FINANCE
Edited by R.A. Jarrow, V. Maksimovic and W.T. Ziemba
PREFACE
The Handbook of Finance is a primary reference work for financial economics and financial modeling students, faculty and practitioners. The expository treatments are suitable for masters and PhD students with discussions leading from first principles to current research with reference to important research works in the area. This handbook is intended to be a synopsis of the current state of various aspects of the theory of financial economics and its application to important financial problems. The coverage consists of thirty-three chapters written by leading experts in the field. The contributions are in two broad categories: capital markets and corporate finance. The chapters are tutorial and survey-like in nature with expositions that vary from discussion of important results of the area in great detail to general treatments to more cursory presentation of key results with reference to where to find their development in their original presentation.
Financial economics has undergone a very rapid development in the past thirty years. While this handbook is in the Operations Research/Management Science series, the treatment is in most cases in the mainstream of financial economics theory and empirical measurement. It is noteworthy that the three Nobel Laureates in Financial Economics, Professors Harry M. Markowitz, Merton H. Miller and William E Sharpe all began their careers with strong operations research/management science backgrounds and used this knowledge and techniques throughout their careers. Some of their work is discussed in this handbook.
While this volume is a large one comprising over 1100 pages and the treatment of topics is thorough, the vastness of the subject matter of finance preludes the possibility of an exhaustive survey. We have chosen to include what we think are the key topics of the theory with strong emphasis on empirical work and practice. Hopefully the background in these thirty-three chapters will lay the foundations for further study of leading journals, books and other research materials.
Capital Markets
Portfolio theory is the analysis of the real world phenomenon of diversification. Chapter 1 by Constantinides and Malliaris exposits this theory in its historical evolution, from the early work on static mean-variance mathematics to its generalization of dynamic consumption and portfolio rules. In its intellectual development, portfolio theory has benefited from empirical work which came from capital asset pricing tests and from statistical investigations of the distribution of asset prices. Furthermore, as more powerful techniques were developed, such as stochastic calculus, portfolio theory became dynamic and many results were generalized. The modification of the theoretical results of portfolio theory due to transaction costs is also presented.
In Chapter 2, Naik presents key results in securities market models and arbitrage. The material in this fundamental chapter underlies the arbitrage-free pricing methodology used in modern option pricing theory [see Chapters 8, 9 and 11 below]. Naik studies finite state securities market models on a finite horizon. This setting facilitates mathematical analysis as well as the economic intuition. In this chapter, the concept of no arbitrage is first defined, and characterized under frictionless markets, i.e., no transaction costs nor trading constraints. This frictionless setting is then relaxed, and a characterization of no arbitrage is given under various types of market frictions.
In Chapter 3, Hakansson and Ziemba review the theory of capital growth, in particular the growth-optimal investment strategy, its properties, its uses, and its links to betting and other investment models. This strategy, also known as the geometric mean model and the Kelly criterion, implies, and is implied by, a logarithmic utility function. The strategy has many very desirable properties such as maximizing the long-run growth of capital asymptotically - even though the optimal policy is myopic. Among the less appealing properties are the fact the growth-optimal strategy does not maximize expected utility for non-log utility functions, and that it is more risk-tolerant than the average investor. This suggests trading off growth for security of wealth using fractional Kelly strategies, for example. Hakansson and Ziemba derive the conditions for optimal capital growth, relate the model to other investment strategies, show its role in inter temporal investment/consumption models and review various applications.
Connor and Korajczyk survey the multi-factor arbitrage pricing theory of Ross and extensions of that theory in Chapter 4. The basic insight is that a linear factor model of asset returns, in an economy with a large number of assets implies that the idiosyncratic risk is diversifiable and that the equilibrium prices of securities will be approximately linear in their factor exposures. They discuss theoretical results, econometric testing and applications of the APT to problems in investments and corporate finance. The model assumes that the random return of each security is a linear combination of a small number of common factors plus asset specific random variables. The vector random process can be divided to separate the nondiversifiable from the diversifiable components of risk as in the CAPM (discussed in Chapter 5 by Ferson). The authors carefully consider the testability of the APT using equilibrium-based derivations of the pricing relationships well diversified portfolio approximations to the latter, via competitive equilibrium models, and with models assuming an infinite number of assets.
