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Abstract:
This Paper analyses firms' capital allocation decisions when optimal capital structure is linked to the risk of underlying assets and when equity capital is costly and cannot be raised instantaneously. In the model, division managers receive private information and authority is delegated to them over risky project choices. The optimal mechanisms are related to EVA compensation and RAROC performance measurement systems. In the optimal mechanism, position limits will be employed but are not always completely utilized. Hurdle rates reflect capital allocation through a division-specific capital structure. In the multidivisional context the optimal capital allocation mechanism incorporates valuable externalities leading to overall firm EVA maximization.

Abstract:
Equity capital allocation plays a particularly important role for financial institutions such as banks, who issue equity infrequently but have continuous access to debt capital. In such a context this paper shows that EVA and RAROC based capital budgeting mechanisms have economic foundations. We derive optimal capital allocation under asymmetric information and in the presence of outside managerial opportunities for an institution with a risky and a riskless division. It is shown that the results extend in a consistent manner to the multidivisional case of decentralized investment decisions with a suitable redefinition of economic capital. The decentralization leads to a charge for economic capital based on the division's own realized risk. Outside managerial opportunities increase the usage of capital and lead to overinvestment in risky projects; at the same time more capital is raised but risk limits are binding in more states. An institution with a single risky division should base its hurdle rate for capital allocated on the cost of debt. In contrast, the hurdle rate tends to the cost of equity for a diversified multidivisional firm. The analysis shows that hurdle rates have a common component in contrast to the standard perfect markets result with division-specific hurdle rates.

capital, allocation, risk, management, equity

Abstract:
Financial institutions are facing increased pressure to enhance shareholder value. This has lead to the popularity of practical techniques such as EVA and RAROC. The major purpose of this study is to illustrate the interaction between incentive-based compensation and performance evaluation in a multiperiod setting. We demonstrate that while EVA can justifiably be used to incentivize managers to make better current investment decisions, performance measurement techniques such as RAROC help the firm to better assess abilities for the future. The model is applied to understand why hard position limits are employed as well as softer incentive contracts and what sort of termination standard should be used for the investment manager.

Abstract:
This paper documents the aggregate trends in the foreign listings of companies and analyzes both their distinctive pre-listing characteristics and their post-listing performance relative to other companies. In the 1986-97 interval, many European companies listed abroad, but did so mainly on US exchanges. At the same time, the number of US companies listed in Europe decreased. The cross-listings of European companies appear to have sharply different motivations and consequences depending on whether they cross-list in the United States or within Europe. In the first case, companies pursue a strategy of rapid expansion fuelled by high leverage before the listing and large equity issues after the listing. They rely increasingly on export markets both before and after the listing, and tend to belong to high-tech industries. In the second case, companies do not grow more than the control group, and increase their leverage after the cross-listing. Also, they fail to increase their foreign sales in the wake of the cross-listing. The only common features of the two groups are their large size, high foreign sales before cross-listing and high R&D spending after cross-listing.

Abstract:
This Paper analyses the effect of dynamic capital structure adjustments on credit risk. Firms may optimally adjust their leverage in response to stochastic changes in firm value. It is shown that capital structure dynamics lower optimal initial leverage ratios but increase both fair credit spreads and expected default probabilities for moderate levels of transactions costs. Numerical examples demonstrate that expected default frequencies do not decrease monotonically in the traditional distance to default measure. The magnitude of the effect of capital structure dynamics depends on firm characteristics, such as asset volatility, the growth rate, the effective corporate tax rate, debt call features and transactions costs. We find that the underestimation of credit spreads and expected default frequencies is exacerbated when the risk-adjusted drift of the underlying stochastic process is inferred from a model which ignores the opportunity to recapitalize. Finally it is shown that the Value-at-Risk of corporate bonds increases with the distance to default (DD) both for very low and for very high values of DD, whereas, it decreases for intermediate values.

Abstract:
This paper presents an analysis of the effect of dynamic capital structure adjustments on credit risk. Firms may optimally adjust their leverage in response to stochastic changes in firm value. This is shown to influence a bond's expected default frequency and its fair credit spread. Generally capital structure dynamics significantly increase both credit spreads and and expected default probabilities. Numerical examples demonstrate that there exists a u-shaped relationship between the traditional distance to default measure and expected default frequencies. The magnitude of the effect of capital structure dynamics is shown to depend on firm characteristics such as asset volatility, the growth rate, the effective corporate tax rate, call features and transactions costs. The results therefore suggest a cross-sectional variation of the relationship between the distance to default and expected default frequencies. Finally we extend the analysis to include the estimation of the firm's asset value and its volatility from observed equity prices. We find that the underestimation of credit spreads and expected default frequencies is exacerbated when the asset value and volatility are inferred from a model which ignores the opportunity to recapitalize.

