Thesis advisor: Zhijie Xiao / This dissertation consists of three independent studies in Financial Economics. The first chapter focuses on the predictive power of the implied correlation index on the future S&P 500 Index returns. The second chapter investigates a nonlinear contemporary relationship between stock returns and oil price changes. The last chapter discusses the relationship between impact trading costs and a number of market factors that affect the costs. In the first chapter, I investigate the predictive power of the implied correlation index on the future S&P 500 Index returns. This new index was launched by Chicago Board Option Exchange following 2007-2008 financial crisis. As it is derived from the S&P 500 Index option price and the option prices of the largest 50 S&P Index stocks, it is widely regarded by market participants as a gauge of average expected future stock return correlation. Because of its role in measuring systematic risks, any changes in this index may provide useful information about the future market movements. Motivated by this index's forward-looking characteristic, I propose a linear regression where the future S&P 500 Index multi-period return is regressed on a number of controls such as the current period changes of S&P index and the implied correlation index etc. I use weekly data and three different sample splits for in-sample estimation and out-of-sample performance evaluation. I find that the implied correlation index is informative for the period 2007-2009 in predicting the S&P 500 Index returns of 28 to 39 weeks. My model consistently outperforms the random walk model using the Superior Predictive Ability test. This implied correlation index is also useful in predicting the S&P index future multi-week returns for the period 2009-2011 and a longer time span from 2007-2011. I also do a test for the Efficient Market Hypothesis by incorporating the implied volatility index in the regression. There is no evidence supporting the view that the market is efficient for those time periods. In the second chapter, I estimate a nonlinear contemporary relationship between stock returns and oil price shocks. Previous studies on this issue suffer a number of limitations. For example, they do not control the factors potentially driving the economy and the oil market simultaneously. Although, Kilian and Park (2009) does a good job in identifying the relationship by distinguishing different oil market shocks, they use a linear regression framework and do not address the contemporary relationship. Considering the different impacts of different-size oil shocks on stock returns, I propose a two-step estimation procedure for identifying their relationship. In the first step, I follow Kilian and Park's methodology, i.e. a structural vector autoregression, to estimate the demand-specific oil shocks. During the second step, I use a nonparametric quantile regression to estimate the relationship between stock returns and the estimated exogenous oil price shocks. This way, I can control for the factors that simultaneously drive the economy and the oil market and am able to identify a nonlinear relationship of stock returns with oil shocks at the same time. The result shows that different-size oil price changes do have quite different impacts on stock returns. I also find an asymmetric effect of large oil shocks on large stock returns. Specifically, the positive impact of the large negative oil shocks on stock returns is much bigger than the negative impact of the large positive oil shocks on stock returns. I carry out a robust check by running regressions for a number of different model setups and the result persists. I also compare my model with Kilian and Park' SVAR model and it turns out that my model is a big improvement on their model in explaining the stock return variations. The third and last chapter focuses on impact trading cost and its relationship with several market factors. In this chapter, I focus on one of financial market microstructure issues, the immediate impact trading cost for major NASDAQ stocks. The immediate impact cost is the extra cost that market traders pay when they execute a large volume transaction without delay during the time when the market is less liquid. Because the market depth is defined to be the market's ability to sustain relatively large market orders without impacting the price of the security, this cost is closely linked to the trading volume. When trading volume becomes large, market liquidity gets worse and therefore the relationship between immediate impact cost and trading volume is virtually nonlinear. People trading in the market are interested in this relationship because they hope to figure out the best strategies in the situation where they want to execute a large volume order when the market is not deep. Another measure of market depth or liquidity people often use is market spread. Because it is the compensation for market makers' willingness to hold an imbalanced portfolio when the market is not liquid, it is regarded as another important factor linked to the impact cost. In this chapter, I use a nonparametric model to estimate the unknown relationship between immediate impact cost and market factors such as trading volume, market spread etc. for the major NASDAQ stocks. The result shows that, for many stock transactions, there is a certain volume threshold of trading volume beyond which impact costs increase dramatically. I find that for 99% of trading, immediate execution is optimal. I also identify a negative relationship between the occurrence likelihood of a large trading cost and the stock market cap. / Thesis (PhD) — Boston College, 2012. / Submitted to: Boston College. Graduate School of Arts and Sciences. / Discipline: Economics.

