Finance Theses and Dissertations
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Item Essays on Market Microstructure and Asset Pricing(2019) Hu, Bo; Kyle, Albert S; Loewenstein, Mark V; Business and Management: Finance; Digital Repository at the University of Maryland; University of Maryland (College Park, Md.)This dissertation contains three essays that explore various topics in market microstructure and asset pricing. These topics include statistical arbitrage, algorithmic trading, market manipulation, and term-structure modeling. Chapter 1 studies a model of statistical arbitrage trading in an environment with fat-tailed information. I show that if risk-neutral arbitrageurs are uncertain about the variance of fat-tail shocks and if they implement max-min robust optimization, they will choose to ignore a wide range of pricing errors. Although model risk hinders their willingness to trade, arbitrageurs can capture the most profitable opportunities because they follow a linear momentum strategy beyond the inaction zone. This is exactly equivalent to a famous machine-learning algorithm called LASSO. Arbitrageurs can also amass market power due to their conservative trading under this strategy. Their uncoordinated exercise of robust control facilitates tacit collusion, protecting their profits from being competed away even if their number goes to infinity. This work sheds light on how algorithmic trading by arbitrageurs may adversely affect the competitiveness and efficiency of financial markets. Chapter 2 extends the basic model in Chapter 1 by considering an insider who strategically interacts with a group of algorithmic arbitrageurs who follow machine-learning-type trading strategies. When market liquidity is good enough, arbitrageurs may be induced to trade too aggressively, giving the insider a reversal trading opportunity. In this case, the insider may play a pump-and-dump strategy to trick those arbitrageurs. This strategy is very similar to those controversial trading practices (such as momentum ignition and stop-loss hunting) in reality. We show that such strategies can largely distort price informativeness and threaten market stability at the expense of common investors. This study reveals a list of economic conditions under which this type of trade-based manipulations are likely to occur. Policy implications are discussed as well. Chapter 3 provides a simple proof for the long-run pricing kernel decomposition developed by Hansen and Scheinkman (Econometrica, 2009). In a stationary Markovian economy, the long forward rate should be flat so that the pricing kernel can be easily factorized in a multiplicative form of the transitory and permanent components. The permanent (martingale) component plays a key role as it induces the change of probabilities to the long forward measure where the long-maturity discount bond serves as the numeraire. I derive an explicit expression for this martingale component. It reveals a strong restriction on the market prices of risk in a popular approach of interest rates modeling. This approach neglects the permanent martingale component and restricts risk premia in a way undesirable for model calibration. Further analysis demonstrates the advantages of equilibrium modeling of a production economy since it is featured with a path-dependent pricing kernel that has a non-degenerate permanent martingale.Item ESSAYS ON INFORMATION PRODUCTION AND DIFFUSION IN FINANCIAL MARKETS(2019) Collina, Stefano; Heston, Steven L; Business and Management: Finance; Digital Repository at the University of Maryland; University of Maryland (College Park, Md.)This dissertation contains two essays that study the information produced by equity analysts and how the diffusion, or lack thereof, of this information affects financial markets. In the first essay, "Does the Precision of Equity Analysts Matter? Evidence from the Textual Content of Analysts’ Reports", I propose that analyst’s precision and opinion jointly explain a range of market outcomes, including returns, volume, and volatility, of the publication of an analyst report. I construct a novel measure of precision based on textual analysis of equity analysts’ reports. I find that for pessimistic reports, higher precision is associated with a significantly larger negative price reaction. Moreover, the higher precision is associated with higher abnormal turnover, higher volatility, and lower change in uncertainty. However, precision is not significantly or only weakly correlated with market reaction for optimistic reports. I argue that this dichotomy is a result of the well-known optimism bias of equity analysts and of a tendency of analysts to inflate the precision of more optimistic reports. I also show that the relation between precision and price reaction varies depending on the information environment and on textual characteristics of the analyst report. In the second essay, "Information Asymmetry, Agency Conflicts, and the Cost of Capital", I study the causal relation between information asymmetry and the cost of capital employing the exogenous increase in information asymmetry caused by the loss of equity analysts due to brokers’ closures or mergers, In particular, I focus on understanding how information asymmetry