<p> Over the past two decades, hedge fund activism has emerged as a new mechanism of corporate governance that brings about operational, financial and governance reforms to a corporation. Many prominent business executives and legal scholars are convinced that the American economy will suffer unless hedge fund activism with its <i>perceived</i> short-termism agenda is significantly restricted. Shareholder activists and their proponents claim they function as a disciplinary mechanism to monitor management and are instrumental in mitigating the agency conflict between managers and shareholders. I find statistically meaningful empirical evidence to reject the anecdotal conventional wisdom that hedge fund activism is detrimental to the long term interests of companies and their long term shareholders. Moreover, my findings suggest that hedge funds generate <i>substantial long term</i> value for target firms and its long term shareholders when they function as a shareholder advocate to monitor management through active <i>board engagement.</i></p>

<p>The relationship between risk and return is a central theme of finance. The classic theoretical model which addresses this relationship is the Capital Asset Pricing Model, ?CAPM?. The CAPM of Sharpe (1964), Lintner (1965), and Black (1972) posits that a security?s return is directly and positively related to its exposure to systematic risk as measured by beta. Tests of the CAPM theorized relationship between risk and return predominantly support a direct, linear relationship. A minority of the research on the CAPM purports to show that the relationship between a security?s beta and its return is either too flat, or even inverse (Blitz, Falkenstein, & Vliet, 2014). This inverse relationship is known as the ?low-beta anomaly?. Such tests of the CAPM largely focus on a single beta estimation interval; five years of monthly returns. The purpose of this study was to assess the nature of the relationship between equity beta, and post-estimation return. Specifically, this study sought to address the validity and persistence of the low-beta anomaly across multiple beta estimation intervals. Within the twenty year sample period from January of 1994 to December of 2013 this research covered ten different beta estimation intervals in order to determine whether a statistically significant and theoretically consistent relationship existed between equity beta and post-estimation realized return. This was done utilizing a double-pass, or ?Fama-MacBeth? regression (Fama & MacBeth, 1973), whereby historical beta is first estimated by regressing a security?s return against the return of the market. The second pass of the regression, which provides the empirical test, is then conducted on the historical beta against post-estimation return. Further, this research appropriately accounted for the conditional nature of the beta-return relationship. This research provided two basic conclusions: First, the low-beta anomaly is not robust across multiple beta estimation intervals. Second, with any test of the relationship between beta and return the choice of beta estimation interval matters. Different estimation intervals sometimes provide contradictory empirical results for the same period.

<p> Most of the largest economic crises in recent history have been bank related. This dissertation contributes to improve our understanding of the causes and implications of financial crises because it approaches the study from a holistic perspective. It covers international, domestic, and systemic aspects that are necessary to understand the challenges imposed by financial liberalization, globalization, technological change, and interconnectivity. Chapter 1 provides the international perspective by examining the effect of global banking flows on credit booms; chapter 2 gives the domestic perspective by estimating the impact of financial crises on a country's long-run output growth; and chapter 3 zooms in further to get to the banking system level in order to study the propagation of shocks in a banking network endogenously generated by banks' profit maximizing decisions. Therefore, this dissertation accounts for the new challenges derived from the process of financial globalization and complex interconnections, and provides new venues for future analyses in this important research area.</p>

<p>This dissertation includes three essays on investments and time series econometrics. This work gives new insight into the behavior of implied marginal tax rates, implied volatility, and option pricing models. The first essay examines the movement of implied marginal tax rates. A body of research points to the existence of implied marginal tax rates that can be extracted from security or derivative prices. We use the LIBOR-based interest rate swap curve and the MSI-based interest rate swap curve to examine changes in the implied tax rate. We document multiple statistically and economically significant structural breaks in the long-run implied marginal tax rate that are not exclusively located in the financial crisis (one as recent as October, 2010). These breaks represent persistent divergence from long run averages and indicate that mean reversion models may not accurately describe the stochastic processes of implied marginal tax rates. In the second essay, I develop an asymmetric time series model of the VIX. I show that the VIX and realized volatility display significant nonlinear effects which I approximate with a smooth-transition autoregressive model. I find that under certain regimes the VIX depends almost exclusively on previous realized volatility. Under other regimes, I find that the VIX depends on both its lags and previous realized volatility. Since the VIX has become a popular hedging instrument, this finding has important implications for risk managers who elect to use the VIX and its related investment vehicles. It also has implications for the use of implied volatility in value-at-risk forecasting. The third essay presents a new model for option pricing model selection. There is a significant performativity issue intrinsic in much of the option pricing literature. Once an option-pricing model (OPM) gains widespread acceptance, volatilities tend to move so that the OPM fits well with observed prices. This often leads to systematic mispricing based purely on model results. A number of systematic issues such as volatility smile are present in OPMs. To remedy this issue, I propose a new method for ranking OPMs based on one step ahead forecasts. This model transforms the data to build a distribution of the stochastic term present in OPM. This sample distribution is then tested for normality so that OPMs can be ranked in a Bayesian-like framework by their closeness to a normal distribution.

