We provide a new framework for valuing multidimensional real options where opportunities to exercise the option are generated by an exogenous Poisson process, which can be viewed as a liquidity constraint on decision times. This approach, which we call the Poisson optional stopping times (POST) method, finds the value function as a monotone sequence of lower bounds. In a case study, we demonstrate that the frequently used quasi-analytic method yields a suboptimal policy and an inaccurate value function. The proposed method is demonstrably correct, straightforward to implement, reliable in computation, and broadly applicable in analyzing multidimensional option-valuation problems.

Short sellers trade more on days with qualitative news, that is, news containing fewer numbers. We show that this behavior is not informationally motivated but can be explained by short sellers exploiting higher liquidity on such days. We document that liquidity and noise trading increase in the presence of qualitative news, enabling short sellers to better disguise their informed trades. Natural experiments support our findings. Qualitative news has a bigger effect on short sellers’ trading after a decrease in liquidity following the stock’s deletion from the Standard & Poor’s 500 index and a smaller effect when investor attention is distracted by the Olympic Games.

The cost of capital concept has for some years permeated both finance theory and textbook treatments of capital structure and business investment decisions. This has been due, to a major extent, to the important works of Modigliani and Miller [10,11] and Solomon [16], among others. In recent years, however, the concept has been the subject of some controversy. A number of authors have shown that the cost of capital, as usually computed, can produce errors except under highly restrictive assumptions and that there continues to be some debate over its proper definition and use. Our purpose in the present paper is to explicate more fully the source of the difficulties with the cost of capital and to suggest that, despite the initial usefulness of the concept, the field of finance would be better off now if it were relegated to history. Both the perfect and imperfect market cases will be considered. We propose that the term “cost of capital” be eliminated from textbooks and research papers and be replaced by superior concepts.

The relationship between heterogeneous expectations on the part of investors with respect to a security's future return and asset prices is an area of increasing interest in finance. Theoretical examples include Miller [14], Williams [23], and Jarrow [8]. Empirical examples include Bart and Masse [1] and Peterson and Peterson [18]. Miller, Bart and Masse, and Peterson and Peterson address issues related to whether an increase in divergence of opinion will lead to an increase in an asset's price. Unfortunately, little is known of how different types of changes in investors' probability distributions of returns influence asset returns. An even more basic problem is that it is not clear what is meant in terms of investor probability distributions when it is said that divergence of opinion increases or decreases. The answer to this problem has important implications for understanding equilibrium price.

The behavior of economic agents in the presence of uncertainty about exogenous events and imperfect information about the endogenously influenced actions of other agents with whom they contract has been receiving growing attention. In particular, the economic theory of agency explicitly recognizes that when agents enter into synergistic relationships, each agent will act in a manner consistent with the maximization of its personal welfare, thus giving rise to a phenomenon called moral hazard. Harris and Raviv [8], Holmström [10], and Shavell [21] have analyzed the nature of Pareto-optimal contractual mechanisms designed to ameliorate moral hazard and achieve efficient risk sharing. Jensen and Meckling [12], Grossman and Hart [6], and Thakor and Gorman [22] have explored the impact of moral hazard on the capital structure decisions of firms. Arrow [1] explained the absence of complete contingent claims markets on the basis of moral hazard, and Harris and Raviv [7] have examined the impact of moral hazard on the structure of health insurance contracts.

Listing of common stock on an exchange is believed by many to have a positive value for the firm. One implication of purported advantages has been improvement in the price of the stock when it is listed. Another advantage to an investor could be a reduction in the risk level of a security through trading location changes. The purpose of this research is to investigate the effect upon a security's risk level when its trading location is transferred to the New York Stock Exchange.

This study examines the wealth effects of convertible bond call announcements on stockholders, straight bondholders, and called and non-called convertible debtholders. We document that forced conversions are associated with a significant loss in firm value. The results suggest that convertible call announcements can trigger both negative signal and wealth transfer effects. We show that at least part of the negative effect on stock prices results from wealth transfer to straight bondholders. Our analysis also lends empirical validity to the common contention that called convertible bondholders suffer wealth expropriation due to the elimination of the premium. The wealth effect on non-called convertible debtholders is insignificant. Cross-sectional analysis reveals that the negative signal effect is important in explaining bond, stock, and firm excess returns. Finally, we present evidence that refutes the notion that bonds are called to relieve the firm from restrictive debt covenants.

The value of American options depends on the exercise policy followed by option holders. Market frictions, risk aversion, or a misspecified model, for example, can result in suboptimal behavior. We study the sensitivity of American options to suboptimal exercise strategies. We show that this measure is given by the Gamma of the American option at the optimal exercise boundary. More precisely, “if B is the optimal exercise price, but exercise is either brought forward when or delayed until a price B̃ has been reached, the cost of suboptimal exercise is given by ½ × Γ(B) × (B − B̃)2, where Γ(B) denotes the American option Gamma.” Therefore, the cost of suboptimal exercise is second-order in the bias of the exercise policy and depends on Gamma. This result provides new insights on American options.

We study whether firms spread out debt-maturity dates, which we call granularity of corporate debt. In our model, firms that are unable to roll over expiring debt need to liquidate assets. If multiple small asset sales are less inefficient than a single large one, it can be optimal to diversify debt rollovers across time. Using a large sample of corporate bond issuers during the 1991–2012 period, we establish novel stylized facts and evidence consistent with our model’s predictions. There is substantial heterogeneity (i.e., firms have both concentrated and dispersed debt structures). Debt maturities are more dispersed for larger and more mature firms and for firms with better investment opportunities, higher leverage, and lower profitability. During the recent financial crisis, firms with valuable investment opportunities implemented more dispersed maturity structures. Finally, firms manage granularity actively and adjust toward target levels.

