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Volume 44: Issue 3 (July 1989)

Institutional Markets, Financial Marketing, and Financial Innovation

Pages: 541-556  |  Published: 7/1989  |  DOI: 10.1111/j.1540-6261.1989.tb04377.x  |  Cited by: 116


Firms and institutions are monitored and controlled through a complex set of implicit and explicit contractual relations. Because of these agency theoretic relations, institutional behavior in financial markets is not a simple reflection of the preference structures of individuals. Institutional preferences give rise to a demand for new financial instruments and innovations, even when the returns on these instruments are “spanned” in the sense of complete pricing. The innovations can be thought of as solving moral hazard problems. An agency theoretic example serves to illustrate the demand, supply, and financial marketing of stripped securities. In short, institutions matter.

Market Created Risk

Pages: 557-569  |  Published: 7/1989  |  DOI: 10.1111/j.1540-6261.1989.tb04378.x  |  Cited by: 28


We develop a multiperiod rational expectations model of securities market equilibrium in which equilibrium prices may move between periods even though it is common knowledge that no new information has arrived about ultimate security payoffs. This happens because investors know they have imperfect information about the endowments of other investors and this knowledge affects their probability beliefs about the prices that will prevail at the intermediate trading date. These beliefs are reflected in the equilibrium at the initial trading date when investors focus on the probabilities of intermediate capital gains and losses, rather than ultimate payoffs.

Pricing Contingent Claims under Interest Rate and Asset Price Risk

Pages: 571-589  |  Published: 7/1989  |  DOI: 10.1111/j.1540-6261.1989.tb04379.x  |  Cited by: 8


This paper presents a general framework for pricing contingent claims under interest rate and asset price uncertainty. The framework extends Ho and Lee's (1986) valuation framework by allowing not only future interest rates but also future asset prices to depend on the current term structure of interest rates. The approach is shown to provide risk‐neutral valuation relationships that are consistent with the initial term structure of interest rates and can be applied to valuation of a broad class of assets including stock options, convertible bonds, and junk bonds.

Arbitrage‐Based Estimation of Nonstationary Shifts in the Term Structure of Interest Rates

Pages: 591-610  |  Published: 7/1989  |  DOI: 10.1111/j.1540-6261.1989.tb04380.x  |  Cited by: 11


The purpose of this paper is to provide a test of a state‐dependent multinomial model of intertemporal changes in the term structure of interest rates. The theoretical background for the model comes from Ho and Lee (1986). The current paper extends their model in several significant ways. First, we perform diagnostic tests on the data to demonstrate that the empirical results reject a binomial model in favor of a trinomial one. After theoretically deriving the appropriate trinomial model, the current paper extends their model to allow for state‐dependent shifts which are determined by the set of ex ante observable state variables. The methodology for the study utilizes OLS regressions to identify the exogenous explanatory variables which drive the hypothesized trinomial process of term structure evolution. The empirical tests indicate that the set of state variables explains a significant portion of the variability in the shifts of the term structure over time. The model also identifies and quantifies a set of variables which impact on changes in the term structure of interest rates.

Management Buyouts: Evidence on Taxes as a Source of Value

Pages: 611-632  |  Published: 7/1989  |  DOI: 10.1111/j.1540-6261.1989.tb04381.x  |  Cited by: 225


This paper estimates the value of tax benefits in 76 management buyouts of public companies completed in the period 1980 to 1986. The median value of tax benefits, estimated at the time the buyout company goes private, has a lower bound of 21% and an upper bound of 143% of the premium paid to pre‐buyout shareholders. The estimated value depends on the rate buyout debt is repaid and the tax rate applied to the interest deductions. The paper also presents evidence on the actual taxes paid and debt repayment rates by these companies after the buyout. The results in this paper suggest that tax benefits are an important source of the wealth gains in management buyouts.

Disclosure Decisions by Firms and the Competition for Price Efficiency

Pages: 633-646  |  Published: 7/1989  |  DOI: 10.1111/j.1540-6261.1989.tb04382.x  |  Cited by: 252


This paper develops a model of the relationship between investment decisions by firms and the efficiency of the market prices of their securities. It is shown that more efficient security prices can lead to more efficient investment decisions. This provides firms with the incentive to increase price efficiency by voluntarily disclosing information about the firm. Disclosure decisions are studied. It is shown that firms may expend more resources on disclosure than is socially optimal. This is in contrast to the concern implicit in mandatory disclosure rules that firms will expend too few resources on disclosure.

Firm Value and the Choice of Offering Method in Initial Public Offerings

Pages: 647-662  |  Published: 7/1989  |  DOI: 10.1111/j.1540-6261.1989.tb04383.x  |  Cited by: 11


A firm raising capital in an initial public offering faces the problems of choosing between a firm‐commitment and a best‐efforts offering and of how to convey information about its value to potential investors. The offering method chosen affects both the firm's cost of obtaining capital and investors' perceptions about firm value. A partially pooling, partially separating equilibrium is found where high‐valued firms have information about their values revealed in a firm‐commitment offering, while low‐valued firms use best‐efforts offerings and are unable to distinguish themselves from other firms.

Debt‐for‐Equity Swaps under a Rational Expectations Equilibrium

Pages: 663-680  |  Published: 7/1989  |  DOI: 10.1111/j.1540-6261.1989.tb04384.x  |  Cited by: 3


This paper analyzes LDC debt‐for‐equity swaps under a rational expectations equilibrium. Under full information, the swap can never be strictly preferred by the LDC, the MNC, and the bank. Under the postulated informational asymmetry assumptions the same results obtain, leading to the “lemons” market in reverse. Under rational expectations, the swap can only occur if the loan is correctly valued relative to all private information in the economy. Given that some swaps do occur, future models must reflect the unique features of swaps.