The Treasury's report "Institutional Investment in the United Kingdom: A Review" (the Myners Review) suggested in 2001 that various sectors of the UK equity market may be suitable for active investment management, tacitly assuming that some sectors are efficient whilst others are not. The validity of this assumption is tested against 29 industrial sector indices within the FTSE All Share index. Sector efficiency is, taken to be that index values reflect information correctly (strong efficient) or to the point where benefits do not exceed costs (weakly efficient). Existence of a sector index following a random walk is used to identify strong efficiency with the subsequent conclusion that passive management would be appropriate. Where the time series is not random, forecasting gains less than the management costs of active trading indicate weak efficiency with the corollary that passive management is still applicable. Industrial sectors where the index can be forecast with gains in excess of costs are not efficient and are appropriate for active management. The indices are tested for stationarity: none are stationary in levels but all reject the Dickey Fuller null hypothesis of a unit root in their first difference, the logarithmic return. Tests for randomness are based on pure random walks and random walks with drift and/or trend. Non-random time series are examined for maintained regressions based on AR, MA and ARMA. Where appropriate, ARCH is applied to the variance, utilising GARCH, Threshold GARCH, GARCH-in mean, Exponential GARCH and Component GARCH. Additionally there is a test for cointegration. All potential data generating processes' residuals are tested for independent identical distributions using the BDS test. If the maintained regression produces residuals that are III) then that series is assumed to be explained. The results show that four indices are strong efficient and five are weak; giving nine sectors that should be managed passively. Only one sector is found where there is scope for active management to make an abnormal gain in excess of costs. Nineteen of the indices had GARCH, which indicated a possible lack of efficiency but no decision on management style. One index was unexplained. Thus the Myners review's suggestion of active management where appropriate was valid, but limited solely to the Personal Care & Household Products sector.

This thesis examines economic uncertainty from various sources, and studies the impact of uncertainty on the macroeconomy. In Chapter I, I theoretically investigate uncertainty on asset returns and its role in financial fragility using a stylized model where the level of uncertainty is endogenously chosen by banks. The risk behavior of banks imposes a negative externality on the profitability of other banks because liquidation of risky assets depresses asset prices in the secondary market. Combined with limited liability, the model can give rise to a vicious feedback loop between collective risk-taking behavior in the banking sector and fire sales of assets. The model suggests that ''panics'' over fire sales of assets can initiate banks' perverse risk-taking incentives, and trigger a self-fulfilling financial crisis where banks are taking risky investment, market liquidity is low, and credit risk is high. In Chapter II, I study empirically the role of productivity uncertainty on firms' investment in customer base. I find that similar to the case of physical capital investment, idiosyncratic uncertainty has a significant negative impact on customer base investment. However, different from the case for physical capital investment, firms with low customer base tend to be more sensitive to uncertainty. The empirical analysis suggests an alternative transmission mechanism for uncertainty shocks to the real economy that relies on the interaction between idiosyncratic uncertainty and product market frictions. In Chapter III, I focus on uncertainty about the monetary policy stance of the central bank. I investigate the optimal monetary policy in a theoretical framework where households are uncertain about central bank credibility. Contrary to the binary ''commitment vs. discretion'' commitment setting, the central bank in this model is able to commit to the optimal plan it formulates, but only over some finite (random) horizons due to its temptation to renege on the plan. Given that central bank credibility deteriorates with high inflation rates in the past, the central bank would contemplate on the impact of inflation on its future credibility and social welfare, in addition to the traditional inflation-output tradeoff. The main finding is that the central bank would enhance its credibility directly through a more conservative inflation policy.

