The Debt-Equity Mix in Preferred Stock and Adverse Selection Costs: An Empirical Investigation

Abstract:     
This paper investigates whether the hybrid nature of preferred stock is reflected in its market microstructure and, in particular, in its information dissemination process. Theory would suggest that information flows, informational asymmetry and transactions costs of trading associated with various kinds of preferred stocks would differ depending on whether debt-type or equity-type asset characteristics dominate in them. Specifically, debt dominated assets are expected to rely more heavily on non-firm specific information, be exposed to adverse selection to a lesser extent and have lower information asymmetry induced transactions costs than securities dominated by equity features. This paper empirically tests this prediction. The main result in the paper is that asset characteristics affect microstructure parameters. In particular, the higher the equity dominance in straight preferred stock, the lower the public information induced volatility and the higher the information asymmetry induced transactions cost and the adverse selection component of the spread. Such relations are not observed in the case of convertible preferred stock. This is attributed to the existence of a lead-lag relationship between this security and its underlying common stock. Finally, the results also indicate that infrequent trading has a significant impact on the adverse selection component of the spread.

Number of Pages in PDF File: 60

Keywords: Preferred stock, bid-ask spreads, adverse selection costs, volatility

JEL Classification: G12, G19

working papers series