Recent Nobel Prizes to Akerlof, Spence, and Stiglitz motivate this review of basic concepts and empirical evidence on information asymmetry and the choice of debt vs. equity. We first review the literature that holds investment fixed. Then we review capital structure issues related to the adverse investment selection problem of Myers-Majluf. Finally, we discuss the timing hypothesis of capital structure. Empirical studies do not consistently support one theory of capital structure under information asymmetry over the others. Thus, the review suggests that additional theoretical contributions are needed to help understand and explain findings in the empirical literature.
We examine the spillover wealth effects of the Orange County, California bankruptcy announcement in December 1994 on municipal bonds, municipal bond funds, and bank stocks. This bankruptcy is prominent because of unprecedented losses and because it was caused by a highly leveraged derivatives strategy rather than a shortage of tax revenues and excess spending. We find contagion in the bond market with significantly negative abnormal returns for municipal bond funds without direct exposure to Orange County and for non-Orange County municipal bonds. In addition, our findings suggest the contagion spills over to the common stocks of investment and commercial banks that deal in or use derivatives; however, the equities of banks unexposed to derivatives are not affected.
"We show how capital structure swaps can increase the wealth of a firm's long-term shareholders when a firm's debt or equity is misvalued. We review the conventional rule that a firm should issue equity and use the proceeds to retire outstanding debt (an equity-for-debt swap) when equity is overvalued, or repurchase equity with proceeds of new debt (a debt-for-equity swap) when equity is undervalued. We also analyse the more complex case where a firm's debt and equity are both undervalued, showing the optimal swap may be to issue undervalued equity, contrary to the conventional rule." Copyright 2007 The Authors Journal compilation (c) 2007 Blackwell Publishing Ltd.
Recent studies find abnormal common stock price behavior associated with ex-dates of stock splits. Volatility increases are substantial and abrupt. This study extends previous analyses to the options market by examining investor perceptions of volatility increases through implied standard deviations of returns. Investors fail to anticipate volatility increases until the ex-date. Furthermore, abnormal option returns are present. The increased volatility and these results suggest option market inefficiency.
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