This paper identifies various components of stock prices and examines the response of stock prices to different types of shocks: permanent and temporary changes in earnings and dividends, changes in discount factors, and non-fundamental factors. The analysis is conducted in a log-linear structural VAR framework. I find that about half of the yearly variation in prices is not related to either earnings or dividend changes. Time-varying interest rates do not help explain the remaining price movements. However, time-varying excess stock returns (i.e., risk premiums) account for much of the remaining variation in stock prices, in particular, in the postwar period. As a result, the deviation of stock prices from these fundamentals reduces to about 10% of stock price movements and tends to persist for a while before it declines eventually. This finding seems more compatible with a fad rather than a bubble interpretation.

In an incomplete contracting environment, bankruptcy is considered to be a renegotiation of the firm's financial contracts. An optimal bankruptcy law is derived as optimal restrictions on the environment within which the claimants to a distressed firm bargain. The law is used as a commitment device to ensure actions that are ex ante optimal but not subgame perfect. We show that the bankruptcy court can use two types of mechanisms to implement the optimal bankruptcy outcome: direct restrictions on the bargaining game between the claimants, and the use of a “restricted auction.” In both cases, the restrictions prevent the strategic use of bankruptcy by firms not in financial distress, provide for truthful revelation of information so that distress results in an ex post efficient allocation of resources, and establish a bias toward the manager in reorganizations that provides correct ex ante decision making incentives.

This paper explores the effect of project interrelationships on investment decisions and project values in a real options framework. We examine in detail the mutually exclusive case where a firm may invest in the development stage of two projects and then may select only a single project to implement. The firm can develop the projects in parallel or in sequence. The choice of development policy depends on the relative values of the embedded options for each strategy. Sequential development is shown to be superior to parallel development when projects have highly correlated values, and when they require a large commitment of capital for development, are short term in nature, and have relatively low volatility. We also show that the optimal ordering of sequential projects does not always begin with the most profitable project.

The ability to identify which factors best capture systematic return covariation is central to applications of multifactor pricing models. This paper uses a common data set to evaluate the performance of various proposed factors in capturing return comovements. Factors associated with the market, size, past return, book-to-market, and dividend yield help explain return comovement on an out-of-sample basis (although they are not necessarily associated with large premiums in average returns). Except for the default premium and the term premium, macroeconomic factors perform poorly. We document regularities in the behavior of the more important factors, and confirm their influence in the Japanese and U.K. markets as well.

The magnitude and determinants of credit and currency risks are topics of considerable importance. This paper uses data on peso- and dollar-denominated debt issued by the Mexican government to identify currency and country risk premia. We show that shocks in equity and debt market returns translate into long-term increases in the premium demanded by investors with respect to currency and country factors. Country and currency premia help explain equity returns and closed-end fund discounts. Additional evidence is provided showing that investors did not anticipate the magnitude or timing of the currency devaluation of December 1994 and the subsequent financial crisis.

We develop a model to value options on commodity futures in the presence of stochastic interest rates as well as stochastic convenience yields. In the development of the model, we distinguish between forward and future convenience yields, a distinction that has not been recognized in the literature. Assuming normality of continuously compounded forward interest rates and convenience yields and log-normality of the spot price of the underlying commodity, we obtain closed-form solutions generalizing the Black-Scholes/Merton's formulas. We provide numerical examples with realistic parameter values showing that both the effect of introducing stochastic convenience yields into the model and the effect of having a short time lag between the maturity of a European call option and the underlying futures contract have significant impact on the option prices.

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 develops a nonparametric model of interest rate term structure dynamics based on a spot rate process that permits only positive interest rates and a market price of interest rate risk that precludes arbitrage opportunities. Both the spot rate process and the market price of interest rate risk are nonparametrically specified so that the model allows for maximal flexibility in fitting into the data. Marginal density of interest rates and historical term structure data are exploited to provide robust estimation of the nonparametric term structure model. The model is implemented using U.S. data, and the estimation results are compared to those in the available literature. Empirical results not only provide strong evidence that most traditional spot rate models and market prices of interest rate risk are misspecified, but also confirm that the nonparametric model generates significantly different term structures and prices of common derivatives.

