The essays empirically show the impact of investors speculation and disagreements on the returns and trading volume of securities. The results also shed light on the central issues of price formation and investors’ trading motives in security markets. The first essay investigates whether the trading activities of retail investors affect option prices through volatility speculation. This essay empirically shows that higher retail trading proportions are related to lower delta-hedged option returns. The phenomenon is more pronounced before earnings announcements and among stocks with more time-varying and positively skewed volatility. The results suggest that retail investors speculate and pay a lottery premium on the expected future volatility, resulting in more expensive options in terms of higher implied volatilities. This systematic deviation of option-implied volatility from realized volatility suggests retail investor clientele as a behavioral-based driving force of volatility risk premium. The second essay investigates the motive of option trading. It is shown that option trading is mostly driven by differences of opinion, a finding different from the current literature that attempts to attribute option trading to information asymmetry. First, option trading around earnings announcements is speculative in nature and mostly dominated by small, retail investors. Second, around earnings announcements, option turnovers do not predict stock returns, once prior stock returns are controlled for. Third, regression results reveal that option trading is also significantly explained by differences of opinion at ordinary times. While informed trading is present in stocks, it is not detected in options. The third essay provides strong evidence of reduction in informational efficiency when there are short-sale constraints and disagreements. Post earnings announcement returns are found to be significantly lower for stocks with more dispersed opinions and stocks that are exogenously short-sale prohibited by the Hong Kong Stock Exchange, supporting Miller’s (1977) overvaluation hypothesis. The results also suggest short-sale constraint as an explanation to negative post earnings announcement drift.

In this thesis I study two fields of empirical finance: market integration and economic forecasting. The first two chapters focus on studying regional integration of Mexican and U.S. equity markets. In the third chapter, I propose the use of the daily term structure of interest rates to forecast inflation. Each chapter is a free-standing essay that constitutes a contribution to the field of empirical finance and economic forecasting. In Chapter 1, I study the ability of multi-factor asset pricing models to explain the unconditional and conditional cross-section of expected returns in Mexico. Two sets of factors, local and foreign factors, are evaluated consistent with the hypotheses of segmentation and of integration of the international finance literature. Only one variable, the Mexican U.S. exchange rate, appears in the list of both foreign and local factors. Empirical evidence suggests that the foreign factors do a better job explaining the cross-section of returns in Mexico in both the unconditional and conditional versions of the model. This evidence provides some suggestive support for the hypothesis of integration of the Mexican stock exchange to the U.S. market. In Chapter 2, I study further the integration between Mexico and U.S. equity markets. Based on the result from chapter 1, I assume that the Fama and French factors are the mimicking portfolios of the underlying risk factors in both countries. Market integration implies the same prices of risk in both countries. I evaluate the performance of the asset pricing model under the hypothesis of segmentation (country dependent risk rewards) and integration over the 1990-2004 period. The results indicate a higher degree of integration at the end of the sample period. However, the degree of integration exhibits wide swings that are related to both local and global events. At the same time, the limitations that arise in empirical asset pricing methodologies with emerging market data are evident. The data set is short in length, has missing observations, and includes data from thinly traded securities. Finally, Chapter 3, coauthored with John Maheu and Alex Maynard, studies the ability of daily spreads at different maturities to forecast inflation. Many pricing models imply that nominal interest rates contain information on inflation expectations. This has lead to a large empirical literature that investigates the use of interest rates as predictors of future inflation. Most of these focus on the Fisher hypothesis in which the interest rate maturity matches the inflation horizon. In general, forecast improvements have been modest. Rather than use only monthly interest rates that match the maturity of inflation, this chapter advocates using the whole term structure of daily interest rates and their lagged values to forecast monthly inflation. Principle component methods are employed to combine information from interest rates across both the term structure and time series dimensions. Robust forecasting improvements are found as compared to the Fisher hypothesis and autoregressive benchmarks.

