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The Application of Statistical Classification to Business Failure Prediction

Description: Bankruptcy is a costly event. Holders of publicly traded securities can rely on security prices to reflect their risk. Other stakeholders have no such mechanism. Hence, methods for accurately forecasting bankruptcy would be valuable to them. A large body of literature has arisen on bankruptcy forecasting with statistical classification since Beaver (1967) and Altman (1968). Reported total error rates typically are 10%-20%, suggesting that these models reveal information which otherwise is unavailable and has value after financial data is released. This conflicts with evidence on market efficiency which indicates that securities markets adjust rapidly and actually anticipate announcements of financial data. Efforts to resolve this conflict with event study methodology have run afoul of market model specification difficulties. A different approach is taken here. Most extant criticism of research design in this literature concerns inferential techniques but not sampling design. This paper attempts to resolve major sampling design issues. The most important conclusion concerns the usual choice of the individual firm as the sampling unit. While this choice is logically inconsistent with how a forecaster observes financial data over time, no evidence of bias could be found. In this paper, prediction performance is evaluated in terms of expected loss. Most authors calculate total error rates, which fail to reflect documented asymmetries in misclassification costs and prior probabilities. Expected loss overcomes this weakness and also offers a formal means to evaluate forecasts from the perspective of stakeholders other than investors. This study shows that cost of misclassifying bankruptcy must be at least an order of magnitude greater than cost of misclassifying nonbankruptcy before discriminant analysis methods have value. This conclusion follows from both sampling experiments on historical financial data and Monte Carlo experiments on simulated data. However, the Monte Carlo experiments reveal that as the cost ratio increases, robustness of linear ...
Date: December 1994
Creator: Haensly, Paul J.

Bank Loans as a Financial Discipline: A Direct Agency Cost of Equity Perspective

Description: In a 2004 study, Harvey, Lin and Roper argue that debt makers with a commitment to monitoring can create value for outside shareholders whenever information asymmetry and agency costs are pronounced. I investigate Harvey, Lin and Roper's claim for bank loans by empirically testing the effect of information asymmetry and direct agency costs on the abnormal returns of the borrowers' stock around the announcement of bank loans. I divide my study into two main sections. The first section tests whether three proxies of the direct agency costs of equity are equally significant in measuring the direct costs associated with outside equity agency problems. I find that the asset utilization ratio proxy is the most statistically significant proxy of the direct agency costs of equity using a Chow F-test statistic. The second main section of my dissertation includes and event study and a cross-sectional analysis. The event study results document significant and positive average abnormal returns of 1.01% for the borrowers' stock on the announcement day of bank loans. In the cross sectional analysis of the borrowers' average abnormal stock returns, I find that higher quality and more reputable banks/lenders provide a reliable certification to the capital market about the low level of the borrowers' direct agency costs of equity and information asymmetry. This certification hypothesis holds only for renewed bank loans. In other words, in renewing the borrowers' line of credit, the bank/lender is actually confirming that the borrower has a low level of information asymmetry and direct costs of equity. Given such a certificate from the banks/lenders, shareholders reward the company/borrower by bidding the share price up in the capital market.
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Date: December 2006
Creator: Hijazi, Bassem

Changes in Trading Volume and Return Volatility Associated with S&P 500 Index Additions and Deletions

Description: When a stock is added into the S&P 500 Index, it is automatically "cross-listed" in the index derivative markets (i.e., S&P 500 Index futures and Index options). I examined the effects of such cross-listing on the trading volume and return volatility of the underlying component stocks. Traditional finance theory asserts that futures and "cash" markets are connected by arbitrage mechanism that brings both markets to equilibrium. When arbitrage opportunities arise, arbitrageurs buy (sell) the index portfolio and take short (long) positions in the corresponding index derivative contracts until prices return to theoretical levels. Such mechanical arbitrage trading tends to create large order flows that could be difficult for the market to absorb, resulting in price changes. Utilizing a list of S&P 500 index composition changes occurring over the period September 1976 to December 2005, I investigated the market-adjusted volume turnover ratios and return variances of the stocks being added to and deleted from the S&P 500, surrounding the effective day of index membership changes. My primary finding is that, after the introduction of the S&P 500 index futures and options contracts, stocks added to the S&P 500 experience significant increase in both trading volume and return volatility. However, deleted stocks experience no significant change in either trading volume or return volatility. Both daily and monthly return variances increase following index inclusion, consistent with the hypothesis that derivative transactions "fundamentally" destabilize the underlying securities. I argue that the increase in trading volume and return volatility may be attributed to index arbitrage transactions as derivative markets provide more routes for index arbitrageurs to trade. Other index trading strategies such as portfolio insurance and program trading may also contribute to the results. On the other hand, a deleted stock is not associated with changes in trading volume and volatility since it represents an ...
Date: December 2007
Creator: Lin, Cheng-I Eric

