When a firm's management needs to raise external capital in order to finance an investment project, it is likely to have better information about the project's future return than do potential investors. In such a case, as has been shown in the literature, management may be able to signal its information through the use of certain financial variables. However, the possibility that management may be able to use the level of investment in the project itself to signal their information has not been considered. The purpose of this paper is to examine this possibility. It is shown here that the level of capital investment may be able to perfectly reveal management's information, with a higher input level signalling more favorable information. It is further demonstrated that even in this equilibrium, financial variables still play an important role. Among other results, it is shown, in contrast to a conclusion of a study by Leland and Pyle, that in this setting the number of shares held by management may be negatively correlated with the favorableness of their information.

This paper examines the influence of risk aversion on the pricing policies of a market maker for securities. It is shown that a market maker's bid-ask spread can be decomposed into a portion for the known limit orders, a risk-neutral adjustment for expected market orders, and a risk adjustment for market order and inventory value uncertainty. It is demonstrated that a risk-averse market maker may set a smaller spread than a risk-neutral specialist. Finally, this paper demonstrates the pervasive role of inventory in affecting both the placement and size of the spread.

The advance of the theory of contingent claim pricing has made it possible to model and analyze very complex financial claims. When the value of the firm can be represented as a contingent claim, then the firm's optimal financial policy can be determined with only a slight modification in standard solution techniques for contingent claims. In this paper, stochastic control theory is used to determine a dynamic investment policy for the valuemaximizing firm. The value of future, stochastic economic rents (i.e., the net present value of the firm), and the firm's optimal investment policy must reflect a rational reaction on behalf of its competitors. A computationally efficient methodology is presented for solving the simultaneous investment-valuation problem for an n-firm game.

This paper is an event-time study of OTC stocks that listed on the New York Stock Exchange (NYSE) over the period 1966–1977. This period was chosen because it spans the introduction of the National Association of Securities Dealers Automatic Quotation (NASDAQ) communications system in the OTC market. In the pre-NASDAQ period, stocks, on average, earn significant positive abnormal returns in response to listing announcements. In the post-NASDAQ period, abnormal returns in response to listing announcements are statistically significantly lower than those for the pre-NASDAQ period. These results are consistent with the hypothesis that NASDAQ has reduced the benefits associated with listing on a major stock exchange. Additionally, in both the pre- and post- NASDAQ periods, stocks, on average, earn significant positive abnormal returns following the initial announcement of listing before listing actually occurs, and they earn significant negative returns immediately after listing. These anomalies are explored and the results are shown to be insensitive to variations in empirical methodology.

This paper examines whether investors with power utility functions choose mean-variance-(MV) efficient portfolios when returns are approximately normally distributed and there is borrowing or lending at a riskless interest rate. The results show that the unlevered portfolios of power utility investors plot very closely to the MV-efficient frontier. However, there are marked differences in the mix of risky assets, regardless of whether the portfolios are highly concentrated or widely diversified. Such differences allow power investors to remain solvent even when they lever their optimal portfolios to a greater extent than “less risk-averse” MV investors who risk bankruptcy. It is concluded that the investment policies of power utility and MV investors with similar risk aversion measures are not as similar as is commonly believed. This is particularly true for high power investors, unless explicit solvency constraints are imposed on the MV problem, and for low power investors when quadratic utility approximations are made to the power utility functions. These differences in the investment policies of power utility and MV investors lead us to question the widely-accepted assertion that the assumptions of homogeneous beliefs, normality, a riskless asset, and risk-averse investors imply the simple MV CAPM where all investors, including power utility investors, hold combinations of the market portfolio and the riskless asset.

Event studies generally seek to measure abnormal security performance associated with firm-specific events. In principle, estimators of and tests for abnormal performance should appropriately reflect cross-sectional dependence between abnormal returns to different securities. Joint generalized least squares provides a natural framework for developing such estimators and tests. This paper derives a joint generalized least squares estimator and related test statistic applicable in the typical event study context. Simulation techniques comparable to those of Brown and Warner [2] are used to assess the frequency distribution of the estimator and power of the test statistic. Several simpler procedures are simulated for comparison. The results provide no evidence that joint generalized least squares is superior to simpler procedures.

