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Volume 59: Issue 6 (December 2004)

A Multinational Perspective on Capital Structure Choice and Internal Capital Markets

Pages: 2451-2487  |  Published: 12/2004  |  DOI: 10.1111/j.1540-6261.2004.00706.x  |  Cited by: 579


This paper analyzes the capital structures of foreign affiliates and internal capital markets of multinational corporations. Ten percent higher local tax rates are associated with 2.8% higher debt/asset ratios, with internal borrowing being particularly sensitive to taxes. Multinational affiliates are financed with less external debt in countries with underdeveloped capital markets or weak creditor rights, reflecting significantly higher local borrowing costs. Instrumental variable analysis indicates that greater borrowing from parent companies substitutes for three‐quarters of reduced external borrowing induced by capital market conditions. Multinational firms appear to employ internal capital markets opportunistically to overcome imperfections in external capital markets.

Bank and Nonbank Financial Intermediation

Pages: 2489-2529  |  Published: 12/2004  |  DOI: 10.1111/j.1540-6261.2004.00707.x  |  Cited by: 31


Conglomerates, trade credit arrangements, and banks are all instances of financial intermediation. However, these institutions differ significantly in the extent to which the projects financed absorb aggregate intermediary risk, in whether or not intermediation is carried out by a financial specialist, in the type of projects they fund and in the type of claims they issue to investors. The paper develops a simple unified model that both accounts for the continued coexistence of these different forms of intermediation, and explains why they differ. Specific applications to conglomerate firms, trade credit, and banking are discussed.

Moral Hazard and Optimal Subsidiary Structure for Financial Institutions

Pages: 2531-2575  |  Published: 12/2004  |  DOI: 10.1111/j.1540-6261.2004.00708.x  |  Cited by: 76


Banks and related financial institutions often have two separate subsidiaries that make loans of similar type but differing risk, for example, a bank and a finance company, or a “good bank/bad bank” structure. Such “bipartite” structures may prevent risk shifting, in which banks misuse their flexibility in choosing and monitoring loans to exploit their debt holders. By “insulating” safer loans from riskier loans, a bipartite structure reduces risk‐shifting incentives in the safer subsidiary. Bipartite structures are more likely to dominate unitary structures as the downside from riskier loans is higher or as expected profits from the efficient loan mix are lower.

Corporate Investment and Asset Price Dynamics: Implications for the Cross‐section of Returns

Pages: 2577-2603  |  Published: 12/2004  |  DOI: 10.1111/j.1540-6261.2004.00709.x  |  Cited by: 519


We show that corporate investment decisions can explain the conditional dynamics in expected asset returns. Our approach is similar in spirit to Berk, Green, and Naik (1999), but we introduce to the investment problem operating leverage, reversible real options, fixed adjustment costs, and finite growth opportunities. Asset betas vary over time with historical investment decisions and the current product market demand. Book‐to‐market effects emerge and relate to operating leverage, while size captures the residual importance of growth options relative to assets in place. We estimate and test the model using simulation methods and reproduce portfolio excess returns comparable to the data.

Does Stock Return Momentum Explain the “Smart Money” Effect?

Pages: 2605-2622  |  Published: 12/2004  |  DOI: 10.1111/j.1540-6261.2004.00710.x  |  Cited by: 229


Does the “smart money” effect documented by Gruber (1996) and Zheng (1999) reflect fund selection ability of mutual fund investors? We examine the finding that investors are able to predict mutual fund performance and invest accordingly. We show that the smart money effect is explained by the stock return momentum phenomenon documented by Jegadeesh and Titman (1993). Further evidence suggests investors do not select funds based on a momentum investing style, but rather simply chase funds that were recent winners. Our finding that a common factor in stock returns explains the smart money effect offers no affirmation of investor fund selection ability.