Crude Oil and Crude Oil Derivatives Transactions by Oil and Gas Producers.

Description: This study attempts to resolve two important issues. First, it investigates the diversification benefit of crude oil for equities. Second, it examines whether or not crude oil derivatives transactions by oil and gas producers can change shareholders' wealth. With these two major goals in mind, I study the risk and return profile of crude oil, the value effect of crude oil derivatives transactions, and the systematic risk exposure effect of crude oil derivatives transactions. In contrast with previous studies, this study applies the Goldman Sachs Commodity Index (GSCI) methodology to measure the risk and return profile of crude oil. The results show that crude oil is negatively correlated with stocks so adding crude oil into a portfolio with equities can provide significant diversification benefits for the portfolio. Given the diversification benefit of crude oil mixed with equities, this study then examines the value effect of crude oil derivatives transactions by oil and gas producers. Differing from traditional corporate risk management literature, this study examines corporate derivatives transactions from the shareholders' portfolio perspective. The results show that crude oil derivatives transactions by oil and gas producers do impact value. If oil and gas producing companies stop shorting crude oil derivatives contracts, company stock prices increase significantly. In contrast, if oil and gas producing companies start shorting crude oil derivatives contracts, stock prices drop marginally significantly. Thus, hedging by producers is not necessarily good. This paper, however, finds that changes in policy regarding crude oil derivatives transactions cannot significantly affect the beta of shareholders' portfolios. The value effect, therefore, cannot be attributed to any systematic risk exposure change of shareholders' portfolios. Market completeness, transaction costs, and economies of scale are identified as possible sources of value effect. The following conclusions have been obtained in this study. Crude oil provides significant diversification benefits ...
Date: December 2007
Creator: Xu, He

Does Underwriter Size Matter? Only Within the Right Context

Description: The initial matching relationships between underwriters and bonds/issuing firms and the certification quality of underwriters, as determined by changes in the issuing firm’s financial strength post issue, are the two primary research topics in this dissertation. Based on total underwriter syndicate market share, two distinct categories, low market power (LMP) syndicates and high market power (HMP) syndicates were defined. Firm financial strength is examined based on a new factor developed in this research. A comparison of the two underwriting categories, or pools, indicates that the HMP underwriters take on firms of lower initial financial strength and additionally, the issuing firms decline more in financial strength two years following bond issuance than do firms using LMP underwriters. Notwithstanding these results, the more interesting findings are the relationships within each of these pools. In the LMP pool of underwriters, financially stronger firms used the larger LMPs to underwrite their bonds, while the weaker firms used smaller LMPs. In contrast, among HMP underwriters, the largest HMPs aligned with the firms of relatively lower financial strength. The relationships in both pools reverse when changes in financial strength are examined. Larger LMPs are associated with greater issuing firm financial decline while larger HMPs correlate with lower levels of decline in firm financial strength. Divergent patterns in initial underwriter-issuer matching and underwriter certification found in this research indicate that there are true differences in the “small” underwriting syndicates as compared to the larger syndicates. These patterns should be considered by both issuing firms and investors as both constituencies contemplate the corporate bond market.
Date: May 2014
Creator: Kendall, Lynn K.

