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Murray Z. Frank, Vidhan Goyal, and Tao Shen

The pecking order theory of corporate capital structure developed by states that issuing securities is subject to an adverse selection problem. Managers endowed with private information have incentives to issue overpriced risky securities. But they also understand that issuing such securities will result in a negative price reaction because rational investors, who are at an information disadvantage, will discount the prices of any risky securities the firm issues. Consequently, firms follow a pecking order: use internal resources when possible; if internal funds are inadequate, obtain external debt; external equity is the last resort. Large firms rely significantly on internal finance to meet their needs. External net debt issues finance the minor deficits that remain. Equity is not a significant source of financing for large firms. By contrast, small firms lack sufficient internal resources and obtain external finance. Although much of it is equity, there are substantial issues of debt by small firms. Firms are sorted into three portfolios based on whether they have a surplus or a deficit. About 15% of firm-year observations are in the surplus group. Firms primarily use surpluses to pay down debt. About 56% of firm-year observations are in the balance group. These firms generate internal cash flows that are just about enough to meet their investment and dividend needs. They issue debt, which is just enough to meet their debt repayments. They are relatively inactive in equity markets. About 29% of firm-year observations are in the deficit group. Deficits arise because of a combination of negative profitability and significant investments in both real and financial assets. Some financing patterns in the data are consistent with a pecking order: firms with moderate deficits favor debt issues; firms with very high deficits rely much more on equity than debt. Others are not: many equity-issuing firms do not seem to have entirely used up the debt capacity; some with a surplus issue equity. The theory suggests a sharp discontinuity in financing methods between surplus firms and deficit firms, and another at debt capacity. The literature provides little support for the predicted threshold effects. The theoretical work has shown that adverse selection does not necessarily lead to pecking order behavior. The pecking order is obtained only under special conditions. With both risky debt and equity being issued, there is often scope for many equilibria, and there is no clear basis for selecting among them. A pecking order may or may not emerge from the theory. Several articles show that the adverse selection problem can be solved by certain financing strategies or properly designed managerial contracts and can even disappear in dynamic models. Although adverse selection can generate a pecking order, it can also be caused by agency considerations, transaction costs, tax consideration, or behavioral decision-making considerations. Under standard tests in the literature, these alternative underlying motivations are commonly observationally equivalent.


Mahendrarajah Nimalendran and Giovanni Petrella

The most important friction studied in the microstructure literature is the adverse selection borne by liquidity providers when facing traders who are better informed, and the bid-ask spread quoted by market makers is one of these frictions in securities markets that has been extensively studied. In the early 1980s, the transparency of U.S. stock markets was limited to post-trade end-of-day transactions prices, and there were no easily available market quotes for researchers and market participants to study the effects of bid-ask spread on the liquidity and quality of markets. This led to models that used the auto-covariance of daily transactions prices to estimate the bid-ask spread. In the early 1990s, the U.S. stock markets (NYSE/AMEX/NASDAQ) provided pre-trade quotes and transaction sizes for researchers and market participants. The increased transparency and access to quotes and trades led to the development of theoretical models and empirical methods to decompose the bid-ask spread into its components: adverse selection, inventory, and order processing. These models and methods can be broadly classified into those that use the serial covariance properties of quotes and transaction prices, and others that use a trade direction indicator and a regression approach to decompose the bid-ask spread. Covariance and trade indicator models are equivalent in structural form, but they differ in parameters’ estimation (reduced form). The basic microstructure model is composed of two equations; the first defines the law of motion of the “true” price, while the second defines the process generating transaction price. From these two equations, an appropriate relation for transaction price changes is derived in terms of observed variables. A crucial point that differentiates the two approaches is the assumption made for estimation purposes relative to the behavior of order arrival, which is the probability of order reversal or continuation. Thus, the specification of the most general models allows for including an additional parameter that accounts for order behavior. The article provides a unified framework to compare the different models with respect to the restrictions that are imposed, and how this affects the relative proportions of the different components of the spread.