Agency theory recognizes that the interests of managers and shareholders may conflict and that, left on their own, managers may make major financial policy decisions, such as the choice of a capital structure, that are suboptimal from the shareholders' standpoint. The theory also suggests, however, that compensation contracts, managerial equity investment, and monitoring by the board of directors and major shareholders can reduce conflicts of interest between managers and shareholders. This research investigates the relationship between the firm's capital structure and 1) executive incentive plans, 2) managerial equity investment, and 3) monitoring by the board of directors and major shareholders. This paper finds a positive relationship between the firm's leverage ratio and 1) percentage of executives' total compensation in incentive plans, 2) percentage of equity owned by managers, 3) percentage of investment bankers on the board of directors, and 4) percentage of equity owned by large individual investors. These findings are consistent with the predictions of agency theory, suggesting, in turn, that capital structure models that ignore agency costs are incomplete.

This article examines the international determinants of capital structure using a large sample of firms from 37 countries. The reliable determinants for leverage are firm size, tangibility, industry leverage, profits, and inflation. The quality of the countries’ institutions affects leverage and the adjustment speed toward target leverage in significant ways. High-quality institutions lead to faster leverage adjustments, whereas laws and traditions that safeguard debt holders relative to stockholders (e.g., more effective bankruptcy procedures and stronger creditor protection) lead to higher leverage.

The Black-Scholes [4] call option model is a member of the class of constant elasticity of variance call option models proposed by Cox [6]. While the Black-Scholes model assumes that the volatility or instantaneous variance of return is constant through time, the other members of the class allow the volatility to change with the stock price. This property is of interest because empirical evidence suggests that returns to common stock are heteroscedastic and also that volatilities, implied from the Black-Scholes model and market prices of call options, are not constant.

Recent research finds that the prior period's worst stock return performers (losers) outperform the prior period's best return performers (winners) in the subsequent period. This potential violation of the efficient markets hypothesis is labeled the “overreaction” phenomenon. This paper shows that the tendency for losers to outperform winners is not due to investor overreaction, but to the tendency for losers to be smaller-sized firms than winners. When losers are compared to winners of equal size, there is little evidence of any return discrepancy, and in periods when winners are smaller than losers, winners outperform losers.

Using an intuitive approach that also provides new intuition concerning the Black and Scholes equation, this paper extends the results of Johnson and Stulz to the pricing of options on the minimum or the maximum of several risky assets.

In this paper, we examine the effect of shareholder rights on reducing the cost of equity and the impact of agency problems from free cash flow (FCF) on this effect. We find that firms with strong shareholder rights have a significantly lower implied cost of equity after controlling for risk factors, price momentum, analysts’ forecast biases, and industry and year effects than do firms with weak shareholder rights. Further analysis shows that the effect of shareholder rights on reducing the cost of equity is significantly stronger for firms with more severe agency problems from FCFs.

A fundamental function of any portfolio selection model is the identification of inefficient portfolios and the consequent reduction of the set of alternative investments that the decision maker must evaluate. In the absence of a specific utility function, the establishment of criteria for the identification of inefficient portfolios must strike a compromise in terms of convenience and effectiveness. Of the myriad possibilities, models employing a criterion based on two parameters have been found most convenient for reasons of simplicity of interpretation and computational feasibility. Certainly, the most popular of the two parameter models has been the expected value-variance (E-V) formulation first proposed by Markowitz [7]. The basic E-V model developed for individual decision making has been extended by Sharpe, Lintner, and others [1, 4, 3, 9] to set forth an extensive theory which seeks to explain the equilibrium price of risky assets. The purpose of the present paper is to review and extend some of the implications of an alternative two-parameter portfolio selection model, called the expected value-semivariance model (E-S). In particular, the discussion focuses on certain contrasts and similarities between the E-V and the E-S models.

This paper tests whether information advantages help explain why some individual investors concentrate their stock portfolios in a few stocks. Stock investments made by households that choose to concentrate their brokerage accounts in a few stocks outperform those made by households with more diversified accounts (especially among those with large portfolios). Excess returns of concentrated relative to diversified portfolios are stronger for stocks not included in the S&P 500 index and local stocks, potentially reflecting concentracted investors' successful exploitation of information asymmetries. Controlling for households' average investment abilities, their trades and holdings perform better when their portfolios include fewer stocks.

This paper examines the intertemporal relation between downside risk and expected stock returns. Value at Risk (VaR), expected shortfall, and tail risk are used as measures of downside risk to determine the existence and significance of a risk-return tradeoff. We find a positive and significant relation between downside risk and the portfolio returns on NYSE/AMEX/Nasdaq stocks. VaR remains a superior measure of risk when compared with the traditional risk measures. These results are robust across different stock market indices, different measures of downside risk, loss probability levels, and after controlling for macroeconomic variables and volatility over different holding periods as originally proposed by Harrison and Zhang (1999).

This paper examines the influence of risk aversion on the pricing policies of a market maker for securities. It is shown that a market maker's bid-ask spread can be decomposed into a portion for the known limit orders, a risk-neutral adjustment for expected market orders, and a risk adjustment for market order and inventory value uncertainty. It is demonstrated that a risk-averse market maker may set a smaller spread than a risk-neutral specialist. Finally, this paper demonstrates the pervasive role of inventory in affecting both the placement and size of the spread.

