Tests of a Signalling Hypothesis: The Choice between Fixed and Adjustable Rate Debt

Abstract

We develop a model wherein the choice between adjustable and fixed rate debt can serve as a signal of firm quality. The nature of the signal depends on expected inflation volatility relative to other risk parameters. Evidence from a matched sample of debt announcements over the period 1978-1986 shows a difference of -2.05% between stock price reactions to adjustable rate and fixed rate announcements when expected inflation volatility is above an estimated threshold. Below this threshold, the difference is a positive 0.98%. The evidence supports the hypothesis that the riskier debt choice serves as a favorable signal of firm quality.

JEL Classification: G30