Contents

Why Include Warrants in New Equity Issues? A Theory of Unit IPOsTitle
Thomas J. Chemmanur and Paolo Fulghieri

Box Spread Arbitrage Profits following the 1987 Market Crash: Real or Illusory?
Michael L. Hemler and Thomas W. Miller, Jr.

Do Investors Ignore Dividend Taxation? A Reexamination of the Citizens Utilities Case
Jeff Hubbard and Roni Michaely

An Empirical Analysis of the Determinants of Corporate Debt Ownership Structure
Shane A. Johnson

Recovering an Asset's Implied PDF from Option Prices: An Application to Crude Oil during the Gulf Crisis
William R. Melick and Charles P. Thomas

Abstracts

We analyze myopic trader models of noisy prices in financial markets. Unlike extant analysis, such as De Long et al. (1990a), a classical equilibrium exists in our analysis, e.g., a riskless perpetuity is priced by arbitrage and its price does not vary with noise. A unique noisy equilibrium exists only when i) noise traders' beliefs are rational regarding volatility and irrational regarding expected returns, and ii) noise traders can hold infinite positions. In the absence of these strong assumptions, multiple noisy equilibria can coexist with the classical equilibrium, but these equilibria exhibit conflicting comparative statics. Furthermore, the price of a long-lived asset with risky cash flows can vary with noise even when investors are not myopic. One conclusion is that myopia is neither a necessary nor a sufficient condition for noisy prices. A second is that it is difficult, if not impossible, to use myopic trader models to derive implications for investment or regulatory policy.

Why Include Warrants in New Equity Issues? A Theory of Unit IPOs
Thomas J. Chemmanur and Paolo Fulghieri

We develop a theory of unit IPOs in which the firm going public issues a package of equity with warrants. We model an equity market where insiders have private information about the riskiness as well as the expected value of their firm's future cash flows. We demonstrate that, in equilibrium, high risk firms issue underpriced "units" of equity and warrants; lower risk firms, on the other hand, issue underpriced equity alone. In contrast to the existing literature, underpricing arises as a signal in our model in the context of a one-shot equity offering. Though developed in the context of IPOs, our model can also explain the issuance of seasoned equity offerings packaged with warrants. Further, the intuition behind the model generalizes readily to provide a new rationale for packaging call-option-like claims with risky securities other than equity, including convertible debt and debt with warrants.

Box Spread Arbitrage Profits following the 1987 Market Crash: Real or Illusory?
Michael L. Hemler and Thomas W. Miller, Jr.

We examine market efficiency before and after the 1987 Market Crash using the box spread strategy implemented with European-style S&P 500 Index (SPX) options. Before the Crash, apparent arbitrage opportunities were rare and simulated trades were unprofitable assuming a one-minute execution delay. After the Crash, apparent arbitrage opportunities were frequent and simulated trades were profitable even assuming a five-minute execution delay. Our analysis makes the routine assumption that quotes are good until updated to construct a time series of prevailing quotes sampled at 30-second intervals. If this assumption is valid, then arbitrage profits were actually available. If this assumption is invalid, then such profits could have been illusory. Either scenario, however, implies that SPX market efficiency decreased following the Crash--prevailing price quotes repeatedly failed to satisfy the fundamental parity relation underlying the box spread.

Do Investors Ignore Dividend Taxation? A Reexamination of the Citizens Utilities Case
Jeff Hubbard and Roni Michaely

Citizens Utilities Company (CU), Stamford, CT, has two classes of common stock, one paying cash dividends and one paying stock dividends. Unless CU shareholders ignore dividend taxation, the price of the cash dividend shares should increase relative to the stock dividend shares after the 1986 tax change. Contrary to this hypothesis, we find that the relative valuation of these two classes of shares was not permanently affected by the tax change. We do observe a pricing change around the time of the tax reform, but the effect is only temporary--the relative valuation before the tax change (1982-1984) and after (1987-1989) is almost equal. Two possible explanations for the observed valuation of the two stocks are clientele effects and differences in liquidity. We find that neither of these explanations can account for the relative pricing of the shares.

An Empirical Analysis of the Determinants of Corporate Debt Ownership Structure
Shane A. Johnson

I examine the relation between corporate debt ownership structure and several firm characteristics suggested by recent theory. The results demonstrate the importance of monitoring and information costs, the likelihood and costs of inefficient liquidation, and borrowers' incentives in affecting firms' debt source preferences. Several theoretical predictions receive support, while others do not. The results also suggest important differences between bank and private non-bank debt, which contrasts with most theoretical models. Additionally, I find evidence of systematic use of bank debt by firms with access to public debt, suggesting the benefits attributed to bank debt in theoretical models remain important after firms gain access to public debt markets. Although different lenders appear to have different maturity preferences, the results also suggest debt maturity and debt ownership decisions may be separable.

Recovering an Asset's Implied PDF from Option Prices: An Application to Crude Oil during the Gulf Crisis
William R. Melick and Charles P. Thomas

We develop a general method for estimating the implied, martingale equivalent, probability density function (PDF) for futures prices from American options prices. The early exercise feature of American options precludes expressing the price of the option in terms of the PDF. There exist tight bounds for the price of American options in terms of the PDF. We demonstrate how these bounds, together with observed option prices, can be used to estimate the parameters of the PDF. We estimate the distribution for crude oil during the Persian Gulf crisis and find the distribution differs significantly from that recovered using standard techniques.