The CAPM holds if the market portfolio (a particular linear combination of factor portfolios) is mean-variance efficient. The CAPM requires observations of the market portfolio returns whereas the APT requires observation of the factors or factor-mimicking portfolios. Whether or not one of the models outperforms the other is difficult to ascertain since neither is a restricted (nested) version of the other. However, in the cases in which the APT is compared to implementation of the CAPM, the APT better explains the cross section in asset returns and explains some pricing anomalies not explained by the CAPM, and it generally has lower pricing errors. The discussion of empirical tests of the APT discusses a variety of applications such as the US and international modeling, portfolio performance evaluation, cost of capital estimation, and event studies.
Ferson, in Chapter 5, integrates the major asset pricing models such as those related to the CAPM, consumption and production based models and ARCHGARCH using a self contained discussion based on simple first principles. He then reviews empirical tests of the models with a unified framework using the generalized method of moments due to Hansen. This allows the estimation and testing of models, termed conditional asset pricing models, where the expected returns and risks of the assets may change over time with the arrival of new information. Ferson concludes by reviewing cross-sectional regression methods. The role of conditioning information in these models represents significant challenges for future theoretical and empirical research on asset pricing.
In Chapter 6, Stultz reviews international portfolio choice theories using a common framework based on the international capital asset pricing model, assesses their empirical tests and discusses their relevance to the field of international finance. If investment and consumption opportunity sets do not differ across countries then currencies have no significant effect on portfolio choice and asset pricing. Traditional approaches to portfolio choice and asset pricing, as discussed in earlier chapters by Constantinides and Mallarios and Ferson, respectively, do not accurately predict asset holdings across countries, in particular, the home bias for investments. However, they are useful in explaining the cross sectional variation in conditional expected returns across countries. Stultz then shows how the predictions of these models change if there are differences in consumption and investment opportunity sets.
In Chapter 7, Carr and Jarrow review the literature in the area of options and futures. This is an immense body of work, spanning more than twenty years of investigation. This chapter studies this literature by synthesizing the existing results as special cases of a more general valuation model based on the evolution of a term structure of futures prices. This general valuation approach is consistent with current research perspectives and is based on the methodology of Chapter 2. The setting is a discrete time, binomial model. Extensions are discussed.
Jarrow, in Chapter 8 summaries the recent literature in the area of interest rate options. A discrete time model illustrates the application of the no arbitrage techniques of Chapter 2 to the pricing of interest rate options. A theoretical perspective is taken where different models in the literature are presented as special cases of a more general formulation. Some of the models included in this analysis are those of Black, Derman and Toy, Hull and White, Ho and Lee, and Heath, Jarrow, and Morton. This review provides an integrative exposition of the various models currently available.
Chapter 9 by Marsh applies the techniques presented in Chapter 8 on interest rate options and the equilibrium pricing methodologies underlying Chapter 1 to the pricing of fixed income claims and bonds. The paper first reviews the pricing models, then applies them to default-free bond valuation. Calibration issues, estimation, and stochastic process specification issues are discussed.
Stock index futures and program trading are among the most important financial market innovations of the 1980's. In Chapter 10, Canina and Figlewski survey the literature and provide an overview of the somewhat controversial area of index arbitrage. They begin with a description of how index futures work, how they should be priced in equilibrium according to the 'cost of carry' model, and how index arbitrage works to enforce the theoretical pricing relationship. In theory, index arbitrage is riskless, but they describe how it is affected in practice by transactions costs, execution risk, capital and short sales constraints, and the possibility of unwinding profitable trades before futures expiration. They conclude with a discussion of the impact of index futures and arbitrage on the volatility of the underlying stock market.
Torous, in Chapter 11, applies the arbitrage pricing theory of Chapter 2 to the valuation of mortgage backed securities. The paper begins with a categorization of the different types of mortgages. It then discusses mortgage pass-through securities and the different types of collateralized mortgage obligations. In valuing these claims, the most difficult component to analyze is the prepayment risk. A general class of prepayment models is provided, and the valuation of mortgage backed securities is illustrated.
In Chapter 12, Easley and O'Hara review the area of market microstructure, an alternative approach to Chapter 1 for understanding the pricing of securities. Market microstructure studies the interaction of the institutional trading rules with the information and trading preferences of investors to obtain the price process. This paper reviews the literature, beginning with a study of the rational expectations paradigm. Included are analyses of the models of Kyle, and the models of Easley and O'Hara, among others.