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In the 1990s, physicists started looking beyond their disciplinary boundaries by using their methods to study various problems usually thrown up by financial economics. This dissertation deals with this extension of physics outside its disciplinary borders. It seeks to determine what sort of discipline econophysics is in relation to physics and to economics, how its emergence was made possible, and what sort of knowledge it produces. Using a variety of evidence including bibliometric analysis Chapter 1 explores the field’s disciplinary identity as a branch of physics even though its intellectual heart is better seen as the re-emergence of a 1960s research programme initiated in economics. Chapter 2 is historical: it identifies the key role played by the Santa Fe Institute and its pioneering complexity research in the shaping of methodological horizons of econophysics. These are in turn investigated in Chapter 3, which argues that there are in fact three methodological strands: statistical econophysics, bottom-up agent-based econophysics, and top-down agent-based econophysics. Viewed from a Lakatosian perspective they all share a conceptual hard-core but articulate the protective belt in distinctly different ways. The last and final chapter is devoted to the way econophysicists produce and justify their knowledge. It shows that econophysics operates by proposing empirically adequate analogies between physical and other systems in exactly the ways emphasised by Pierre Duhem. The contrast between such use of analogy in econophysics and modeling practices implemented by financial economics explains why econophysics remains so controversial to economists.

This work consists of five separate essays that examine the banking industry from a number of viewpoints. In the first essay, I consider how the ratchet effect interacts with workers' ability to cooperate to determine effort provision in teams. I show how the dominant constraint varies with both the size of the team and the members' ability to monitor each other's effort. Small teams tend to have their effort provision constrained by the ratchet effect; large teams are instead constrained by the inability of the team members to demand effort from each other. In the second essay, I examine the phenomenon of large team transfers in professional service firms, especially investment banks. I argue that large team moves occur because employees benefit by working with the most talented coworkers. Above-average teams may move together to effectively exclude younger, less-talented workers. These team transfers are optimal when employees are remunerated with team-based bonuses, which may explain their significance in investment banking. In the third essay, I consider the securitization market. First, I provide an explanation for equilibrium credit ratings inflation that does not require investor irrationality. Second, I argue that moral hazard in securitization results in banks either selling the entirety of securitized products, or none at all. Finally, I consider a number of possible government interventions in the market and conclude that many proposed interventions are either ineffectual or counterproductive. In the fourth essay, we design an improved LIBOR reporting mechanism. This mechanism, which we name the "whistleblower mechanism," uses the revealed preference of other banks to determine the borrowing rate of a given bank. Truthful reporting is the sole equilibrium of the mechanism that we design; the mechanism is budget-balanced. In the fifth essay, we consider the analogy between systemic risk and pollution. We argue that an ex post tax cannot replicate capital regulation because of a 'polluter cannot pay' problem. Secondly, we show an equivalency result between ex ante taxation and capital regulation. We then show that unless the ex ante tax is levied in capital, however, it may perversely increase the amount of debt in the financial system. We argue for further capital regulation.

This thesis is a collection of essays where I explore and extend the study of the role of financial frictions for the determination of asset prices, financial stability, and economic resilience. The frictions included in the analysis are individual and aggregate uncertainty, agent heterogeneity, money, liquidity and default. The first essay is an empirical study that motivates my research objectives. This work starts with the exploration of the role of liquidity on asset prices, specifically on sovereign bonds of emerging countries. I present a comprehensive model where I developed a novel methodology for finding the role of liquidity in the determination of asset prices during the financial crisis. In the second essay, illuminated by the empirical findings, I apply and expand the general equilibrium theory of money, default and financial stability. The contributions at the theoretical level are the extension of two-period model with discrete state space to the infinite horizon dynamic stochastic setting, and the inclusion of liquidity restrictions. In the third essay, I further extend this framework, allowing for production technology and endogenous market liquidity. Given the theoretical setting, I have analyzed the responses of financial stability and economic performance variables to real and financial shocks. Finally, in the fourth essay I produce an empirical application of this work. I apply a novel semi-parametric financial stability metric, and evaluate its relevance for the determination of asset prices, in the presence of liquidity restrictions. As a result, this thesis suggest plausible explanations for financial and economic issues that conventional models have not dealt with adequately.

