Essays on Strategic Behavior in Financial Markets

Abstract

This dissertation explores the role of strategic behavior in financial markets and highlights the effects of such behavior on portfolio choice, trading behavior and asset prices.

In Chapter 1 I study portfolio choice of strategic fund managers in the presence of a peer-based underperformance penalty. While the penalty generates herding behavior, correlated trading among managers is exacerbated when a strategic setting is considered. The equilibrium portfolios are driven by the least restricted manager, who may vary according to the realization of returns. I compare model predictions to evidence from the Colombian pension fund management industry, where six asset managers are in charge of portfolio allocation for the mandatory contributions of the working population. These managers are subject to a peer based underperformance penalty, known as the Minimum Return Guarantee (MRG). I study trading behavior by managers before and after a change in the strictness of the MRG in June 2007. The evidence suggests that a tighter MRG results in more trading in the direction of peers, a behavior that is more pronounced for underperforming managers. I show that these findings are consistent with the qualitative and quantitative predictions of the theoretical model.

In Chapter 2 I explore the limits to the allocational role of stock prices in a strategic setting. Stock prices are thought to help firms' managers make more efficient real investment decisions, because they aggregate information about fundamentals that is not otherwise known to managers. In this chapter I identify a limitation to this view. I show that if informed traders internalize that firms use prices as signal, stock price informativeness depends on the quality of managers' prior information. In particular, managers with low quality information would like to learn about their own fundamental by relying on the information aggregated in the stock price. However, in this case, the profitability of trading falls for informed speculators, who therefore reduce their trading volume, reducing the informativeness of prices. As a result, stock prices are not as useful to guide capital towards the most productive use, leading to inefficient investment decisions. Using a sample of U.S. publicly traded companies between 1990-2010, I document a positive correlation between the quality of managerial information and stock price informativeness. Contrary to the conventional view that less informed managers should rely more on stock prices when making investment decisions, I find no differences in the sensitivity of investment to stock price for different levels of managerial information. The evidence suggests that while firms do learn from prices, the learning channel and its effects on real investment are limited.