Economic Motivation of the Ex-Dividend Day Anomaly: Evidence from an Alternative Tax Environment

Description: Several studies have observed that stocks tend to drop by an amount that is less than the dividend on the ex-dividend day, the so-called ex-dividend day anomaly. However, there still remains a lack of consensus for a single explanation of this anomaly. Different from other studies, this dissertation attempts to answer the primary research question: How can investors make trading profits from the ex-dividend day anomaly and how much can they earn? With this goal, I examine the economic motivations of equity investors through four main hypotheses identified in the anomaly’s literature: the tax differential hypothesis, the short-term trading hypothesis, the tick size hypothesis, and the leverage hypothesis. While the U.S. ex-dividend anomaly is well studied, I examine a long data window (1975 to 2010) of Thailand data. The unique structure of the Thai stock market allows me to assess all four main hypotheses proposed in the literature simultaneously. Although I extract the sample data from two data sources, I demonstrate that the combined data are consistently sampled. I further construct three trading strategies: “daily return,” “lag one daily return,” and “weekly return” to alleviate the potential effect of irregular data observation. I find that the ex-dividend day anomaly exists in Thailand, is governed by the tax differential and is driven by short-term trading activities. That is, investors trade heavily around the ex-dividend day to reap the benefits of the tax differential. I find mixed results for the predictions of the tick size hypothesis and results that are inconsistent with the predictions of the leverage hypothesis. I conclude that, on the Stock Exchange of Thailand, juristic and foreign investors can profitably buy stocks cum-dividend and sell them ex-dividend while local investors should engage in short sale transactions. On average, investors who employ the daily return strategy have earned significant abnormal ...
Date: December 2011
Creator: Anantarak, Sarin

The Effect of Stock Splits on Small, Medium, and Large-sized Firms Before and After Decimalization

Description: This study examines the impact of reducing tick size and, in particular decimalization on stock splits. Based on previous studies, this study examines hypotheses in the following three areas: first, market reaction around stock split announcement and ex-dates, second, the effect of tick size on liquidity after stock split ex-dates, and third, the effect of tick size on return volatility after stock split ex-dates. The impact of tick size on market reaction around split announcement and ex-dates is measured by abnormal returns and buy and hold abnormal returns (BHARs). Also, this study investigates the long term impact of decimalization on market reaction for small, medium, and large firms for the three different tick size periods. The effect of tick size on liquidity after stock split ex-dates is measured by turnover, relative bid ask spread, and market maker count. The effect of tick size on return volatility around stock split announcement and ex-dates is measured by return standard deviation. Also, this study investigates the long term impact of decimalization on volatility after split ex-dates for small, medium, and large firms for three different tick size periods.
Date: December 2013
Creator: Jang, Seon Deog

Empirical Evidence of Pricing Efficiency in Niche Markets

Description: Unique and proprietary data of the illiquid, one-year non cancelable for three month Bermudan swaps (1Y NC 3M swaps) and one-year non callable for three months Bermudan CDs (1Y NC 3M CDs), provides evidence of market efficiency. The 1Y NC 3M swap and 1Y NC 3M CD markets efficiently reflected unexpected economic information. The 1Y NC 3M swaption premiums also followed the European one-year into three-month (1Y into 3M) swaption volatilities. Swaption premiums were computed by pricing non-optional instruments using the quoted 1Y NC 3M swap rates and the par value swap rates and taking the difference between them. Swaption premiums ranged from a slight negative premium to a 0.21 percent premium. The average swaption premium during the study period was 0.02 percent to 0.04 percent. The initial swaption premiums were over 0.20 percent while the final swaption premiums were 0.02 percent to 0.04 percent. Premiums peaked and waned throughout the study period depending on market uncertainty as reflected in major national economic announcements, Federal Reserve testimonies and foreign currency devaluations. Negative swaption premiums were not necessarily irrational or quoting errors. Frequently, traders obligated to provide market quotes to customers do not have an interest and relay that lack of interest to the customer through a nonaggressive quote. The short-dated 1Y NC 3M swaption premiums closely followed 3M into 1Y swaption volatilities, indicating the 3M into 1Y swaption market closely follows the 1Y NC 3M swaption market and that similar market factors affect both markets or both markets efficiently share information. Movements in 1Y NC 3M swaption premiums and in 3M into 1Y swaption volatilities reflected a rational response by market participants to unexpected economic information. As market uncertainty decreased in the market place, risk measured both by swaption premiums and swaption volatilities decreased; vice verse when economic factors showed ...
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Date: May 2000
Creator: Koch, Sandra Idelle

