This thesis investigates the economic value of incorporating intraday volatility estimators into the volatility forecasting process. The increased reliance on volatility forecasting in the financial industry has intensified the need for more rigorous analysis from an economic perspective instead of merely statistical point of view. A better understanding of the available methods has implications for portfolio optimization, volatility trading and risk management. More recently, volatility of asset returns was once again under spotlight during the 2008-2009 financial crisis. The study contributes to the extant volatility forecasting literature in three areas. First, it addresses the question of how to practically and effectively exploit intraday price information for variance and covariance modelling and forecasting. Second, it addresses the development of an 'optimal' intraday volatility model that accommodates market practitioners preferences. Third, it evaluates the economic value of combining realized (intraday) volatility estimators for utilizing unique information embedded in each estimator. The thesis is organised as follows. One of the most visible indicators of the crisis that captured the attention of the financial industry was the extremely high level of asset return volatility. This uncertainty prompted much interest for a more accurate, yet practically applicable approach for volatility forecasting. Chapter 2 introduces the various realized volatility estimators, volatility forecasting procedures and their corresponding realized extensions used in our subsequent empirical investigations. Chapter 3 evaluates the economic value of various intraday covariance estimation approaches for mean-variance portfolio optimization. Economic loss functions overwhelmingly favour intraday covariance matrix models instead of their daily counterparts. The constant conditional correlation (CCC) augmented with realized volatility produces the highest economic value when applied with a time-varying volatility timing strategy. Chapter 4 compares the practical value of intraday based single index (univariate) and portfolio (multivariate) models through the lens of Value-at-Risk (VaR) forecasting. VaR predictions are generated from standard daily univariate or multivariate GARCH models, as well as GARCH models extended with ARFIMA forecasted realized measures. Conditional coverage test results indicate that intraday models, both univariate and multivariate ones, outperform their daily counterparts by providing more accurate VaR forecasts. Chapter 5 investigates the economic value of combining intraday volatility estimators for volatility trading. The simulated option trading results indicate that a naive combination of an intraday estimator and implied volatility cannot be outperformed by the best individual estimator. In addition, trading performance can be further boosted by applying more complex combination models such as a regression based combination of 42 single volatility estimators.

The thesis presents three papers in the field of international finance and provides a study of the foreign exchange (FX) market from a microstructure perspective. From the empirical identification of a common component in liquidity across currencies, referred to as FX market liquidity, the thesis investigates its asset pricing implications, determinants and cross-market dynamics. The first paper is an empirical study of global liquidity risk in the FX market. Estimating liquidity with the Pastor-Stambaugh measure originally developed for the stock market, the paper documents strong liquidity commonality across currencies. Given this observation, it estimates a measure of global FX liquidity risk and shows that the risk is priced in the cross-section of currency returns. It finally evaluates the associated risk premium at around 4.7 percent per annum. The second paper provides an empirical analysis of the determinants of the time variation in FX market liquidity documented in the first paper. Employing two measures of liquidity, transaction costs and the Pastor-Stambaugh measure from the first paper, the study finds a significant role of traditional determinants, such as global volatility, market returns and seasonality, and of funding liquidity constraints to explain both aspects of market liquidity. Finally, the third paper is an empirical investigation of illiquidity linkages across the FX and US stock markets. Focusing on transaction costs, the paper finds strong evidence of co-movement, especially during the recent financial crisis. In this respect, illiquidity contagion across the two markets is documented. Given dealers' role as liquidity providers in both markets, their trading behaviour may have significant implications for cross-market liquidity dynamics. Indeed, focusing on the potential sources of the observed cross-market linkages, transaction costs are found to be strongly related to the liquidity supplied to the financial system.