Abstract:
This paper analyzes the time-series dynamics of closed-end fund discounts and their relation to portfolio performance and manager turnover. We find that a fund underperforms its peer group prior to manager replacement, but improves afterwards. We also find that, prior to replacement, the discount initially increases as fund performance worsens, then stops responding to further poor performance. For domestic equity funds, the peer-adjusted discount first increases by about 5%, then decreases by about 3% by the time of replacement. This pattern is consistent with discount changes reflecting investor learning about fund manager skills, as well as investor anticipation of an impending manager replacement. Finally, we find that discount changes reflect past and forecast future portfolio performance among funds without manager replacements. Overall, our results are consistent with a significant component in closed-end fund discounts being related to manager talent.

Closed-end fund, manager turnover, discount

Abstract:
Intermediaries such as financial advisers and funds of funds serve a vital role in the financial services industry as an interface between portfolio managers and investors. A large fractioon of their compensatioon is often provided through rebates or kickbacks from the portfolio manager rather than directly by their clients. In a model with ratioonal agents we provide an explanation for the widespread use of intermediaries and rebates in compensation practices. We also explore the effects of these arrangements on fund size, flows, performance and investor welfare. Intermediated funds will underperform direct channel funds based on net returns as well as gross returns. Rebates allow higher management fees to be charged, with the consequence that equilibrium fees and net returns are negatively related.

investment management, intermediation, investment adviser, kickback

Abstract:
We develop a continuous-time model in which a portfolio manager is hired by a management company. On the basis of observed portfolio returns, all agents update their beliefs about the manager’s skills. In response, investors can move capital into or out of the mutual fund, and the management company can fire the manager. Introducing firing rationalizes several empirically documented findings, such as the positive relation between manager tenure and fund size or the increase of portfolio risk before a manager replacement and the following risk decrease. The analysis predicts that the critical performance threshold that triggers firing increases significantly over a manager’s tenure and that management replacements are accompanied by capital inflows when a young manager is replaced but may be accompanied by capital outflows when a manager with a long tenure is fired. Our model yields much lower valuation levels for management companies than simple applications of discounted cash flow (DCF) methods and is thus more consistent with empirical observations.

G11, G23, G30

Abstract:
We develop a continuous-time model in which a portfolio manager is hired by a management company. Based on observed portfolio returns, all agents update their beliefs about the manager's skills. In response, investors can move capital into or out of the mutual fund and the management company can fire the manager. Introducing firing rationalizes several empirically documented findings, such as the positive relation between manager tenure and fund size or the increase of portfolio risk before a manager replacement and the following risk decrease. The analysis predicts that the critical performance threshold which triggers firing increases significantly over a manager's tenure and that management replacements are accompanied by capital inflows when a young manager is replaced, but may be accompanied by capital outflows when a manager with a long tenure is fired. Our model yields much lower valuation levels for management companies than simple applications of DCF methods and is thus more consistent with empirical observations.

mutual funds, portfolio management, governance, market discipline

Abstract:
We develop a continuous-time model in which a portfolio manager is hired by a management company. Based on observed portfolio returns, all agents update their beliefs about the manager's skills. In response, investors can move capital into or out of the mutual fund and the management company can fire the manager. Introducing firing rationalizes several empirically documented findings, such as the positive relation between manager tenure and fund size or the increase of portfolio risk before a manager replacement and the following risk decrease. The analysis predicts that the critical performance threshold which triggers firing increases significantly over a manager's tenure and that management replacements are accompanied by capital inflows when a young manager is replaced, but may be accompanied by capital outflows when a manager with a long tenure is fired. Our model yields much lower valuation levels for management companies than simple applications of DCF methods and is thus more consistent with empirical observations.

mutual funds, portfolio management, governance, market discipline

Abstract:
We investigate the distribution of trading volume across different venues after a company lists abroad. In most cases, after an initial blip, foreign trading declines rapidly to extremely low levels. However, there is considerable cross-sectional variation in the persistence and magnitude of foreign trading. The ratio between foreign and domestic trading volume is higher for smaller, more export and high-tech oriented companies. It is also higher for companies that cross-list on markets with lower trading costs and better insider trading protection. Foreign trading is high close to the cross-listing date but decreases dramatically in the subsequent six months. This accords with the 'flow-back hypothesis' that declining foreign trading is associated with the gravitational pull of the home market.