An Empirical Investigation of Portfolios with Little Idiosyncratic Risk

Description: The objective of this study is to answer the following research question: How large is a diversified portfolio? Although previous work is abundant, very little progress has been made in answering this question since the seminal work of Evans and Archer (1968). This study proposes two approaches to address the research question. The first approach is to measure the rate of risk reduction as diversification increases. For the first approach, I identify two kinds of risks: (1) risk that portfolio returns vary across time (Evans and Archer (1968), and Campbell et al. (2001)); and (2) risk that returns vary across portfolios of the same size (Elton and Gruber (1977), and O'Neil (1997)). I show that the times series risk reaches an asymptote as portfolio size increases. Cross sectional risk, on the other hand, does not appears to reach an asymptote as portfolio size increases. The second approach consists of comparing portfolios' performance to a benchmark portfolio that is assumed to be diversified (Statman (1987)). I develop a performance index. The performance index is calculated, for any given test portfolio, as the ratio of the Sharpe-like measure of the test portfolio to the Sharpe-like measure of the benchmark portfolio that is assumed to be diversified. The index is based on the intuition that an increase in portfolio size reduces times series risk and cross sectional risk, and increases transaction costs. Portfolio size is worth increasing as long as the marginal increase in the performance index from a decrease in risk is greater than the marginal decrease of the performance index from an increase in transaction costs. Diversification is attained when the value of the index reaches one. The results of my simulations indicate that the size of a well diversified portfolio is at the very least 30. This number can be ...
Date: May 2004
Creator: Benjelloun, Hicham

Empirical Tests of the Signaling and Monitoring Hypotheses for Initial Public Offerings

Description: The research questions investigated are: 1. Are the expected post-issue fractional holdings of the directors and officers, venture capitalists and institutions signals of firm value? 2. Are the expected post-issue fractional holdings of the directors and officers, venture capitalists and institutions signals of underpricing? and 3. Are the directors and officers, venture capitalists and institutions monitors of IPO investments? The signaling theory developed by Grinblatt and Hwang (1989) (GH) and the monitoring theory for IPO investments have been used to develop the hypotheses for this dissertation. Four factors make my methodology unique. These factors are: 1. I apply and test the GH IPO signaling model over a unique data set collected from the IPO prospectuses, proxy statements and annual reports; 2. I disaggregate the expected post-issue holdings of the different groups of pre-issue blockholders and insiders and hypothesizes that these individual groups represents signals of firm value and underpricing; 3. I hypothesize that these groups, in aggregate and separately, monitor IPO investments over the long term; And 4. I develop signaling and monitoring hypotheses to make predictions at the two stages of the IPO. The results show that firm value is positively related to the level of underpricing, at a given variance of the firms cash flows; the level of underpricing is positively related to the holdings of the directors and officers as a group and the aggregate of the directors and officers, VCs and institutions, at given variances of the firm's cash flows; the firm value is not related to the level of underpricing, at a given level of capital outlay and holdings of either the aggregate blockholders, directors and officers, VCs or institutions. For the monitoring hypotheses, the results show that the long-run buy-and-hold-returns are positively related to the investment bank reputation and the gross spread. Also, the ...
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Date: May 2006
Creator: Gordon, Sean Anthony Garnet

Institutional ownership and dividend policy: A framework based on tax clientele, information signaling and agency costs.

Description: This study is an empirical examination of a new theory that links dividends to institutional ownership in a framework of both information signaling and agency costs. Under this theory put forth by Allen, Bernardo and Welch in 2000, dividends are paid out to attract tax-favored institutional investors, thereby signaling good firm quality and/or more efficient monitoring. This is based on the premise that institutions are considered sophisticated investors with superior ability and stronger incentive to be informed about the firm quality compared to retail investors. On the agency level, institutional investors display monitoring capabilities, and can detect and correct managerial pitfalls, thus their presence serves as an assurance that the firm will remain well run. The study provides a comprehensive analysis of the implications of the theory by testing various aspects of the relationship between dividends and institutional holdings. Unlike the prevalent literature on this topic, I give specific attention to the different types of institutional investors and their incentives to invest in dividend paying stocks. Moreover, I analyze the signaling and the agency effects on the market reaction to dividend initiations within the framework proposed by the theory. Finally, I test the smoothing effect institutions have on dividends by examining the firm's propensity to increase dividends given the level of institutional ownership. I find institutional holders to respond positively to dividend initiation announcements as they adjust their portfolios by buying or increasing their holdings of the dividend paying stock following the announcement. I also find that this response is displayed more strongly among tax-favored institutions. My test results also reveal that positive abnormal returns to dividend initiation announcements are a decreasing function of institutional holdings in the dividend initiating firm, and that this mitigating effect of institutional ownership on the market reaction to dividend initiations is stronger for firms ...
Date: August 2008
Creator: Zaghloul Bichara, Lina

Reconciling capital structure theories in predicting the firm's decisions.

