Three Essays in Empirical Asset Pricing

The financial crisis of 2007-2008 led to extraordinary government intervention in firms and markets. The scope and depth of government action rivaled that of the Great Depression. Many traded markets experienced dramatic declines in liquidity leading to the existence of conditions normally assumed to be promptly removed via the actions of profit seeking arbitrageurs. These extreme events motivate the three essays in this work. The first essay seeks and fails to find evidence of investor behavior consistent with the broad 'Too Big To Fail' policies enacted during the crisis by government agents. Only in limited circumstances, where government guarantees such as deposit insurance or U.S. Treasury lending lines already existed, did investors impart a premium to the debt security prices of firms under stress. The second essay introduces the Inflation Indexed Swap Basis (IIS Basis) in examining the large differences between cash and derivative markets based upon future U.S. inflation as measured by the Consumer Price Index (CPI). It reports the consistent positive value of this measure as well as the very large positive values it reached in the fourth quarter of 2008 after Lehman Brothers went bankrupt. It concludes that the IIS Basis continues to exist due to limitations in market liquidity and hedging alternatives. The third essay explores the methodology of performing debt based event studies utilizing credit default swaps (CDS). It provides practical implementation advice to researchers to address limited source data and/or small target firm sample size.

Essays in asset price bubbles

This thesis studies the field of asset price bubbles. It is comprised of three independent chapters. Each of these chapters either directly or indirectly analyse the existence or implications of asset price bubbles. The type of bubbles assumed in each of these chapters is consistent with rational expectations. Thus, the kind of price bubbles investigated here are known as rational bubbles in the literature. The following describes the three chapters. Chapter 1: This chapter attempts to explain the recent US housing price bubble by developing a heterogeneous agent endowment economy asset pricing model with risky housing, endogenous collateral and defaults. Investment in housing is subject to an idiosyncratic risk and some mortgages are defaulted in equilibrium. We analytically derive the leverage or the endogenous loan to value ratio. This variable comes from a limited participation constraint in a one period mortgage contract with monitoring costs. Our results show that low values of housing investment risk produces a credit easing effect encouraging excess leverage and generates credit driven rational price bubbles in the housing good. Conversely, high values of housing investment risk produces a credit crunch characterized by tight borrowing constraints, low leverage and low house prices. Furthermore, the leverage ratio was found to be procyclical and the rate of defaults countercyclical consistent with empirical evidence. Chapter 2: It is widely believed that financial assets have considerable persistence and are susceptible to bubbles. However, identification of this persistence and potential bubbles is not straightforward. This chapter tests for price bubbles in the United States housing market accounting for long memory and structural breaks. The intuition is that the presence of long memory negates price bubbles while the presence of breaks could artificially induce bubble behaviour. Hence, we use procedures namely semi-parametric Whittle and parametric ARFIMA procedures that are consistent for a variety of residual biases to estimate the value of the long memory parameter, d, of the log rent-price ratio. We find that the semi-parametric estimation procedures robust to non-normality and heteroskedasticity errors found far more bubble regions than parametric ones. A structural break was identified in the mean and trend of all the series which when accounted for removed bubble behaviour in a number of regions. Importantly, the United States housing market showed evidence for rational bubbles at both the aggregate and regional levels. In the third and final chapter, we attempt to answer the following question: To what extend should individuals participate in the stock market and hold risky assets over their lifecycle? We answer this question by employing a lifecycle consumption-portfolio choice model with housing, labour income and time varying predictable returns where the agents are constrained in the level of their borrowing. We first analytically characterize and then numerically solve for the optimal asset allocation on the risky asset comparing the return predictability case with that of IID returns. We successfully resolve the puzzles and find equity holding and participation rates close to the data. We also find that return predictability substantially alter both the level of risky portfolio allocation and the rate of stock market participation. High factor (dividend-price ratio) realization and high persistence of factor process indicative of stock market bubbles raise the amount of wealth invested in risky assets and the level of stock market participation, respectively. Conversely, rare disasters were found to bring down these rates, the change being severe for investors in the later years of the life-cycle. Furthermore, investors following time varying returns (return predictability) hedged background risks significantly better than the IID ones.