A primary focus of empirical earnings research is whether accounting earnings contain meaningful and timely information that can be used by market participants to value securities. Empirically, accounting earnings numbers are considered to be reliable representations of economic performance if abnormal returns and unexpected earnings are associated. A critical assumption made when estimating this association by ordinary least squares (OLS) is that the explanatory variable (unexpected earnings) is independent of the error term. If unexpected earnings is measured with error, this assumption is violated, and OLS will produce biased estimates of the parameters. It's widely recognized that empirical measures of unexpected earnings contain measurement error, biasing the OLS estimate of the earnings response coefficient (ERC) towards zero. Prior studies have used various techniques to address measurement error in the unexpected earnings proxy. These techniques include: using multiple proxies for unexpected earnings; including lagged security returns; grouping by size of abnormal returns; using reverse regression; and using instrumental variables. No general conclusion has been reached, however, about which technique is the 'best' or whether any of these techniques completely eliminates bias in the ERC. Therefore, in this study I provide a discussion of the conditions under which each error-reduction technique is most effective in reducing measurement error bias in the ERC. In addition, I provide empirical evidence on each technique's ability to reduce coefficient bias. The empirical results show that none of these techniques is useful at reducing measurement error bias in the ERC. The ERC estimate increases by at most 8%. I also introduce and assess a new technique that yields consistent parameter estimates in the presence of measurement error (Fuller (1987, 1991)). The empirical results indicate that this technique is fairly successful at reducing measurement error bias in the ERC. The ERC estimate increases by as much as 52%. This technique is most successful at eliminating bias in the ERC estimates of larger firms and for firms whose earnings changes are primarily transitory. This technique provides a promising alternative approach to address measurement error bias in the ERC when investigating the information content of earnings.

With recent trends toward globalization and capital market integration, emerging markets have increasingly become the target of many investors in search for higher returns. Before placing their money abroad, however, investors need to bear considerable challenges in mind. While investments in developing economies can result in spectacular returns, emerging capital markets can be highly volatile, reacting strongly to the international investor sentiment, and economic and political changes. Understanding these risks is critically important to those who want to navigate successfully through emerging capital markets. Elucidating some of the challenges faced by the emerging market investor is the aim of my thesis. This dissertation consists of three essays addressing different issues related to emerging capital markets: (1) contagion in emerging debt markets, (2) closed-end fund managerial performance and other factors affecting fund premiums, and (3) the relationship between credit default swap (CDS) spreads and sovereign credit rating changes. In the first essay I test for the existence of contagion in emerging debt markets following Russia and Argentina's government defaults. Using several techniques that have been previously suggested to test for contagion in stock markets I find that debt and stock markets respond differently to financial crises. In the second essay I show that country fund premiums strongly reflect past management skill, but are also indicative of the investors' expectations about future managerial performance. Additionally, in time-series analyses country funds, regional equity funds and global bond funds are influenced quite differently by the suggested factors. In cross-sectional regressions, three variables emerge as significant in explaining the variation in fund premiums: the U.S. investor sentiment, excess volatility, and fund liquidity. In the third essay, inconsistent with previous work, I find that positive events are more anticipated, have a more consistent impact on sovereign CDS markets in the short period surrounding the event, and are more likely to spill over to other emerging markets, whereas negative events have a higher probability of being predicted by the CDS premium. Last, in an investigation of the determinants of emerging market CDS spread changes, I find that financial factors appear to explain spread changes better than either macroeconomic variables or political risk.