This paper investigates the effects of stochastic convenience yields, stochastic interest rates, and jumps in the spot price on the pricing of commodity futures, forwards, and futures options. Numerical examples show that one-factor prices differ materially from the stochastic convenience yield two-factor prices when convenience yield is considerably above its long-term average. The extension to a three-factor model with stochastic interest rates leads to a different futures price but the forward price is unchanged. The extension of the three-factor model to include jumps in the spot price process does not affect forward or futures prices but it can have an impact on options prices. The model is applied to price the present value of future cash flows from a real asset.

We provide a comprehensive examination of shareholder resolutions to rescind poison pills. We find that pill rescission proposals are more frequent the more negative the market reaction to the initial pill adoption and the lower the insider and unaffiliated block ownership. Votes for such a proposal increase when performance is poor and for more onerous poison pills. While we document a stock price decline associated with the proposal announcements, we find poison pills are more likely to be restructured or rescinded when there is a shareholder resolution. Moreover, pill revisions are associated with stockholder wealth increases. Collectively, our results suggest that pill rescission proposals are more frequent when the pill is more likely to harm shareholders and that managers respond to shareholder proposals.

The exchange rate is an important variable that affects international competitiveness and performance of Japanese firms. We use an unconditional and a conditional multi-factor asset pricing model to examine whether exchange risk is recognized and priced in the Japanese stock market. The results indicate that the exchange risk is generally priced in Japan. More specifically, we provide evidence, in the unconditional model, that the exchange risk is priced in both weak and strong yen periods, when the bilateral yen/U.S. dollar exchange rate measure is used. The results are more mixed when the trade-weighted exchange rate is used. For the conditional model, the exchange risk is priced regardless of the exchange rate measure used. The combined evidence from the two models suggests an interesting observation about the role of the secular exchange rate trend in shaping the perception of exchange risk in the Japanese capital markets.

Suppose the ICAPM governs asset prices and there is a total of S state variables that might be of hedging concern to investors. Can we determine which state variables are, in fact, of hedging concern? What does it mean to say that these state variables are priced, that is, that they give rise to special risk premiums in expected returns? The goal of this paper is to formulate this problem clearly and show when it can and cannot be solved. Ignoring estimation problems, it is possible to find the set of priced state variables when the state variables are identified (named). When we know the number of state variables, but not their names, confident conclusions about even the number of them that produce special risk premiums are probably impossible, unless the number is zero, so the ICAPM collapses to the CAPM.

The debt overhang problem is shown to arise in the context of an entrepreneurial project that requires a sequence of investments financed by an outside lender. The entrepreneur, not internalizing losses accruing to the lender which financed the initial investments, may inefficiently cancel the project and instead pursue an outside opportunity. It is shown that loan commitments (contracts that allow the entrepreneur to borrow a variable amount at a set interest rate in return for a fixed fee) are the optimal financial contracts in this setting, strictly dominating standard debt. The existence of the fixed fee allows loan commitments to set a relatively low interest rate, improving the entrepreneur's incentives to continue the project. The paper specifies the optimal contract fully, derives robust comparative statics properties (using an extension of Milgrom and Roberts (1994)), and extends the results to more realistic settings (e.g., allowing the market risk-free rate to be stochastic).

It has long been market folklore that the best time to buy stocks is when individual investors are bearish, and the best time to sell is when individual investors are bullish. We examine the forecast power of three popular measures of individual investor sentiment: the level of discounts on closed-end funds, the ratio of odd-lot sales to purchases, and net mutual fund redemptions. Using data from 1933 to 1993, we find that fund discounts and net redemptions predict the size premium, the difference between small and large firm returns, but little evidence that the odd-lot ratio predicts returns.

