ILLIQUIDITY RISK,PROJECT CHARACTERISTICS,AND THE OPTIMAL MATURITY OF CORPORATE DEBT

I derive the optimal maturity period for corporate debt used to finance a specific project, when costly financial distress is triggered by the inability to meet coupon obligations. My model predicts a negative relation between bond risk and maturity, and it explains why high-grade bonds show greater maturity dispersion than low-grade bonds, as observed in U.S. corporate bond markets. The major determinant of bond maturity is project duration for low-risk bonds and project risk for high-risk bonds. Other determinants of bond maturity are debt burden, reorganization costs, corporate tax rate, interest rate, and project growth rate.     

Belief Networks for Expert System Development in Auditing

This study examines the use of a belief network based expert system for an auditing task—financial distress evaluation for banks. A belief network uses probability measures to store important dependencies across variables of interest in a problem domain, and makes inferences based on observed evidence using probability calculus. This paper discusses how belief network structures can be constructed, and used to assist auditor's in making appropriate recommendations regarding the financial health of a bank under audit. The ability of a belief network to make reliable predictions depends on how well the network structure reflects the underlying dependencies across variables in the problem domain (e.g. financial ratios and the financial health of a bank). The first part of this study illustrates how a computer program developed by the authors can be used to generate and evaluate different feasible belief network structures based on historical data. The program uses an information-theoretic measure to compare the alternative structures. The ability of the program to identify existing dependencies across variables is demonstrated by using it to reconstruct a known network structure from simulated data. Next, the program is used on a database of twelve important bank financial ratios over a three-year period. The predictive ratios identified by the program reflect important areas of a bank's health, such as loan quality, efficiency, profitability and capital adequacy. Finally, a belief revision mechanism is encoded for the belief network structure identified earlier, and is used to illustrate how it can assist auditors in making recommendations about financial health based on a bank's critical financial ratios. The probability estimates provided by the system are validated using data on banks not used in the network design stage, and are found to be reliable.     

A “matching auction” for targets with heterogeneous bidders

When potential bidders for a target firm are heterogeneous, standard auction methods for selling the firm are not optimal, as they treat the bidders symmetrically. In a two-bidder contest, one way to discriminate against the stronger bidder is to impose an order of moves. A simple “matching auction” can achieve this objective, in which the “strong” bidder is asked to make a first and final offer, and the other bidder is asked to match this bid. We consider two sources of bidder heterogeneity in a common-value setting: differences in initial toeholds, and asymmetric effects of the bidders' private signals on value. The matching auction results in a higher expected selling price than the standard auctions when the asymmetry is sufficiently large. Other properties of the matching auction are discussed.     

Managerial risk-taking incentives, product market competition and welfare

Managers’ compensation may increase with the variance of the firm's profits. This paper investigates how this affects their choice of strategic variables, and how that affects managerial compensation. The social welfare aspects of this interaction are analyzed in a duopoly setting with uncertain linear demand and linear marginal cost. Compared to a situation in which the managers’ compensation does not depend on the variance of profits, social welfare may be either higher, lower, or remain unaffected, depending on the slope of the marginal cost curve and whether the competing firms produce goods that are demand substitutes or complements.     

Time varying consumption covariance and dynamics of the equity premium: Evidence from the G7 countries

We examine implications of time-varying correlation and covariance between excess equity returns and consumption growth for the equity premium of the G7 countries. We find that the correlation and covariance are higher when there is a negative shock to labor income and a positive shock to returns. The combined effect is that the correlation and covariance are countercyclical and so is the equity premium. We test asset pricing models with time-varying consumption risk and find that the conditional price of risk is generally positive. These results survive several robustness checks. Our results highlight the importance of labor income for understanding dynamics of the equity premium.     

Statistical Causality and Strategic Behavior in Industrial Markets

This paper proposes a simple test of the leader-follower model of strategic behavior. This test relates the temporal notions of leadership central to such models to the empirical methods of statistical causality. This test is performed using data from the US softwood plywood industry of the last three decades. Others have productively explored the spatial pricing practices of this industry by applying a leader-follower model. Similarly, we find that a leader-follower model explains well the temporal relations between key strategic variables (prices) in the industry. We conclude that the leader-follower model imposes meaningful restrictions on observable time-series data and that statistical causality is a useful method for testing these restrictions.     

Insider Trading, Investment, and Liquidity: A Welfare Analysis

We compare equilibrium trading outcomes with and without participation by an informed insider, assuming inflexible ex ante aggregate investment choices by agents. Noise trading arises from aggregate uncertainty regarding other agents' intertemporal consumption preferences. The welfare levels of outsiders can thus be ascertained. The allocations without insider trading are not ex ante Pareto efficient, because our model differs from standard ones with negative exponential utility functions and normal returns. We characterize the circumstances under which the revelation of payoff-relevant information via prices—arising from insider trading—benefits outsiders with stochastic liquidity needs, by improving risk-sharing among them.     

Optimal Bond Refunding: A Practical Approach

Although there is substantial research on optimal bond refunding, an important real-life feature is missing from the existing literature: imperfect adjustment or 'stickiness' of bond yields to short term interest rate changes. Our model takes this behavior into account, and also has the ability to handle mean reverting interest rates. The results indicate that the former has a significant effect on the optimal refunding policy (especially for longer maturities), but the latter does not. By incorporating these features, our model will hopefully offer a fairly complete and easily implementable guide to managers with regard to the bond refunding decision.