A Generalized Econometric Model and Tests of a Signalling Hypothesis with Two Discrete Signals.

To test the major prediction of a signalling hypothesis-that the market price is m onotonic in the signal-the price response to the signal must be measu red. Since a signal is an outcome of a rational decision rule of the signaller, the market can infer the true type of the signaller from t he signal. This necessitates estimation of the price response to the signal, conditional on the rational decision rule. Thus, the empirica l models (e.g., event studies in corporate finance) that estimate the market price responses to signals without conditioning on the ration al decision rules are misspecified if viewed as tests of the predicti on of a signalling hypothesis. This paper builds a generalized econom etric model with two possible discrete signals, derives the rational decision rules, presents a simple estimator of the price response to a signal, and illustrates its use in testing a recently expounded hyp othesis that firms signal their true value by forcing or not forcing an outstanding convertible bond. Copyright 1988 by American Finance Association.