differentially affects the cost of debt and the cost of equity and how managerial and debt agency conflicts affect this relation. I find that an increase in information asymmetry results in higher cost of equity (debt) when the shock is greater and when incentives to engage in debt-equity wealth transfers are low (high). These results suggest that for some firms, differently from what usually assumed, the cost of debt can actually be more sensitive than the cost of equity. I argue that these findings are consistent with the hypothesis that an information asymmetry increase is not necessarily costly for shareholders, since it can facilitate debt-equity wealth transfers that can reduce equity risk.Item Essays on Market Microstructure and Asset Pricing(2017) Chen, Wen; Kyle, Albert S; Business and Management: Finance; Digital Repository at the University of Maryland; University of Maryland (College Park, Md.)This dissertation contains two essays exploring the asset pricing implications of asymmetric information, hedging and market making. Chapter 1 studies position limits on strategic speculators in commodity futures. In this chapter I develop an equilibrium model with both spot and futures markets to evaluate the effects of speculative position limits proposed by commodity regulators. One of the main implications of this model is that the imperfectly competitive speculators can benefit from the limits at the expense of unconstrained market participants. Therefore, it is important to take into account the market competitiveness when setting position limits. I also find that the limits always reduce market liquidity and thereby increase the cost of hedging. Thus, position limits would benefit market makers but hurt hedgers. Moreover, the loss of liquidity due to the limits has a spillover effect on the spot market as futures prices reveal less information which makes all spot market participants worse off. Contrary to regulators' beliefs, the model suggests that an aggregate position limit may reduce speculators' competition and market liquidity even when the limit does not bind. The model provides an alternative explanation of magnet effect of position limits, which is imperfect competitive speculators tend to exert their market power to make the limits bind. Chapter 2 (joint with Yajun Wang) studies dynamic of market making and asset pricing. In this chapter, we develop a dynamic model of market making with asymmetric information where imperfectly competitive market makers match offsetting trades and carry zero inventory over time. Our model captures key features of market making in many financial markets: market makers optimally facilitate trading in both bid and ask markets by adjusting bid and ask prices and they hold close-to-zero inventories at the end of the day. We solve for equilibrium bid/ask prices and market depths in closed-form, and examine how informed traders dynamically hedge liquidity shocks and reveal private information. We further study the dynamics of bid-ask spread and trading volume to understand how these may interact with each other in shaping asset prices and market liquidity.Item Essays in Corporate Finance(2017) Hu, Xiaoyuan; Maksimovic, Vojislav; Business and Management: Finance; Digital Repository at the University of Maryland; University of Maryland (College Park, Md.)This dissertation presents two essays about corporate finance, product market, and corporate governance. The first essay shows that, depending on product market structure, firms adjust executive compensation differently in response to shocks to firm risk. Using a natural experiment that increases firm risk due to discoveries of carcinogens, I find that treated firms increase CEO risk-taking incentives to mitigate underinvestment. This result is mainly driven by treated firms in less affected industries, which suggests that firms respond to shocks more strongly when fewer rivals face the same shock, and extends existing work on executive compensation adjustments based on industry-level analyses. The second essay provides evidence that the effect of product market competition on corporate performance depends on the overlap in customer base. Competition between firms supplying to a same customer mitigates the decline in firms' operating performance after the passage of a business combination law. This finding is more evident when the common customer is the only major customer or when firms produce specific inputs. In addition, competition between firms supplying to different customers has little effect on firm performance. These results highlight the impact of the structure of production cluster, defined as a group of same-industry firms that supply to a same customer, on corporate outcomes.Item Essays in Corporate Finance(2016) Bowen III, Donald Eugene; Faulkender, Michael; Business and Management: Finance; Digital Repository at the University of Maryland; University of Maryland (College Park, Md.)This dissertation is comprised of three essays about investment, technology transfer, and corporate governance mandates. The first essay, “Patent Acquisition, Investment, and Contracting”, examines the transfer of intellectual property via the secondary market for patents and asks how patent acquisitions