Description: Past literature attempts to resolve the issue of the motivation behind managers' choice of a given capital structure. Despite several decades of intensive research, there is still no consensus about which theory dominates capital structure decisions. The present study empirically investigates the relative importance of two prominent theories of capital structure- the trade-off and the pecking order theories by exploring the conditions under which each theory can explain the financing choices of firms. These conditions are defined along two dimensions: (i) a firm's degree of information asymmetry, and (ii) its observed leverage relative to target leverage. The results show that, in the short-run, pecking order theory has more explanatory power in explaining the financing choices of firms. The target leverage theory assumes limited importance: Over-leveraged firms, when faced with low adverse information, are more inclined to adapt to the trade-off policies. In the presence of high information asymmetry, however, firms appear to be more concerned about adverse selection costs and make financing decisions that are more consistent with the pecking order theory. An analysis of the market reaction to seasoned equity issuances during announcement periods reveals that firms with high information asymmetry are penalized more than firms with low information asymmetry. This may explain the contradiction when over-leveraged firms continue to issue debt. However, the situation is reversed in the long run. Firms' long term financing goals appear to follow the leverage re-balancing theory. An analysis of financial activities over a five-year period, subsequent to security issuance decisions when they appear to be inconsistent with trade-off theory, reveals that firms follow an active policy of moving closer to the target leverage. In sum, the notion of target capital structure appears to exist. In the short-term, the management's financing decisions are consistent with the modified version of the pecking order theory, ...
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Date: December 2006
Creator: Palkar, Darshana

Studies in Bank Contagion: Three Regulatory Events

Description: This research describes an analysis, using event-study methodology, of the reaction of the stock returns of a sample, drawn from the one-hundred largest bank holding companies, to certain actions of regulatory agencies. The first part of the analysis examines the reaction of the bank stocks to the closure of the Bank of New England, using cross-sectional variables not previously examined by other investigators. The second event considers the invalidation of interest-rate swap contracts by the British Law Lords, the highest court in Britain. The third case is an examination of the effects of actions taken to enforce the Community Reinvestment Act. All three events have significant abnormal returns in at least one sub-sample and event window. The results of the cross-sectional analysis and the lack of response to later events are consistent with market efficiency in the semi-strong form. The results are also consistent with the hypothesis that regulatory policies that emphasize consistency and banking system safety are desirable.
Date: May 1998
Creator: Springstube, Woodard R. (Woodard Rex)

Three Essays on Insurers’ Performance and Best’s Ratings

Description: This dissertation consists of three essays: essay 1, Underwriting Use of Credit Information and Firm Performance ‐ An Empirical Study of Texas Property‐Liability Insurers, essay 2, Prediction of Ratings in Property‐Liability Industry when The Organizational Form Is Endogenous, and essay 3, A Discussion of Parsimonious Methods Predicting Insurance Companies Ratings. The purpose of the first essay is to investigate the influence of underwriting use of credit information on variation in insurers’ underwriting performance. Specifically, this study addresses the following two research questions: first, what firm‐level characteristics are associated with the insurers’ decision to use credit information in underwriting? second, is there a relationship between the use of credit information and variation in insurers’ underwriting performance? The empirical results indicate that larger insurance companies, companies having more business in personal auto insurance, and those with greater use of reinsurance are more likely to use credit information in underwriting. More importantly, the results indicate that use of credit information is associated with lower variation in underwriting performance, consistent with the hypothesis that use of credit information enables insurers to better predict their losses. The purpose of the second essay is to resolve the inconsistent relationship between the organizational forms (i.e., stock versus mutual insurers) and insurers’ financial strength ratings. Specifically, this study takes into account the potential endogenous nature of organizational forms to investigate the influence of organizational forms on insurers’ financial strength ratings. The empirical results from the models employed indicate that the stock dummy variable is indeed a significant predictor of insurers’ ratings and that the relationship between the stock dummy and insurers’ financial strength ratings is not affected after the endogenous nature of organizational forms is considered. However, such relationship flips to be negative when additional rating predictors are included into the models. The purpose of the third essay ...
Date: May 2015
Creator: Huang, Jing‐Hui