An increasing number of people in Sweden and in the rest of the world are becoming more interested in the mutual fund sector. Investments in mutual funds have grown rapidly these past few years. Nilsson (2004) wrote that 85 percent of the Swedish population invested in mutual funds in 2004. The Swedish Investment Fund Association also found an increase in investments in mutual funds; 83 billion Swedish crowns were invested in mutual funds in 2005, an increase from 56 billion in 2004. The purpose of this thesis is to evaluate whether or not there is a relationship between low fee, middle fee, and high fee charging Swedish Equity funds and their respective performance (unadjusted and risk-adjusted returns). The Modigliani & Modigliani (1997) risk-adjusted performance measurement was used to calculate the risk-adjusted performance of the 130 mutual funds. And the linear regression was used to analyze whether or not there was a relationship between the variables (management fee vs. returns/risk-adjusted returns). The mutual funds were also divided into three different categories, based on their management fees; low, middle and high fee mutual funds. The analysis illustrated that there was no clear relationship between the management fee and the returns/risk-adjusted returns. There was some connection found between the management fee and the low, middle fee category. However, this research confirms that investors should not believe that a mutual fund which charges higher fees necessarily generate higher returns.

<p>An increasing number of people in Sweden and in the rest of the world are becoming more interested in the mutual fund sector. Investments in mutual funds have grown rapidly these past few years. Nilsson (2004) wrote that 85 percent of the Swedish population invested in mutual funds in 2004. The Swedish Investment Fund Association also found an increase in investments in mutual funds; 83 billion Swedish crowns were invested in mutual funds in 2005, an increase from 56 billion in 2004.</p><p>The purpose of this thesis is to evaluate whether or not there is a relationship between low fee, middle fee, and high fee charging Swedish Equity funds and their respective performance (unadjusted and risk-adjusted returns). The Modigliani & Modigliani (1997) risk-adjusted performance measurement was used to calculate the risk-adjusted performance of the 130 mutual funds. And the linear regression was used to analyze whether or not there was a relationship between the variables (management fee vs. returns/risk-adjusted returns). The mutual funds were also divided into three different categories, based on their management fees; low, middle and high fee mutual funds.</p><p>The analysis illustrated that there was no clear relationship between the management fee and the returns/risk-adjusted returns. There was some connection found between the management fee and the low, middle fee category. However, this research confirms that investors should not believe that a mutual fund which charges higher fees necessarily generate higher returns.</p>

This dissertation investigates agency problems within risk transfer contracts. We pay particular attention to the consequences of credit risk transfer in the context of banking. The first two chapters provide an introduction and literature review. We then analyze the effect of counterparty risk on financial insurance contracts in the following two chapters, and uncover a new moral hazard problem on the part of the insurer. If the insurer believes it is unlikely that a claim will be made, it is advantageous for them to invest in assets which earn higher returns, but may not be readily available if needed. We find that counterparty risk can create an incentive for the insured to reveal superior information about the risk of their "investment". In particular, a unique separating equilibrium may exist even in the absence of any signalling device. This constitutes a first example in which the separation of types can be achieved without a costly signalling device. Our research suggests that regulators should be wary of risk being offloaded to other, possibly unstable parties, especially in financial markets such as that of credit derivatives. The fifth chapter models loan sales and loan insurance (e.g. credit default swaps) as two key instruments of risk transfer within the banking environment. Recent empirical evidence suggests that the asymmetric information problem is as relevant in loan insurance as it is in loan sales. Contrary to previous literature, this paper allows for informational asymmetries in both markets. Our results show that a well capitalized bank will tend to use loan insurance regardless of loan quality in the presence of moral hazard and relationship banking costs of loan sales. Finally, we show that a poorly capitalized bank may be forced into the loan sales market, even in the presence of possibly significant moral hazard and relationship banking costs that can depress the selling price. / Thesis (Ph.D, Economics) -- Queen's University, 2008-09-26 13:03:32.81