interact with firm investment policy. I find that patent acquirers subsequently invest in more R&D, increase internal patenting, and eventually make new investments in CAPX. Firms with more technological expertise and investment opportunities acquire more patents. Patent sales are the dominant type of contract and maximize investment incentives; patent licenses frequently contain royalties, which induce underinvestment problems. Nevertheless, licensing can be explained in part by financial and strategic considerations. Licensing is more likely when buyers become financially constrained, when revenue can be shifted to low tax sellers, and when the buyer is a competitor acquiring rights to a valuable patent. Overall, these results suggest patent acquisitions are motivated by the pursuit of investment synergies, rather than innovation substitution, commercialization motives, or legal threats. The second essay, “What's your Identification Strategy? Innovation in Corporate Finance Research”, co-authored with Laurent Fresard and Jerome P. Taillard, studies the diffusion of techniques designed to identify causal relationships in corporate finance research. We estimate the diffusion started in the mid-nineties, lags twenty years compared to economics, and is now used in the majority of corporate finance articles. Consistent with recent theories of technology diffusion, the adoption varies across researchers based on individuals' expected net benefits of adoption. Younger scholars, holders of PhDs in economics, and those working at top institutions adopt faster. Adoption is accelerated through networks of colleagues and alumnis and is also facilitated by straddlers who cross-over from economics to finance. Our findings highlight new forces that explain the diffusion of innovation and shape the norms of academic research. The third essay, “Were non-independent boards really captured before SOX?”, exploits the legal implementation of rules used by the major US stock exchanges following Sarbanes-Oxley (SOX) to study the pre-SOX optimality of board structure. The rules allowed firms to change the legal independence of their board without changing personnel by reclassifying a director from non-independent to independent. Many firms required to change their board structure used reclassification in order to minimize the alterations they made to their pre-SOX board structure, and I call these “placebo firms”. This observation makes feasible a DDD test that identifies the effect of the mandate by comparing treatment firms to placebo firms. Consistent with the view that boards are chosen optimally, real outcomes (profitability) are better for placebo firms than treatment firms. The magnitude of the difference, 4.9 percentage points, is economically meaningful, implying that the constraint is a significant impediment to the conduct of firms targeted by the regulations. Increased profitability is accounted for by increased revenue and typically flat expenses, including investment levels.Item Essays in Corporate Finance(2017) Duquerroy, Anne Nicole; Faulkender, Michael W; Business and Management: Finance; Digital Repository at the University of Maryland; University of Maryland (College Park, Md.)This dissertation presents two essays in Corporate Finance. In the first essay, I study how political institutions affect corporate investment through the policy uncertainty channel. I examine investment response to changes in the ability of the governing party to implement its political agenda due to checks and balances. I use US gubernatorial elections from 1978 to 2010 and a regression discontinuity design to estimate the causal effects of giving a single party full versus split control over a state government. I find that shifts from a divided to a unified government depress investment and job creation. Investment drops by an average of 3 to 5 percent in the year after the election giving a single party control of the government. The effect is not limited to public firms, is stronger for firms operating in a single state and firms with more irreversible investment. The findings support the hypothesis that moving from divided to unified government translates into policy uncertainty, which in turn affects the investment and employment cycles. The second essay is joint with William Mullins and Christophe Cahn. How to support private lending to SMEs during aggregate contractions is a crucial but still open policy question. This paper exploits an unexpected drop in 2012 in the cost of funding bank loans to some firms but not others in France to uncover how banks adjust their SME lending portfolios in a crisis. The cost reduction causes bank debt to rise and payment defaults with suppliers to fall, providing evidence that funding cost can be an effective policy lever. The effect is driven by firms with only one bank relationship, a numerous but understudied group. The size of the effect varies, with additional credit flowing to firms with stronger observables, to high growth firms, to firms with high demand, and to firms with a deeper banking relationship. Further, a richer relationship appears to substitute for stronger observables in the lending decision. Finally, we provide suggestive evidence that, compared to multi-bank