The credit default swap (CDS) market has blossomed to become a major asset class in the capital markets. Once largely confined to banks, the market participants have expanded to include insurance companies, hedge funds, mutual funds, pension funds, and other investors looking for yield enhancement or credit risk transference. The applications have evolved from the financial institutions’ needs to manage their illiquid credit concentrations to hedge their credit exposure. The literature review presents the recent work on credit default swap valuation. Structural models, reduced form models, and incomplete information models are reviewed, together with the modeling frameworks and related empirical performances. The first essay examines the reason of low correlation observed between equity returns and credit spread changes. In a recent article, Collin-Dufresne, Goldstein and Martin (2001) point out that the correlation between equity and credit markets are low, considering the fact that both stocks and bonds are claims on the same underlying firm value. We investigate whether this is so because arbitrageurs face impediments to arbitrage. Using arbitrage impediments measures, we find support for the hypothesis that greater impediments lead to a lower correlation between the two markets of a given firm. The impediments include transaction costs and holding costs, which are measured as the liquidity in the credit and equity markets and the idiosyncratic risk exposure, respectively. In addition, we include the information measure, which is related to the unobservability of the underlying firm value in the arbitrages across stocks and bonds. The second essay examines various liquidity measures across the credit derivatives and corporate bond markets. The results, from the factor decompositions for individual liquidity measures and across various measures, show that there is a strong commonality in the liquidity measures of the fixed income markets. In addition, the CDS innovation, unexplained part in the credit spreads by structural models, is estimated from the linear and nonlinear regressions, respectively. The paper finds that the liquidity common factors have significant impact on the part of the credit spread changes unexplained by default risk factors. The third essay explores the components of the credit spread changes related to expected default, market risk premium and liquidity. The firm level factors, proxy for expected default, include equity returns, changes in volatility, changes in firm leverage, changes in book to market equity ratio, and changes in profitability. The common factors include changes in treasury yields, changes in the slope of the yield curve, changes in VIX, and three Fama-French factors. The liquidity factors include the aggregate stock market liquidity measure and the credit market depth. Furthermore, the paper examines whether the news from firm level or common factors that mainly drives the credit spread changes. The paper explores the relative impact of these factors to the credit spread changes in a vector autoregressive model. The results suggest that the innovation from the firm level factors have larger impact than that from the common factors for high yield firms while the investment grade firms are more affected by the news from the common factors.

The hedge fund industry and hedge fund related research have grown rapidly in the last decade. In 1990, hedge funds controlled an estimated $39 billion in assets. At the end of 2006, hedge funds had an estimated $1.72 trillion in assets under management. This dissertation consists of three essays exploring the hedge fund industry. In the first essay, I use the recent controversial and ultimately unsuccessful SEC attempt to increase hedge fund disclosure to examine the value of disclosure to investors. By examining SEC mandated disclosures filed by a large number of hedge funds in February 2006, I am able to construct a measure of operational risk distinct from market risk. Leverage and ownership structures as of December 2005 suggest that lenders and hedge fund equity investors were already aware of hedge fund operational risk characteristics. However, operational risk has no effect on the flow-performance relationship, suggesting that investors either lack this information, or they do not regard it as material. In the second essay, I examine hedge fund management and incentive fee structures and changes as well as the use of redemption fees. Overall, I find hedge funds’ fee structures are related to their other fund characteristics in a manner consistent with the mutual fund area and previous fee theory. I observe management fees are negatively related to fund characteristics that lower administrative overhead and positively related to tax incentives. Incentive fees are positively correlated with return characteristics that raise the total values of managers’ option-like incentive fee contracts. Hedge fund fee changes are found to be a function of pricing power and managers attempting to decrease investor demand in capacity constrained styles while redemption fees are used to protect managers against poor performance. Finally, funds of funds have positively associated incentive and management fees, which create a negative relationship between incentive fees and fund alphas. In the third essay, I examine if hedge fund managers close and reopen funds to investment to preserve performance. While my results show closed hedge funds do experience significantly lower flows, managers’ and management companies’ primary objective is to hoard assets. Hedge funds in capacity constrained styles do not close more often, do not close at lower relative asset levels and do not reopen at lower relative asset levels. Hedge funds reopen to investment to generate additional fees, not when funds are capable of generating out performance. These results suggest even high performance-pay deltas are not strong enough to overcome additional fees generated from larger amounts of assets. Other monitoring mechanisms are necessary to reduce agency costs for investors. ^