This thesis consists of empirical and theoretical studies on the liquidity of bond markets. In the first study, we present an extended model for the estimation of the effective bid-ask spread that improves the existing models and offers a new direction of generalisation. The quoted bid-ask spread represents the prices available at a given time for transactions only up to some relatively small trade size. Trades can be executed inside or outside the quoted bid-ask spread. Thus, we extend Roll's model to include multiple spreads of different sizes and their associated probabilities. The extended model is estimated via a Bayesian approach, and the fit of the model to a time series of a year of corporate bond transaction data is assessed by a Bayesian model selection method. Results show that our extended model fits the data better. Our second study examines the relationships between different liquidity proxies and the non-default corporate yield spread as well as the effective bid-ask spread. We first separate the non-default component of bond spreads from the default one by using the information contained in credit default swaps. We then apply our state-space extension of the Roll model to disentangle the unobservable non-default yield spread from the effective bid-ask spread. The empirical results show that the non-default yield spread has a nonlinear relationship with time to maturity and a positive correlation with the bid-ask spread as well as with the default risk, and therefore may reflect the future expected liquidity. We find that the effective bid-ask spread is related to bond characteristics associated with illiquidity (e.g. timeto-maturity and issue amount) and trading activity measures (e.g. daily turnover, and daily average trade size), indicating that transactions costs are more likely to be associated with the current level of liquidity rather than the future expected liquidity. We also find that the non-default component accounted for a bigger proportion of the yield spread before the financial crisis 2007 - 2009, whereas during the crisis credit risk played a more influential role in determining the yield spread. Common factors such as the underlying volatility and CDS spread explain more of the variation in the non-default yield spread and the bid-ask spread than idiosyncratic factors such as timeto-maturity, issue size, and trading activity proxies do. The third study presents an equilibrium model in which the heterogeneity of liquidity among bonds is determined endogenously. In particular we show that bonds differ in their liquidity despite having identical cash flow, riskiness and issue amount. Under certain conditions, we show that investors have strong preference for concentrating trading on a small number of bonds. We conjecture that the identity of the ones which are traded may result from a `Sunspot' equilibrium where it is optimal for traders to randomly label a subset of the bonds as the `liquid' ones and concentrating trading on them. We also show that changing the model assumptions leads to different equilibrium configurations where trading is spread over the bonds. In addition, by utilising the concepts of stochastic dominance, utility indifference pricing, and some specific assumptions on asset value and order arrival rate, the equilibrium prices and bid-ask spreads can be quantified.

Banks' role as intermediaries between short term investors and long term borrow- ers has dominated the literature. Whilst this is an important feature, there are many other characteristics of banks. Each chapter in this PhD explores a different aspect of banking, from other forms of lending to banks' role in payment services. The first, and principal, chapter considers credit lines: `commitments' to lend if required. These remain off the bank's balance sheet until drawn upon. As off-balance sheet items, unused commitments face low capital charges under existing capital regulation. I ex- plore how this regulatory feature incentivises banks to build up exposure to these lines. This may lead to a suboptimal allocation of credit, ex post, following a market shock, as high drawdowns cause the balance sheet to balloon and the capital requirement to bind. In the second chapter, I consider banks as agents in large-value payment systems. In choosing the optimal time to settle a payment, banks trade off delay costs against the risk of having insuffcient liquidity to make future payments. With banks participating in multiple systems, I show how default in one system may spill over into another, through the strategic behaviour of multi-system participants. I explore how this risk varies with the degree of information asymmetry between agents in different systems. The third chapter focuses on retail banking. In joint work, we examine how the provision of consumer credit, either through current account overdrafts, or through credit card credit lines, affects the way in which debit and credit card networks com- pete. We find that, even when debit and credit cards compete, there are elements of complementarity between them. Banks providing debit cards and current accounts benefit when the consumer delays withdrawal of funds from her current account by using a credit card. This leads to surprisingly high debit merchant fees.