firms, single bank firms are particularly credit constrained in crisis periods.Item Essays on Financial Constraints, R&D Investments, and Competition(2016) Lin, Danmo; Mathews, Richmond D; Loewenstein, Mark; Business and Management: Finance; Digital Repository at the University of Maryland; University of Maryland (College Park, Md.)This dissertation consists of two chapters of theoretical studies that investigate the effect of financial constraints and market competition on research and development (R&D) investments. In the first chapter, I explore the impact of financial constraints on two different types of R&D investments. In the second chapter, I examine the impact of market competition on the relationship between financial constraints and R&D investments. In the first chapter, I develop a dynamic monopoly model to study a firm’s R&D strategy. Contrary to intuition, I show that a financially constrained firm may invest more aggressively in R&D projects than an unconstrained firm. Financial constraints introduce a risk that a firm may run out of money before its project bears fruit, which leads to involuntary termination on an otherwise positive-NPV project. For a company that relies on cash flow from assets in place to keep its R&D project alive, early success can be relatively important. I find that when the discovery process can be expedited by heavier investment (“accelerable” projects), a financially constrained company may find it optimal to “over”-invest in order to raise the probability of project survival. The over-investment will not happen if the project is only “scalable” (investment scales up payoffs). The model generates several testable implications regarding over-investment and project values. In the second chapter, I study the effects of competition on R&D investments in a duopoly framework. Using a homogeneous duopoly model where two unconstrained firms compete head to head in an R&D race, I find that competition has no effect on R&D investment if the project is not accelerable, and the competing firms are not constrained. In a heterogeneous duopoly model where a financially constrained firm competes against an unconstrained firm, I discover interesting strategic interactions that lead to preemption by the constrained firm in equilibrium. The unconstrained competitor responds to its constrained rival’s investment in an inverted-U shape fashion. When the constrained competitor has high cash flow risk, it accelerates the innovation in equilibrium, while the unconstrained firm invests less aggressively and waits for its rival to quit the race due to shortage of funds.Item Essays in Corporate Finance(2016) Starkweather, George Austin; Maksimovic, Vojislav; Faulkender, Michael; Business and Management: Finance; Digital Repository at the University of Maryland; University of Maryland (College Park, Md.)Prior research has been divided regarding how firms respond to bankruptcy risk, largely revolving around two competing forces. On the one hand, asset substitution encourages firms to increase the riskiness of assets to extract value from creditors. On the other, firms want to minimize bankruptcy risk, either by reducing cash flow risk or through increasing the size of the firm. I test these two theories using a natural experiment of chemicals used in production processes being newly identified as carcinogenic to explore how firms may respond to potential negative cash flow resulting from litigation risk. I use plantlevel chemical data to study firm exposure to risk. I examine how responses between firms of differing levels of chemical exposure may vary within the industry, how firm financial distress affects firm response and whether public and private firms respond differently. In general, my research provides support for the asset substitution theory. My first paper studies how investment response varies based on level of carcinogenic exposure. I find that firms with moderate levels of exposure make efforts to mitigate their cash flow risk and reduce their exposure. At the same time, firms with high levels of exposure increase their exposure and riskiness of future cash flows. These findings are consistent with asset substitution theory. My second paper analyzes the interaction of financial distress and risk exposure. I find that firms in a stronger financial position are more likely to limit their exposure by reducing the number of exposed facilities. On the other hand, not only do firms in weaker financial position not decrease their exposure, I find that, in some instances, they increase their exposure to carcinogens. This work again supports the theory of asset substitution. Finally, in my third paper, I explore if public firms respond differently to a potential negative cash flow shock than do private firms. I test whether existing public firms are more likely to attempt to minimize their cash flow risk and thus reduce their carcinogen exposure than are private firms. I do not find evidence that public firms respond differently to this shock than do private firms.Item ESSAYS ON MARKET MICROSTRUCTURE(2015) BAE, KYOUNG HUN; Kyle, Albert S.; Business and Management: Finance; Digital Repository at the University of Maryland; University of Maryland (College Park, Md.)This