Three essays on capital market with incomplete and asymmetric information

Abstract

This thesis includes one essay on incomplete information and two essays on

the capital market implications of asymmetric information.

The acquisition of information and its dissemination to all economic units are

central activities in capital markets. Limits to information diffusion may exist when

market participants have limited processing ability or when market structure causes

information asymmetry to persist. Merton (1987) proposes a simple capital market

equilibrium model with incomplete information, in which difference in a stock’s

investor recognition affects its cost of capital. Myers and Majluf (1984) lay out the

theoretical foundation for the role of asymmetric information in corporate finance

and its capital market implications.

The first essay tests and offers support to Merton’s (1987) theory. In the U.S.

market, using the breadth of ownership among retail investors as a proxy for investor

recognition, I show that a long-short portfolio based on the annual change of

shareholder base earns a compounded annual abnormal return of 6.42% after

controlling for the Fama-French three factors. These results are more pronounced

among young, low visibility and high idiosyncratic volatility stocks. Moreover, I

present evidence that the investor recognition effect can explain approximately 20%

of the puzzling net equity issuance effect documented by Pontiff and Woodgate

(2008).

The second essay suggests a novel signaling mechanism in the framework of

asymmetric information. When a firm’s convertible debt is issued, it is not only

determined by the fundamentals of the firm such as past stock performance, but also

related to whether this performance is realized during the tenure of current CEO who

decides the issues. I define the performance that the current CEO achieves in the firm

ever since the CEO comes to the helm as CEO-specific performance. Higher CEOspecific

performance leads to (1) a higher probability of convertible issues, and (2) a

less negative abnormal stock return in response to the convertible issue

announcement, controlling for other firm characteristics. These evidences indicate

that CEO-specific performance serves as a credible information signal to influence

the adverse selection costs between the firm and outside investors in convertible

bond financing.

The third essay explores the possibility of asymmetric information in

explaining the pronounced share issue anomaly in the cross-sectional variations of

stock returns, as documented by Pontiff and Woodgate (2008). A lot of equity share

issue and repurchase actions are actively determined by the decision of corporate

stakeholders, such as employees at the stock options exercises. As these stakeholders

hold a large amount of private information about the firm, it is in their optimal

decisions to try to time the exercise of their share purchase activity, but outside

investors are likely to fail to interpret the information revealed from these actions. I

present strong evidence that a negative relation between share issues and stock

returns is affected to a greater extent when the information asymmetry problem is

more severe.