Market timing hypothesis

From Wikipedia, the free encyclopedia

The market timing hypothesis is a theory about how firms and corporations in the economy decide whether to finance their investment with equity or with debt instruments. It is one of many such corporate finance theories, and is meant to be contrasted with the pecking order theory and the trade-off theory, for example. The market timing hypothesis, first expressed by Baker and Wurgler in 2002, states that the first order determinant of a corporation's capital structure, that is, the fractions of debt and equity in their liabilities, is the relative mis-pricing of these instruments at the time the firm needs to finance investment. In other words, firms do not generally care whether they finance with debt or equity, they just choose the form of financing which, at that point in time, seems to be more valued by financial markets.[1]

This theory can be classified as part of the behavioral finance literature, because it does not explain why there would be any asset mis-pricing, or why firms would be better able to tell when there was mis-pricing than financial markets. Rather it just assumes these mis-pricing exists, and describes the behavior of firms under the even stronger assumption that firms can detect this mis-pricing better than markets can.

The empirical evidence for this hypothesis is mixed. On the one hand Baker and Wurgler themselves show that an index of financing that reflects how much of the financing was done during hot equity periods and how much during hot debt periods is a good indicator of firm leverage. On the other hand, Aydogan Alti has shown that, if studied in terms of issuance events, the effect of market timing disappears after only two years.[2]

[edit] See also

[edit] References

  1. ^ Baker and Wurgler, "Market Timing and Capital Structure", the Journal of Finance, 2002. http://www.blackwellpublishing.com/content/BPL_Images/Journal_Samples/JOFI0022-1082~57~1~414%5C414.pdf
  2. ^ AYDOĞAN ALTI. "How Persistent Is the Impact of Market Timing on Capital Structure?", The Journal of Finance, 2006. http://www.blackwell-synergy.com/doi/abs/10.1111/j.1540-6261.2006.00886.x