In Chapter 13, DeBondt and Thaler provide a selected review of recent work in behavioral finance. They observe that financial economics is, perhaps, the least behavioral of the various subdisciplines of economics in that the standard paradigm does not consider what people actually do but rather what they should do. In financial economics, as surveyed in many of the chapters in this volume, it is assumed that investors optimize their actions subject to rational economic models without error. Several contributions in the volume, particularly chapters 16-18, utilize results along the lines discussed by DeBondt and Thaler that consider behavioral aspects, non-optimal behavior and various imperfections. The authors begin by discussing concepts such as overconfidence, non-Bayesian forecasting, loss aversion, framing, mental accounting, fashions and fads, regret, responsibility and prudence. They then consider investor psychology and market prices in general with discussions of the effects of trading volumes, contrarian investment strategies, investor sentiment, closed-end mutual fund discounts and premiums, the equity premium puzzle, dividend policy, earnings management, and corporate expansion and decline. The ideas point to problems with the ability of many existing theories to explain observed market behavior and to possible ways to improve these theories.
In Chapter 14, Le Roy and Steigerwald use Monte Carlo methods to compare the power of volatility and returns tests of the present-value model of stock prices against the alternative that stock prices contain a white noise component. The variances of the price dividends ratio and rate of return are assumed constant and, in the case of the model-based volatility test, dividends are specified to follow a geometric random walk. These assumptions were assumed satisfied in the Monte Carlo runs as well. They find that a model-free volatility test has greater power than the benchmark returns test and that a model-based volatility test constructed on the assumption that dividends follow a geometric random walk has far greater explanatory power than the benchmark returns test. These results are due to low sample variability as the sample variances of the ex-post rational price dividends ratio, the actual price dividends ratio and the rate of return are highly correlated. The superiority of the volatility tests demonstrated by the Monte Carlo results reflects the fact that the volatility tests require stronger assumptions than the returns tests.
Asset allocation choices are the most important investment decisions for long term investors. Chapter 15, by Mulvey and Ziemba, describes a range of practical techniques for modeling the allocation mix over time. Starting with the static Markowitz mean-variance model, they show that additional realistic issues can be handled via multi-stage stochastic programming models. The advantages of integrating assets, liabilities, and investment goals using discrete probability scenarios to model the uncertainty over time are discussed. The role of global investing is emphasized in the context of optimal diversification strategies. The authors review various practical applications of asset-liability management modeling systems for pension plans, insurance companies, and individual investors.
In Chapter 16, Kleidon studies stock market crashes focusing on whether particular large decreases in investor wealth in short periods are consistent with rational individual behavior. He first outlines evidence from experimental security markets in settings when individuals do not completely aggregate their private information to yield fully revealing prices. The laboratory results suggest that crashes are more likely to occur when there is an absence of common information about preferences or beliefs of other traders and a lack of market experience in the market setting. These results are consistent with the economics of information aggregation. Kleidon then examines alternative explanations of the October 1987 crash. This includes an examination of models that contain new internal information about fundamentals operating within a framework of rational expectations. A crash may occur even without new identifiable external news but rather from the aggregation of diverse information already known to various individuals. Changes in external information about fundamentals can explain some crashes such as October 1989. However, the crashes of 1929 and 1987 require changes in internal information about fundamentals revealed through the trading process to be consistent with rational economic models. This chapter concludes with a discussion of various responses to crashes such as the Brady Commission's proposals for a single regulatory authority to oversee the stock, futures and options market, unified margin requirements and circuit breakers, as well as sunshine trading, securities transactions costs and the responses of monetary authorities to crashes.
In Chapter 17, Hawawini and Keim examine empirical findings concerned with the predictability of stock prices in US and worldwide equity markets. They survey numerous findings that document persistent cross section and time series patterns in returns that are not predicted by asset pricing models such as those discussed in chapters 4 and 5. The authors do not focus on tests of market inefficiency which would be joint tests of particular equilibrium models with the possible market inefficiency. Rather they concentrate on a presentation of the evidence. This consists of cross sectional predictability in the relationship of returns with fundamental variables such as size, earnings to price and price to book ratios. They also document evidence concerning in time series returns such as return autocorrelations and seasonal return patterns. The latter focuses on anomalous return distributions such as the January turn-of-the-year, turn-of-the-month, holiday and day-of-the-week effects.
