In recent years, several papers [Mossin [13], Hamada [7], Rubinstein [14]] have addressed the normative implications of the CAPM (developed by Sharpe [15], Lintner [9] and Mossin [12]) for the capital budgeting and capital structure decisions of a value maximizing firm. The model has been extended by Chen and Boness [3] to analyze the effects of uncertain inflation and by Adler and Dumas [1] to study optimal international acquisitions.

We analyze how employee compensation contracts of target firms affect merger terms and outcomes. Using unique data from merger agreements, we document that in 80.0% of all merger and acquisition (M&A) deals, at least some of the target’s employee stock options (ESOs) are canceled by the acquirer and not replaced by new equity-based grants. Contract modifications reduce the value of ESOs by 38.4% in the average M&A deal. Further, the combined merger returns are larger when employees experience greater losses. Overall, our results indicate that the benefits of reducing the number of ESOs outweigh the potential negative effects on firm value.

This paper develops a two-country asset pricing model with defaultable firms and governments. This model shows that higher sovereign credit risk in a country depresses equity prices internationally and increases their volatility. The effect is strongest during adverse economic conditions and when firms are close to financial distress. A structural estimation provides evidence that sovereign default risk in Europe affects European and U.S. stock markets through the threat of an economic slowdown.

We investigate the causal effect of intangible capital on leverage. To address endogeneity, we exploit patent invalidations by a U.S. court in which judges are randomly assigned to cases. Differences in judge leniency provide exogenous variation in the probability that firms’ patents are invalidated. Using this probability as an instrument for exogenous losses in intangible capital, we find a patent invalidation leads to a 14.1% reduction in leverage, suggesting that intangible capital causally supports leverage. This local average treatment effect is stronger in firms that use patents as loan collateral and in less creditworthy as well as smaller firms.

I examine acquisitions of private firms by public acquirers to better understand the effects of financial constraints on the division of economic gains in takeovers. Empirical tests exploit interstate bank branching deregulation, which relaxes financial constraints on private firms and can strengthen their bargaining position in an acquisition. Using a proxy for the degree to which targets depend on acquirers for financing, I find that private targets depend less on acquirers as a result of interstate bank branching deregulation. Relaxing financial constraints on private targets leads to an increase in target valuation multiples and a decrease in acquirer wealth gains.

Many students of business finance subsume the risks associated with a firm's income stream under two general cognomens, namely, “business risk” and “financial risk.”1 The degree of business risk associated with a firm's income stream is considered to be a function of all determinants of risk except those that relate to the means by which a firm's operations are financed (i.e., the nature of a firm's capital structure). In general, business risk is determined by a firm's asset structure, the purposes for which a firm's assets are used, and the efficiency and effectiveness with which a firm's assets are utilized. The determinants of business risk include the competitive position of a firm, the nature of a firm's operating expenses, the intensity of demand for a firm's products, and a firm's managerial resources, inter alia. A measurement of the variability of net operating income (i.e., earnings before interest expenses and income taxes) is usually employed as a surrogate of business risk.

Consider a productive investment project (or financial security), which would yield a stream of cash flows, positive and negative, over time. A major index of the acceptability of such a project is its internal rate of return, i.e., that rate of interest which discounts all the cash flows from the project to a present worth of zero. Soper [8] has developed a sufficient condition for the internal rate to be unique in the interval, (−1,∞), along the real line. Then, if the project requires an initial outlay, if Soper's condition holds, and if the unique internal rate exceeds the market rate of interest in each period of the project's life, the project's present worth is positive, and hence, other things being equal, it is worth undertaking.

Empirical immunization studies have considered the efficacy of immunization strategies, in which the durations of assets and of liabilities are equated, against a strategy involving maturity matching. However, all these studies have ignored tax effects. In the presence of tax-clientele effects, immunization requires that the portfolio consists only of bonds that are correctly priced for a particular clientele. Testing for these effects, therefore, requires the identification of the correctly priced bonds for the investors in the clientele. However, since bond prices contain noise, determining these bonds is still an unresolved problem. Consequently, an empirical test of the magnitude of the error caused by ignoring taxes may be an impossible task in some markets, and indeed has never been conducted. The Canadian bond market provides perfect laboratory conditions for such a test. Tax-clientele effects are present in the Canadian market, and among the clienteles is a representative clientele. This paper examines the tax effects on immunization strategies. The results show that the error caused by ignoring tax effects is not negligible, and practitioners should use immunization with reference to tax effects.

This paper presents a hedonic index of residential services fit to 1975 data for the St. Joseph County, Indiana, rental housing market. The work it reports is part of a larger research effort, the Housing Assistance Supply Experiment (HASE), being conducted for the U.S. Department of Housing and Urban Development.

We present a theory of the linkages between corporate governance, corporate finance, and the real sector of an economy. Using a structural model of industry equilibrium with endogenous entry, we show that poor corporate governance leads to low levels of competition, and to firms with high insider ownership and leverage. In contrast, good corporate governance promotes the adoption of more efficient technologies and development of sectors more exposed to moral hazard. We use our model to study equity market liberalization, and we show that liberalizations facilitate entry and adoption of more productive technologies, especially in countries with good corporate governance.