This study examines the effects of time-varying volatility and transaction costs on replication of foreign currency futures options. Evidence in various financial markets, including currency and currency futures markets, clearly indicates that the constant volatility model is inadequate. This evidence motivates us to consider alternatives to the constant volatility model. I consider three models two of which assume that the volatility process follows GARCH(1,1) model and the third alternative assumes that volatility is a mean-reverting process. I construct replicating portfolios, which are rebalanced dynamically, and test if payoff of options is met. To construct the replicating portfolios, I use the derivatives with respect to futures price (delta) and the volatility (vega) prescribed by the models. My results indicate that the models generally replicate smaller strike options fairly accurately while producing somewhat larger errors for larger strike options and that the hypothetical futures contract on a hypothetical volatility index is useful hedging instrument. Of the three alternative models considered, I find that error correction model with GARCH(1,1) volatility is the best model. Since dynamic rebalancing of the replicating portfolio is quite expensive when there are proportional transaction costs, an acceptable alternative should provide optimal tradeoff between transaction costs and replication error. I consider three alternative rebalancing strategies using Black (1976) model and Monte Carlo simulation to examine the transaction costs and replication error with the objective of determining profit or loss from each simulation run. After 10,000 simulation runs, based on the 95th percentile profit, I determined that the rebalancing strategy based on the no-transaction bound on delta of the option suggested by Whalley and Wilmott (1993) gives the best results in terms of profits. Another form of transaction cost is bid-ask spread in the markets for assets underlying options. This spread results in different option prices for buyers and sellers of options; that is, the bid price of the option should be less than or equal to the ask price of the replicating portfolio while the ask price of the option should be greater than or equal to the bid price of the replicating portfolio. I test these equilibrium bounds, violations of which provide arbitrage opportunities, using actual market bid-ask data on both underlying futures and options obtained from Chicago Mercantile Exchange. The market prices generally satisfy the equilibrium bounds though I find in my analysis that choice of volatility used as input for simulation can be critical.

This dissertation develops a supply and demand based theory of equity price determination to investigate the unprecedented run-up in U.S. equity values during 1982–1999. The model draws insight from both fundamental valuation analysis, and various speculative market theories. It also incorporates aspects of portfolio theory, Shiller's (1984, 1989) model of fads, fashions and bubbles, Toporowski's (1999) theory of capital market inflation and Minsky's (1982) model of financial fragility. Based on the theoretical model and empirical evidence it is concluded that the bull market, while originating in increased corporate profitability, was driven to a larger extent by the significant reduction in the supply of equity and the enormous inflow of domestic and foreign funds into the stock market. In contrast, three influential theories regarding the bull market can be gleaned from the academic literature and business press: (1) the “new economy” hypothesis maintains that the boom was justified purely on the basis of discounted future dividends, (2) the declining risk premium theory holds that the required rate of return has fallen dramatically and (3) the speculative bubble hypothesis argues investors have underpriced risk and overestimated the profit potential of U.S. corporations. Our findings show these intuitively appealing answers to be incomplete. The quantitative analysis exploits the vector autoregressive technique, OLS, and the instrumental variables methodology. The evidence from Granger-causality tests, innovation accounting and the structural model approach is consistent with the hypothesis that net flows effectively set prices. The finding that mutual fund flows explain stock prices, even when controlling for fundamentals, suggests the validity of the “irrational exuberance” theory. Similarly, foreign portfolio flows impacting U.S. equity prices is consistent with the notion that internationalization has transformed financial markets. The significance of share issuance in explaining price movements contradicts both the notion that changes in the supply of equity are inconsequential for market valuation, and the theory that exuberant expectations alone explains the ascent in stock prices. Thus, we maintain that in 1999 U.S. equity valuations were unwarranted by fundamentals and the general case for the efficient market hypothesis, which marginalizes supply and demand changes, has been overstated.