Essays on Corporate Activities and Asset Prices

Abstract

My dissertation investigates the economic driving forces behind the behavior of asset prices and firm activities. It consists of two chapters. Chapter One, “Extrapolative Expectations, Corporate Activities, and Asset Prices”, studies how extrapolative expectations affect corporate activities and asset prices. Empirically, an increase in misperception on earnings growth, a firm-level proxy for extrapolation, is associated with an increase in investment, debt and equity issuance, and bond and stock prices in the short term, but is predictive of a decline in all these activities and prices in the long term. These patterns are more pronounced among financially constrained firms. Theoretically, I build a firm dynamics model with extrapolative expectations and financial frictions, and show that the interaction between these two frictions is crucial in explaining the empirical findings. Intuitively, after a sequence of favorable shocks, agents extrapolate and become overoptimistic about future productivity. Firms invest and borrow more in the short term. A lower perceived default probability improves financing conditions, further increasing investment and borrowing. Future realizations then turn out worse than expected, subjecting real and financial activities and asset prices to predictable reversals in the long term. In Chapter Two, “Product Market Competition and the Profitability Premium”, I study the impact of product market competition on the well-documented positive relation between firms' current profitability and future stock returns. I find that this relation is robust only in competitive industries. A long-short portfolio sorted on profitability earns an average monthly return of 1.1% in competitive industries and only 0.14% in concentrated industries. Firms' differential exposure to investment-specific technology shocks explains this gap. To understand these results, I build a production-based model with imperfect competition. Market power reduces a firm's investment response to these shocks and thus lowers risk exposure. Empirical tests confirm the model's predictions.