Sports and lottery betting markets are well suited for testing market efficiency and bettor rationality. Vast price and fundamental data is available, and technical and fundamental systems abound that utilize this information. Each bet has a specified termination point when its final asset value (possibly zero) is determined. For rationality tests this latter property has an advantage over most security markets where current value depends upon future events and current expectations of future values. Since the expected return in these betting markets is negative there is a search for systems that provide winning strategies. Such technical systems exist in a number of circumstances such as in blackjack by card counting, in horseracing by using price information in simple markets to fairly price wagers in more complex markets, and in lotteries by wagering on unpopular numbers. In Chapter 18, Hausch and Ziemba survey this literature. They discuss the level of gambling in the US. They then focus on racetrack efficiency in various markets such as win, place, show, exotics and cross tracks. They describe how efficiencies might be exploited using the capital growth methods discussed by Hakansson and Ziemba in Chapter 3. They conclude by discussing efficiency of football, basketball and lottery betting markets.
Institutional investors manage trillions of dollars in equity portfolios. Together with individual investors, they are the market. Grinblatt and Titman, in Chapter 19, study performance evaluation of managers and seek to develop theories that will evaluate the economic worth of portfolio managers. They begin with the basic premise that mean returns are positively related to risk. The performance measures studied adjust returns for priced risk and, in some cases, for diversification. They compare active management returns with benchmark passive buy and hold portfolios with the same level of risk. They consider two classes of measures, namely, those that require the observation of the returns of the evaluated portfolio plus those of one or more benchmark portfolios and a risk-free asset; and those with information about the composition of the evaluated portfolio but not necessarily any benchmark portfolios. They utilize strong stationary assumptions for both classes, with normality required for some in the first class. They attempt to address the Roll critique concerning the choice of the passive portfolio benchmark and joint test problems. Measures in the first class include Treynor's ratio, Jensen's alpha and the Treynor-Black appraisal ratio. Measures in the second class include the event study measure used by Copeland and Mayers to study the Value Line rankings and measures devised by Grinblatt and Titman. They conclude that there is little evidence that mutual funds can time the market but that some mutual funds consistently achieve abnormal returns through their stock selection procedures.
In Chapter 20, Cherian and Jarrow study the impact of relaxing the competitive market assumption in Chapter 1 on security pricing theory. This impact is analyzed from the perspective of market manipulation, which (roughly defined) is the strategic manipulation of prices to one's advantage. This is a new area of financial economic theory. This chapter reviews this literature via a general model where the existing theories can be classified as special cases.
Corporate Finance
Chapters 21-33 deal with various aspects of corporate finance theory and empirical testing of these theories.
In Chapter 21, Sick summaries the basic techniques for analyzing real options. Such options arise from the flexibility a manager has to choose the time to commence a project, to abandon a project and to adjust production levels within an operating project. The ideas are related to those of the financial option literature. However, the early exercise decision is more important in real options analysis. Also, the underlying risk often cannot easily be summarized by the price changes of a traded financial asset, so greater flexibility in modeling project value is needed. The ability to formulate useful and understandable models is more important than precise estimates of option values. This Chapter relates real option analysis to the classic capital budgeting techniques of cost of-capital and present value analysis. Sick also relates asset pricing to state-space pricing, martingale pricing and consumption asset pricing theory; develops a tax adjustment to the riskless bond return for a real options analysis; develops the intuition behind the fundamental partial differential equations that are used to price options and futures; and shows how to use futures markets to impute convenience dividends, which are necessary for real options analysis. Additive and lognormal diffusions as well as two mean-reverting models are discussed. Sick discusses how to build treelike lattice structures to value these options. The chapter concludes by discussing other work from the real options literature.
Financial economists have devoted considerable attention to contracts between different classes of investors and between the firm and its managers. These contracts are important because they determine the incentives of both the firm's equity holders and its managers, thereby affecting the firm's conduct.
The traditional approach to analysis of the firm's contractual arrangements has been to take as given the existence of commonly observed contractual arrangements, such as debt and equity, and to trace out the effects on incentives of changing the levels of these instruments. An advantage of this approach is that it often yields tractable models. However, because the form of the contracts is exogenous in these models, the question whether the firms being modeled would optimally chose this set of contracts is not discussed.
