Tests of a Signaling Hypothesis: The Choice between Fixed- and Adjustable-Rate Debt

Abstract

We develop a model wherein the choice between adjustable- and fixed-rate debt can serve as a signal of firm quality. The nature of the signal depends on expected inflation volatility relative to other risk parameters. Evidence from a matched sample of debt announcements over the period 1978 to 1986 shows a difference of − 2.05 p e r c e n t between stock price reactions to adjustable rate and fixed rate announcements when expected inflation volatility is above an estimated threshold. Below this threshold, the difference is + 0.98 p e r c e n t . The evidence supports the hypothesis that the riskier debt choice serves as a favorable signal of firm quality.