Three Essays on the Effects of Equity Option Introduction

Description: This dissertation is structured as three essays on various aspects of equity option introduction. Topics addressed include the relative predictability of introduction, the relationship between predictability of introduction and the price effect associated with introduction, and a comparison of the price response of optioned versus nonoptioned stocks to changes in dividends. Essay 1 involves use of firm-specific variables in a LOGIT model to allow assignment of a probability of equity option introduction. Two samples were developed: one of firms that were optioned, the other of firms which met the objective standards but were not optioned. A LOGIT model is used to assign a probability of optioning to each firm. A holdout sample is used to test the out-of-sample predictive power of the model. Firms were correctly classified as optioned or nonoptioned in about 85 percent of cases. Various researchers have detected abnormal positive returns associated with stock option introduction. In an efficient market context, this would indicate that option introduction is "good" news to financial markets. If optioning is predictable, stocks with a higher probability of optioning would be expected to show less price response when options are introduced. In Essay 2, the relationship between the probability of optioning and abnormal returns is tested using a standard event methodology. Utilizing nonparametric statistics, no significant differences were detected among abnormal returns of portfolios formed on the basis of probability of option introduction. Essay 3 compares abnormal returns of optioned and nonoptioned stocks around announced dividend changes. Two samples were obtained. Firms in the first (second) sample had significant dividend changes while options were (were not) available on their stocks. Standard event methodology is used to compare price responses of the two samples. If the price response of optioned stocks is less pronounced than the price response of nonoptioned stocks, this may ...
Date: August 1996
Creator: Ragle, William F.

What insight do market participants gain from dividend increases?

Description: This study examines the reactions of market makers and investors to large dividend increases to identify the motives for dividend increases. Uniquely, this study simultaneously tests the signaling and agency abatement motivations as explanations of the impact of dividend increases on stock prices and bid-ask spreads. The agency abatement hypothesis argues that increased dividends constrict management's future behavior, abating the agency problem with shareholders. The signaling hypothesis asserts that dividend increases signal that managers expect higher or more stable cash flows in the future. Mean stock price responses to dividend increase announcements during 1995 are examined over both short ( _1, 0) and long ( _1, 504) windows. Changes in bid-ask spreads are examined over a short ( _1, 0) window and an intermediate (81 day) period. This study partitions dividend increases into a sample motivated by agency abatement and a sample motivated by cash flow signaling. Further, this study examines the agency abatement and cash flow signaling explanations of relative bid-ask spread responses to announcements of dividend increases. Estimated generalized least squares models of market reactions to sampled events support the agency abatement hypothesis over the cash flow signaling hypothesis as a motive for large dividend increases as measured by Tobin's Q and changes in the distribution of cash flows.
Date: May 2000
Creator: Ellis, R. Barry

Which version of the equity market timing affects capital structure, perceived mispricing or adverse selection?

Description: Baker and Wurgler (2002) define a new theory of capital structure. In this theory capital structure evolves as the cumulative outcome of past attempts to time the equity market. Baker and Wurgler extend market timing theory to long-term capital structure, but their results do not clearly distinguish between the two versions of market timing: perceived mispricing and adverse selection. The main purpose of this dissertation is to empirically identify the relative importance of these two explanations. First, I retest Baker and Wurgler's theory by using insider trading as an alternative to market-to-book ratio to measure equity market timing. I also formally test the adverse selection model of the equity market timing: first by using post-issuance performance, and then by using three measures of adverse selection. The first two measures use estimates of adverse information costs based on the bid and ask prices, and the third measure is based on the close-to-offer returns. Based on received theory, a dynamic adverse selection model implies that higher adverse information costs lead to higher leverage. On the other hand, a naïve adverse selection model implies that negative inside information leads to lower leverage. The results are consistent with the equity market timing theory of capital structure. The results also indicate that a naïve, as opposed to a dynamic, adverse selection model seems to be the best explanation as to why managers time equity issues.
Date: August 2004
Creator: Chazi, Abdelaziz