Limits of Arbitrage and Corporate Financial Policy

Massimo Massa, Urs Peyer () and Zhenxu Tong

No 4829, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: We focus on an exogenous event that changes the cost of capital of a company ? the addition of its stock to the S&P 500 index ? and investigate how companies react to it by modifying their corporate financial and investment policies. This allows us to test capital structure theories in an ideal controlled experiment, where the effect of the index addition on the stock price is exogenous from a manager?s point of view. Consistent with both traditional theories and Stein?s (1996) market timing theory, we find more equity issues and increases in investment in response to higher index addition announcement returns. However, in the 24 months after the index addition, firms that issue equity and increase investment display negative abnormal returns and they perform worse than firms that issue but do not increase investment. This finding is consistent only with the market timing theory of Stein (1996) and supports a ?limits of arbitrage? story in which the stocks display a downward sloping demand curve and companies themselves act as ?arbitrageurs? taking advantage of the window of opportunity.

Keywords: Corporate financial policies; Limits of arbitrage; Market timing (search for similar items in EconPapers)
JEL-codes: G30 G31 G32 (search for similar items in EconPapers)
Date: 2005-01
New Economics Papers: this item is included in nep-fin and nep-fmk
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (13)

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