Although stock returns of intangibles-intensive firms tend to exceed physical assets-intensive firms, risk-adjusted returns of actively managed mutual funds significantly decrease (increase) with their portfolios’ exposure to intangibles-intensive (physical assets-intensive) firms. Fund managers tend to exhibit skill when they focus on difficult-to-value (e.g., small) firms, except when the firms are intangibles-intensive. In sum, the worst-performing funds are in areas of the market that seem to offer ample opportunities for professional investors due to exacerbated mispricing. The negative impact of investments in intangibles-intensive firms on fund performance appears to be driven by extrapolation bias and decreases with learning from experience.

We study whether it is better to enforce the zero lower bound (ZLB) in models of U.S. Treasury yields using a shadow rate model or a quadratic term structure model. We show that the models achieve a similar in-sample fit and perform comparably in matching conditional expectations of future yields. However, when the recent ZLB period is included in the sample, the models’ ability to match conditional expectations away from the ZLB deteriorates because the time-series dynamics of the pricing factors change. In addition, neither model provides a reasonable description of conditional volatilities when yields are away from the ZLB.

In portfolio risk minimization, the inverse covariance matrix of returns is often unknown and has to be estimated in practice. Yet the eigenvalues of the sample covariance matrix are often overdispersed, leading to severe estimation errors in the inverse covariance matrix. To deal with this problem, we propose a general framework by shrinking the sample eigenvalues based on the Schatten norm. The proposed framework has the advantage of being computationally efficient as well as structure-free. The comparative studies show that our approach behaves reasonably well in terms of reducing out-of-sample portfolio risk and turnover.

We study the agency implications of increased disclosure using a regulatory change in the mutual fund industry as an experimental setting. This quasi-natural experiment mandated more frequent portfolio disclosure, which we show imposes managerial skill-reassessment risks from investors on funds with high relative performance volatility. In turn, this risk translates into greater agency costs to investors. We show that high-volatility funds, relative to low-volatility funds, responded to the increased skill-reassessment risk after regulation with an increase in management fees and a decrease in risk taking. These actions get transmitted to fund investors in the form of inferior net performance.

We find that an increase in a firm’s incentives to use trade secrets to protect its intellectual property results in a more actively managed capital structure. Exploiting U.S. states’ adoption of the Uniform Trade Secrets Act as a positive “shock” in the protection afforded to trade secrets, we find that firms covered by the Act reduce debt levels while increasing investments in intangibles. Additional tests suggest that firms fund these financing and investment activities by issuing more equity. Consistent with an increase in overall intangibility magnifying contracting problems with creditors, we find that covered firms experience higher costs of debt.

Staleness in measured prices imparts a positive statistical bias and a negative dilution effect on mutual fund performance. First, evaluating performance with nonsynchronous data generates a spurious component of alpha. Second, stale prices create arbitrage opportunities for high-frequency traders whose trades dilute the portfolio returns and hence fund performance. This paper introduces a model that evaluates fund performance while controlling directly for these biases. Empirical tests of the model show that alpha net of these biases is on average positive although not significant and about 40 basis points higher than alpha measured without controlling for the impacts of stale pricing. The difference between the net alpha and the measured alpha consists of 3 components: a statistical bias, the dilution effect of long-term fund flows, and the dilution effect of arbitrage flows. Whereas the former 2 components are small, the latter is large and widespread in the fund industry.

This paper proposes a measure of ex ante equity premium, IPOFDR, which is the average difference between the initial public offering (IPO) offer price and the 1st-trading-day close price. I test the idea in 3 ways. First, there is a positive relation between IPOFDR and future market returns. Second, changes in IPOFDR help explain the cross section of stock returns. Third, the predictive power of IPOFDR for stock returns reflects mainly its close relation with market variance and average idiosyncratic variance—arguably measures of systematic risk. These results cast doubt on the notion that the IPO 1st-day return is a measure of investor sentiment.

Since the Second World War the corporate pension trust has become a prominent method of provision for employees' retirement income. The continuing liberalization of pension provisions and pressures to match pension trust liabilities with assets has established pension contributions as a significant component of corporate cash outlays. Asset accumulation in pension trusts has rendered such institutions a major source of capital funds.

In a recent study, Levy and Markowitz [15] demonstrate that, at least for some utility functions, expected utility can be approximated by a judiciously chosen function defined over mean and variance. In addition to resurrecting mean-variance analysis from the limbo into which it was placed by the criticisms of Borch [10] and others, the analysis by Levy and Markowitz yields a more direct approach to portfolio analysis than that provided by the current empirical literature. The current portfolio literature is concerned with notions of efficient sets and systematic risk rather than with utility functions and mean-variance. While much has been gained from a utility-free methodology, it is ultimately predicated upon a separation theorem and, hence, an environment with zero transactions costs. But security markets are not costless and the separation theorem may not hold. In that event, a utility-dependent approach to portfolio analysis could potentially lead to more powerful results especially if such an approach could be empirically implemented.

An abundance of evidence relates facial width-to-height ratio (fWHR) to masculine behaviors in males. We show that hedge funds operated by high-fWHR managers underperform those operated by low-fWHR managers, bear greater downside risk, are more susceptible to fire sales, and fail more often. High-fWHR managers compensate for their underperformance by marketing their funds more aggressively, thereby garnering higher flows and fee revenues. By exploiting major personal events that shape testosterone, namely marriage and fatherhood, we trace the biological mechanism underlying the relation between fWHR and investment performance to circulating testosterone. Our findings are robust and extend to equity mutual funds.