Another strand of the literature, examined by Allen and Winton in Chapter 22, explicitly derives optimal financial contracts as responses to conflicts of interest between different agents in the corporation.
One of the most significant conflicts of interest within the firm is that between the firm's insiders (owners and managers) and potential new investors. In many cases the firm's insiders have better access to information about the firm than potential investors. As a result, investors attempt to infer the insiders' information from the firm's decisions to issue securities and its choice of securities to issue. As Myers and Majluf (1984) showed, these responses to the informational asymmetry by investors may induce insiders to deviate from investment decisions that maximize firm value.
Several important recent contributions to the theory corporate finance have extended the argument in Myers and Majluf to argue that the firm's principal financial decisions, such as its dividend policy and the timing of the initiation of investment projects, can act as signals that convey information that mitigates the problems identified by Myers and Majluf. As pointed out in the literature, attempts to communicate with investors in this way themselves introduce costly distortions in the firm's optimal financial and investment policies.
The signaling role of each of these financial decisions has typically been considered in isolation. As a result, it is not clear if the financial signals considered in the literature induce equivalent policy distortions, and if not, how their costs compare. In Chapter 23, Daniel and Titman provide a unified framework for analyzing a large class of signals proposed in the literature. They show that many of these signals impose costs that are equivalent to money burning. They further show how the dissipative costs of different signals is affected by the nature of the information asymmetry.
In the last thirty years numerous contributions in the financial economics literature have explored how the tax system affects the choice of securities that firms issue. Systematic differences in the tax treatment of income from different classes of securities suggest that taxes may be an important determinant of firms' financing choices. However, because the effective marginal tax rates on income differs across investors, a full understanding of how taxes affect financing choices requires considerations of the entire tax system.
In Chapter 24, Swoboda and Zechner present a framework for analyzing the capital structure equilibria for the tax systems in the principal developed economies. The framework enables them to exhibit clearly how the finer features of the tax system, such as the priority in bankruptcy of tax payments, principal repayments and interest payments, may affect the existence of optimal financing choices for firms. They also describe how the insights from single country tax models can be extended to analyze financing choices in a multinational setting.
Decisions on dividends are among the most visible components of a corporation's financial policy and dividend policy has received a great deal of attention by researchers. As a result of a large body of empirical work, we have made a great deal of progress in characterizing the dividend policies of American firms.
As pointed out by Allen and Michaely in Chapter 25, the challenge to financial economists has been to explain the empirically observed dividend policies by models based on optimizing behavior of firms and investors. Unfortunately, this has proved more difficult to accomplish than might have been expected. Several important observations have been difficult to explain satisfactorily. In particular, the fact that corporations pay dividends even though share repurchases offer substantial tax advantages has puzzled financial economists (Black (1976)) and has provoked a great many attempts to explain it.
Allen and Michaely begin their review of the theoretical literature by discussing Miller and Modigliani (1961). Modigliani and Miller exhibit conditions under which the firm's dividend policy does not affect its value. Allen and Michaely use this model as a benchmark against which they evaluate the assumptions of subsequent models that attempt to justify dividend policy in terms of value maximization. They conclude that the theoretical literature has identified several potential "imperfections" - taxes, informational asymmetries, institutional constraints, transactions costs and incomplete contracts - that may induce value maximizing firms to adopt specific dividend policies. However, as they point out, financial economists are not yet in a position to convert these insights into specific policy advice.
In Chapter 26, Hirshleifer studies strategic and informational issues in takeovers (both mergers and acquisitions). Leaving aside whether takeovers have positive, neutral or negative economic value, he focuses on the decision making relevant to takeovers. There are many conflicts of interest and informational differences among parties to takeovers: bidding shareholders may only want an acquisition if the price of the target is not too high compared to underlying value; bidding management may seek self-aggrandizement through takeover; target shareholders may wish to obtain a price that fully reflects any possible takeover improvements; target management may wish to retain private benefits of control; and potential competing bidders must decide whether to make their own offers. In some cases, the decisions of a few shareholders are pivotal. Hirshleifer describes the relationships between different models of the takeover process and integrates major trends in the literature. He focuses on models of tender offers which examine the decisions of individual shareholders whether to tender (sell) their shares to a bidder; models of competition among multiple bidders; and models that examine the voting power of target managers who own shares. He considers the impact of asymmetric information, bid revision, regulations, means of payment, and how pivotal a shareholder is (concentration of ownership).