This thesis contains three essays exploring the asset pricing implications of asymmetric information and trading constraints. Chapter 1 studies how short-sale constraints affect the informational efficiency of market prices and the link between prices and economic activity. I show that under short-sale constraints security prices contain less information. However, short-sale constraints increase the informativeness of prices to some agents who learn about the quality of an investment opportunity from market prices and have additional private information. This, in turn, can lead to higher allocative efficiency in the real economy. My result thus implies that the decrease in average informativeness due to short-sale constraints can be more than compensated by an increase in informativeness to some agents. In Chapter 2, I develop an equilibrium model of strategic arbitrage under wealth constraints. Arbitrageurs optimally invest into a fundamentally riskless arbitrage opportunity, but if their capital does not fully cover losses, they are forced to close their positions. Strategic arbitrageurs with price impact take this constraint into account and try to induce the fire sales of others by manipulating prices. I show that if traders have similar proportions of their capital invested in the arbitrage opportunity, they behave cooperatively. However, if the proportions are very different, the arbitrageur who is less invested predates on the other. The presence of other traders thus creates predatory risk, and arbitrageurs might be reluctant to take large positions in the arbitrage opportunity in the first place, leading to an initially slow convergence of prices. Chapter 3 (joint with Dömötör Pálvölgyi) studies the uniqueness of equilibrium in a textbook noisy rational expectations economy model a la Grossman and Stiglitz (1980). We provide a very simple proof to show that the unique linear equilibrium of their model is the unique equilibrium when allowing for any continuous price function, linear or not. We also provide an algorithm to create a (non-continuous) equilibrium price that is different from the Grossman-Stiglitz price.

At the heart of any investment fund (whether public or private) is an investor protection concern that arises from the collectivized nature of the fund. In a bilateral arrangement, a client may negotiate ‘bespoke’ terms with a prospective investment manager. By contrast, an investment fund provides ‘off the shelf’ terms to prospective participants, many of whom may have relatively small percentage positions in the ultimate fund, although the sums of money they provide may often be very significant to them. The governance challenge at the heart of all collectivized investment structures is most clearly seen in connection with private investment funds. Largely, the structure of such funds has been driven by the need to comply and obtain necessary exemptions under the financial regulatory rules, while simultaneously addressing a series of interrelated tax issues arising from various pieces of antiavoidance legislation adopted over the years. Three private monitoring solutions are identified which would enable fund investors to address more directly the problems arising from the governance challenge by facilitating a better flow of information from the fund manager to the investors: (1) side letters, which provide a particular investor with further information and/or control rights with regard to the operation of the fund; (2) improving the operation of the board of directors in either corporate-based funds or the general partner vehicle of limited partnership structures by the inclusion of independent directors; and (3) listings of private investment funds on securities exchanges as a means of adopting ongoing compliance oversight. Each approach recognizes the commercial contexts in which private investment funds operate by emphasizing voluntary steps that fund managers and investors can take incrementally. Further, each focuses on the provision of information as the means to overcome the investment protection concerns that arise due to the collectivized nature of the private investment fund.

The thesis includes three papers: 1. Limited Arbitrage Analysis of CDS Basis Trading By modeling time-varying funding costs and demand pressure as the limits to arbitrage, the paper shows that assets with identical cash-flows have not only different expected returns, but also different expected returns in excess of funding costs. I solve the model in closed-form to show that the arbitrage on the CDS and corporate bond market is a risky arbitrage. The sign of the expected excess return of the arbitrage is decided by the sign and size of market frictions rather than the observed price discrepancy. The size and risk of the arbitrage excess return are increasing in market friction levels and assets' maturities. High levels of market frictions also destruct the positive predictability of credit spread term structure on credit spread changes. Results from the empirical section support the above-mentioned model predictions. 2. General Equilibrium Analysis of Stochastic Benchmarking This paper applies a closed-form continuous-time consumption-based general equilibrium model to analyze the equilibrium implications when some agents in the economy promise to beat a stochastic benchmark at an intermediate date. For very risky benchmark, these agents increase volatility and risk premium in the equilibrium. On the other hand, when they promise to beat less risky benchmark, they decrease volatility and risk premium in the equilibrium. In both cases, the degree of effect is state-dependent and stock price rises. 3. Institutional Asset Pricing with Heterogenous Belief (Co-authored) We propose an equilibrium asset pricing model in which investors with heterogeneous beliefs care about relative performance. We find that the relative performance concern leads agents to trade more similarly, which has two effects. First, similar trading directly decreases volatility. Second, similar trading decreases the impact of the dominant agents. When the economy is extremely good or bad, the second effect is dominant so that the relative performance concern enlarges the excess volatility caused by heterogeneous beliefs. When the first effect is dominant, which corresponds to a normal economy, the volatility is lower than without the relative performance concern. Moreover, this paper shows that the relative performance concern also influences investors' holdings, stock prices and risk premia.

