View All Issues

Volume 62: Issue 1 (February 2007)

Why Do Firms Issue Equity?

Pages: 1-54  |  Published: 1/2007  |  DOI: 10.1111/j.1540-6261.2007.01200.x  |  Cited by: 212


We develop and test a new theory of security issuance that is consistent with the puzzling stylized fact that firms issue equity when their stock prices are high. The theory also generates new predictions. Our theory predicts that managers use equity to finance projects when they believe that investors' views about project payoffs are likely to be aligned with theirs, thus maximizing the likelihood of agreement with investors. Otherwise, they use debt. We find strong empirical support for our theory and document its incremental explanatory power over other security‐issuance theories such as market timing and time‐varying adverse selection.

Why Is Long‐Horizon Equity Less Risky? A Duration‐Based Explanation of the Value Premium

Pages: 55-92  |  Published: 1/2007  |  DOI: 10.1111/j.1540-6261.2007.01201.x  |  Cited by: 264


We propose a dynamic risk‐based model that captures the value premium. Firms are modeled as long‐lived assets distinguished by the timing of cash flows. The stochastic discount factor is specified so that shocks to aggregate dividends are priced, but shocks to the discount rate are not. The model implies that growth firms covary more with the discount rate than do value firms, which covary more with cash flows. When calibrated to explain aggregate stock market behavior, the model accounts for the observed value premium, the high Sharpe ratios on value firms, and the poor performance of the CAPM.

Common Failings: How Corporate Defaults Are Correlated

Pages: 93-117  |  Published: 1/2007  |  DOI: 10.1111/j.1540-6261.2007.01202.x  |  Cited by: 378


We test the doubly stochastic assumption under which firms' default times are correlated only as implied by the correlation of factors determining their default intensities. Using data on U.S. corporations from 1979 to 2004, this assumption is violated in the presence of contagion or “frailty” (unobservable explanatory variables that are correlated across firms). Our tests do not depend on the time‐series properties of default intensities. The data do not support the joint hypothesis of well‐specified default intensities and the doubly stochastic assumption. We find some evidence of default clustering exceeding that implied by the doubly stochastic model with the given intensities.

Corporate Yield Spreads and Bond Liquidity

Pages: 119-149  |  Published: 1/2007  |  DOI: 10.1111/j.1540-6261.2007.01203.x  |  Cited by: 767


We find that liquidity is priced in corporate yield spreads. Using a battery of liquidity measures covering over 4,000 corporate bonds and spanning both investment grade and speculative categories, we find that more illiquid bonds earn higher yield spreads, and an improvement in liquidity causes a significant reduction in yield spreads. These results hold after controlling for common bond‐specific, firm‐specific, and macroeconomic variables, and are robust to issuers' fixed effect and potential endogeneity bias. Our findings justify the concern in the default risk literature that neither the level nor the dynamic of yield spreads can be fully explained by default risk determinants.

Information Cascades: Evidence from a Field Experiment with Financial Market Professionals

Pages: 151-180  |  Published: 1/2007  |  DOI: 10.1111/j.1540-6261.2007.01204.x  |  Cited by: 191


Previous empirical studies of information cascades use either naturally occurring data or laboratory experiments. We combine attractive elements from each of these lines of research by observing market professionals from the Chicago Board of Trade (CBOT) in a controlled environment. Analysis of over 1,500 individual decisions suggests that CBOT professionals behave differently from our student control group. For instance, professionals are better able to discern the quality of public signals and their decisions are not affected by the domain of earnings. These results have implications for market efficiency and are important in both a positive and normative sense.

Learning by Observing: Information Spillovers in the Execution and Valuation of Commercial Bank M&As

Pages: 181-216  |  Published: 1/2007  |  DOI: 10.1111/j.1540-6261.2007.01205.x  |  Cited by: 144


We offer a new explanation for why academic studies typically fail to find value creation in bank mergers. Our conjectures are predicated on the idea that, until recently, large bank acquisitions were a new phenomenon, with no best practices history to inform bank managers or market investors. We hypothesize that merging banks, and investors pricing bank mergers, learn by observing information that spills over from previous bank mergers. We find evidence consistent with these conjectures for 216 M&As of large, publicly traded U.S. commercial banks between 1987 and 1999. Our findings are consistent with semistrong stock market efficiency.

