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Volume 59: Issue 4 (August 2004)


Presidential Address, Committing to Commit: Short-term Debt When Enforcement Is Costly

Pages: 1447-1479  |  Published: 8/2004  |  DOI: 10.1111/j.1540-6261.2004.00669.x  |  Cited by: 110

Douglas W. Diamond

In legal systems with expensive or ineffective contract enforcement, it is difficult to induce lenders to enforce debt contracts. If lenders do not enforce, borrowers will have incentives to misbehave. Lenders have incentives to enforce given bad news when debt is short‐term and subject to runs caused by externalities across lenders. Lenders will not undo these externalities by negotiation. The required number of lenders increases with enforcement costs. A very high enforcement cost can exceed the ex ante incentive benefit of enforcement. Removing lenders' right to immediately enforce their debt with a “bail‐in” can improve the ex ante incentives of borrowers.


Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles

Pages: 1481-1509  |  Published: 8/2004  |  DOI: 10.1111/j.1540-6261.2004.00670.x  |  Cited by: 1521

Ravi Bansal, Amir Yaron

We model consumption and dividend growth rates as containing (1) a small long‐run predictable component, and (2) fluctuating economic uncertainty (consumption volatility). These dynamics, for which we provide empirical support, in conjunction with Epstein and Zin's (1989) preferences, can explain key asset markets phenomena. In our economy, financial markets dislike economic uncertainty and better long‐run growth prospects raise equity prices. The model can justify the equity premium, the risk‐free rate, and the volatility of the market return, risk‐free rate, and the price–dividend ratio. As in the data, dividend yields predict returns and the volatility of returns is time‐varying.


The Nature of Discipline by Corporate Takeovers

Pages: 1511-1552  |  Published: 8/2004  |  DOI: 10.1111/j.1540-6261.2004.00671.x  |  Cited by: 65

Omesh Kini, William Kracaw, Shehzad Mian

This paper provides a comprehensive examination of the disciplinary role of the corporate takeover market using a sample of U.S. target firms over the period 1979 to 1998. The time period spanned allows a broader study not only of the disciplinary role of the takeover market in general, but also of the interaction between the takeover market and alternative governance mechanisms during the 1980s and 1990s. Overall, our evidence is consistent with the view of the corporate takeover market as a “court of last resort,” that is, it is an external source of discipline that intercedes when internal control mechanisms are relatively weak or ineffective.


Information and the Cost of Capital

Pages: 1553-1583  |  Published: 8/2004  |  DOI: 10.1111/j.1540-6261.2004.00672.x  |  Cited by: 1107

David Easley, Maureen O'hara

We investigate the role of information in affecting a firm's cost of capital. We show that differences in the composition of information between public and private information affect the cost of capital, with investors demanding a higher return to hold stocks with greater private information. This higher return arises because informed investors are better able to shift their portfolio to incorporate new information, and uninformed investors are thus disadvantaged. In equilibrium, the quantity and quality of information affect asset prices. We show firms can influence their cost of capital by choosing features like accounting treatments, analyst coverage, and market microstructure.


Employee Stock Options, Corporate Taxes, and Debt Policy

Pages: 1585-1618  |  Published: 8/2004  |  DOI: 10.1111/j.1540-6261.2004.00673.x  |  Cited by: 81

John R. Graham, Mark H. Lang, Douglas A. Shackelford

We find that employee stock option deductions lead to large aggregate tax savings for Nasdaq 100 and S&P 100 firms and also affect corporate marginal tax rates. For Nasdaq firms, including the effect of options reduces the estimated median marginal tax rate from 31% to 5%. For S&P firms, in contrast, option deductions do not affect marginal tax rates to a large degree. Our evidence suggests that option deductions are important nondebt tax shields and that option deductions substitute for interest deductions in corporate capital structure decisions, explaining in part why some firms use so little debt.


Why Do Firms Use Incentives That Have No Incentive Effects?