In the last several years, there has been increased theoretical emphasis on the agent-principal problem as it applies to corporate finance. This paper is an attempt to empirically test for the presence of the agency costs and their relation to the debt policy of corporations. We find that firms with higher insider ownership have greater debt ratios than firms with lower insider ownership, which may be explained by the agency costs of debt and/or the agency costs of equity. Other regression results tend to confirm the theoretically optimal relationships put forth by Myers. We find that high-growth firms use less debt rather than more debt, high-operating-risk firms use more debt rather than less debt, and firm size appears to be uncorrelated to the level of debt.

Pricing models for American call and put options on futures contracts are derived herein. These models are used to investigate the efficiency of the market for options on Standard & Poor 500 and German Mark futures. The evidence presented here indicates that market prices for these options deviate substantially from their corresponding model prices. In addition, it is shown that a hedging strategy originated at prices that indicate a deviation of market from model is successful in translating the observed mispricing into excess profits after transactions costs. However, these net profits are eliminated if the origination of the strategy is delayed by one trade, or if bid-ask spreads are accounted for.

New cross-sectional tests of the Mixture of Distributions Hypothesis are presented. The tests assume that the distribution of the mixing variable (often interpreted as the daily rate of flow of information) is not identical for all securities. Cross-security differences in the mixing distribution cause cross-security differences in the joint distribution of returns and volume. The Hypothesis provides predictions about how these differences appear in the joint distribution. The predictions are confirmed in tests based on cross-security correlations among summary statistics that characterize shape and covariational attributes of the joint distribution of returns and volume. The results are consistent with the Mixture of Distributions Hypothesis.

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.

This paper investigates the efficiency of the market for foreign currency options with the help of a modified version of the Black-Scholes model. The evidence in the ex post tests is inconsistent with this hypothesis since we find a large number of opportunities for abnormal profits. A second set of tests is conducted on an ex ante basis to determine whether these profit opportunities exist even if the execution of the strategy is delayed by one day. The evidence from these tests provides more support for the hypothesis of market efficiency.

This paper explores the effects of mergers on the investment incentives of the levered firm and on levered firm value. Under a fairly broad set of assumptions, it is shown that most firm combinations “improve” investment incentives, bringing about a reduction in the agency costs of underinvestment associated with risky debt. The effect of the merger on debt and equity claim values is also explored. If not properly anticipated, the merger may create a wealth transfer from equity holders to bondholders. Such a wealth transfer includes, but is not limited to, the “coinsurance effect.”

Previous anomaly research may have misinterpreted corrected, for the market index, mean returns on small firms. Assuming mean-variance preferences, it is shown theoretically that corrected mean returns (i.e., market line deviations) are not indicative of the relative desirability of increasing the proportional investment in small firms. The correct improvement criterion is derived and estimated. Tests indicate that the value-weighted market index is not significantly improved with greater weight on small firms, in the average month. When seasonality is considered, the observed performance improvements due to small or large firms are significant in some months, but the required portfolio position is unclear. If a case exists for a small firm anomaly in January, it probably exists in other months and it also exists for large firms. It is doubtful whether such an anomalous stock market exists.

Three alternative characterizations of corporate debt management policy, which have had wide currency in the literature, are examined. They are shown to give rise to substantial differences in their predictions of total-firm value. This study concludes that, of the three, the one that assumes that management periodically rebalances the firm's debt levels in response to evolving new information on expected future operating cash flows is the most logically consistent. On that basis, a reinterpretation of the available empirical evidence on the “tax effect” of debt is indicated.

