Larry J. Merville

Financial Policy and Market Expectations

If financial managers do indeed seek to maximize shareholder wealth, it is incumbent on them to know something of the effects of financial decisions on investor expectations. This article seeks to provide insight into how financial policy affects shareholder expectations, and presents some evidence regarding the relative importance of decisions concerning liquidity, investment, and financing. The first section of this article contains a brief discussion of previous research and introduces the capital asset pricing model-the model that facilitates explicit study of expectations. An intuitive explanation of why the financial, marketing, and production decisions of the firm affect investor expectations follows. Then a market expectation/financial decision model is formulated and tested using multiple regression analysis. A summary of results and implications concludes the article.

Stock-price volatility, mean-reverting diffusion, and noise

Abstract Using weekly call option prices on twenty-five stocks over a ten-year period (1975–1985) and calls on the S&P 500 stock-index futures, we find that ex ante market volatility follows a mixed mean-reverting diffusion with noise process. Changes in volatility are correlated across stocks and a marketwide volatility effect is found. Strong forces pull the volatility back to its long-term value. The findings suggest the development of new option pricing models.

An Analysis of the Underreported Magnitude of the Total Indirect Costs of Financial Distress

In this paper we examine 1,041 ongoing firms over the time period 1982–92. Using quarterly data for the detection and measurement of the magnitude of the indirect costs of financial distress, we find three important explanatory factors: (a) the distinctiveness of the pattern of increasing financial distress over time, (b) the degree of leverage in the capital structure and (c) the size of the firm. For those firms with a distinctive pattern of increasing financial distress over time, the average annual losses as a percentage of market value is −10.3%. The maximum loss is −76%. Even if the firm never fails, its market value can be severely impacted by the presence of the indirect costs of bankruptcy over time. This study finds a significantly positive relationship between Altmans Z-score and the firm capital investment growth rate. This relation holds after controlling for other variables such as leverage, firm size and market/book ratio. This implies that lost investment opportunities may be also an important part of the total indirect costs of financial distress, which appear now to be much larger than previously recorded.

Constitutional democracy and the theory of agency

A unanimously adopted democratic constitution is a contract between the people as principal and the government as agent. However, none of the incentive devices employed in private principal-agent contracting assure enforcement of a constitution. Under majority voting, candidates for the job of agent cannot win the job without promising tobreak the contract, and the agent cannot be re-elected unless he keeps that promise.

Identifying the Factor Structure of Equity Returns

A challenge for modern portfolio managers and security analysts is understanding the variables or factors that drive security returns. Statistical methods such as principal components analysis are useful but lack meaningful interpretations. Real economic factors comport with intuitive understanding but lack explanatory power. This study seeks to bridge the gap between these two approaches by interpreting “statistical factors” using economic factors. The authors examine the factor structure of equity portfolio returns widely used in a sample period from 1963 through 1999. They find there are three major factors for equity returns, which can be associated with 1) the market return; 2) market capitalization; and 3) the investment opportunity set. Higher–order factors can be uniquely identified with macroeconomic variables.

Monitoring, diversification and managerial incentive contracts

Abstract A principal-agent model is extended to examine the optimal incentive contract when the manager is motivated by both diversification in product lines and monitoring over subordinates.