Pages: 1619-1650  |  Published: 8/2004  |  DOI: 10.1111/j.1540-6261.2004.00674.x  |  Cited by: 267

Paul Oyer

This paper illustrates why firms might choose to implement stock option plans or other pay instruments that reward “luck.” I consider a model where adjusting compensation contracts is costly and where employees' outside opportunities are correlated with their firms' performance. The model may help to explain the use and recent rise of broad‐based stock option plans, as well as other financial instruments, even when these pay plans have no effect on employees' on‐the‐job behavior. The model suggests that agency theory's often‐overlooked participation constraint may be an important determinant of some common compensation schemes, particularly for employees below the highest executive ranks.


The Timing of Option Repricing

Pages: 1651-1676  |  Published: 8/2004  |  DOI: 10.1111/j.1540-6261.2004.00675.x  |  Cited by: 51

Sandra Renfro Callaghan, P. Jane Saly, Chandra Subramaniam

We investigate whether executive stock option repricings are systematically timed to coincide with favorable movements in the company's stock price. For a sample of 236 repricing events, we observe sharp increases in stock price in the 20‐day period following the repricing date. In addition, repricing dates tend to either precede the release of good news or follow the release of bad news in the quarterly earnings announcements. Since information about stock option repricing is not generally released to the public around the repricing date, these findings suggest that CEOs opportunistically manage the timing of the option repricing date.


Diversification as a Public Good: Community Effects in Portfolio Choice

Pages: 1677-1716  |  Published: 8/2004  |  DOI: 10.1111/j.1540-6261.2004.00676.x  |  Cited by: 94

Peter M. Demarzo, Ron Kaniel, Ilan Kremer

Within a rational general equilibrium model in which agents care only about personal consumption, we consider a setting in which, due to borrowing constraints, individuals endowed with local resources underparticipate in financial markets. As a result, investors compete for local resources through their portfolio choices. Even with complete financial markets and no aggregate risk, agents may herd into risky portfolios. This yields a Pareto‐dominated outcome as agents introduce “community” risk unrelated to fundamentals. Moreover, if some agents are behaviorally biased, or cannot completely diversify their holdings, rational agents may choose more extreme portfolios and amplify the effect.


Tobin'sQ, Debt Overhang, and Investment

Pages: 1717-1742  |  Published: 8/2004  |  DOI: 10.1111/j.1540-6261.2004.00677.x  |  Cited by: 165

Christopher A. Hennessy

Incorporating debt in a dynamic real options framework, we show that underinvestment stems from truncation of equity's horizon at default. Debt overhang distorts both the level and composition of investment, with underinvestment being more severe for long‐lived assets. An empirical proxy for the shadow price of capital to equity is derived. Use of this proxy yields a structural test for debt overhang and its mitigation through issuance of additional secured debt. Using measurement error‐consistent GMM estimators, we find a statistically significant debt overhang effect regardless of firms' ability to issue additional secured debt.


Estimation and Test of a Simple Model of Intertemporal Capital Asset Pricing

Pages: 1743-1776  |  Published: 8/2004  |  DOI: 10.1111/j.1540-6261.2004.00678.x  |  Cited by: 172

Michael J. Brennan, Ashley W. Wang, Yihong Xia

A simple valuation model with time‐varying investment opportunities is developed and estimated. The model assumes that the investment opportunity set is completely described by the real interest rate and the maximum Sharpe ratio, which follow correlated Ornstein–Uhlenbeck processes. The model parameters and time series of the state variables are estimated using U.S. Treasury bond yields and expected inflation from January 1952 to December 2000, and as predicted, the estimated maximum Sharpe ratio is related to the equity premium. In cross‐sectional asset‐pricing tests, both state variables have significant risk premia, which is consistent with Merton's ICAPM.


The Cash Flow Sensitivity of Cash

Pages: 1777-1804  |  Published: 8/2004  |  DOI: 10.1111/j.1540-6261.2004.00679.x  |  Cited by: 957

Heitor Almeida, Murillo Campello, Michael S. Weisbach

We model a firm's demand for liquidity to develop a new test of the effect of financial constraints on corporate policies. The effect of financial constraints is captured by the firm's propensity to save cash out of cash flows (the cash flow sensitivity of cash). We hypothesize that constrained firms should have a positive cash flow sensitivity of cash, while unconstrained firms' cash savings should not be systematically related to cash flows. We empirically estimate the cash flow sensitivity of cash using a large sample of manufacturing firms over the 1971 to 2000 period and find robust support for our theory.