Price Discovery in the U.S. Treasury Market: The Impact of Orderflow and Liquidity on the Yield Curve

Pages: 2623-2654  |  Published: 12/2004  |  DOI: 10.1111/j.1540-6261.2004.00711.x  |  Cited by: 275


We examine the role of price discovery in the U.S. Treasury market through the empirical relationship between orderflow, liquidity, and the yield curve. We find that orderflow imbalances (excess buying or selling pressure) account for up to 26% of the day‐to‐day variation in yields on days without major macroeconomic announcements. The effect of orderflow on yields is permanent and strongest when liquidity is low. All of the evidence points toward an important role of price discovery in understanding the behavior of the yield curve.

Near‐sighted Justice

Pages: 2655-2684  |  Published: 12/2004  |  DOI: 10.1111/j.1540-6261.2004.00712.x  |  Cited by: 15


Chapter 11 structures complex negotiations between creditors and debtors that are overseen by a bankruptcy court. We identify conditions where the court should sometimes err in determining which firms should be liquidated. Such errors affect actions by both good and bad entrepreneurs. We first characterize the optimal error rate without renegotiation. When creditors and debtors can renegotiate to circumvent an error‐riven court, for one class of actions a blind court that ignores all information is optimal. For another class, the court should place the burden of proof on the entrepreneur. The robust feature is that the court should sometimes err.

Market Valuation and Merger Waves

Pages: 2685-2718  |  Published: 12/2004  |  DOI: 10.1111/j.1540-6261.2004.00713.x  |  Cited by: 631


Does valuation affect mergers? Data suggest that periods of stock merger activity are correlated with high market valuations. The naïve explanation that overvalued bidders wish to use stock is incomplete because targets should not be eager to accept stock. However, we show that potential market value deviations from fundamental values on both sides of the transaction can rationally lead to a correlation between stock merger activity and market valuation. Merger waves and waves of cash and stock purchases can be rationally driven by periods of over‐ and undervaluation of the stock market. Thus, valuation fundamentally impacts mergers.

Collars and Renegotiation in Mergers and Acquisitions

Pages: 2719-2743  |  Published: 12/2004  |  DOI: 10.1111/j.1540-6261.2004.00714.x  |  Cited by: 113


I examine the motivation for, and effect of, including a collar in a merger agreement. The most important cross‐sectional determinants of the bid structure (cash vs. stock, and whether to include a collar) are the market‐related stock return standard deviations for the bidder and target. This evidence supports the hypothesis that the method of payment is dependent on the sensitivities of the bidder and target to market‐related risk because either has the incentive to demand renegotiation of the merger terms if the value of the bidder's offer changes materially relative to the value of the target during the bid period.

How to Discount Cashflows with Time‐Varying Expected Returns

Pages: 2745-2783  |  Published: 12/2004  |  DOI: 10.1111/j.1540-6261.2004.00715.x  |  Cited by: 108


While many studies document that the market risk premium is predictable and that betas are not constant, the dividend discount model ignores time‐varying risk premiums and betas. We develop a model to consistently value cashflows with changing risk‐free rates, predictable risk premiums, and conditional betas in the context of a conditional CAPM. Practical valuation is accomplished with an analytic term structure of discount rates, with different discount rates applied to expected cashflows at different horizons. Using constant discount rates can produce large misvaluations, which, in portfolio data, are mostly driven at short horizons by market risk premiums and at long horizons by time variation in risk‐free rates and factor loadings.

Financial Development and Intersectoral Allocation: A New Approach

Pages: 2785-2807  |  Published: 12/2004  |  DOI: 10.1111/j.1540-6261.2004.00716.x  |  Cited by: 99


This paper uses a new methodology based on industry comovement to examine the role of financial market development in intersectoral allocation. Based on the assumption that there exist common global shocks to growth opportunities, we hypothesize that country pairs should have correlated patterns of sectoral growth if they are able to respond to these shocks. Consistent with financial markets promoting responsiveness to shocks, countries have more highly correlated growth rates across sectors when both countries have well‐developed financial markets. This effect is stronger between country pairs at similar levels of economic development, which are more likely to experience similar growth shocks.