This article studies whether debt renegotiation mitigates debt overhang and increases corporate investment. Using mergers between lenders participating in the same syndicated loans as natural experiments that reduce the number of lenders and thus make renegotiation easier, I find that the firms affected by the mergers become more likely to renegotiate the loans and increase capital investment. The effect is stronger for firms with higher Q and firms in financial distress, supporting the hypothesis that the lender mergers mitigate the debt-overhang problem.

The performance of firms operating in highly concentrated industries continues to be of interest. Substantial empirical research has focused on shareholder benefits in the form of book equity returns. Research by Bain [1] and by Mann [6], as well as others, found that higher rates of return on equity capital are associated with greater market power (measured by industry concentration ratios and entry barriers).

This paper extends the default model of yield spreads for bonds by showing that, in general, they are a complex function of maturity and, in particular, are not always monotonically increasing, contrary to what one traditional view suggests. Our results may help explain the apparently conflicting empirical results found in the literature.

A fundamental statistical test of serial independence is developed and applied to daily stock returns. Let xt be the deviation of the daily return on a stock from its sample mean after any autocorrelation present has been removed. If xt is serially independent, then the cumulative sum of xt over time is the position of a one-dimensional random walk on a line. The empirical distribution of step lengths over a large sample allows the distribution of the largest absolute excursion in a T-step walk to be calculated by repeated simulation. The observed maximal excursions are found to be significantly smaller than one would expect, based on serial independence and the observed distribution of step lengths. It is concluded that these daily stock returns are not serially independent and that the market value of the corporations studied has a tendency to return to an interval around the trend value.

I examine abnormal stock returns associated with “stock highlights” published by the Value Line Investment Survey. At the time of their publication, stock highlights elicit strong positive abnormal returns. They also have positive abnormal returns at the time of the earnings announcement preceding stock highlight publications. Post-earnings announcement drift is present, but is much too small to explain abnormal returns at the time of the publication of stock highlights. Thus, Value Line stock highlights provide useful information to investors. This information is rapidly reflected in stock prices, consistent with market efficiency.

Using a fast numerical technique, we investigate a large database of investors’ suboptimal nonexercise of short-maturity American call options on dividend-paying stocks listed on the Dow Jones. The correct modeling of the discrete dividend is essential for a correct calculation of the early exercise boundary, as confirmed by theoretical insights. Pricing with stochastic volatility and jumps instead of the Black–Scholes–Merton benchmark cuts the amount lost by investors through suboptimal exercise by one-quarter. The remaining three-quarters are largely unexplained by transaction fees and may be interpreted as an opportunity cost for the investors to monitor optimal exercise.

We present a prediction model to forecast corporate defaults. In a theoretical model, under incomplete information in a market with publicly traded equity, we show that our approach must outperform ratings, Altman’s Z-score, and Merton’s distance to default. We reconcile the statistical and structural approaches under a common framework; that is, our approach nests Altman’s and Merton’s approaches as special cases. Empirically, the combined approach is indeed the most powerful predictor, and the numbers of observed defaults align well with the estimated probabilities. With a new transformation method, we obtain cycle-adjusted forecasts that still outperform ratings.

This paper explores the cross-sectional variation of expected returns for a large cross section of industry and size/book-to-market portfolios. We employ mixed data sampling (MIDAS) to estimate a portfolio’s conditional beta with the market and with alternative risk factors and innovations to well-known macroeconomic variables. The market risk premium is positive and significant, and the result is robust to alternative asset pricing specifications and model misspecification. However, the traditional 2-pass ordinary least squares (OLS) cross-sectional regressions produce an estimate of the market risk premium that is negative, and significantly different from 0. Using alternative procedures, we compare both beta estimators. We conclude that beta estimates under MIDAS present lower mean absolute forecasting errors and generate better out-of-sample performance of the optimized portfolios relative to OLS betas.

Banks are growing ever larger compared to their national economies. We show that increases in relative bank size (measured as a bank’s liabilities divided by national GDP) are linked to banks displaying higher tail risk. This effect is not entirely due to risk channels that disproportionately expose relatively large banks to systematic tail risks, sovereign risks, or banking crises. Instead, we detect a persistent component in the tail risk of relatively large banks that is bank-specific and connected to government guarantees. Furthermore, as banks grow in relative size, tail risks are shifted to debtholders without wealth gains for shareholders.

Relying on a simple general equilibrium model of the term structure, we show that both nominal yields and real consumption growth rates can be affine in the unobservable state variables. We can then express real consumption growth rates in terms of nominal yields rather than the unobservable state variables with the coefficients of the resultant forecasting relation being endogenously determined by the term structure model. Using term structure data over the 1985 to 2000 sample period, the empirical evidence is consistent with our model more accurately predicting real consumption growth rates than a regression model based on the term spread.

We develop an equilibrium model in a 2-country, 2-good, pure exchange economy in which investors with logarithmic utility functions have heterogeneous beliefs about exogenously given output or endowment processes. We obtain closed-form representations of real exchange rates and of stock prices. We show that heterogeneous beliefs together with heterogeneous preferences make the volatility of real exchange rates and of stocks exhibit some properties that have been well documented in the empirical literature. These properties include the high volatility of both real exchange rates and stocks compared with that of economic fundamentals, the high correlation of stocks during periods of volatile markets. The model can also generate the clustering of the volatility of foreign exchange rates and stocks if the differences of beliefs are clustering.