The adoption of the incentive-signalling framework gives a reasonably good explanation of the corporate dividend decision. The equilibrium optimal dividend decision under such a framework is presented and analyzed, assuming a reward-penalty managerial incentive scheme is used. It is shown that the size of the declared dividend is an increasing function of expected cash flow. However, there exists a trend that points out that the higher the level of expected cash flow, the lower the marginal effects of cash flow on dividends. A similar relationship is observed with respect to changes in expected cash flows. These conclusions are in harmony with “real world” behavior as reported by several empirical studies. The effects of uncertainty and interest rates on dividends are also analyzed. It is shown, in agreement with observed phenomena, that the higher the uncertainty, the lower the dividend/payout ratio.

When portfolio optimization is implemented using the historical characteristics of security returns, estimation error can degrade the desirable properties of the investment portfolio that is selected. Given the problem of estimation risk, it is natural to formulate rules of portfolio selection within a Bayesian framework. In this framework, portfolio selection is based on maximization of expected utility conditioned on the predictive distribution of security returns. Most researchers have addressed the problem of estimation risk by asserting a noninformative diffuse prior that reduces the detrimental effect of estimation risk, but does not directly reduce estimation error. Portfolio performance can be improved by specifying an informative prior that reduces estimation error. An informative prior that all securities have identical expected returns, variances, and pairwise correlation coefficients is asserted. This informative prior reduces estimation error by drawing the posterior estimates of each security's expected return, variance, and pairwise correlation coefficients toward the average return, average variance, and average correlation coefficient, respectively, of all the securities in the population. The amount that each of these parameters is drawn toward its grand mean depends upon the degree to which the sample is consistent with the informative prior. This empirical Bayes method is shown to select portfolios whose performance is superior to that achieved, given the assumption of a noninformative prior or by using classical sample estimates.

This paper investigates the effect on shareholder wealth of two events that change management's choice between negotiated and competitive underwritten equity offerings. These two events are the suspension and termination of suspension of Rule 50. (This rule is based on the Public Utility Holding Company Act of 1935 and requires certain utilities to use the competitive method.) The results indicate that the shareholders of the affected utilities experience an abnormal negative return on the announcement of the suspension of Rule 50, and an abnormal positive return on the announcement of the termination of suspension. This evidence is consistent with the joint hypothesis: (i) competitive offerings are less costly than negotiated offerings, and (ii) manager-shareholder agency costs are a determinant of the corporate choice between these two methods of raising equity.

This paper discusses two fundamental issues in capital structure theory and analyzes the recent recapitalizations of Phillips and Unocal. It is shown that a value-maximizing capital structure may be inconsistent with shareholder utility maximization and that the Miller debt and taxes equilibrium may be inconsistent with a complete capital market. In spite of these and other unresolved issues, the markets's reactions to the recent recapitalizations of Phillips and Unocal are consistent with the predictions of capital structure theory. Except for small redistribution effects against bondholders, the recapitalizations per se had no positive impact on common stock values.

Empirical studies and much marketplace opinion have it that the spread between private money market rates and the U.S. Treasury bill rate of comparable maturity is due to differential default risk, liquidity risk, and relative supplies. This paper presents an argument and empirical evidence that the bulk of the systematic and medium-term differential between privates rates—in this case, domestic CDs, commercial paper, bankers' acceptances, and Eurodollar CDs—and the T-bill rate is due to the exemption of interest on Treasury securities from state and local taxation. In the case of Eurodollar CDs, the additional and major systematic factor explaining the spread (vis a vis T-bills) is the exemption of Eurodollar CDs from the Federal Reserve's “tax” via reserve requirements. An empirical section confirms the role of standard default risk, liquidity risk, and market “absorption” variables in determining short-term deviations from tax-adjusted parity. The taxadjusted parity condition, however, remains the major systematic and medium-term determinant—certainly more important than has been suggested previously in the literature.

Recent studies indicate that the widespread assumption of parameter stationarity in empirical applications of asset pricing models may be inappropriate. This paper investigates the feasibility of modeling parameter instability as a sequence of persistent stable regimes. Recursive residual and log likelihood techniques are combined to detect and locate shift points. The results indicate that regime shifts are widespread, frequent, and often large enough to significantly effect empirical findings. The nature of the shifts appears to be a rotation of the regression line, indicating that correction of both alpha and beta parameters is required.