Corporate finance is largely concerned with the effect of financial and capital budgeting policies on the choice and the value of exogenously given projects. Relatively little attention has been paid to the firm's product market environment. As a result, less is known about how the structure of the firm's financial contracts affects its ability to compete with rival firms and to contract with customers. However, recently, several means by which financial structure affects value in product markets have been identified in the literature.
In Chapter 27, Maksimovic reviews recent contributions that have attempted to characterize possible links between the firm's product market strategy and its financing choices. The links considered are: the effect of investment choices of other firms in the industry on the interaction between the firm's financial structure and its investment incentives; the effect of debt on a firm's ability to enter into advantageous implicit and explicit contracts with competitors or customers; the effects of changes in leverage on firms' incentives and on industry equilibrium in oligopolies; and the exploitation by competitors of conflicts of interest caused by the firm's need to finance its investments externally.
This chapter also reviews several attempts to empirically test models of financial -product market interactions. Empirical testing is still at an early stage. The range of interactions that have to be quantified is greater than that in typical financial models and the product-market data is usually more difficult to obtain. Moreover, the predictions of the models frequently depend on values of specific parameters. Despite these difficulties considerable progress has been made in empirically testing several of the models.
A key question in the corporate finance literature is whether insolvent firms are efficiently reorganized and the assets of unproductive firms are effectively redeployed. In the United States, the legal framework for the resolution of impaired contractual claims held against the firm is provided by the Bankruptcy Act of 1978. In Chapter 28, Senbet and Seward discuss the economic implications of the main provisions of the Act and, more generally, the incentives of the firm's stakeholders when the firm is in financial distress.
As Senbet and Seward show, financial economists have made important strides in the analysis of financial distress and bankruptcy. One of the primary contributions has been to clarify the distinction between economic distress, which results from the inability of the firm to meet the demands of the marketplace, and financial distress, which results from the difficulty in meeting its financial obligations. This distinction is important because the resolution of the two problems often differs: a reorganization of the firm's operations is required in the former case, whereas a restructuring of its financial claims may be appropriate in the latter case. Once the distinction is understood, then the direct and indirect costs of financial distress can be identified and attempts in the literature to measure them empirically can be evaluated. Senbet and Seward also review the literature on financial distress and incentives. Financial distress frequently alters the incentives of the firm's stakeholders - owners, managers, workers, customers and others whose well-being depends on the firm's performance. If invoked, the Bankruptcy Act itself changes the bargaining power of the stakeholders in economically significant ways. These effects on incentives are important because they affect the likelihood of an efficient resolution of financial distress. They are also interesting from a research perspective, because the heightened conflicts between the stakeholders provide an excellent setting in which to observe the effects of incentives on the behavior of agents, the consequences of asymmetries of information between the firm's insiders and investors and the effect of financial structure on the firm's product market behavior. These issues are discussed in the chapters by Allen and Winton [221, Daniel and Titman [231, and Maksimovic [271, respectively.
A primary empirical research methodology in empirical corporate finance is the use of financial market reactions to corporate events to test hypotheses about the process by which the firm creates value. While most empirical researchers in corporate finance use this research design, known as event study methodology, there has not existed a unified analysis and evaluation of these methods. In Chapter 29, Thompson provides a systematic treatment of the empirical methods used in event studies and a guide to practitioners. As described by Thompson, in an event study the researcher first postulates a link between a specific event of interest (e.g., the disclosure of a takeover attempt) and the value of traded securities issued by the corporation. The researcher then attempts to estimate the difference between the value of the traded security conditional on the event occurring and the value of the security conditional on the event not occurring. Inferences about the validity of the initial hypotheses are based on these estimates.
The appropriate estimator of the differences of the conditional valuations depends in general on the specifics of the event being examined. Thompson introduces a general framework that encompasses many of the existing empirical studies and discusses specific methods appropriate to several important estimation problems faced in practice. He also addresses several conceptual problems that arise in the application of event-study methodology. In particular, any methodology that relies on market reactions to corporate events as a measure of value may be affected by the market's prior expectations of the event. As Thompson points out, this may have implications about the hypotheses that can be tested by event-study methods.
