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In Rememberance: World Trade Center (WTC)

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Eberhart, Allan C. and Richard J. Sweeney, "A Note on Noise in the Market for Bankrupt Firms' Securities", Journal of Banking & Finance, Vol. 20, No. 2, (March 1996), pp. 401-415.

Abstract: The well-documented phenomena of departures from the absolute priority rule (APR) have provoked an important public policy debate over their consequences. Some scholars argue that APR violations increase economic efficiency because they play an important role in the avoidance of inefficient liquidations and also mitigate inefficient risk incentives. Another group argues that APR violations should be abolished because they add greater uncertainty to the security valuation process; that is, they increase noise in security prices. To date, however, no evidence has been presented on the issue of how much noise APR violations add. We develop a theoretical model that allows an empirical test of the effect of APR violations on noise; our results suggest that APR violations importantly increase noise. Indeed, at least 30 percent, and as much as 85 percent of the noise in security prices may be attributable to APR violations. This does not suggest that the beneficial effects of APR violations are nonexistent or unimportant, but it does imply that failing to account for the effect of APR violations on noise in any modelling of optimal bankruptcy rules may lead to a suboptimal design. We also find that the amount of noise in this market appears to have declined over time as more institutional/informed investors have entered the market for bankrupt firms' securities and the effect of change in the bankruptcy law has become clearer, both consistent with the noisy rational expectations hypothesis.

JEL Classification: G33, G14.

Keywords: Bankruptcy, Noise, Absolute priority rule.