Essays on asset pricing

Abstract

This thesis explores the interplay between asset prices, the financial market, and the real economy. It aims to investigate the impact of the financial market on firms’ decisionmaking processes through three essays. These essays focus on analyzing risk factors, studying investor behavior in major financial markets, and examining the feedback effects between the financial market and the real economy. In the first essay coauthored with Sining Liu, Thomas Maurer, and Andrea Vedolin. We study the risk factors in the FX market. Contrary to existing literature, we establish that two factors, dollar and carry, suffice to explain a large cross-section of currency returns with R2s exceeding 80%. Our paper highlights the importance of accounting for time variation in conditional moments. Unconditional estimations that ignore this time variation mistakenly reject the two-factor model. We propose a parsimonious framework to estimate conditional currency factor models and provide testable restrictions. Our findings imply that currency markets are well described by a model in which (i) each country-specific SDF loads on one country-specific—dollar—and one global—carry— shock, and (ii) risk loadings are time-varying. Other risk factors proposed in the literature are useful to describe the time variation in dollar and carry factor risk premia. The second essay is coauthored with Tse-Chun Lin. We examine the investor behavior and the pricing pattern in the corporate bond market. We find that the lower the corporate bond minimum daily returns in the previous month, the higher the subsequent month’s excess returns in the cross-section. The annualized differences in one-month holding returns between the lowest and the highest minimum daily returns deciles are 6.24% and 6% for equal-weighted and value-weighted portfolios, respectively. This return predictability is stronger when the minimum daily return occurs on days closer to the month-end, suggesting that investors overextrapolate the extremely negative daily returns in corporate bond pricing. The return predictability is robust to controlling for other bond characteristics including, illiquidity, downside risk, idiosyncratic volatility, etc. In the third essay, I study the feedback effect of the financial market on the firms’ real investment decisions. I demonstrate that firm managers actively learn from their corporate bond prices when making capital investment decisions. The positive firm investment-bond q sensitivity is particularly pronounced when bonds are more liquid with greater incentives for informed trading. Conversely, the investment-bond q relationship negatively responds to the institutional sell-herding measure, which identifies non-fundamental-based price changes. Managers rely more on corporate bond prices in firms with larger leverage ratios. This corporate bond prices learning channel makes extra contributions alongside the equity learning channel, providing evidence of the better empirical predictability of bond prices on firms’ investment. Notably, the bond learning channels are more significant for firms of low rating, high-illiquid, closer to default, and with shorter maturity, suggesting that firm managers are learning the information about the firm’s default probability from the corporate bond investors.