Initial public offerings (IP0s) have received considerable attention in the corporate finance literature. Much interest has been generated by the fact that researchers have identified several interesting empirical facts about 1P0s that have not been successfully explained by theory. Thus, there have been no wholly satisfactory explanations for the fact that new issues tend, on the average, to be underpriced, that there appear to be cycles in the magnitude of this underpricing and that, in the long-run, new issues appear to underperform the market. Equally perplexing, some entrepreneurs appear to be pleased when the after-market price of their shares exceeds the offer price, allowing the initial purchasers of their shares to realize a quick gain.
Researchers have sought to explain these anomalies as rational outcomes in a market with significant asymmetries of information. As discussed in the chapters by Allen and Winton [22] and Daniel and Titman [23], such asymmetries may generate seemingly perverse incentives and market failures. Since IP0s frequently involve small, risky firms exploiting untried technologies, these problems are likely to be particularly severe in the market for new issues. The conjunction of anomalous observations, together with the conviction that these observations can be explained by adverse selection or moral hazard, has produced several very creative theoretical explanations. Ibbotson and Ritter begin their chapter on IP0s by examining the three 1P0 empirical anomalies noted above and by discussing the principal proposed explanations. They then discuss the 1P0 as an event in the firm's life-cycle. Finally, they briefly review some of the mechanisms by which firms go public.
In Chapter 31, Eckbo and Masulis survey research on seasoned equity offerings. Seasoned equity offerings are important, both in their own right, and because firms' choices while making a seasoned offering (e.g., choices of flotation method, timing and issue size) provide investors with information about their financial standing. By analyzing these choices and the stock market's reactions to them, researchers have gained insights into the asymmetries of information that exist between issuing firms and investors. Eckbo and Masulis begin by examining the empirical evidence on the frequency of seasoned offerings and the differences in costs of alternative floatation methods. They relate the empirical findings to models of flotation choice that explicitly allow for asymmetries of information between issuing firms and investors. In their concluding sections they focus on the decision to issue, and review research on the relationship between issue activity and the business cycle. In their examination of secondary offerings, Eckbo and Masulis address some of the most fundamental theoretical issues in corporate finance. In particular, their chapter is closely related to Daniel and Titman's chapter on the theory of financing investment under asymmetric information. The two chapters complement each other: Daniel and Titman systematically explore a specific theoretical paradigm while Eckbo and Masulis review the empirical evidence on an important class of transactions and draw a broader set of theoretical arguments as required.
In recent years there has been dramatic innovation in the services offered by financial intermediaries. There has also been corresponding progress in techniques for valuing these services and analyzing the economic benefits they provide for sellers and buyers. In Chapter 32, Thakor provides an overview of the principal services provided by intermediaries and illustrates how tools from information economics can be used in evaluating them. Thakor classifies the services provided by intermediaries into two categories: brokerage services and qualitative asset transformations. A brokerage service is provided when an intermediary facilitates a financial transaction without affecting the payoffs either party receives from the traded contract. A qualitative asset transformation occurs when the intermediary's participation affects the payoffs of the claims being traded. For each of these types of services, Thakor identifies the potential value added by an intermediary and discusses the role of diversification. Issues in qualitative asset transformation are illustrated by extended consideration two examples: loan commitments and interest rate swaps.
Certain types of qualitative asset transformation may require that intermediaries take on risks. In Chapter 32, Thakor argues that because it is difficult to monitor the amount of risk that intermediaries take on, they may have an incentive to engage in excessive risk-taking. Pyle's Chapter 33 on the U.S. Savings and Loan Crisis illustrates both the risks of qualitative asset transformation and the incentives for opportunistic behavior that accompanied it. The crisis that engulfed the U.S. savings and loans industry was of major proportions. As Pyle notes, over 1100 insolvent S&Ls were closed down by government agencies. The final cost of the debacle is in excess of two hundred billion dollars. In the period leading up to the crisis S&Ls were heavily engaged in a specific asset transformation: their assets were principally long-term fixed rate mortgages while their liabilities were short-term deposits. Pyle shows how this imbalance, when combined with dysfunctional governmental regulations and deposit guarantees that provided perverse incentives, created the conditions for the crisis. One of the few heartening aspects of this account is Pyle's demonstration of how the tools of financial analysis can be used to analyze the incentives of depositors and the S&Ls in the period before the crisis.
Robert Jarrow
Wjislav Maksimovic
William T. Ziemba
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