What Do Entrepreneurs Pay for Venture Capital Affiliation?

Pages: 1805-1844  |  Published: 8/2004  |  DOI: 10.1111/j.1540-6261.2004.00680.x  |  Cited by: 547

David H. Hsu

This study empirically evaluates the certification and value‐added roles of reputable venture capitalists (VCs). Using a novel sample of entrepreneurial start‐ups with multiple financing offers, I analyze financing offers made by competing VCs at the first professional round of start‐up funding, holding characteristics of the start‐up fixed. Offers made by VCs with a high reputation are three times more likely to be accepted, and high‐reputation VCs acquire start‐up equity at a 10–14% discount. The evidence suggests that VCs' “extra‐financial” value may be more distinctive than their functionally equivalent financial capital. These extra‐financial services can have financial consequences.


Short-Selling Prior to Earnings Announcements

Pages: 1845-1876  |  Published: 8/2004  |  DOI: 10.1111/j.1540-6261.2004.00681.x  |  Cited by: 221

Stephen E. Christophe, Michael G. Ferri, James J. Angel

This paper examines short‐sales transactions in the five days prior to earnings announcements of 913 Nasdaq‐listed firms. The tests provide evidence of informed trading in pre‐announcement short‐selling because they reveal that abnormal short‐selling is significantly linked to post‐announcement stock returns. Also, the tests indicate that short‐sellers typically are more active in stocks with low book‐to‐market valuations or low SUEs. The levels of pre‐announcement short‐selling, however, mostly appear to reflect firm‐specific information rather than these fundamental financial characteristics. We believe that these results should encourage financial market regulators to consider providing more extensive and timely disclosures of short‐selling to investors.


Electricity Forward Prices: A High-Frequency Empirical Analysis

Pages: 1877-1900  |  Published: 8/2004  |  DOI: 10.1111/j.1540-6261.2004.00682.x  |  Cited by: 183

Francis A. Longstaff, Ashley W. Wang

We conduct an empirical analysis of forward prices in the PJM electricity market using a high‐frequency data set of hourly spot and day‐ahead forward prices. We find that there are significant risk premia in electricity forward prices. These premia vary systematically throughout the day and are directly related to economic risk factors, such as the volatility of unexpected changes in demand, spot prices, and total revenues. These results support the hypothesis that electricity forward prices in the Pennsylvania, New Jersey, and Maryland market are determined rationally by risk‐averse economic agents.


The Price Response to S&P 500 Index Additions and Deletions: Evidence of Asymmetry and a New Explanation

Pages: 1901-1930  |  Published: 8/2004  |  DOI: 10.1111/j.1540-6261.2004.00683.x  |  Cited by: 264

Honghui Chen, Gregory Noronha, Vijay Singal

We study the price effects of changes to the S&P 500 index and document an asymmetric price response: There is a permanent increase in the price of added firms but no permanent decline for deleted firms. These results are at odds with extant explanations of the effects of index changes that imply a symmetric price response to additions and deletions. A possible explanation for asymmetric price effects arises from the changes in investor awareness. Results from our empirical tests support the thesis that changes in investor awareness contribute to the asymmetric price effects of S&P 500 index additions and deletions.


Report of the Editor ofThe Journal of Financefor the Year 2003

Pages: 1931-1932  |  Published: 8/2004  |  DOI: 10.1111/j.1540-6261.2004.00684.x  |  Cited by: 0

Robert F. Stambaugh


Minutes of the Annual Membership Meeting,

Pages: 1933-1934  |  Published: 8/2004  |  DOI: 10.1111/j.1540-6261.2004.00685.x  |  Cited by: 0

David H. Pyle


Report of the Executive Secretary and Treasurer

Pages: 1935-1948  |  Published: 8/2004  |  DOI: 10.1111/j.1540-6261.2004.00686.x  |  Cited by: 0

David H. Pyle


MISCELLANEA

Pages: 1949-1950  |  Published: 8/2004  |  DOI: 10.1111/j.1540-6261.2004.00687.x  |  Cited by: 0