When shareholders have different plans to sell their shares, they will, in general, have different preferences concerning the firm's decision to pay out cash using dividends or share repurchase. We illustrate these different preferences and explore a model of payout policy that highlights the adverse selection costs of repurchases when managers have superior information about the value of the firm. We show that, in the absence of fixed costs to repurchasing shares, there is a separating equilibrium in which managers use taxable dividends to signal the quality of the firm, with better firms paying lower dividends, using repurchases for the remainder of the payout. With fixed costs to repurchasing, small payouts are made via dividend and large payouts are divided between repurchases and dividends, as in the no-fixed cost case. In both cases, the percentage of shares repurchased increases with the size of the payout and larger repurchases are better news.

This paper studies the high frequency reaction of the DEM/USD exchange rate to publicly announced macroeconomic information emanating from Germany and the U.S. By using data sampled at a five-minute frequency, we are able to identify significant impacts of most announcements on the exchange rate change in the 15 minutes post-announcement, although the significance of these effects decreases rapidly as the interval over which the post-announcement change in exchange rates is increased. The direction of the exchange rate response conforms, in general, with a reaction function interpretation whereby reactions to macroeconomic news are driven by the likely operations of monetary authorities in domestic money markets. Further, we detect influences of German monetary policy decisions on the reaction of the exchange rate, and also differences between U.S. and German announcements in the exchange rate reaction time pattern.

This paper models the U.S. Treasury securities auction market and demonstrates that market manipulation can occur in a rational equilibrium. It is a dynamic model with traders participating in a “when-issued” market, a Treasury auction, and a resale market. Manipulations occur when dealers in the when-issued market use their knowledge of the net order flow in order to corner the auction and squeeze the shorts (from the when-issued market). This manipulation equilibrium generates bubbles in Treasury security prices and specials in repo rates. We also compare discriminatory and uniform price auction rules with respect to manipulation. Our analysis shows that manipulations can occur in long-run equilibrium under discriminatory price auctions, but not under uniform price auctions.

We develop a dynamic game-theoretic model of a futures market in which prices can be manipulated by corner and squeeze. We investigate equilibrium trading strategies and the price dynamics these strategies produce. Price paths produced by our model can mimic observed prices for potentially comerable commodities and explain the volatility of certain prices even when no manipulations occur. Our model also generates occasional apparent price bubbles and accounts for the existence of normal backwardation in futures markets even when players are risk neutral.

Arithmetic Asian options are difficult to price and hedge as they do not have closed-form analytic solutions. The main theoretical reason for this difficulty is that the payoff depends on the finite sum of correlated lognormal variables, which is not lognormal and for which there is no recognizable probability density function. We use elementary techniques to derive the probability density function of the infinite sum of correlated lognormal random variables and show that it is reciprocal gamma distributed, under suitable parameter restrictions. A random variable is reciprocal gamma distributed if its inverse is gamma distributed. We use this result to approximate the finite sum of correlated lognormal variables and then value arithmetic Asian options using the reciprocal gamma distribution as the state-price density function. We thus obtain a closed-form analytic expression for the value of an arithmetic Asian option, where the cumulative density function of the gamma distribution, G(d) in our formula, plays the exact same role as N(d) in the Black-Scholes/Merton formula. In addition to being theoretically justified and exact in the limit, we compare our method against other algorithms in the literature and show our method is quicker, at least as accurate, and, in our opinion, more intuitive and pedagogically appealing than any previously published result, especially when applied to high yielding currency options.

The literature suggests two competing explanations for reincorporations: efforts at managerial entrenchment and attempts to improve contractual efficiency. The empirical evidence to date is inconclusive. To seek further evidence, we examine a large sample of firms that changed their state of incorporation over the period 1980–1992. We find that shareholder wealth is decreased by reincorporations that erect takeover defenses, but is increased by reincorporations that establish limits on director liability. Firms that claim they reincorporate to limit the personal liability of their board members and thereby attract better qualified outside directors do, in fact, expand the outside representation on their boards, whereas firms citing other motives do not.