Segmentation of capital markets produces incentives for firms to adopt countermeasures, one of which is dually listing their stocks on foreign capital markets. In this paper, the behavior of stock returns surrounding such international listings is examined for a sample of firms. Assuming that the capital markets are either completely or “mildly” segmented beforehand, it is hypothesized that the international listing of a security should, in general, accompany a reduction in its expected return. The sample reveals evidence consistent with this hypothesis.

DeMiguel, Garlappi, and Uppal (2009) report that naïve diversification dominates mean-variance optimization in out-of-sample asset allocation tests. Our analysis suggests that this is largely due to their research design, which focuses on portfolios that are subject to high estimation risk and extreme turnover. We find that mean-variance optimization often outperforms naïve diversification, but turnover can erode its advantage in the presence of transaction costs. To address this issue, we develop 2 new methods of mean-variance portfolio selection (volatility timing and reward-to-risk timing) that deliver portfolios characterized by low turnover. These timing strategies outperform naïve diversification even in the presence of high transaction costs.

This paper develops a corporate bond valuation model that takes into account both early default and interest rate risk. It corrects a defect of recent contributions where pricing equations do not assure that the payment to bondholders upon bankruptcy is no greater than firm value. The bankruptcy-triggering mechanism is directly related to the payoff received by bondholders when early bankruptcy is forced upon the firm. More specifically, the default barrier is defined simply as a fixed quantity discounted at the riskless rate up to the maturity date of the risky corporate bond. As soon as this threshold is crossed, bondholders receive an exogenously specified fraction of the remaining assets. Deviations from the absolute priority rule also are captured. Because it accounts for Gaussian interest rate uncertainty, default risk, and deviations from the absolute priority rule, this model is capable of producing quite diverse shapes for the term structure of yield spreads.

If stocks were severely undervalued in the late 1970s and early 1980s, then the bull market starting in 1982 was partly just a correction to more normal valuation levels. This paper tests the hypothesis that investors suffer from inflation illusion, resulting in the undervaluation of equities in the presence of inflation, with levered firms being undervalued the most. Using firm level data and a residual income/EVA model, we find evidence that errors in the valuation of levered firms during inflationary times result in depressed stock prices. Our misvaluation measure can be used with expected inflation to make statistically reliable predictions for real returns on the Dow during the subsequent year. Our model suggests that stocks were overvalued at the end of the 1990s.

The recent split share structure reform in China involves the nontradable shareholders proposing a compensation package to the tradable shareholders in exchange for the listing rights of their shares. We find that state ownership (the major owners of nontradable shares) has a positive effect on the final compensation ratio. In contrast, mutual fund ownership (the major institutional owner of tradable shares) has a negative effect on the compensation ratio and especially in state-owned firms. The evidence is consistent with our predictions that state shareholders have incentives to complete the reform quickly and exert political pressure on mutual funds to accept the terms without a fight.

If shareholders own diversified portfolios, and if companies impose externalities on one another, shareholders do not want value maximization to be corporate policy. Instead, shareholders want companies to maximize portfolio values. This occurs when firms internalize between-firm externalities. Any kind of externality, pecuniary or nonpecuniary, vertical or horizontal, suffices. What matters is simply that one company's actions affect another's value. Thus, besides the traditional benefit of risk reduction, portfolio diversification offers additional benefits to shareholders through helping internalize externalities. This paper documents the extent of diversification and cross-ownership of stocks among companies where these externalities are likely to be large and provides a capital market test of how merger offers vary with the extent of cross-ownership.

Of the behavioral recommendations garnered from modern capital market theory, few, if any, generalizations have been documented as convincingly as the simple advice to hold several assets in one's portfolio. Sharpe made such a conclusion perfectly clear when he stated [27, p. 184]:

If the market is efficient and if an investor is privy to no special information or predictive power, what should he do? First, and most important: diversify.

This paper studies the binomial approximation to the continuous trading term structure model of Heath, Jarrow, and Morton (1987). The discrete time approximation makes the original methodology accessible to a wider audience, and provides a computational procedure necessary for calculating the contingent claim values derived in the continuous time paper. This paper also extends and generalizes Ho and Lee's (1986) model to include multiple random shocks to the forward rate process and to include an analysis of continuous time limits. The generalization provides insights into the limitations of the existing empirical implementation of Ho and Lee's model.

The ability to identify which factors best capture systematic return covariation is central to applications of multifactor pricing models. This paper uses a common data set to evaluate the performance of various proposed factors in capturing return comovements. Factors associated with the market, size, past return, book-to-market, and dividend yield help explain return comovement on an out-of-sample basis (although they are not necessarily associated with large premiums in average returns). Except for the default premium and the term premium, macroeconomic factors perform poorly. We document regularities in the behavior of the more important factors, and confirm their influence in the Japanese and U.K. markets as well.

This paper examines holding period returns to constant duration portfolios of U.S. Government notes and bonds, and measures the return premium generated by liquidity differences in bonds. The approach compares constant duration portfolios constructed in two distinct ways: one using only bonds issued in the most recent Treasury auction, one using all other bonds. Comparisons of the resulting series are made meaningful by choosing narrow duration ranges in the portfolio formation procedure. This, in turn, induces a missing data problem in the created time series. Parameters of return distributions are therefore estimated employing a maximum likelihood framework that explicitly accounts for the missing data. It is estimated that recently issued bonds are priced to return a premium of around 55 basis points per annum over otherwise equivalent instruments.