China’s unique approach to the market economy during its transitional phase has provoked widespread interest among researchers. While the Western literature can certainly not be directly applied under Chinese economic conditions, it offers important theoretical grounds on which we can build our understanding of different behaviour of firms and banks in China. In the first chapter, we employ a unique set of data on financial information of over 6,000 firms and study the lending pattern of banks in China at a firm level. We find that in addition to common factors such as profitability, size, and credit history, state ownership is highly correlated with banks’ lending decision;the evidence is consistent with the existence of soft budget constraint. The debate over whether such lending bias is caused by the supply side (banks) leads us to the second chapter. We examine and compare investment behaviour of firms under different ownership, with a focus on investment to cash flow sensitivity, using financial and accounting data on over 1,700 listed firms in China. We find opposite effects of cash flow on firms when sample is split between different ownership, with privately owned firms showing a higher sensitivity of investment to cash flow. This result enables us to establish that the cause of lending bias and soft budget constraint in China is indeed a supply side effect. We also find that such sensitivity is positively correlated with firm size and age, but not related to Tobin’q, which we interpret as indicating the lack of market value information about firms in China. Institutional development in the sense of enhancement of the effectiveness of the market is widely viewed as the core to economic reform in transition economies. As privately owned firms generally outperform their state owned counterparts (see Estrin et al. 2009), we study the impact of regional institutions on total factor productivity (TFP) of firms under different ownership. We find that the quality of institutions is highly correlated with firms’ TFP, and that improving institutions to facilitate business operations is crucial for firms to achieve higher effectiveness and sustainable growth. The results also suggest that urgent reform is needed for the state owned sector in China.

The aim of my thesis is to investigate the effect of competition on financial intermediaries in light of the conflicts of interest and perverse incentive structures that exist in the financial system. The first chapter of my thesis, Credit Rating and Competition investigates the conflict of interest arising from the issuer pay compensation model of the credit rating industry using a theoretical model of competitive interaction. Rating agencies balance the benefits of maintaining reputation (to increase profits in the future) and inflating ratings today (to increase current profits). Our results suggest that, unless new entrants have a higher reputation vis-a-vis incumbents, rating agencies are more likely to inflate ratings under competition relative to monopoly, resulting in lower expected welfare. The second chapter, Market Frictions, Interbank Linkages and Excessive Interconnections, studies banks' decision to form financial interconnections. I develop a model of financial contagion that explicitly takes into account the possibility of crisis. This allows me to model the network formation decision as optimising behaviour of competitive banks. I show that regulatory intervention in the form of deposit insurance and more implicit too big to fail type perceptions of government guarantees creates a wedge between social and private optimality. In the presence of these implicit and explicit guarantees, competitive banks find it optimal to form socially suboptimal interconnections in equilibrium. The final chapter, Competition, Premature Trading and Excess Volatility, attempts to explain the empirically observed excess asset price volatility as a consequence of competitive interaction between market participants. Our model shows that in the presence of competitive pressures, market participants find it optimal to act prematurely on unverified, noisy information. This premature reaction leads to lower total profits, excess market volatility and spike in volatility at the closing time of the market.

The aim of my thesis is to study the impact of three different types of credit supply shocks on the US economy during the recent boom-bust cycle. I apply rigourous identification strategies using a comprehensive mortgage loan-application level dataset that spans two decades to identify the causal effect of each shock on the US housing market { the market at the epicentre of the recent global financial crisis. The first chapter examines how shocks to the geographic distance between borrowers and lenders affected the quality of loans originated by US banks. I show that US banks that originated loans at relatively long distances recorded relatively high shares of delinquent mortgages, which suggests that geographic distance hampers a bank's ability to screen bor- rowers. The second chapter assesses how the supply of mortgage credit was affected by the closure of the private-label securitisation market in 2007. By impairing lender financing conditions, I demonstrate that the shock to the securitisation market caused US mortgage lenders to curtail new lending and that this adversely affected the aggregate level of new mortgage credit. The third chapter explores whether shocks to bank lending standards affect household borrowing and spending. I show that the introduction of US state anti-predatory lending laws, by tightening lending standards, caused a decline in the level of household mortgage credit, although this had little subsequent impact on household spending.