Three essays on capital market with incomplete and asymmetric information

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 ...