Trading volume, cross-listing, flow-back

Abstract:
We investigate the distribution of trading volume across different venues after a company lists abroad. In most cases, after an initial blip, foreign trading declines rapidly to extremely low levels. However, there is considerable cross-sectional variation in the persistence and magnitude of foreign trading. The ratio between foreign and domestic trading volume is higher for smaller, more export and high-tech oriented companies. It is also higher for companies that cross-list on markets with lower trading costs and better insider trading protection. Domestic trading increases around the cross-listing, and afterwards is negatively correlated with past foreign trading activity. This accords with the flow-back hypothesis that declining foreign trading is associated with the gravitational pull of the home market.

trading volume, cross-listing, flow-back

Abstract:
This paper shows that long debt maturities destroy equityholders' incentives to reduce leverage in response to poor firm performance. By contrast, a sufficiently short debt maturity commits equityholders to implement such leverage reductions. However, a short debt maturity also generates transactions costs associated with rolling over maturing bonds. We show that this tradeoff between higher expected transactions costs against the commitment to reduce leverage when the firm is doing poorly motivates an optimal maturity-structure of corporate debt. Since firms with high costs of financial distress benefit most from committing to leverage reductions, they have a stronger incentive to issue short-term debt. The debt maturity required to commit to future leverage reductions decreases with the volatility of the firm's cash flows. We also find that the equityholders' incentives to reduce debt is non-monotonic in the firm's leverage. If the firm is pushed to bankruptcy by a persistent series of low cash flows, then equityholders resume issuing debt to refinance maturing bonds, even when debt maturities are short.

debt maturity, optimal capital structure choice

Abstract:
We explore two main questions. First, can two markets for a company's shares coexist and, if so, what determines the distribution of trading volume across them? For firms cross-listed in the U.S. we find that in most cases the U.S. market attracts a significant fraction of total trading volume, and tends to be more active when the company is based in a country that is geographically close, has low financial development and relatively poor anti-insider trading protection. Moreover, the relative size of the U.S. market is larger if the company is small, volatile and high-tech. Second, we ask whether developing an active foreign market entails lower domestic trading activity. We find that for firms based in developed markets, the domestic turnover rate increases in the wake of cross-listing and remains permanently higher. In contrast, emerging market firms tend to experience a decrease in domestic trading activity.

cross-listing, trading volume, trade creation

Abstract:
This paper analyzes the determinants of secondary debt market liquidity, identifying conditions under which trading in competitive markets results in sufficient ownership concentration to induce ex post efficient debt relief. The feasibility of debt relief is path-dependent, hinging upon interim economic conditions. Secondary debt markets are likely to freeze during recessions, precisely when trading has high social value. This is due to three factors: severe free-riding reduces profits of large bondholders; uninformed small bondholders are reluctant to sell due to high informational sensitivity of debt; and large investors are more likely to face wealth constraints. However, secondary markets need not freeze during recessions since high liquidity demand of uninformed bondholders increases their willingness to trade. Additionally, broader liquidity shocks during recessions increase the equilibrium stake held by large investors, promoting debt relief.

Liquidity, Debt, Restructuring

Abstract:
We derive a firm's optimal capital structure and managerial compensation contract when employees are averse to bearing their own human capital risk, while equity holders can diversify this risk away. In the presence of corporate taxes, our model delivers optimal debt levels consistent with those observed in practice. It also makes a number of predictions for the cross-sectional distribution of firm leverage. Consistent with existing empirical evidence, it implies persistent idiosyncratic differences in leverage across firms. An important new empirical prediction of the model is that, ceteris paribus, firms with more leverage should pay higher wages.

Abstract:
We analyze the location of stock trading for firms with a US cross-listing. The fraction of trading that occurs in the United States tends to be larger for companies from countries that are geographically close to the United States and feature low financial development and poor insider trading protection. For companies based in developed countries, trading volume in the United States is larger if the company is small, volatile, and technology-oriented, while this does not apply to emerging country firms. The domestic turnover rate increases in the cross-listing year and remains higher for firms based in developed markets, but not for emerging market firms. Domestic trading volume actually declines for companies from countries with poor enforcement of insider trading regulation.

G15, G30

Abstract:
This paper documents aggregate trends in the foreign listings of companies, and analyzes their distinctive prelisting characteristics and postlisting performance. In 1986-1997, many European companies listed abroad, mainly on U.S. exchanges, while the number of U.S. companies listed in Europe decreased. European companies that cross-list tend to be large and recently privatized firms, and expand their foreign sales after listing abroad. They differ sharply depending on where they cross-list: The U.S. exchanges attract high-tech and export-oriented companies that expand rapidly without significant leveraging. Companies cross-listing within Europe do not grow unusually fast, and increase their leverage after cross-listing.

Abstract:
Given recent public attention paid to high-flying internet IPOs such as Yahoo and Amazon.com, this paper explores a product market motive for going public. We develop a model where consumers look to the stock price to make inferences. The model predicts that only better quality firms will go public. Effects of IPO announcements on rival firms' stock prices are related to inferences of market size and market share. The model also predicts that the likelihood of "hot issue" markets depends on the distribution of market size uncertainty and the degree of network externalities present in consumer preferences.