Is financial instability male-driven? Gender and cognitive skills in experimental asset markets

The hypothesis that price stability would reliably increase with the fraction of women operating in financial markets has been frequently suggested in policy discussions. To test this hypothesis we conducted 10 male-only, 10 female-only and 10 mixed-gender experimental asset markets, and compared the effects of gender composition, confidence, risk attitude and cognitive skills. Male and female markets have comparable volatility and deviations from fundamentals, whereas mixed-gender markets are substantially more stable. On the other hand, higher average cognitive skills of the group are associated with reduced market volatility. Individual-level analysis shows that subjects with higher cognitive skills trade at prices closer to fundamental values and earn significantly higher profits; similarly, mixed markets exhibit lower mispricing, particularly for traders with lower cognitive skills. Our results are demonstrated to hold in other experimental asset market studies, suggesting that a mixed-gender composition reduces mispricing across different types of asset markets.

Asset Price Instability and Policy Responses: The Legacy of Liberalisation

The debate about the dynamics and potential policy responses to asset inflation has intensified in recent years. Some analysts, notably Borio and Lowe, have called for 'subtle' changes to existing monetary targeting frameworks to try to deal with the problems of asset inflation and have attempted to developed indicators of financial vulnerability to aid this process. In contrast, this paper argues that the uncertainties involved in understanding financial market developments and their potential impact on the real economy are likely to remain too high to embolden policy makers. The political and institutional risks associated with policy errors are also significant. The fundamental premise that a liberalised financial system is based on 'efficient' market allocation cannot be overlooked. The corollary is that any serious attempt to stabilize financial market outcomes must involve at least a partial reversal of deregulation.

Is the Australian wool futures market efficient as a predictor of spot prices?

Giles and Goss (1980) have suggested that, if a futures market provides a forward pricing function, then it is an efficient market. In this article a simple test for whether the Australian Wool Futures market is efficient is proposed. The test is based on applying cointegration techniques to test the Law of One Price over a three, six, nine, and twelve month spread of futures prices. We found that the futures market is efficient for up to a six-month spread, but no further into the future. Because futures market prices can be used to predict spot prices up to six months in advance, woolgrowers can use the futures price to assess when they market their clip, but not for longer-term production planning decisions. (C) 1999 John Wiley & Sons, Inc.

Qualitative assessment of stock prices listed on the Sao Paulo stock exchange: An approach from the perspective of homogeneity analysis

The stock market suffers uncertain relations throughout the entire negotiation process, with different variables exerting direct and indirect influence on stock prices. This study focuses on the analysis of certain aspects that may influence these values offered by the capital market, based on the Brazil Index of the Sao Paulo Stock Exchange (Bovespa), which selects 100 stocks among the most traded on Bovespa in terms of number of trades and financial volume. The selected variables are characterized by the companies` activity area and the business volume in the month of data collection, i.e. April/2007. This article proposes an analysis that joins the accounting view of the stock price variables that can be influenced with the use of multivariate qualitative data analysis. Data were explored through Correspondence Analysis (Anacor) and Homogeneity Analysis (Homals). According to the research, the selected variables are associated with the values presented by the stocks, which become an internal control instrument and a decision-making tool when it comes to choosing investments.

Adjusting prices in the multiple-partners assignment game

Starting with an initial price vector, prices are adjusted in order to eliminate the excess demand and at the same time to keep the transfers to the sellers as low as possible. In each step of the auction, to which set of sellers should those transfers be made is the key issue in the description of the algorithm. We assume additively separable utilities and introduce a novel distinction by considering multiple sellers owing multiple identical objects and multiple buyers with an exogenously defined quota, consuming more than one object but at most one unit of a seller`s good and having multi-dimensional payoffs. This distinction induces a necessarily more complicated construction of the over-demanded sets than the constructions of these sets for the other assignment games. For this approach, our mechanism yields the buyer-optimal competitive equilibrium payoff, which equals the buyer-optimal stable payoff. The symmetry of the model allows to getting the seller-optimal stable payoff and the seller-optimal competitive equilibrium payoff can then be also derived.