Essays in financial economics

In Part I we develop a model of entry in which an entrant with private information about its production cost and cost of entry has an opportunity to trade in the stock of a single incumbent before entry. We assume an efficient stock market populated by risk-neutral liquidity sellers who randomly trade each period. We construct a linear rational expectations equilibrium in which the optimal proportion of the incumbent\u27s stock to sell short or buy prior to entry, chosen by the entrant, depends on the value of its private information, the volatility of the liquidity trading, and the cost efficiency of the two firms. It is shown that informed trading allows the entrant to increase its expected profits from entry. It is also demonstrated that informed trading changes the output market structure. Finally, we show that informed trading non-trivially affects the expected producer surplus and the expected welfare of noise traders. In Part II we construct a general technique for the valuation of risky defaultable bonds based on the structural approach to the modeling of default risk. We show that a defaultable bond can be valued as a riskless one, provided that future cashflows from the bond are discounted at a credit risk-adjusted interest rate. We then apply the technique to value the Liquid Yield Option Note which is a zero-coupon, convertible, callable, puttable bond which is subject to default and interest rate risk. We examine to what extent and when the inclusion of these two types of risk in the valuation framework affects theoretical bond prices. We also investigate to what extent the embedded conversion and put options reduce the price sensitivity to the two sources of risk. We find that the omission of the default risk leads to an overvaluation of risky convertible bonds which is especially pronounced for non-puttable debt. We also find the pricing effects of the interest rate risk to be quite strong, especially when the riskless rate is expected to change. Finally, we demonstrate that the conversion and put option in general reduce bond price sensitivity to the fluctuations in the interest rate