The Size and Incidence of the Losses from Noise Trading

Pages: 681-696  |  Published: 7/1989  |  DOI: 10.1111/j.1540-6261.1989.tb04385.x  |  Cited by: 155


Recent empirical research has identified a significant amount of volatility in stock prices that cannot easily be explained by changes in fundamentals; one interpretation is that asset prices respond not only to news but also to irrational “noise trading.” We assess the welfare effects and incidence of such noice trading using an overlapping‐generations model that gives investors short horizons. We find that the additional risk generated by noise trading can reduce the capital stock and consumption of the economy, and we show that part of that cost may be borne by rational investors. We conclude that the welfare costs of noise trading may be large if the magnitude of noise in aggregate stock prices is as large as suggested by some of the recent empirical litrature on the excess volatility of the market.

Asset Pricing in Partially Segmented Markets: Evidence from the Finnish Market

Pages: 697-718  |  Published: 7/1989  |  DOI: 10.1111/j.1540-6261.1989.tb04386.x  |  Cited by: 92


This paper analyzes asset pricing in a partially segmented market where citizens of a small country are allowed to hold only their domestic securities, whereas the rest of the investors (“foreigners”) are essentially allowed to hold all securities. In this market setting it may occur that the citizens of the small country are willing to pay less for their domestic securities than are the foreign investors. The paper derives equilibrium required rates of return for different investors in this market setting which perfectly occurred in Finland and tests this equilibrium model using data from the Finnish stock market. Empirical results are consistent with the hypotheses derived from the model.

Comovements in Stock Prices and Comovements in Dividends

Pages: 719-729  |  Published: 7/1989  |  DOI: 10.1111/j.1540-6261.1989.tb04387.x  |  Cited by: 98


The comovements in real stock prices between the U.K. and the U.S. appear to be too large to be accounted for in terms of the comovements of real dividends between the countries even after consideration of the possibility of information pooling. When consideration is made of the comovements of real interest rates between the countries, there is weaker evidence of excess comovement of price.

Information Losses in a Dynamic Model of Credit

Pages: 731-746  |  Published: 7/1989  |  DOI: 10.1111/j.1540-6261.1989.tb04388.x  |  Cited by: 5


This paper examines dynamic information losses associated with loan terminations. We assume that the aggregated returns of current borrowers contain information about the mean returns to future borrowers. In a competitive loan market, the value of this information is not fully internalized by individual borrowers and lenders, and loan decisions fail to be first best. Introducing heterogeneous borrowers, who know their own risk characteristics better than lenders, safer borrowers are less willing to borrow when risk premia rise. As they cease borrowing, the information generated in credit markets becomes noisier and this tends to increase risk premia. The model produces alternating and persistent periods of “tight” and “loose” credit.

An Empirical Investigation of U.S. Firms in Reorganization

Pages: 747-769  |  Published: 7/1989  |  DOI: 10.1111/j.1540-6261.1989.tb04389.x  |  Cited by: 283


The purpose of this paper is to understand the institutional features of Chapter 11 from an empirical examination of thirty firms that have emerged from reorganization. We find the recontracting framework of Chapter 11 to be complex, lengthy, and costly. Violations of absolute priority in favor of stockholders are frequently encountered. These deviations may result from the bargaining process of Chapter 11 or from a recontracting process between creditors and stockholders which recognizes the ability of stockholder‐oriented management to preserve firm value. An example of such recontracting addresses Myers' underinvestment problem. An investigation of the effects of Chapter 11 on the pricing of risky debt is also provided.

Free Cash Flow and Stockholder Gains in Going Private Transactions

Pages: 771-787  |  Published: 7/1989  |  DOI: 10.1111/j.1540-6261.1989.tb04390.x  |  Cited by: 538


We investigate the source of stockholder gains in going private transactions. We find support for the hypothesis advanced by Jensen that a major source of these gains is the mitigation of agency problems associated with free cash flow. Using a sample of 263 going private transactions from 1980 through 1987, our results indicate a significant relationship between undistributed cash flow and a firm's decision to go private. In addition, we find that premiums paid to stockholders are significantly related to undistributed cash flow. These results are especially strong for firms that went private between 1984 and 1987 and also for firms whose managers owned relatively little equity before the going private transaction.

The Term Structure of Interest Rates in a Partially Observable Economy

Pages: 789-812  |  Published: 7/1989  |  DOI: 10.1111/j.1540-6261.1989.tb04391.x  |  Cited by: 30


This paper investigates the term structure of interest rates in a multiperiod production and exchange economy with incomplete information. Unable to observe their stochastic investment opportunities, investors engage in dynamic Bayesian inference. This results in the endogenous identification of a more complex production function which generates a richer term structure, resembling the one that actual market prices imply. In addition, this paper introduces a characteristic function of the term structure and demonstrates that, in contrast with a fully observable economy, the widely investigated expectations hypothesis holds true only if interest rates are nonstochastic.

Minutes of the Annual Membership Meeting

Pages: 813-814  |  Published: 7/1989  |  DOI: 10.1111/j.1540-6261.1989.tb04392.x  |  Cited by: 0

Michael Keenan

Report of the Executive Secretary and Treasurer

Pages: 815-815  |  Published: 7/1989  |  DOI: 10.1111/j.1540-6261.1989.tb04393.x  |  Cited by: 0

Michael Keenan

Consolidated Revenues and Expenses Reports

Pages: 816-817  |  Published: 7/1989  |  DOI: 10.1111/j.1540-6261.1989.tb04394.x  |  Cited by: 0

Report of the Managing Editor of The Journal of Finance for the Year 1988

Pages: 819-825  |  Published: 7/1989  |  DOI: 10.1111/j.1540-6261.1989.tb04395.x  |  Cited by: 0

René M. Stulz