidask spreads, on the other hand, widen at the timeof the announcements, but then revert to normal values after five to 15 minutes. The implications for yield curve modeling and for the microstructure of bond markets.

We develop a positive behavioral portfolio theory (BPT) and explore its implications for portfolio constrution and security design. The optimal portfolios of BPT investors resemble combinations of bonds and lotterly tickets consistent with Friedman and Savage's (1948) observation. We compare the BPT efficient frontier with the mean-variance efficient frontier and show that, in general, the two frontiers do not coincide. Optimal BPT portfolios are also different from optimal CAPM portfolios. In particular, the CAPM two-fund separation does not hold in BPT. We present BPT in a single mental account version (BPT-SA) and a multiple mental account version (BPT-SA). BPT-SA investors integrate their portfolios into a single mental account, while BPT-SA investors segregate their portfolios into several mental accounts. BPT-SA portfolios resemble layered pyramids, where layers are associated with aspirations. We explore a two-layer portfolio where the low aspiration layer is designed to avoid poverth while the high aspiration layer is designed for a shot at riches.

This study examines how the institutional environment influences capital structure and debt maturity choices of firms in 39 developed and developing countries. We find that a country’s legal and tax system, corruption, and the preferences of capital suppliers explain a significant portion of the variation in leverage and debt maturity ratios. Specifically, firms in more corrupt countries and those with weaker laws tend to use more debt, especially short-term debt; explicit bankruptcy codes and deposit insurance are associated with higher leverage and more long-term debt. More debt is used in countries where there is a greater tax gain from leverage.