While there is great concern about the potential impact of aging populations on health care systems in the developed world, evidence from recent decades has shown at best a weak relationship between population aging and health expenditures at the aggregate level. This thesis explores the literature that frames the relationship between age and health care utilization in the context of reduced mortality and shorter periods of morbidity at the end of life. We add to this literature with an empirical study of individual health expenditures of the British Columbia senior population in the years 1991-2001 in the categories of hospital services, continuing care, doctor billings, and pharmaceutical prescriptions. Expenditures for decedent and survivors of the same age are compared and are fitted to a model using age and time-to-death as explanatory factors. The partial derivative of the model with respect to age is analyzed for empirical estimates of the effect of age after controlling for time-to-death. Results show that decedent costs rose over the study period while costs for survivors fell, particularly in continuing care, so that the relative cost of dying increased. The effect of age, after controlling for time to death, was muted or negative for hospitals, doctors, and drugs, but strongly positive for continuing care and, as a result, for all services combined. Overall, these results suggest that age is not a ‘red herring’, as some researchers have suggested, with respect to forecasting future demands on health systems. While future reductions in mortality and morbidity could mitigate pressures on hospitals, aging populations will put increased pressure on long-term residential care and other forms of social care.

This thesis studies information in financial markets from three perspectives: the role of information asymmetry in alleviating dividend payers’ seasoned equity offering (SEO) announcement returns, the leading behavior of equity analysts who collect and process information, and the pricing of productivity-related information. More specifically, Chapter 1 studies whether the market reacts less negatively to dividend payers’ SEO announcements. Using US data from 1975 to 2002, I find that prior to SEO announcement dates, dividend payers have less information asymmetries than non-dividend payers. This difference was not large before the mid-1980s, but increased dramatically since then. This finding, together with the disappearing dividend puzzle documented in Fama and French (2001), suggests that a firm’s dividend status was not an important signal for SEOs prior to the mid-1980s, but became important since then. The market reacts less negatively to dividend payers’ SEO announcements since the mid-1980s. Chapter 2 studies equity analysts’ leading behavior in equity recommendations. I develop a measure of leading recommendations based on the observation that other recommendations move towards those of the leader. I find that analysts who are more likely to lead are past leaders, past All-American stars, analysts from large brokerage houses, and analysts with fewer recommendations. I find that the market reacts more strongly to recommendations of leaders and leaders are less likely to be terminated from their jobs. Chapter 3 examines the link between productivity and the cross-section of security returns. The CAPM and CCAPM have had problems finding empirical validations. In contrast, by creating factor mimicking portfolios with respect to productivity, I introduce a stock market factor that mimics the driving force behind the CCAPM. First, I find that the productivity factor affects the overall market return and that on average it contributes 0.75 to 2.41 percent annually, for the range of productivity factors I construct. Further, I show that productivity is priced even when the market excess return and factors based on size and book-to-market are included in standard asset pricing tests. However, the market excess return and the book-to-market factor still explain asset returns.

The S&P 500 Index is a leading indicator of U.S. equities and is meant to reflect the risk and return on the U.S. stock market. Many derivatives based on the S&P 500 are available to investors. The S&P 500 Futures of the Chicago Mercantile Exchange and the S&P 500 Index Options of the Chicago Board Options Exchange are both actively traded. My thesis argues that the S&P 500 Index is only a summary statistic designed to reflect the evolution of the stock market. It is not the value of a self-financed tradable portfolio, and its modifications do not coincide with changes of the value of any mimicking portfolio, due to the particular way the S&P 500 Index is computed and maintained. Therefore, the Spot-Futures Parity and the Put-Call Parity do not hold for the S&P 500 Index and its derivatives. Furthermore, its derivatives cannot be priced by using the standard option pricing models, which assume that the underlying asset is tradable. Chapter One analyzes why the S&P 500 Index does not represent the value of a self-financed tradable portfolio and why it cannot be replaced by the value of a tracker such as the SPDR. In particular, we show that the nonlinear and extreme risk dynamics of the SPDR and of the S&P 500 Index are very different. Chapter Two provides empirical evidence that the non-tradability of the S&P 500 Index can explain the Put-Call Parity deviations. Even after controlling for the liquidity risk of the options, we find that the Put-Call Parity implied dividends depend significantly on the option strike. In Chapter Three, we develop an affine multi-factor model to price coherently various derivatives such as forwards and futures written on the S&P 500 Index, and European put and call options written on the S&P 500 Index and on the S&P 500 futures. We consider the cases when the underlying asset is self-financed and tradable and when it is not, and show the difference between them. When the underlying asset is self-financed and tradable, an additional arbitrage condition has to be introduced and implies additional parameter restrictions.