Systemic Risk and International Portfolio Choice

Pages: 2809-2834  |  Published: 12/2004  |  DOI: 10.1111/j.1540-6261.2004.00717.x  |  Cited by: 309


Returns on international equities are characterized by jumps; moreover, these jumps tend to occur at the same time across countries leading to systemic risk. We capture these stylized facts using a multivariate system of jump‐diffusion processes where the arrival of jumps is simultaneous across assets. We then determine an investor's optimal portfolio for this model of returns. Systemic risk has two effects: One, it reduces the gains from diversification and two, it penalizes investors for holding levered positions. We find that the loss resulting from diminished diversification is small, while that from holding very highly levered positions is large.

The Choice of Private Versus Public Capital Markets: Evidence from Privatizations

Pages: 2835-2870  |  Published: 12/2004  |  DOI: 10.1111/j.1540-6261.2004.00718.x  |  Cited by: 143


We examine the impact of political, institutional, and economic factors on the choice between selling a state‐owned enterprise in the public capital market through a share issue privatization (SIP) and selling it in the private capital market in an asset sale. SIPs are more likely in less developed capital markets, for more profitable state‐owned enterprises, and where there are more protections of minority shareholders. Asset sales are more likely when there is less state control of the economy and when the firm is smaller. Our results suggest the importance of privatization activities in developing the equity markets of privatizing countries.

Do Initial Public Offering Firms Purchase Analyst Coverage with Underpricing?

Pages: 2871-2901  |  Published: 12/2004  |  DOI: 10.1111/j.1540-6261.2004.00719.x  |  Cited by: 272


We report that initial public offering (IPO) underpricing is positively related to analyst coverage by the lead underwriter and to the presence of an all‐star analyst on the research staff of the lead underwriter. These findings are robust to controls for other determinants of underpricing and to controls for the endogeneity of underpricing and analyst coverage. In addition, we find that the probability of switching underwriters between IPO and seasoned equity offering is negatively related to the unexpected amount of post‐IPO analyst coverage. These findings are consistent with the hypothesis that underpricing is, in part, compensation for expected post‐IPO analyst coverage from highly ranked analysts.

The Effect of Banking Relationships on the Firm's IPO Underpricing

Pages: 2903-2958  |  Published: 12/2004  |  DOI: 10.1111/j.1540-6261.2004.00720.x  |  Cited by: 184


This paper investigates the effects of pre‐IPO banking relationships on a firm's IPO. Using a new and unique data set, which compares the firm's pre‐IPO banking relationships to the underwriters managing the firm's new issue, I test whether banking relationships established before the firm's IPO ameliorate asymmetric informa tion problems behind high IPO underpricing. The results show that firms with a pre‐IPO banking relationship with a prospective underwriter face about 17% lower underpricing than firms without such banking relationships. These results are robust to controlling for the firm's endogenous selection of the pre‐IPO banking institution.

Luxury Goods and the Equity Premium

Pages: 2959-3004  |  Published: 12/2004  |  DOI: 10.1111/j.1540-6261.2004.00721.x  |  Cited by: 234


This paper evaluates the equity premium using novel data on the consumption of luxury goods. Specifying utility as a nonhomothetic function of both luxury and basic consumption goods, we derive pricing equations and evaluate the risk of holding equity. Household survey and national accounts data mostly reflect basic consumption, and therefore overstate the risk aversion necessary to match the observed equity premium. The risk aversion implied by the consumption of luxury goods is more than an order of magnitude less than that implied by national accounts data. For the very rich, the equity premium is much less of a puzzle.


Pages: 3005-3006  |  Published: 12/2004  |  DOI: 10.1111/j.1540-6261.2004.00722.x  |  Cited by: 0