A Theory of Friendly Boards

Pages: 217-250  |  Published: 1/2007  |  DOI: 10.1111/j.1540-6261.2007.01206.x  |  Cited by: 1500


We analyze the consequences of the board's dual role as advisor as well as monitor of management. Given this dual role, the CEO faces a trade‐off in disclosing information to the board: If he reveals his information, he receives better advice; however, an informed board will also monitor him more intensively. Since an independent board is a tougher monitor, the CEO may be reluctant to share information with it. Thus, management‐friendly boards can be optimal. Using the insights from the model, we analyze the differences between sole and dual board systems. We highlight several policy implications of our analysis.

Whom You Know Matters: Venture Capital Networks and Investment Performance

Pages: 251-301  |  Published: 1/2007  |  DOI: 10.1111/j.1540-6261.2007.01207.x  |  Cited by: 1254


Many financial markets are characterized by strong relationships and networks, rather than arm's‐length, spot market transactions. We examine the performance consequences of this organizational structure in the context of relationships established when VCs syndicate portfolio company investments. We find that better‐networked VC firms experience significantly better fund performance, as measured by the proportion of investments that are successfully exited through an IPO or a sale to another company. Similarly, the portfolio companies of better‐networked VCs are significantly more likely to survive to subsequent financing and eventual exit. We also provide initial evidence on the evolution of VC networks.

Lower Salaries and No Options? On the Optimal Structure of Executive Pay

Pages: 303-343  |  Published: 1/2007  |  DOI: 10.1111/j.1540-6261.2007.01208.x  |  Cited by: 232


We calibrate the standard principal–agent model with constant relative risk aversion and lognormal stock prices to a sample of 598 U.S. CEOs. We show that this model predicts that most CEOs should not hold any stock options. Instead, CEOs should have lower base salaries and receive additional shares in their companies; many would be required to purchase additional stock in their companies. These contracts would reduce average compensation costs by 20% while providing the same incentives and the same utility to CEOs. We conclude that the standard principal–agent model typically used in the literature cannot rationalize observed contracts.

Interest Rate Caps “Smile” Too! But Can the LIBOR Market Models Capture the Smile?

Pages: 345-382  |  Published: 1/2007  |  DOI: 10.1111/j.1540-6261.2007.01209.x  |  Cited by: 93


Using 3 years of interest rate caps price data, we provide a comprehensive documentation of volatility smiles in the caps market. To capture the volatility smiles, we develop a multifactor term structure model with stochastic volatility and jumps that yields a closed‐form formula for cap prices. We show that although a three‐factor stochastic volatility model can price at‐the‐money caps well, significant negative jumps in interest rates are needed to capture the smile. The volatility smile contains information that is not available using only at‐the‐money caps, and this information is important for understanding term structure models.

The Impact of Collateralization on Swap Rates

Pages: 383-410  |  Published: 1/2007  |  DOI: 10.1111/j.1540-6261.2007.01210.x  |  Cited by: 76


Interest rate swap pricing theory traditionally views swaps as a portfolio of forward contracts with net swap payments discounted at LIBOR rates. In practice, the use of marking‐to‐market and collateralization questions this view as they introduce intermediate cash flows and alter credit characteristics. We provide a swap valuation theory under marking‐to‐market and costly collateral and examine the theory's empirical implications. We find evidence consistent with costly collateral using two different approaches; the first uses single‐factor models and Eurodollar futures prices, and the second uses a formal term structure model and Treasury/swap data.

The Value of Embedded Real Options: Evidence from Consumer Automobile Lease Contracts

Pages: 411-445  |  Published: 1/2007  |  DOI: 10.1111/j.1540-6261.2007.01211.x  |  Cited by: 16


Under the common assumption of constant interest rates, we show that penalties for early termination of a lease are often structured in such a way that the cancellation option embedded in consumer automotive leases has little value. Furthermore, our estimates drawn from a sample of three popular car models over 1990 to 2000 indicate that the stand‐alone value of the lease‐end purchase option is, on average, about 16% of the market value of underlying used vehicles, or about $1,462 per contract. Finally, we examine the sensitivity of our option value estimates to model parameters and default risk.

The Initial Public Offerings of Listed Firms

Pages: 447-479  |  Published: 1/2007  |  DOI: 10.1111/j.1540-6261.2007.01212.x  |  Cited by: 70


A number of firms in the United Kingdom list without issuing equity and then issue equity shortly thereafter. We argue that this two‐stage offering strategy is less costly than an initial public offering (IPO) because trading reduces the valuation uncertainty of these firms before they issue equity. We find that initial returns are 10% to 30% lower for these firms than for comparable IPOs, and we provide evidence that the market in the firm's shares lowers financing costs. We also show that these firms time the market both when they list and when they issue equity.


Pages: 481-482  |  Published: 1/2007  |  DOI: 10.1111/j.1540-6261.2007.01214.x  |  Cited by: 0