This thesis is a collection of three essays in empirical studies on derivatives. In the first chapter, I investigate whether credit default swap spreads are affected by how the total risk is decomposed into the systematic risk and the idiosyncratic risk for a given level of the total risk. The risk composition is measured by the systematic risk proportion, defined as the proportion of the systematic variance in the total variance. I find that a firm’s systematic risk proportion has a negative and significant effect on its CDS spreads. Moreover, this empirical finding is robust to various alternative specifications and estimations. Therefore, the composition of the total risk is an important determinant of CDS spreads. In the second chapter, I estimate the illiquidity premium in the CDS spreads based on Jarrow’s illiquidity-modified Merton model using the transformed-data maximum likelihood estimation method. I find that the average model implied CDS illiquidity premium is about 15 basis points, accounting for 12% of the average level of the CDS spread. I further investigate how this parameter is affected by CDS liquidity measures such as the percentage bid-ask spread and the number of daily CDS spreads available in one month. I find that both liquidity measures are significant determinants of the model implied CDS illiquidity premium. In terms of relative importance, the bid-ask spread is more important than the number of daily CDS spreads statistically and economically. In the third chapter, I investigate the impact of the systematic risk on the volatility spread, i.e, the difference between the risk-neutral volatility and the physical volatility. I find that the systematic risk proportion of an underlying asset has a positive and significant impact on its volatility spread. The risk-neutral volatility in this study is measured with the increasingly popular approach known as the model-free risk-neutral volatility. The surprising positive systematic risk effect was first documented in Duan and Wei (2009) using the Black-Scholes implied volatility. I show that this effect is actually more prominent using the clearly better model-free risk-neutral volatility measure.

In the first chapter, I study a recent and important innovation, the shift towards independent compensation consultants that provide advice only to boards. I construct a theoretical model to conceptualize the potential impact of independent consultants and then develop an empirical strategy to quantify the impact. One contribution of the paper is to provide strong identification of the impact of independent advice, something that has been challenged by the lack of appropriate data. I use a unique sample of Canadian firms which allows me to directly measure the impact of non-compensation related consulting fees on compensation advice. I conduct a number of empirical experiments but the main tests exploit a "quasi-natural experiment" provided by the creation of an independent consultant, Hugessen Consulting, as a spin-off from Mercer. I show that switching from an a ffiliated consultant to an independent consultant is associated with an increase in managerial incentives. Despite the benefits of independent advice, independent consultants may not be hired due to higher fees, the influence of powerful CEOs, or because boards already possess adequate expertise. In the second chapter, using a simple model of incentive contracting as a guide, I examine empirically whether some aspects of executive stock option backdating may be an optimal response of firms to distortions in the institutional environment, in particular tax law and accounting rules. Some of the findings suggest that firms may attempt to effi ciently lower the exercise price of the executive options in order to enhance managerial incentives for risk averse and poorly diversified executives. In the presence of restrictive accounting and tax rules, backdating may be a mechanism by which to achieve this objective of better incentives. Consistent with this explanation I find that backdating is associated with lower CEO pay levels but higher CEO incentives. In the final chapter, I use a dynamic structural model to show that on average firms excessively smooth their payout while maintaining larger than optimal levels of cash (excess cash) on their balance sheets. I provide an agency explanation for the positive correlation between dividend smoothing and cash savings. I show that the dynamic effect of managerial perceived cost to cutting payout results in accumulation of excess cash and distortion of shareholder value.

This thesis investigates the role of institutions in shaping macroeconomic phenomena. The first two chapters focus on financial institutions, formalizing interactions between information and competition in frictional credit markets and providing novel predictions for output and efficiency. The third chapter then presents a new approach for empirically assessing the relationship between political institutions and growth. In Chapter 1, I construct a credit-based model of production to analyze how learning through lending relationships affects the monetary transmission mechanism. I examine how monetary policy changes the incentives of borrowers and lenders to engage in relationship lending and how these changes then shape the response of aggregate output. A central finding is that relationship lending induces a smoother steady state output profile and a less volatile response to certain monetary shocks. This result provides a theoretical basis for cross-country transmission differences via a relationship lending channel. In Chapter 2, I investigate financial sector inefficiency when banks divide resources between attracting clients and learning about them via screening. I show that banks do not fully internalize the effects that their allocation decisions have on the beliefs and outside options of other lenders. These externalities result in an inefficiently high amount of low-quality credit and thus motivate a tax on activities designed to attract rather than screen borrowers. Steady state results suggest that production exhibits a hump-shaped response to increases in this tax and the model's dynamics indicate that a mild tax can also attenuate business cycle fluctuations. Chapter 3 then turns to the interaction between political institutions and economic outcomes. In collaboration with Gordon Anderson, I use a notion of distributional dominance to evaluate intertemporal dependence between polity and growth without hindrance from the mix of discrete and continuous variables in our data set. We also use this notion to measure the joint contribution of polity and growth to wellbeing. The results support the view that institutions promote growth more than growth promotes institutions. They also suggest that polity has dominated growth in determining the evolution of wellbeing over the past few decades.