dissertation includes two essays on topics related to market microstructure. In the first essay, we analyze algorithmic trading in the Korean Index Futures market. We document that short-term traders consistently anticipate the order flow of large traders that build large positions within a short period of time. We study trade-by-trade data around 36,164 trades by large traders among the largest 1% of all active trades during 66 trading days in 2009 from the Korean Index Futures market. We find that large traders manage their orders first by executing small, positively correlated trades, which are followed by a single large trade. While the small trades are executed, short-term traders gradually increase their inventories in the direction of the forthcoming large trade. After the execution of the large trade, short-term traders unload their inventories to other traders. We find that short-term traders correctly anticipate the direction of large trades 56.06% of the time. Furthermore, the aggregate positions of short-term traders are statistically significant predictors for the direction of large trades that will arrive within 120 seconds. In the second essay, we explore market microstructure invariance in the Korean stock market. We define the number of buy-sell “switching points” based on the number of times that individual traders change the direction of their trading. Based on the hypothesis that switching points take place in business time, market microstructure invariance predicts that the aggregate number of switching points is proportional to the 2/3 power of the product of dollar volume and volatility. Using trading data from the Korea Exchange (KRX) from 2008 to 2010, we estimate the exponent to be 0.675 with standard error of 0.005. Invariance explains about 93% of the variation in the logarithm of the number of switching points each month across stocks.Item Short-Term Funding Markets and Systemic Risk(2015) Munyan, Benjamin Kendrick; Kyle, Albert S; Wermers, Russell R; Business and Management: Finance; Digital Repository at the University of Maryland; University of Maryland (College Park, Md.)This dissertation presents two essays to study both theoretically and empirically the interaction of short-term funding and the banking system and its effects on systemic risk. Before its collapse in September 2008, Lehman Brothers had been using the repurchase agreement (repo) market to hide up to $50 billion from their balance sheet at the end of each quarter. When this "Repo 105" scheme was uncovered (a type of strategy called window dressing), the Securities and Exchange Commission conducted an inquiry into public US financial institutions and concluded that Lehman was an isolated case. Using confidential regulatory data on daily repo transactions from July 2008 to July 2014, in my first essay, I show that non-US banks continue to remove an average of $170 billion from the US tri-party repo market every quarter-end. This amount is more than double the $76 billion market-wide drop in tri-party repo during the turmoil of the 2008 financial crisis and represents about 10% of the entire tri-party repo market. Window dressing induced deleveraging spills over into agency bond markets and money market funds and affects market quality each quarter. Demand deposit contracts provide liquidity to investors; however by their nature they can expose the issuer to self-fulfilling runs. Existing models treat depositors as agents facing uncertain liquidity shocks, who seek to insure against that liquidity risk through use of a bank financed solely by deposits. Welfare-reducing bank runs then arise from the inherent difficulties depositors face in coordinating their withdrawals. My second essay extends the classic model of Diamond & Dybvig (1983) to allow for a more realistic mixed capital structure where the bank's investments are partly financed by equity, and where differing incentives between shareholders and depositors are allowed to operate. I also further extend the model to allow shareholders to choose the level of risk in bank-financed projects. I compute the ex-ante probability of a bank run in consideration of the bank capital ratio, and I additionally compute the level of bank risk chosen by utility-maximizing shareholders who are disciplined by uncoordinated depositors. I find that even in the absence of bank negotiating power of the form in Diamond & Rajan (2000), banks can be welfare-improving institutions, and there exists a socially optimal level of bank capital. I consider the policies of a minimum capital requirement, deposit insurance, and suspension of convertibility, and provide guidance on creating optimal bank regulation. I show that the level of bank capital involves a tradeoff between sharing portfolio risk and sharing liquidity risk. Increased bank capital results in less risk-sharing between shareholders and depositors. The demand deposit contract disciplines the bank and its shareholders, and equity capital in effect disciplines the depositors (by making runs less likely). There is a socially optimal level of natural bank capital, even when I make no further social planner restrictions on bank portfolio choice in the model.
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