This thesis studies information in financial markets from three perspectives: the role of information asymmetry in alleviating dividend payers’ seasoned equity offering (SEO) announcement returns, the leading behavior of equity analysts who collect and process information, and the pricing of productivity-related information. More specifically, Chapter 1 studies whether the market reacts less negatively to dividend payers’ SEO announcements. Using US data from 1975 to 2002, I find that prior to SEO announcement dates, dividend payers have less information asymmetries than non-dividend payers. This difference was not large before the mid-1980s, but increased dramatically since then. This finding, together with the disappearing dividend puzzle documented in Fama and French (2001), suggests that a firm’s dividend status was not an important signal for SEOs prior to the mid-1980s, but became important since then. The market reacts less negatively to dividend payers’ SEO announcements since the mid-1980s. Chapter 2 studies equity analysts’ leading behavior in equity recommendations. I develop a measure of leading recommendations based on the observation that other recommendations move towards those of the leader. I find that analysts who are more likely to lead are past leaders, past All-American stars, analysts from large brokerage houses, and analysts with fewer recommendations. I find that the market reacts more strongly to recommendations of leaders and leaders are less likely to be terminated from their jobs. Chapter 3 examines the link between productivity and the cross-section of security returns. The CAPM and CCAPM have had problems finding empirical validations. In contrast, by creating factor mimicking portfolios with respect to productivity, I introduce a stock market factor that mimics the driving force behind the CCAPM. First, I find that the productivity factor affects the overall market return and that on average it contributes 0.75 to 2.41 percent annually, for the range of productivity factors I construct. Further, I show that productivity is priced even when the market excess return and factors based on size and book-to-market are included in standard asset pricing tests. However, the market excess return and the book-to-market factor still explain asset returns.

The S&P 500 Index is a leading indicator of U.S. equities and is meant to reflect the risk and return on the U.S. stock market. Many derivatives based on the S&P 500 are available to investors. The S&P 500 Futures of the Chicago Mercantile Exchange and the S&P 500 Index Options of the Chicago Board Options Exchange are both actively traded. My thesis argues that the S&P 500 Index is only a summary statistic designed to reflect the evolution of the stock market. It is not the value of a self-financed tradable portfolio, and its modifications do not coincide with changes of the value of any mimicking portfolio, due to the particular way the S&P 500 Index is computed and maintained. Therefore, the Spot-Futures Parity and the Put-Call Parity do not hold for the S&P 500 Index and its derivatives. Furthermore, its derivatives cannot be priced by using the standard option pricing models, which assume that the underlying asset is tradable. Chapter One analyzes why the S&P 500 Index does not represent the value of a self-financed tradable portfolio and why it cannot be replaced by the value of a tracker such as the SPDR. In particular, we show that the nonlinear and extreme risk dynamics of the SPDR and of the S&P 500 Index are very different. Chapter Two provides empirical evidence that the non-tradability of the S&P 500 Index can explain the Put-Call Parity deviations. Even after controlling for the liquidity risk of the options, we find that the Put-Call Parity implied dividends depend significantly on the option strike. In Chapter Three, we develop an affine multi-factor model to price coherently various derivatives such as forwards and futures written on the S&P 500 Index, and European put and call options written on the S&P 500 Index and on the S&P 500 futures. We consider the cases when the underlying asset is self-financed and tradable and when it is not, and show the difference between them. When the underlying asset is self-financed and tradable, an additional arbitrage condition has to be introduced and implies additional parameter restrictions.